On 5 October 2015, the Organization of Economic Cooperation and Development (OECD) published 15 final reports and an explanatory statement on the Base Erosion and Profit Shifting (BEPS) project. After an intensive two-year process, the international tax reform mandated by the G20 leaders and coordinated by the OECD has finally come to fruition. The post-BEPS era focusing on the implementation of the BEPS outcomes was ushered in. One thing that made this reform different from the previous ones is the involvement of many developing countries in both the early stage when the various measures were developed and the later implementation phase. Voice of the developing countries has started to be heard by the global community when international tax policies were made. This unprecedented event has provided the developing countries with an opportunity to begin at the same starting line as their developed counterparts. However, the opportunity comes with challenges. Having the right to speak does not necessarily mean being ready to speak. Getting involved is far from being able to lead. After all, it is imperative that the developing countries continue to build capacity in tax administration to get more ready to speak and lead.

​​​​​​As a G20 member, the world’s major economy and the largest devel-oping country, China has been actively involved with the BEPS project since 2013. The State Taxation Administration (“STA”) has endeavored to attend every relevant BEPS meeting, trace the progress of the project, research on many topics such as intangibles for transfer pricing purposes and comparability analysis. In the process, the STA has provided China’s position on various issues like location specific advantages (“LSAs”), exploitation of intangibles, and application of PSM. During the post-BEPS phase, China values the outcomes of BEPS project and has adopted some of them into domestic legislations. China welcomes OECD’s effort to build the Inclusive Framework by inviting more jurisdictions especially the developing countries to commit to the follow-up work including further research on specific areas as well as implementation accompanied by review and monitoring. This will lead to enhanced coordination and cooperation across the globe. On the other hand, China calls for more respect to jurisdictions’ sovereignty during the review and monitoring process. Given the nature of developing countries, more flexibility is also essential for them to play on the level field with devel-oped countries. A fair and equitable international tax system that benefits all the participants can only be built if the jurisdictions remain autonomous and informed even though they are subject to review. As the G20 leaders’ communiqué at Hangzhou summit pointed out, all the members “will continue the support for international tax cooperation to achieve a globally fair and modern international tax system and to foster growth”.

​​​​​Transfer pricing is a weighty component of the international tax reform as 10 of the 15 action plans relate to it. The BEPS project was set to tackle the epidemic situation where profits had been left untaxed because multinational enterprises (“MNEs”) had managed to shift the income to no-tax or low-tax jurisdictions. Historically, transfer pricing administration had been focus-ing on dealing with how to allocate taxing rights between jurisdictions and preventing/eliminating double taxation under mutual agreement procedures (“MAP”). The priority of the ongoing international tax reform, however, was to address double non-taxation where MNEs paid no taxes or less than their fair share of taxes in jurisdictions with well-established corporate income tax regimes. The support shown by more than 100 countries and regions for the BEPS project suggests that this common goal was able to rally interested tax jurisdictions including both developed and developing countries to work together. Yet some important questions remain unanswered. For example, has the project resolved all the differences developed and developing countries have in transfer pricing? Or, have the international tax rules become fairer and less biased as the result of the reform? Thanks to the concerted efforts by developed and developing countries in combating tax avoidance, the reform now needs to reconsider the classic transfer pricing question of how to allocate profits retrieved from the tax havens. The rules need to be fair and clear on who creates value and how the profits should be allocated between countries. The overarching principle of the BEPS project that the profits should be taxed where economic activities occur and value is created has guided jurisdictions to develop measures to counter tax avoidance in tax havens. That being said, developing countries need more specific rules and practical guidance on important issues such as how to determine the places of economic activities and value creation, how to allocate the profits retrieved from the tax havens between countries with corporate income tax system, how to divide the pie between countries both of which are the places of economic activities and value creation, and above all, how to apply arm’s length principle in transfer pricing legislation and practice. This is where this United Nations Practical Manual on Transfer Pricing for Developing Countries comes in handy.

Amongst the 15 Action Items of the BEPS Project, Action 1 drew a lot of attention. However, the 2015 Final Report failed to deliver a solution to the broader tax challenges raised by the digitalization of economy. Since then, member states of the Inclusive Framework, including China, have been working together towards reaching a consensus-based solution. As the solution is still under development, how it will interact with the existing international tax rules, and how it will affect the post-BEPS international tax landscape shaped by the other 14 Action Items is remained to be seen. Nonetheless, developing countries need to be prepared for the new challenges and opportunities that this change will bring about, including in the area of transfer pricing.

​​​​​The transfer pricing tax regime was first introduced in China in 1991. Over the past 3decades, the Chinese tax administration has been exploring ways to improve the transfer pricing administration and have made significant improvements over the last 10 years. Drawing from practical experience and international best practices, the Chinese tax administration was able to establish a well-rounded transfer pricing tax regime that includes legal frame-work, practical guidance, administrative process and operational mechanism. Dedicated transfer pricing teams were also trained and deployed at various levels of tax offices. With the view to stopping profit shifting and protecting China’s taxing right, the Chinese tax administration also recognizes that it is important to respect facts and data in any transfer pricing analysis.

​​​​​​Transfer pricing administration has been put at the centre of STA’s anti-avoidance work agenda in the recent years. Recognizing that preventative measures are as important as transfer pricing audits, the STA has built a three-pronged tax avoidance prevention and control system with consist-ent and standardized approach for administration, service and investigation. It is important that tax avoidance prevention should run parallel to transfer pricing investigations. Ways to prevent taxpayers from evading tax obligation include strengthened tax administration and improved taxpayer service. Investigations are only used as deterrence to foster taxpayer voluntary compliance. Moreover, different measures were taken to build a three-pronged tax avoidance prevention and control system. The first aspect of the three-pronged system is administration. A tracking system was put in place to monitor the profits of foreign MNEs operating in China. Chinese tax administration has put extra emphasis on routine review of related party filings and contemporaneous transfer pricing documentation. Follow-up monitoring subsequent to transfer pricing audits was implemented to encourage taxpayers to ensure their profitability is in line with the arm’s length principle. As to the second prong, service, seminars and trainings were provided to inform taxpayers of the latest tax regulations and policies. Double taxation was prevented (eliminated) through unilateral/bilateral APAs and resolution of MAP cases. With regard to the last aspect, investigation, both isolated and coordinated anti-avoidance audits were carried out to act as deterrence to regulate the profitability of individual companies or particular industries. Above all, the tax offices across the country have coordinated their actions to ensure that both domestic laws and international policies were followed in a consistent and standardized manner. As a result, inconsistency due to different work procedures was reduced to the minimal. The developments in China’s transfer pricing administration can be therefore summarized in the following 8 aspects.

​​​​​Legislation always comes first in transfer pricing. The Tax Collection and Administration Law and its Implementation Regulations and the Enterprise Income Tax Law and its Implementation Regulations and Individual Income Tax Law all contain clauses on transfer pricing. The first time that China introduced a comprehensive anti-avoidance regime into the legislation was through the “Special Tax Adjustment” provision in Chapter 6 of the Enterprise Income Tax Law and its Implementation Regulations in 2008. Not only did this chapter include provisions on transfer pricing and APA with which China had more experience but also clauses on cost sharing agreement, thin capitalization, control foreign companies, general anti-avoidance rule and the levy of interest as a result of transfer pricing adjustments for which China had to draw on international experience. In January 2009, the STA released the Implementation Measures of Special Tax Adjustments (Trial Version) (more commonly known as the “Circular 2”). It had since served as the practical guidance for China’s transfer pricing, and in broader scope, the anti-avoidance administration. and provided the legal basis for tax administration’s assessments and taxpayer compliance. In August 2018, transfer pricing rules, controlled foreign corporations rules, and general anti-avoidance rules were introduced into the newly revised Individual Income Tax law. Starting from 2016, STA has released a series of regulations to revise and update the Circular 2. Firstly, the Public Notice on Matters Regarding Refining the Filing of Related Party Transactions and Administration of Contemporaneous Transfer Pricing Documentation (Public Notice of the STA [2016] 42, hereafter referred to as the “Public Notice No. 42”) was put into effect in June 2016. As set out in the BEPS Action 13, Public Notice No. 42 has adopted clauses to require qualified taxpayers to file Country-by-Country reports in China. Public Notice on Matters Regarding Enhancing the Administration of Advance Pricing Arrangements (Public Notice of the State Administration of Taxation [2016] 64, hereafter referred to as “Public Notice No. 64”) was then released to provide more detailed guidance on the APA process. The release of Public Notice of the State Administration of Taxation on Issuing the “Administrative Measures of Special Tax Investigation and Adjustment and Mutual Agreement Procedure” (Public Notice of the State Administration of Taxation [2017] 6, hereafter referred to as the “Public Notice No. 6”) replaced the procedural guidance relating to transfer pricing as set out in the Circular 2.

There are more than 720,000 tax officials and 36 provincial level tax offices in China. It is paramount for a big country like China to be consistent and standardized in law enforcement especially when it comes to transfer pricing administration. A MNE might set up 30 subsidiaries across China. Without a consistent standard, tax administrations from different areas may find disparate comparable sets and derive various profit levels for transfer pricing cases of similar nature. To prevent this from happening, the STA has put in place a national anti-avoidance system under which tax administrations are to report and obtain approval from the STA headquarters when they need to initiate or close an anti-avoidance (including transfer pricing) case since 2015. The reporting chain put in place to standardize the audit procedures, improve the quality of closed cases, strengthen audit efforts, and organize national coordinated investigation. In 2012, the STA released the “Internal Approval Procedures for Substantial Special Tax Adjustment Cases (Trial Version) (Guoshuifa [2012]16) (hereafter referred to as the “Internal Approval Procedures”) to streamline procedures including related party filing review, contemporaneous transfer pricing documentation analysis, high-risk taxpayer identification, case initiation, audit and analysis, case closing, and follow-up taxpayer monitoring and tracking subsequent to an audit. As required by the “Internal Approval Procedures, a three-level transfer pricing audit system was established. The system features collective decision and penal approval. First, for every audit case, the in-charge tax administration needs to set up special task team to conduct the investigation. Second, the task team needs to formulate the preliminary assessment and report it to the tax administration at provincial level whose specialist panel is responsible for approving the case. In addition, for a case qualified as a substantial case especially a case that requires national coordination, the STA headquarters needs to call upon a nation-wide expert panel to make the final decision on the case. In September 2016, the STA has released the Internal Procedures for Special Tax Adjustment (Shuizongfa [2016]137), in which the roles and responsibilities of tax administrations at different levels and the collective review and approval system were further clarified. This system has enabled the tax administrations of different areas to work in a manner that would ensure the consistency in the selection of transfer pricing method and the determination of appropriate profit levels. A unified work standard across the country was formed accordingly. The consistency has made tax assessments more effective as deterrence measures. Tax officials are better protected from risks in enforcing the law thanks to the internal control system built according to the “Internal Procedures for Special Tax Adjustment”.

Audit efforts for nationally coordinated cases that involve several companies in a same industry or multiple subsidiaries of a same MNE group were intensified to improve the quality of closed cases. Investigations should be carried out in a consistent and standardized manner so that inconsistent assessment simply because tax administrations have different ways to go about cases that involve companies in the same industry or subsidiaries of a same group can be avoided. The transfer pricing audits can therefore be more effective as a tax avoidance deterrence measure. In the past years, China has initiated several nationally coordinated audits targeting industries including shoe manufacturing, computer manufacturing, high speed road construction, retail stores and hotels and fast moving consumer goods. Apart from being subject to the nationally coordinated audits, automobile sector, luxury goods industry and pharmaceutical companies were also being analyzed at the industry level. The “income approach” was developed and applied to multiple cases to address the challenges posed by transfer of equity and intangibles between related parties. The Chinese tax administration has attached great importance to several key industry sectors and been paying attention to possible base erosion transactions including outbound payments and transfer of equity. In the meantime, the use and transfer of intangibles, intragroup services, and financial transactions have gradually come to the fore of Chinese tax administration’s work, which has contributed to the quantitative analysis of location specific advantage

​​​​​​The tax revenue contributed by the anti-avoidance work was RMB 679,000,000 in 2006 and RMB 64,634,000,000 in 2019. The number was more than 94 times higher with an annual increase rate of 41.97%. The revenue contribution from the administration measures was 56,872,000,000, whereas the revenue collected through the service measures was 2,719,000,000. And the rest was contributed by the audit adjustments.

China has in place a MAP mechanism to eliminate double taxation resulted from transfer pricing audits and a bilateral APA programme to provide early certainty for cross-border taxpayers. Unilateral APAs can also be reached between the Chinese tax administration and the taxpayers. By the end of 2019, China has signed 76 bilateral APAs and 113 MAP agreements with 15 countries. During the negotiations, where appropriate, concepts such as value chain analysis and factors contributing to value creation long held by the Chinese tax administration were discussed with and recognized by some treaty partners. In order to better inform the public of China’s APA programme, the STA started to release “China APA Annual Report” in 2010. So far 10 reports have been published on the OECD official website and met with well reception from the international community.

Internal data extracted from corporate income tax returns and VAT refund database has played a primary role in identifying high-risk taxpayers. Meanwhile, external data obtained from National Bureau of Statistics, General Administration of Customs, State Administration of Foreign Exchange along with business information compiled in the National Database of Companies in Secondary Sector, Bureau van Dijk, Standard & Poor’s Net Advantage was also put to good use in comparability analysis.

The STA has actively participated in meetings organized by the UN and the OECD. The STA has also presented China’s position on important issues including intangibles, transfer pricing documentation and comparability analysis and brought in concepts like exploitation of intangibles, quantification of location specific factors, value contribution by decision execution that were later incorporated into the updated OECD Transfer Pricing Guidelines. By taking opportunities to talk to tax officials from other countries as well as representatives from MNEs, the STA was able to foster mutual understanding with them. On top of that, the STA has always been willing to share China’s experience in transfer pricing legislation and practice with other developing countries. Productive discussions on application of location savings and market premium in transfer pricing was generated in the process.

​​​​​Building a dedicated transfer pricing team has always been the prior-ity of the STA. Trainings on anti-avoidance has been conducted in various forms such as discussions on domestic legislation, peer-to-peer case sharing, seminars delivered by experts from the OECD as well as from other countries, special training sessions on difficult topics such as transfer pricing involving intangibles, financial service sector, and pharmaceutical industry. The combination of in-class training and on-job learning has yielded good results as evidenced by significant improvement in tax officials’ professional capabilities. On the other hand, resources have been devoted to transfer pricing administration as well. Tax bureaus specialized in anti-avoidance work were set up in Beijing, Jiangsu province and Shenzhen. The purpose was to pool the local talents and let them focus on transfer pricing and other anti-avoidance work. In addition, in response to the increased workload related to transfer pricing audits and bilateral negotiation in the post-BEPS era, the STA has enhanced efforts in the training and development of talents for transfer pricing to ensure that sufficient resources and manpower is allocated to the work.

​​​​​​As provided by the Tax Collection and Administration Law, Enterprise Income Tax Law and the Individual Income Tax Law, the core of China’s transfer pricing regime is the arm’s length principle. Just like many countries in the world, China has made great efforts to uphold the arm’s length principle despite many challenges encountered in the process. That being said, China’s transfer pricing regime has drawn on some other internationally recognized norms besides the arm’s length principle. Transfer pricing is essentially an issue of allocation of taxing rights among countries which could lead to audit adjustment that could result in double taxation for a MNE group. Both the country that initiates the audit and the country in which the related party is resident should ensure that the treaty obligations to prevent and eliminate double taxation are implemented. In order to resolve double taxation, the two countries need to negotiate with each other. The agreement can only be reached if both the negotiating parties are looking at the same principles, rules and methods. Therefore, it is necessary to have a set of international rules on transfer pricing that are respected by all countries.

​​​​​​However, the inherent disparity between countries cannot be over-looked. Countries may be subject to different domestic conditions or have unique tax regimes. Different stages of economic and social development might pose distinct challenges too. All these factors need to be taken into account when designing international rules. Both developed and develop-ing countries can find the general rules to be fair and easier to accept if they reflect different needs and conditions of the countries. By the time this chap-ter is drafted, China has signed double taxation treaties with 108 countries and the number is only dwarfed by that of UK and France. In addition, China is the top destination for foreign investment in the meantime has the volume of outbound investment that is only second to the US. The extensive treaty network and ever-growing need for cross-border investment has prompted China to engage in bilateral treaty negotiation with many countries. The situation dictates China to follow international standards in dealing with transfer pricing or other international taxation issues. The fast economic and social development for the past 40 years has also made China one of a kind. The uniqueness shows in China’s transfer pricing area as well. This is why China needs to strike a balance between conforming to international conventions while being able to deal with some unique issues for transfer pricing purposes.

​​​​​​Article 43 of the “Enterprise Income Tax Law” stipulates that taxpayers need to attach related party transaction report to their annual corporate income tax returns. Both resident and non-resident taxpayers required to file annual corporate income tax returns shall submit related-party filings. Public Notice No. 42 added some forms, including the forms for CbC reporting, to the original “Annual Reporting Forms for Related Party Transactions” and making them 19 altogether. Aside from filling the 6 forms for CbC reporting (3 in Chinese and 3 in English), companies should report related party transactions incurred by type (i.e., tangibles, intangibles, financial assets, intragroup financing, service provision, etc.). According to the Public Notice No. 42, Chinese Tax resident enterprises that fall into any of the following two categories shall file the CbC report: (1) The resident enterprise is the ultimate holding company of a MNE group having total consolidated group revenue of more than 5.5 billion RMB during the fiscal year immediately preceding the reporting fiscal year as reflected in its consolidated financial statements for such preceding fiscal year. (2) The resident enterprise has been appointed by the MNE group to file the CbC report. The introduction of CbC report filing obligation set out by Public Notice No. 42 was one of the measures taken by China to implement the 4 minimum standards of the BEPS project.

​​​​​The existence of related party relationships is the prerequisite for related party filing and the basis for tax administration’s transfer pricing adjustments. Article 109 of the Implementation Regulations for the Enterprise Income Tax Law provides that the related party relationship refers to direct or indirect control relationship with respect to capital, business operation, purchases and sales. The definition was exemplified in Public Notice No. 42 which provides for 7 types of related party relationships. For example, 25% shareholding is the ownership threshold to constitute the related party relationship.

​​​​​​Chinese corporate taxpayers are required by the law to prepare contemporaneous transfer pricing documentation by tax year and submit it when requested by the tax administration. Contemporaneous transfer pricing documentation may include master file, local file and special issue file. Any enterprise that meets one of the following criteria shall prepare a master file : (1) The enterprise that has incurred cross-border related party transactions during the tax year concerned, and the MNE group to which the ultimate holding company which consolidates the enterprise belongs has prepared a master file. (2) The annual total amount of the enterprise’s related party transactions exceeds RMB 1 billion. The master file is to provide an overview of the global business operations of the MNE group to which the ultimate holding company belongs. Different from the recommended legislation template set out in the BEPS Action 13 report, the master file submitted to Chinese tax administration also needs to include (1) A description of business restructurings, industrial restructurings, transfers of functions, risks or assets occurred within the group during the fiscal year; (2) functions, risks, assets and personnel of principle research and development facilities; (3) Name and location of the constituent entity that files the CbC report for the MNE group; and (4) a list of the MNE group’s existing unilateral advance pricing agreements, bilateral APAs.

​​​​​​Any enterprise that meets one of the following criteria during the fiscal year shall prepare a local file: (1) The annual related party transfer of tangible asset exceeds RMB 200 million (for toll manufacturing transaction, the amount is calculated using the import/export customs declaration prices); (2) the annual related party transfer of financial assets exceeds RMB 100 million; (3) The annual related party transfer of intangibles exceeds RMB 100 million; (4) the annual total amount of other related party transactions exceeds RMB 40 million. In addition to what is required in the Action 13 report, taxpayers need to provide (1) value chain analysis that notes the measurement and attribution of value creation contributed by location specific factors; (2) information on outbound investment; (3) information on related party equity transfer; and (4) information on provision/receipt of related party service. Also, Public Notice No. 42 has set out detailed filing requirements for the description of business, related party, and related party transactions of local entities. Furthermore, taxpayers need to describe local entities’ contribution to the group’s overall profit or residual profit regardless of the transfer pricing method selected. Aside from the master file and local file, Chinese taxpayers need to prepare special issue file as part of their contemporaneous transfer pricing documentation if certain criteria are met. Special issue files include report on cost sharing agreements and thin capitalization. An enterprise that is a party toa cost sharing agreement shall prepare a special issue file. Similarly, an enterprise with a related party debt-to-equity ratio exceeding the prescribed threshold shall prepare a special issue file.

Chinese taxpayers whose transfer pricing of the related party transaction are inconsistent with the arm’s length principle could be subject to audits conducted by the tax administration. The transfer pricing audit procedures are made very clear in the Public Notice No.6. It embodies the essence of the minimum standards required by the BEPS Action 14 (Making Dispute Resolution Mechanisms More Effective) and is the culmination of China’s efforts to revise and update the Circular 2. Public Notice No.6 also reflects the outcomes of the BEPS Action 8-10 Final Report (Aligning Transfer Pricing Outcomes with Value Creation).

Through reviewing taxpayers’ related party filings and contemporaneous transfer pricing documentation as well as tracking profitability of MNEs in China, the Chinese tax administration has been able to identify taxpayers with transfer pricing risks and alert the taxpayers to the risks. The taxpayers are allowed to make self-adjustment after recognizing the existence of the risks either as the result of the tax administration’s alerts or an effective internal control system. To the extent that the adjusted results do not conform to the arm’s length principle, the tax administration may initiate transfer pricing audits on the taxpayers.

​​​​​​Taxpayers fall into the following categories would be more likely to be identified as the potential transfer pricing audit targets during the screening process. (1) Enterprises with large amount of related party transaction or multiple types of related party transactions; (2) Enterprises with long-term losses, thin profit margin or fluctuating profit; (3) Enterprises with profit lower than the industry average level; (4) Enterprises with profit level that does not align with its functional and risk profile or with returns that do not correspond to cost allocated; (5) Enterprises that enter into transactions with related parties located in low-tax countries (regions); (6) Enterprises that fail to report the related party transaction or prepare contemporaneous documentation as required; (7) Enterprises with a related party debt-to-equity ratio exceeding the prescribed threshold; (8) Enterprises owned or controlled by Chinese resident enterprises or jointly controlled by Chinese resident enterprises and Chinese resident individuals, established in a country (region) with effective tax rate lower than 12.5% and do not distribute or under-distribute profits without reasonable business needs; and (9) Enterprises that implement other tax planning schemes or arrangements without proper commercial purposes.

​​​​​​Like most countries, Chinese tax administration and taxpayers are allowed to choose from the following 6 transfer pricing methods: CUP Method, RPM, CPM, TNMM, PSM and other appropriate methods. Neither does one method have priority over other methods nor does the method applied needs to be proved as the best method. Other appropriate methods include asset valuation methods through cost approach, market approach and income approach or other methods that can reflect that the profits are taxed in the jurisdiction where economic activities take places and value is created.

​​​​​In accordance with the Implementation Regulation of the Tax Collection and Administration Law, the Enterprise Income Tax Law and its Implementation Regulations, Chinese taxpayers can enter into APAs with tax administration on the pricing principles and calculation methods for related party transactions for future years. The APA process involves the following 6 stages: pre-filing meeting, intent submission, analysis and evaluation, formal application, negotiation and signing, implementation and monitoring. There are 3 types of APAs that are available: unilateral APAs, bilateral APAs and multilateral APAs. An APA generally covers related party transactions for 3 to 5 consecutive years in the future. Per taxpayer’s application, the APA can be retrospectively applied to the prior years not exceeding 10 years. The general threshold which a taxpayer needs to meet in order to apply for an APA is that the amount of annual related party transactions should be more than RMB 40 million for the past 3 years prior to the application year.

Chinese tax administration can prioritize the acceptance of an APA application from a taxpayer if it falls into one of the following categories. (1) The taxpayer’s annual reporting of related party dealings and contemporaneous transfer pricing documentation are well completed with adequate disclosures. (2) The taxpayer has a level A tax credit rating. (3) Special tax investigation on the taxpayer was conducted and closed. (4) Renewal application was submitted by the taxpayer upon expiration of the existing APA with no substantial change to the facts and circumstances specified in the existing APA. (5) Information and documents submitted by the taxpayer are complete and adequate; value chain analysis and supply chain analysis are clear and thorough; location specific factors including location savings and market premium, etc. have been given adequate consideration; and the proposed transfer pricing method and the calculation method are appropriate. (6) The taxpayer can actively cooperate with the tax authorities during the APA process. (7) For a taxpayer applying for a bilateral APA, the compe-tent authority of the relevant treaty partner has displayed strong intention to move forward with the APA negotiation and attach importance to the case. (8) There are any other factors present that could benefit the negotiation and signing of the APA requested by the taxpayer.

​​​​​​Chinese tax administration attaches great importance to the implementation of APA. Upon expiration of the APA, if the weighted average operating profitability of the enterprise during the term of the advance pricing arrangement falls below the median of the interquartile range and are not adjusted to the median, tax authorities will decline the renewal application.

​​​​​In accordance with the relevant provisions in the tax treaties, the STA provides MAP assistance to both requests submitted by the taxpayers and requests initiated by the competent authorities of the treaty partner. Aimed to prevent or eliminate double taxation resulted from transfer pricing adjustments, the STA would consult with the competent authorities of the treaty partner to resolve the disputes. One area which MAP can be applied to is taxation resulted from transfer pricing adjustments that may require corresponding adjustments from the treaty partner. MAP can also be used to negotiate bilateral/multilateral APAs.

​​​​​​Taxpayers who wish to request MAP assistance should complete the Application Form for Mutual Agreement Procedures and submit it with necessary documentation to the STA headquarters within the timeframe specified in the relevant tax treaties. The STA can initiate the MAP process after receiving the aforementioned documents if the submitted documentation is in accordance with provisions in the relevant tax treaties. The STA can require the taxpayers to provide additional information if the submitted documentation is found insufficient. In cases where the competent authority of the other contracting state requests to initiate the MAP process, the STA will start the MAP process upon the receipt of the formal notification if the request is in accordance with provisions in the relevant tax treaties. The STA needs to give written notification to the relevant local tax administration and inform the competent authority of the other contracting state if it decides to initiate the MAP process.

​​​​​If an agreement is reached between the STA and the competent authority of the other contracting state under the MAP, the agreement will be forwarded to the relevant local tax administrations. The local tax administrations need to deliver the agreement to the taxpayer within 15 days from the day it receives the written notification from the STA headquarters. If there is additional tax payment (refund) involved, the local tax administration will also need to deliver the “Notification of Additional Tax Payment (Refund) Resulted from Mutual Agreement with Respect to Special Tax Adjustments” or “Notification of Additional Tax Payment (Refund) Resulted from Advance Pricing Arrangement” to the taxpayers. Moreover, the local tax administrations are responsible for ensuring the implementation of the agreements.

China shares many things with other developing countries in terms of transfer pricing administration. As a relatively late starter in the area, China has drawn on the OECD Transfer Pricing Guidelines and the experience of developed countries. In the meantime, China has encountered many challenges including lack of appropriate comparables, quantification and allocation of location specific advantages, identification and valuation of intangibles to which solutions were not readily available in the OECD Transfer Pricing Guidelines. Now, developing countries are looking to this UN Practical Manual on Transfer Pricing to provide solutions to these challenges that are more common to them.

​​​​​The arm’s length principle is at the core of OECD Transfer Pricing Guidelines. Most Countries including China see it as the fundamental principle in transfer pricing. The arm’s length principle requires that transactions between associated companies of a same MEN group to be benchmarked to uncontrolled transactions under comparable conditions. But uncontrolled comparable transactions are often hard to find in real life. In practice, companies that perform similar functions, assume similar risks, own similar assets, and operate under comparable circumstances to the tested companies are used instead. Yet most times the comparability of the comparable companies found could still be called to question.

​​​​​​The arm’s length principle dates back to as early as the 1920s when there were very few MNEs and hence very few related party transactions. It was much easier to find independent comparables back then. The introduction of the arm’s length principle had pointed out a workable direction for tax practitioners to resolve the thorny issue of transfer pricing. However, after almost a century, the application of the arm’s length principle has become more challenging as the number of MNEs grew. The statistics shows that over 2/3 of the world trade involves MNEs. More than 50% of the world trade involves related party transactions. With more and more companies poised to conduct business on a group level, economic activities are more and more likely to take place in the inner circle of MNE groups. It is nearly impossible to take out one piece of a value chain of a MNE group and try to match it to third-party transactions or independent companies. Take a pharmaceutical group as an example. Suppose the parent company developed a new formulation and has contracted a subsidiary to use the formulation to manufacture the drug. The question is how much royalty should the subsidiary pay for the use of the formulation in the manufacturing. The arm’s length principle can hardly be applied here as there are no comparable transactions on the market to be found because the parent company would not give the formulation to a third-party company to manufacture.

​​​​​​The challenges to the arm’s length principle are not something unique to developing countries. Developed countries are facing it as well since the trend for companies to work as MNE groups to conduct cross-border trans-actions does not discriminate between developed and developing countries. It is just that the developing countries are dealing with the challenges with more difficulty as this chapter will explain later in more detail.

The biggest shortfall of applying the arm’s length principle is that it may leave taxpayers uncertain about whether the pricing of related party transactions or the profit of the related companies is reasonable. In fact, no one has a definite answer. Most audits or MAP cases are the result of compromises between tax administrations and taxpayers or competent authorities of two/more countries.

One of the key challenges for developing countries is the lack of reliable, public information on comparables. For a developing country, there are usually only a small number of public companies, while information on domestic private companies is lacking or inadequate. This limits the amount of publicly available information on domestic companies that can be used for transfer pricing analysis. Take China as an example. Up till the end of 2019 , there are about 4000 listed companies in China whereas the private companies are not bound by law to disclose financial information to the public. It is unrealistic to expect that reliable comparables to the tested companies can be found in 4000 listed companies. In particular, there would be a lack of comparables for companies who are first movers in an industry not yet fully exploited. In practice, foreign companies are often used as an alternative to domestic comparables. As a result, comparables sets are often dominated by companies in developed countries, simply because there are usually a much larger number of public companies in these countries.

​​​​​While globalization and free capital mobility are the basis for the use of foreign comparables, the existence of foreign exchange controls in many developing countries violates this precondition. Accordingly, significant comparability adjustments may be necessary for companies in developed countries to be used as comparables for companies in developing countries. In some cases, it may require a different methodology such as profit split as no sufficiently reliable comparability adjustment may be feasible.

​​​​​One of the most common adjustments in China is accounting for differences in geographic comparability when applying profit based trans-fer pricing methods, such as the TNMM, to determine an arm’s length price. For example, when an Asia Pacific set of companies is used to benchmark the transfer prices of a Chinese taxpayer, it often includes companies from both developed countries (such as Japan and Korea), as well as developing countries (such as Indonesia and Vietnam). Generally speaking, the Asia Pacific set is more likely to contain companies from developed countries due to a greater number of listed companies in those countries and hence there is a greater volume of publicly available financial information.

China takes the view that there may be instances where the differences in geographical markets are so material that it warrants comparability adjustments to bridge the differences. By making such comparability adjustments, taxpayers in developing countries can overcome the practical difficulties in applying the arm’s length principle to their transfer pricing analysis.

​​​​​​The globalization of trade and economies has given rise to concepts such as “location savings”, “market premium,” and more generally, location specific advantages (“LSAs”). The LSAs are advantages for production arising from assets, resource endowments, government industry policies and incentives, etc. which exist in specific localities. For example, household electronics manufacturers invest in China to take advantage of a large pool of well-educated low-cost labour and a well-developed network of suppliers, or global automotive companies set up joint ventures (“JVs”) in China to assemble automobiles locally to be close to the market and the customers and to take advantage of lower costs. Limited guidance is available on these concepts in the OECD Transfer Pricing Guidelines. It has been seen that certain issues such as location savings and market premium arise more frequently in China and other developing economies, rather than in established and developed economies (which comprise the bulk of the membership of the OECD). Location savings are the net cost savings derived by a MNE when it sets up its operations in a low-cost jurisdiction. Net cost savings are commonly realized through lower expenditure on items such as raw materials, labour, rent, transportation and infrastructure even though additional expenses (“dis-savings”) may be incurred due to the relocation, such as increased training costs in return for hiring less skilled labour.

​​​​​Market premium relates to the additional profit derived by a MNE by operating in a jurisdiction with unique qualities impacting on the sale and demand of a service or product.

In dealings with Chinese taxpayers, the Chinese tax administration has adopted a four-step approach on the issue of LSAs:

1. Identify if an LSA exists;
2. Determine whether the LSA generates additional profit;
3. Quantify and measure the additional profits arising from the LSA; and
4. Determine the transfer pricing method to allocate the profits arising from the LSA.

​​​​​In determining LSAs and their impact on transfer pricing, both industry analysis and quantitative analysis are critical.

The automotive industry is a good example where there are many LSAs that have led to extraordinarily high profits that are rightly earned by Chinese taxpayers. The LSAs include:

1. The “market-for-technology” industry policy, which requires foreign automotive manufacturers to form JVs in order to assemble automobiles in China, forcing foreign automotive manufacturers to compete for limited market access opportuni-ties by offering favourable terms including provision of tech-nologies at below market price;
2. Chinese consumers’ general preference to foreign brands and imported products—this general preference, as opposed to loyalty to a specific brand, creates opportunities for MNEs to charge higher prices and earn additional profits on automotive products sold in China;​​​​​​​
3. Huge, inelastic demand for automotive vehicles in China due to the large population and growing wealth of the population;
4. Capacity constraints on the supply of domestically assembled automotive vehicles;
5. Duty savings from the lower duty rates on automotive parts (e.g. 10%) compared to imported vehicles (e.g. 25%)—when MNEs manufacture products in China as opposed to importing the products from outside of China, they are able to generate overall savings from the lower duty rates, even if the MNEs incur manufacturing costs and sell their domestically-manufactured products at a lower sales price compared to a foreign-manufactured vehicle; and
6. A large supply of high quality, low costs parts manufactured by suppliers in China.

​​​​​For a 50/50 JV with partners having conflicting interest in the Chinese automotive industry, the Chinese JV partner generally contributes local distribution network, intimate knowledge about the local market, and the right market access. However, it does not typically have control of the JV operation, which is usually controlled by the foreign JV partner. The foreign JV partner also controls the supply chain of the parts. To the extent there could still be potential transfer pricing issues, the primary issue involves the JV being overcharged for the parts and services that are provided by related parties. In the absence of such overcharges, the JV’s results mainly reflect an arm’s length outcome, which in turn reflect the contribution of LSAs to the JVs.

A further example can be that of a Chinese taxpayer performing contract research and development (“R&D”) services for an offshore affiliate, and the full cost mark-up (“FCMU”) as the profit level indicator for a comparable set comprising of foreign companies located in developed countries (and hence, incurring higher costs). The following example outlines the steps to calculate the adjusted FCMU taking into consideration of the location savings.

It is assumed that the Chinese taxpayer’s cost base was 100, the aver-age cost base for the company’s R&D centres in developed countries was 150, and the median FCMU of the comparables was 8%. The comparison of the cost base between the Chinese taxpayer and that of the foreign companies is measured on an equal platform, such as the total costs (labour, raw materials, land and rent, etc.) per unit of output.

Steps Calculations

​​​​​​The Chinese tax administration has come across many other cases of market premiums for Chinese taxpayers, particularly in the luxury goods, pharmaceutical and automotive industries. These three industries have gained significant momentum over the past decade with booming demand from the market. Many MNEs have set up sales subsidiaries which have been involved in heavy marketing and sales activities to build the brand image among Chinese customers and cultivate their appetite for the MNEs’ products. The exponential growth in sales revenue has brought in additional profits for the MENs. Given that the taxation should follow value creation, the Chinese tax administration takes the view that the additional profits should be taxed in China if they are derived from the unique characteristics of Chinese market. For example, the Chinese subsidiaries of some luxury brands have undertaken significant promotion activities to educate Chinese customers who had known nothing about the brands before. With more and more Chinese customers now are familiar with the brands and products, sales revenue has experienced great increase for the Chinese subsidiaries. On the other hand, deterred by the high prices set by the MNEs in the Chinese stores, some Chinese customers who would have went to luxury stores in China instead chose to go abroad. The money spent by Chinese shoppers in overseas luxury stores has been growing at the fast rate and constituted a sizeable portion of sales revenue of overseas affiliates. This portion of the sales revenue and the profits realized thereof should be attributed to the marketing contribution made by Chinese subsidiaries.

​​​​​Intangibles are as major an issue for developing countries as they are for developed countries. While MNEs in developed countries often have superior technology intangibles, they need the fast growing market in the developing countries and contribution of the subsidiaries in these countries to develop the market in order to monetize the value in such intangibles. For developing countries, marketing intangibles and LSAs are often closely integrated, and due consideration is necessary to properly compensate the contribution of the subsidiaries in developing countries.

MNEs often provide intangibles to their Chinese affiliates in the initial stages of the local operation to help establish the business in China. These intangibles may take various forms, such as global brand name, technical know-how or business processes. Over time, the local Chinese subsidiaries acquire the skill and experience from operations in China, and may even contribute to the improvement of the MNE’s original intangibles. The issue in this scenario is whether the local Chinese affiliates should be entitled to additional profit, and if so, what is the appropriate method to calculate the additional profit?

For example, if a Chinese affiliate was charged a 3% royalty for the use of a manufacturing process when the Chinese operations were established 10 years ago, then it may not be reasonable for the Chinese affiliate to continue paying the same royalty in the current year without revisiting whether the intangible has continued to provide the same value over time. This is particularly the case if the Chinese affiliate has improved a manufacturing process provided by its parent company, through a process of trial and error and conducting manufacturing operations over a 10-year period. The Chinese tax administration would question whether the Chinese affiliate should continue to pay a royalty to the parent company for the manufacturing process, or whether the Chinese affiliates should be entitled to a return on the intangibles that they have developed and shared with the group companies.

​​​​​​The Chinese tax administration is glad to see that the updated OECD Transfer Pricing Guidelines on intangibles has made it clear that entities involved with the development, enhancement, maintenance, protection and exploitation of intangibles should be compensated for their contributions. The value of an intangible developed by the parent company might be enhanced, maintained, protected and exploited by the local subsidiaries. Developing countries need to give special consideration to the value creation to intangibles contributed by these economic activities undertaken by the local subsidiaries.

​​​​​In a globalizing economy, MNEs usually set up operations in developing countries to take advantage of comparative advantages that these countries offer. For example, they set up manufacturing operations to take advantage of the abundant cheap labour or natural resources to supply products for overseas markets, R&D to take advantage of local talent for overseas principals, and distribution of imported products to the local market. These operations often take the form of contract or toll manufacturing, contract R&D, and limited risk distribution to leave little profit to the local country, despite the fact that many such comparative advantages contribute significant profits to the MNE group. The following paragraphs share some of the Chinese experience in dealing with these transfer pricing issues.

A holistic view of functions and risks may need to be taken. Many MNEs have set up multiple companies in China with each company performing only a single function, such as manufacturing, distribution, R&D, and services, and claim that each of these entities is entitled to a limited return. Others have some or all of manufacturing, distribution, R&D, and services functions in one entity, and still claim that each of these functions is entitled to only a routine return. The Chinese tax administration takes the view that when a group has multiple single function entities, they may have to be taken into consideration as a whole in order to properly determine the return the group of companies should earn in China. Similarly, an entity with multiple functions may have to be reviewed in its entirety in order to properly determine its returns.

While China generally respects the limited risk characterization of sole function entities¹⁵³; determining an adequate return for such entities is a challenge, as explained below. Further, China’s legislation has a specific article in its transfer pricing rules to require that such entities should not bear risks or suffer from losses arising from strategic failures, capacity under-utilization, or holdup in the sales of products, etc. if they do not perform business strategy decision making, product R&D, or sales functions. Simply put, if their upside is limited, their downside should be limited too. Contract R&D is an area where the contribution of developing countries is often underestimated. The transfer pricing method commonly used to reward R&D activities performed by a subsidiary of a MNE in China is cost plus. Sometimes, it has been found that the principal entity that is claimed to be responsible for the R&D has neither the technical expertise nor the financial capacity to be responsible. In other instances, the Chinese entity has obtained “high and new technology status” in Chinese law and therefore enjoys tax incentives on the basis of ownership of valuable core technology. However, it also claims to be a contract R&D service provider with no valuable intangibles. These are but a few examples where a cost plus approach would not be adequate. It is expected that companies claiming high tech status should be performing activities that result in the creation of intellectual property of which they can claim economic or legal ownership. It is not sufficient by itself that the contract R&D entity has shifted the majority of its risks (e.g. unsuccessful research) to its entrepreneurial related party. A proper analysis of the value provided by the contract R&D entity to the over-all group operations should be conducted to determine the appropriate arm’s length return for the R&D entity.

​​​​​​Contract manufacturing is one of the most common forms of manufacturing used by MNEs in China, particularly dealing with manufacturing products for export. In evaluating a contract manufacturer’s return, the TNMM is often used as the transfer pricing method with the FCMU being the most commonly used profit level indicator.

​​​​​​The arm’s length principle involves testing controlled transactions with uncontrolled transactions to determine how independent parties would have acted in broadly comparable situations. This principle becomes challenging to apply where a company relies on its related parties for both input purchase and output sales. If such a company is to be evaluated on a cost plus basis, a low intercompany purchase price results in an undervalued cost base that will ultimately under-compensate the contract manufacturer. However, the reasonableness of the purchase price is often difficult to assess. A further issue therefore arises on how the reasonableness of a taxpayer’s intercompany arrangements in this situation should be evaluated.

​​​​​​The Chinese approach to evaluating such companies is to start with the general presumption that the related party purchase price of materials is at arm’s length, and evaluate the reasonableness of the mark-up earned by the contract manufacturer on its cost base. The rationale for accepting the related party purchase price is that Customs can act as a check on the reasonableness of the import price of materials and safeguard against unreasonably low intercompany purchase prices. The next step is to proceed with the transfer pricing analysis by adopting a cost plus methodology and using the FCMU as the profit level indicator. The challenge that follows lies in the search for suitable comparable companies, as discussed earlier in this paper.

​​​​​​Toll manufacturing is a common form used by MNEs in developing countries, but its proper return is difficult to determine since there are only a few independent listed companies that perform such activities. Some taxpayers simply use the FCMU for contract manufacturers as the mark-up for toll manufacturers. This grossly underestimates the return to toll manufacturers. Others use return on assets as a profit level indicator based using contract manufacturers as comparables, and this may also underestimate the return, particularly for labour intensive toll manufacturers as often being the case in developing countries.

​​​​​In practice, the Chinese tax administration has sought to first estimate the total cost of the toll manufacturing operation as if it were a contract manufacturer, usually by adding back costs of raw materials which may be obtained from Customs. It then estimates the appropriate returns (say, FCMU) for contract manufacturing based on contract manufacturing comparables, and apply this to the estimated total cost to arrive at the total contract manufacturing profit, from which it then adjusts for factors such as inventory carrying costs, to arrive at the total profit for the toll manufacturer. This approach works well when reliable customs information on raw mate-rials is available. If customs information on raw materials is not available or not reliable, then there are unresolved issues as to what should be an appropriate profit level indicator and how it could be derived.

​​​​​Sales, marketing and distribution are another set of functions where it has been seen that MNEs often underestimate the contribution of developing countries. Chinese experience shows that many MNEs treat its Chinese distribution entities as a limited risk distributor, and use a set of simple distributors performing limited functions in a mature market such as Japan as the comparables. There are a couple of obvious deficiencies in such an approach. First, there often is a mismatch in terms of functional profile, as the Chinese entity may perform significantly more functions than these so-called comparables, which is evident as it incurs significantly more operating expenses relative to sales. Second, it does not account for market differences, with China being a fast growing economy and having strong demand which requires relatively less selling effort and therefore can achieve higher efficiency and profitability. Other LSAs such as country premium and any marketing intangibles that are created by the Chinese entity are also commonly ignored.

​​​​​​In practice, the Chinese tax administration has attempted to correct such deficiencies by using a more appropriate transfer pricing method, such as profit split in the cases where significant local marketing intangibles or LSAs is identified, or performing comparability adjustments when TNMM is used. For example, if the median operating expense to sales ratio for the comparable set is only 7%, and the same ratio for the taxpayer was 40%, to the extent there is location savings, the Chinese tax administration would adjust the cost base first. The Chinese tax administration would then calculate the additional return required for the extra efforts made by the Chinese taxpayer to derive the total return for the Chinese taxpayer.

​​​​​​While the TNMM may still be used when there is a lack of adequate local comparables, such as using foreign comparables with proper adjustments, as in the contract R&D example, sometimes a different method such as the profit split may be more appropriate. An example is the electronic manufacturing services (“EMS”) sector, where the entire, or nearly the whole manufacturing and assembly activities of a foreign EMS MNE group, have been outsourced to its Chinese affiliates.

​​​​​​The typical set up for these manufacturing and assembly opera-tions is such that the majority of the work force and tangible assets of these foreign EMS MENs are located in China, including many high level operational staff. The headquarters of these EMS companies are located outside of China, with the EMS group’s revenues supported by significant manufacturing contracts with third-party global consumer electronics companies. Often, in such instances, the MNE group’s transfer pricing policies have little regard for properly compensating the Chinese manufacturer. The profits of the Chinese manufacturer are stripped away as much as possible on the basis that the manufacturer is a contract manufacturer or a toll manufacturer with a very low risk profile.

​​​​​Under this scenario, China takes the view that a risk based approach may place insufficient regard for the fact that there are sizeable assets located in China (i.e. the work force and factory plants). In many cases, the majority of the headcount of the EMS group are based in China, with only a few management personnel residing outside of China. Rather than a transac-tional or profits based approach, a contribution analysis approach may be more suitable. This means that remuneration to each party involved would be commensurate with its role and contribution to the value chain in the group. In this case, the assets and the people should largely dictate where the group’s profits should stay, and a global formulary approach should be a realistic and appropriate option.

​​​​​Alternatively, the Chinese tax administration may determine the proper return for the headquarters, with the Chinese manufacturer earning the residual profits. Another potential alternative may be to evaluate the Chinese manufacturer on the return on its assets or capital employed, using the group’s results as a comparable for the Chinese manufacturer.

​​​​​One of the key issues faced by developing countries is the lack of experience and knowledge on how MNEs operate and on a particular industry. Transfer pricing is commonly acknowledged as one of the most difficult international tax issues, and MNEs as well as tax administrations in developed countries have developed and dedicated substantial resources including talents to this area. The Chinese experience has been that a dedicated team, with accounting, economics, and industry background would be very critical, in order for tax administrations in developing countries to effectively administer their transfer pricing rules.

​​​​​​Issues such as location specific factors further raise the stakes. To effectively deal with such issues, solid economic and quantitative analyses are necessary. Compared with MNEs, which have vast resources at their disposal to hire the best professionals, and with tax administrations in developed countries which also have developed a large team of economists and quantitative analysts, developing countries such as China have a clear disadvantage, which has to be fixed urgently. As explained earlier in this paper, the STA has committed to putting in place a dedicated team by adding more staff and resources. Also, in order to assure the consistency in transfer pricing administration, substantial cases are centrally approved by specialist panel either at provincial level or national level depending on the significance of the cases.

​​​​​​One way to address the disadvantages faced by developing countries in transfer pricing is to extend the statute of limitations. For example, the statute of limitations for corporate income tax is normally five years in China. However, the statute of limitation for transfer pricing has been extended to ten years, allowing more time for tax administration to check on taxpayers’ transfer pricing issues. Another way is to set clear compliance and penalty rules, putting the burden of proof on taxpayers and encouraging taxpayers to be in compliance and make self-adjustments when needed. It has been found that contemporaneous transfer pricing documentation requirements coupled with penalty rules have been very effective in encouraging taxpayer compliance. An industry wide or a group wide audit has also been a very effective and efficient way for the tax administrations to make the best use of its limited resources.

As an emerging market economy, China’s has established a three-pronged tax avoidance prevention and control system with consistent and standardized approach for administration, service and investigation. As the second part of this paper states, China does not always have the same tech-nical expertise and resources that developed countries possess. Nevertheless, experience on transfer pricing in China is accumulating quickly. The underlying objective in conducting audits is to show Chine’s resolve to enforce tax compliance and to remind the MNEs to take into account Chinese companies’ contribution to the global profit when determining the transfer pricing policies.

​​​​​​The BEPS project has reshaped the international tax landscape in an unprecedented manner, and the ongoing work on addressing the tax challenges arising from the digitalization of economy will further change the status quo. In the time when the globalization is at the crossroads, combined with the trade frictions among countries and severe impact of Covid-19 pandemic, the MNEs are likely to be pressured to rethink their global operation and value chain distribution. This will in turn bring in new challenges, especially in the area of transfer pricing that the tax administrations of developing countries will need to deal with.

​​​​​The Chinese tax administration appreciates the opportunity to share with fellow developing countries the experience and insight on transfer pricing administration, and welcomes inputs that could provide useful perspectives.

​​​​​Transfer pricing provisions were introduced in the Indian Income-tax Act in 2001. The provisions were broadly aligned with the OECD Transfer Pricing Guidelines. Over the years, transfer pricing audits in India have brought up a number of issues and challenges. Administration of transfer pricing laws has also resulted in several disputes and protracted litigation. With a view to reducing transfer pricing disputes, many initiatives have been introduced by the tax administration. Some of the initiatives are the introduction of an Advance Pricing Agreement (APA) scheme, inclusion of safe harbour provisions, utilization of the Mutual Agreement Procedure (MAP) provision in bilateral tax treaties to resolve transfer pricing disputes, migration from a quantum of transactions-based selection to risk-based selection of transfer pricing cases for audit, and issuance of various Circulars and Instructions on transfer pricing matters to provide clarity on transfer pricing issues, etc.

​​​​​​Owing to these initiatives, there has been an impact on the number of cases under audit as well as the number of disputes arising from such audits, which have both shown a downward trend. The Indian tax administration has a robust system of identifying high-risk transfer pricing cases, while providing a reasonable degree of certainty to low risk taxpayers. The new approach is expected to raise the quality of transfer pricing audits without creating an environment of tax uncertainty and protracted litigation.

Various aspects pertaining to the transfer pricing regime in India and the outstanding issues that continue to pose challenges to the transfer pricing administration are discussed in the subsequent paragraphs of this chapter.

​​​​​​The Indian Transfer Pricing Regulations are based on the arm’s length principle. The regulations came into effect from 1 April 2001. The regulations provide that any income arising from an international transaction between associated enterprises (AEs) shall be computed having regard to the arm’s length price (ALP). The concept of “associated enterprise” has been defined in detail in the regulations.

The ALP is to be determined by any of the prescribed transfer pricing methods. The methods prescribed for the determination of the ALP are the following: Comparable Uncontrolled Price (CUP) Method, Resale Price Method (RPM), Cost Plus Method (CPM), Transactional Net Margin Method (TNMM), Profit Split Method (PSM) and a residual method known as “any other method”. The regulations do not provide any hierarchy of the methods and support the concept of the “most appropriate method” which provides the most reliable measure of an arm’s length result under a particular set of facts and circumstances.

The regulations prescribe mandatory annual filing requirements as well as maintenance of contemporaneous documentation by taxpayers if international transactions between associated enterprises cross a thresh-old, and they contain penalty implications in case of non-compliance. The primary onus of proving the ALP of a transaction lies with the taxpayer. In most cases, the Indian entity is taken as the tested party and Indian comparables are used. If the foreign associated enterprise is the less complex entity, it is taken as the tested party.

In order to provide uniformity in the application of transfer pricing law, there are specialized “Commissionerates”(i.e. geographical districts) under the supervision of a Principal Chief Commissioner of Income-tax (International Taxation) at Delhi and two Chief Commissioners of Income-tax (International Taxation) stationed at Mumbai and Bengaluru. Transfer Pricing Officers are vested with powers of inspection, discovery, enforcing attendance, examining a person under oath, on-the-spot enquiry/verification and compelling the production of books of account and other relevant documents during the course of a transfer pricing audit. The mechanism of the Dispute Resolution Panel is also available to taxpayers to resolve disputes relating to transfer pricing.

The legislature, in 2020, authorized the Government of India¹⁵⁴ to make a scheme that provides for team-based transfer pricing audits with elimination (to the extent feasible) of interface between the Transfer Pricing Officers and the taxpayers.¹⁵⁵

The Government of India has a dedicated website which contains comprehensive information about the latest provisions of tax law and related rules, Circulars and Instructions including those related to transfer pricing. The website has a user-friendly interface.¹⁵⁶

Comparability analysis is the key to determining the arm’s length price of an international transaction. However, increased market volatility and increased complexity in international transactions have thrown open serious challenges to comparability analysis and determination of the arm’s length price. Some of these challenges and the responses of the Indian transfer pri-ing administration in dealing with these challenges are analyzed below.

​​​​​​​Use of multiple-year data: With a view to avoiding disputes arising from the earlier rule of using data of only the current year, i.e., the year in which the international transaction was undertaken, use of multiple-year data has now been permitted. Thus, for transactions undertaken on or after 1st April 2014 (i.e., from Assessment Year 2015-16), multiple-year data of comparable uncontrolled transactions entered into by the comparable companies can be used for the purpose of benchmarking international transactions with associated enterprises.

The multiple-year data would include data of a maximum of three years (for example, the data of the current year and of two immediately preceding years). In certain situations, where data of all three years are not available, the data could be of two years (for example, if the data of the current year is not available, the data of two immediately preceding years) or even of one year (for example, data of only the current year or, if the data of the current year is not available, only the data of the year immediately preceding the current year). The data of one or both of the preceding years can be used only if the enterprise used as a comparable undertakes the same or similar uncon-trolled transactions in the current year.

A comparison of functions performed, assets employed and risks assumed is the basis of any comparability analysis. Indian practice has been to evaluate risk in conjunction with functions and assets. India believes that it is unfair to give undue importance to risks in determination of the arm’s length price in comparison to functions performed and assets employed.

Identification of risks and of the party which bears such risks are important steps in comparability analysis. India believes that the conduct of the parties is key to determining whether the actual allocation of risks conforms to contractual risk allocation. Allocation of risks depends upon the ability of parties to the transaction to exercise control over such risks. Core functions, key responsibilities, key decision-making and levels of individual responsibility for the key decisions are important factors to identify the party which has control over the risks. Besides, financial capability to bear the risk is also important in establishing whether a party actually bears or controls the risk.

​​​​​​In India, Multinational Enterprises (MNEs) often make claims before the Transfer Pricing Officers that related parties engaging in contract research and development or other contract services in India are risk-free entities. Accordingly, these related parties are said to be entitled to only routine (low) cost plus remuneration. MNEs also contend that the risks of research and development (R&D) activities or services are being controlled by them and Indian entities being risk-free entities are only entitled to a low cost plus remuneration.

​​​​​​The notion that risks can be controlled remotely by the parent company and that the Indian subsidiary engaging in core functions, such as carrying out R&D activities or providing services, is a risk-free entity has not been found acceptable. India believes that in many cases the core function of performing R&D activities or providing services is located in India, which in turn requires important strategic decisions to be taken by the management and employees of the Indian subsidiaries. These strategic decisions could be in terms of designing the product or the software; the direction of R&D activities or providing services; and the monitoring of R&D activities. Accordingly, the Indian subsidiary exercises control over the operational and other risks. In these circumstances, the ability of the parent company to exercise control over the risks remotely from a place where core functions of R&D and services are not located is very limited.

• • •  
• a dataset of the results/profit margins of six or more comparable companies are to be arranged in an ascending order and an arm’s length range beginning with the thirty-fifth percentile of the dataset and ending with the sixty-fifth percentile of the data-set (the “Middle 30” of the dataset) is to be constructed;
• if the price at which the international transaction has actually been undertaken is within the range referred to above, then the price of the transaction shall be deemed to be the ALP;
• if the price at which the international transaction has actually been undertaken is outside the range referred to above, then the ALP shall be the median of all the values included in the dataset (i.e. the 50th percentile); and
• however, if the range is not used due to the non-availability of at least six comparable companies, the arithmetic mean, with a tolerance range qua (relevant to) the nature of business activities, shall continue to be used to determine the ALP.

As with many other countries, the Indian transfer pricing regulations require “reasonably accurate comparability adjustments”. The onus to prove a “reasonably accurate comparability adjustment” is on the taxpayer. The experience of the Indian transfer pricing administration indicates that it is possible to provide capacity utilization and working capital adjustments. However, the Indian transfer pricing administration finds it difficult to make risk adjustments in the absence of any reliable, robust and internationally agreed methodology to provide risk adjustment.

​​​​​​In certain specified situations, for transactions undertaken on or after 1st April 2016 where an adjustment is made to the transfer price leading to an increase in income or reduction in the loss of the taxpayer, the excess money(i.e., the difference between the transfer price and the arm’s length price) available with the associated enterprise, if not repatriated to the taxpayer in India within the specified time, is deemed to be an advance made by the taxpayer to such associated enterprise, on which interest at prescribed rates is chargeable. For transactions undertaken on or after 1st September 2019, the taxpayer also has the option to pay one-time additional income-tax at the rate of eighteen per cent on the unrepatriated excess money.

​​​​​​The concept of “location savings”, i.e., cost savings in a low-cost jurisdiction such as India, is one of the aspects taken into account while carrying out a comparability analysis during transfer pricing audits. The expression “location savings” has a broad meaning; it goes beyond the issue of relocating a business from a “high-cost” to a “low-cost” location and relates to any cost advantage that a jurisdiction can provide. MNEs continuously search for options to lower their costs in order to increase their profits. In this respect, India provides various operational advantages to MNEs, such as availability of low-cost labour or skilled employees, lower raw material cost, lower transaction cost, reasonably priced rental space, lower training costs, availability of infrastructure at a lower cost, various direct and indirect tax incentives, etc.

In addition to the above cost advantages, India provides the following Location-Specific Advantages (LSAs) to MNEs:

• highly skilled, specialized and knowledgeable workforce;
• access and proximity to large and growing local/ regional markets;
• large customer base with increased spending capacity;
• superior information networks;
• superior distribution networks;
• various policy incentives; and
• market premium.

The incremental profit from LSAs is known as a “location rent”. The main issue in transfer pricing is the quantification and allocation of location savings and location rents among the associated enterprises. Using an arm’s length pricing approach, the allocation of location savings and rents between associated enterprises should be made by reference to what independent parties would have agreed in comparable circumstances. It is possible to use the PSM to determine the arm’s length allocation of location savings and rents in cases where comparable uncontrolled transactions are not available. In these circumstances, it is considered that the functional analysis of the parties to the transaction (functions performed, assets owned and risks assumed), and the bargaining power of the parties (which at arm’s length would be determined by the competitiveness of the market, availability of substitutes, cost structure, etc.) should both be considered as appropriate factors.

​​​​​​However, in situations where comparable uncontrolled transactions are available, the comparability analysis and benchmarking by using the results/profit margins of such local comparable companies will determine the ALP of a transaction with a related party in a low-cost jurisdiction. If good local comparables are available, the benefits of location savings can be said to have been captured in the ALP so determined. However, if good local comparables that could capture the benefits of location savings are not avail-able or in situations where the overseas AE is chosen as the tested party, the issue of capturing the benefits of location savings would remain an issue in determining the ALP.

Many MNEs have captive service centres and contract manufacturing facilities in India. As part of their transfer pricing policy, they usually reimburse the Indian entity using TNMM with the profit indicator mark-up on total costs as the most appropriate method. Under this method, a mark-up on the cost base is provided by overseas associated enterprises to the Indian company. Transfer pricing examination in India has revealed that certain costs are often not included in the cost base. As a result, the mark-up is calculated on a reduced cost base by the taxpayer. The cost base is normally changed by the Indian transfer pricing authorities to include such costs. Some of these costs are as under:

1. Stock-based compensation

Under the group policy, the overseas associated enterprise some-times pays a remuneration/performance bonus to the employees of the Indian entity through an Employee Stock Option Plan or Plans (ESOPs) or similar plans. As per the practice in India, ESOP expenses should be included in the cost base for the limited purpose of computing the mark-up, since the additional compensation is given by the overseas associated enterprise for performance of the employees of the Indian company. This is based on the principle that stock-based compensation is a part of the remuneration structure of the employees and is therefore included in the cost base for the purpose of computing mark-up in the same way as cash component of remuneration.

2. Third-party consultancy cost and infrastructure cost borne by the overseas AE, but report/ data/ insights from the consultancy, or facilities, used by the taxpayer in the course of business

It has been found in some cases that the Indian company uses certain training materials, expert opinions, due diligence reports, and advisory reports, in discharge of its business. However, payments for such material/ opinion/reports are made by the overseas associated enterprise to the consultant directly. An overseas associated enterprise may also be paying for connectivity, communication channels, and other common group infrastructure. If the Indian taxpayer does not include such costs in the cost base, for the limited purpose of computing the amount of mark-up, transfer pricing authorities will make necessary changes to the cost base.

3. Software and assets received free of cost

It is seen in many cases that one group entity purchases software for the entire group and shares the license with various AEs. The Indian associated enterprise may be a beneficiary of the software, but may not be paying for it. Such costs should be included in the cost base when computing the mark-up amount. In some cases, it is seen that overseas associated enterprises provide free-of-cost assets to the Indian associate, which are then used by the Indian associate. In such situations, a depreciation on the value of such free of cost assets should be included in the cost base for limited purpose of computing the mark-up amount. The above would apply even in situations where the software/ assets are provided at a discounted price.

4. Third-party vendor cost incurred by the Indian associated enterprise:

Sometimes, a captive service company may outsource part of its work to a third-party vendor and may argue that it does not do any value addition with respect to the work outsourced to such a vendor, and is to be treated like a “pass-through entity”. Consequently, it would not apply the profit mark-up on the outsourced costs. As per the practice in India, such third-party costs should normally be included in the cost base, where they are found to be related to the functions and associated risks of the Indian entity.

Transfer pricing of intangibles has been a difficult area of work for tax administrations across the world. The situation has been the same for the Indian tax administration. The pace of growth of the intangible economy has opened up new challenges to the arm’s length principle.

​​​​​​​Transactions involving intangible assets are difficult to evaluate for the following reasons:

1. intangibles are rarely traded in the external market and it is very difficult to find comparables in the public domain;
2. intangibles are often transferred bundled along with tangible assets; and
3. they may be difficult to detect.

A number of complications arise while dealing with intangibles. Some of the key issues revolve around determination of the arm’s length rate of royalties, allocation of the cost of development of the market and brand in a new country, remuneration for development of marketing and R&D intangibles, their use, transfer pricing of co-branding, etc. Some of the Indian experiences in this regard are discussed below.

With regard to payment of royalties, MNEs often enter into agreements allowing use of brands, trademarks, know-how, design, technology, etc. by their subsidiaries or related parties in India. Such payments can be made as a lump sum or by way of periodic payments or a combination of both types of payment. Intellectual property, which is owned by one entity and used by another entity, generally requires a royalty payment as consideration for its use. However, the important issue in this regard has been the determination of the arm’s length rate of royalty. The main challenge in determining the arm’s length royalty rate is to find comparables in the public domain with sufficient information for comparability analysis. Further, it is difficult to find a comparable ALP in most cases. The use of the PSM as an alternative is generally not a feasible option due to the lack of requisite information.

Serious difficulties have been encountered in determining the rate of royalty charged for the use of brands and trademarks in certain cases. In some cases, the user had borne significant costs in promoting the brand/ trademark, and in promoting and developing customer loyalty for the brand/ trademark in a new market. In these cases, the royalty rate charged by the MNE should depend upon the cost borne by the subsidiary or related party to promote the brand and trademark and to develop customer loyalty for that brand and product. In many cases, no royalty is charged from the local subsidiary in an uncontrolled environment and the subsidiary would require an arm’s length compensation for economic ownership of the brand and trademark developed by it, and for enhancing the value of the brand and trademark (legally owned by the parent companies) in an emerging market such as India.

​​​​​In many cases, Indian subsidiaries using the technical know-how of their parent company have incurred significant expenditure to customize such know-how and to enhance its value by their R&D efforts. Costs of activities, such as R&D activities which have contributed to enhancing the value of the know-how owned by the parent company, are generally considered by the Indian transfer pricing administration while determining the ALP of royalties for the use of technical know-how.

Significant transfer pricing issues have also arisen in cases of co-branding of a new foreign brand owned by the parent MNE (a brand which is unknown to a new market such as India) with a popular Indian brand name. Since the Indian subsidiary has developed a valuable Indian brand in the domestic market over a period of time, incurring very large expenditure on advertisement, marketing and sales promotion, it should be entitled to an arm’s length remuneration for contributing to increasing the value of the little-known foreign brand by co-branding it with a popular Indian brand and therefore increasing market recognition.

Several global MNEs have established subsidiaries in India for R&D activities on a contract basis to take advantage of the large pool of skilled manpower which is available at a lower cost. These Indian subsidiaries are generally compensated on the basis of routine and low cost plus mark-ups. The parent MNEs of these R&D centres justify low cost plus mark-ups on the ground that they control all the risks and their subsidiaries or related parties are risk-free or limited risk bearing entities. The claim of the parent MNEs that they control the risk and are entitled to a major part of the profits from R&D activities is typically based on the contention that they:

• design and monitor all the research programmes of the subsidiary;
• provide the funds needed for the R&D activities;
• control the annual budget of the subsidiary for R&D activities;
• control and take all the strategic decisions regarding the core functions of R&D activities of the subsidiary; and
• bear the risk of unsuccessful R&D activities.

In transfer pricing audits of certain contract R&D centres, the following facts have emerged:

1. most parent companies of Indian subsidiaries were not able to file relevant documents to justify their claim of controlling the risk of core functions of R&D activities and assets (including intangible assets), which are located in the country of their subsidiary;
2. contrary to the claims made by the parent companies, it was found that day-to-day strategic decisions and monitoring of R&D activities were carried out by personnel of the subsidiary who were engaged in actual R&D activities and bore relevant operational risks;
3. the management of the Indian subsidiary also took decisions concerning the allocation of budget to different streams of R&D activities and Indian management also monitored the day-today performance of R&D activities; and
4. while it was true that funds for R&D activities were provided by the parent companies that bore the financial risk of the R&D activities, the other important aspects of R&D activities, such as technically skilled manpower, know-how for R&D activities, etc. were developed and owned by the Indian subsidiaries. Accordingly, control over risks of R&D activities lay both with the parent MNE and the Indian subsidiary but the Indian subsidiary controlled more risks as compared to its parent.

​​​​​​It has thus been inferred that the Indian subsidiaries were not risk-free entities but bore economically significant risks. Accordingly, Indian subsidiaries were entitled to an appropriate return for their functions, including strategic decision-making, monitoring R&D activities, use of their tangible and intangible assets and exercising control over the risks. In view of these facts, a routine and low cost plus compensation model would not arrive at an ALP.

​​​​​Transfer pricing aspects of marketing intangibles have been a focus area for the Indian transfer pricing administration. The issue is particularly relevant to India due to its unique market specific characteristics such as location advantages, market accessibility, large customer base, market premium, spending power of Indian customers, etc. The Indian market has witnessed substantial marketing activities by the subsidiaries/related parties of MNE groups in the recent past, which have resulted in creation of local marketing intangibles.

The functions carried out by Indian subsidiaries of an MNE Group relating to marketing, market research and market development, including adding value to intangibles such as brands, trademarks and trade names owned by parent companies, as well as creation and development of market-ing intangibles like customer lists and dealer networks, have been the subject matter of transfer pricing adjustments in India. The expenditure incurred on these marketing functions has been considered for adjustment by Indian tax authorities on the premise that the Indian taxpayers were incurring these expenses for and on behalf of their parent companies outside India, and that:

1. these expenses promoted the brands/ trademarks that are legally owned by the overseas associated enterprises; and
2. these expenditures created or developed marketing intangibles in the form of brands/ trademarks, customer lists, dealer/distribution channels, etc. even though the Indian company may have had no ownership rights in these intangibles.

Based on this premise, it has been held by the Indian tax authorities that the functions carried out, which are in the nature of development of the relevant intangibles, deserve compensation.

For computing the value of compensation and the required adjustment, a comparison with the average Advertisement, Marketing and Promotion (AMP) spends by comparable businesses in a broadly similar line of business has been made to determine the routine spend on AMP for product sale. The expenditure over and above this has been held to be purely incurred for developing the brand value or other marketing intangibles for the benefit of the associated enterprise and as a service to it. Such excess expenditure has been considered for adjustment along with a mark-up as a service charge on the same, worked out on a cost plus basis. The understanding going into this approach has been that functions relating to development, enhancement and exploitation of marketing intangibles, now termed as DEMPE (Development, Enhancement, Maintenance, Protection and Exploitation) functions under the BEPS Final Report on Action Point 8 to 10, result in the following two-fold benefit to the AEs:

​​​​​​The adjustments made by Transfer Pricing Officers have been subject to judicial reviews in India and although the matter is still to be finally adju-dicated by the Supreme Court, the following principles have emerged from the decisions of the High Courts and Tribunals:

1. The existence of an international transaction in relation to any service or benefit will have to be established before transfer pric-ing provisions can be applied to place a value on the service or benefit for the purpose of determining compensation; and
2. The mere fact of unusual or excessive AMP expenditure cannot establish the existence of such a transaction. However, once such a transaction is established, it is possible to benchmark it separately and it need not always be aggregated with other inter-national transactions.

The present approach of the Indian tax administration for carrying out transfer pricing adjustments in accordance with the above judicial principles is as follows:

• carrying out a detailed Functions, Assets, and Risks (FAR) anal-ysis to identify all the functions of the taxpayer and the associated enterprises pertaining to all international transactions, e.g., purchase of raw material/components, payment of royalty, purchase of finished goods, export of finished goods, support services, direct sales by the associated enterprise in India, etc.;
• examining whether the marketing activities, marketing research, market development, distribution channel, dealers channel, customer list, etc. (DEMPE functions) reflected by the expenditure incurred by the taxpayer and the associated enterprise in India are in conformity with the functional and risk profiles and the benefits derived by the taxpayer and the AE, and whether the AE, assuming a risk in the Indian market or benefitting from India in one way or the other, is dependent upon the DEMPE func-tions carried out by the Indian subsidiary; and
• finding the most appropriate method to determine the arm’s length compensation for the functions performed, assets used or contributed, and risks assumed by the Indian entity. The most appropriate method would depend on the facts of the case. Where the TNMM is found to be the most appropriate method, one of the approaches adopted by tax authorities is comparison of the intensity of AMP functions of the taxpayer with that of comparable entities by comparing their respective market-ing and related expense as a percentage of revenue. Only after the appropriate adjustment, the operating profit ratios of the comparables are compared with the operating profit ratio of the taxpayer. In several cases, where residual PSM is held as the most appropriate method, the tax authorities first identify the non-routine AMP expense of the taxpayer by comparing its AMP expense with that of comparable entities performing routine manufacturing/ distribution activity. Non-routine AMP expense, if any, is excluded from the operating expense of the taxpayer and the resulting operating profit margin is compared with the operating profit margin of comparable entities performing routine manufacturing/ distribution activity. If any residual profit is identified as a result of such comparison, it is split between the taxpayer and its associated enterprise in the ratio of the marketing related functions performed, assets used or contributed and risks assumed by them. In case the taxpayer’s share of residual profit combined with its routine profit exceeds the profit declared by it, an adjustment is made.

The BEPS Report on transfer pricing issues illustrates through examples, the situations in which a marketeer/distributor can expect compensation for the AMP functions carried out by it. The common threads arising from these examples are:

• Compensation for the AMP function will depend on the intensity with which the function is performed, the extent of assets employed and the amount of risk borne by the parties in respect of the AMP function;
• Compensation can be part of the price of another transaction. For example, the taxpayer could be compensated by way of reduced price of goods or raw material or through a reduced rate of brand royalty;
• The taxpayer may be compensated directly for the excess marketing expenditure it incurs over and above that incurred by comparable independent enterprises, along with an appropriate mark-upon such expenditure;
• The combined profits from sales of goods can first be split by giving the distributor and the associated enterprise that owns the brand a basic return on their functions. The residual profitcan then be split taking into account the relative contributions of both entities to the generation of income and the value of the brand or trademark; and
• Where the results of the AMP function performed by the tax-payer are entirely exploited by the taxpayer itself, no separate compensation is receivable for the function.

The entity that takes the important decisions relating to the AMP function such as deciding the strategy, fixing the budget and exercising overall control over the function is the entity that bears the risk relating to the AMP activity and is entitled to all the excess profits generated on account of the function.

​​​​​​The Indian tax administration keeps these principles in view to make adjustments but it is apparent that the process is complex, fact intensive and not free from disputes. The efforts being made by the Indian tax authorities to bring uniformity in approach and the expected judicial verdict from the Indian Supreme Court are likely to bring more clarity in the process.

​​​​​​Globalization and the drive to achieve efficiencies within MNE groups have encouraged sharing of resources to provide support to group entities in one or more locations by way of shared services. Some of the services are relatively straightforward in nature, such as marketing, advertisement, trading, management consulting, etc. However, other services may be more complex and can often be provided either on a stand-alone basis or as part of a package and are linked one way or other to the supply of goods or intangible assets.

The following questions are relevant to identify intragroup services requiring arm’s length remuneration:

• have the Indian subsidiaries received any related party services, i.e., intragroup services?
• what are the nature and details of services, including the quan-tum of services received by the related party?
• have services been provided in order to meet the specific needs of the recipient of the services?
• are they duplicate services (i.e., was the Indian subsidiary avail-ing similar services on its own)?
• did the Indian subsidiary have the capacity to absorb the ser-vices provided by the AE?
• what are the economic and commercial benefits derived by the recipient of intragroup services?
• in comparable circumstances, would an independent enterprise be willing to pay for and procure such services?
• would an independent third-party be willing and able to provide such services?

The answers to the above questions help in determining if the Indian subsidiary has received or provided intragroup services that require arm’s length remuneration. Determination of the ALP of intragroup services normally involves the following steps:

• identification of the cost incurred by the group entity in providing intragroup services to the related party;
• understanding the basis for allocation of cost to various related parties, i.e., the nature of “allocation keys” used by the MNE;
• considering whether intragroup services will require reimbursement of expenditure along with mark-up; and
• identification of the ALP of a mark-up for rendering such services.

Identification of the services requiring arm’s length remuneration is one of the main challenges for the transfer pricing administration. India believes that shareholder services, duplicate services and incidental benefits from group services do not give rise to intragroup services requiring arm’s length remuneration. However, such a conclusion would need a great deal of analysis. The biggest challenge in determination of the arm’s length price is the allocation of cost by using allocation keys. The nature of allocation keys generally varies with the nature of services.

Another challenge for the transfer pricing administration is the identification of pass-through costs, on which mark-ups either should not be paid (if the Indian entity is the recipient of such services) or not received (if the Indian entity is the service provider). Wherever a mark-up is to be paid or received, the determination of an arm’s length mark-up is also a challenge.

Payments for intragroup services received are recognized as one of the riskiest international transactions to price. Hence, different perspectives are carefully examined by the Indian tax administration in a transfer pricing audit of such payments. Firstly, the cost charged out by the associated enterprises to Indian subsidiaries is carefully evaluated. As mentioned above, the composition of such costs, removal of duplicative and shareholder costs from the cost pool to be allocated, the allocation keys used to allocate such costs to the Indian subsidiary, etc. are important aspects of such evaluation. Secondly, there are situations where the Indian subsidiaries have been observed to be making duplicate or double payments for the same set of services received. For example, payment of a technology royalty, as well as, payments for tech-nical support services received could both be made to the AEs. A careful analysis is required to see that the two payments are not for the same set of services. This requires going into the components of the royalty and the IGS agreements/arrangements to identify overlapping elements. Thirdly, the mark-up charged on IGS costs by the associated enterprises is an important element of the transfer pricing audit. While the safe harbour provided for receipt of low value-added intragroup services builds in a 5% mark-up, the quantum of mark-up needs to be analyzed in detail in a case under an audit. There is no principle that a mark-up has to be charged invariably in every case. Rather, the charging of a mark-up should be guided by the market value of the services provided by the AEs. However, in most cases, it is difficult to evaluate the market value of such services as they are scarcely seen in unrelated transactions.

In view of the above facts, transfer pricing of intragroup services is considered a high risk area in India. India considers the payment for such intragroup services to be base-eroding in nature and, accordingly, attaches great importance to the transfer pricing of such payments. Further, even if an arm’s length result is achieved in respect of such payments from India, an additional protection in the form of an overall ceiling on the amount of such payments may be required. This may be justified because even an arm’s length payment might result in erosion of all the profits of the Indian entity or in enhancement of losses of the Indian entity, thereby, making the arm’s length nature of such payments questionable. Thus, an overall ceiling on such payments in the form of a certain percentage of the sales or revenue of the Indian entity is being used in appropriate cases.

In India, the transfer pricing approach for inter-company loans and guarantees revolves around:

• examination of the loan agreement;
• a comparison of terms and conditions of loan agreements;
• the determination of credit ratings of lender and borrower;
• the identification of comparable third-party loan agreements; and​​​​​​​
• suitable adjustments to the comparables to enhance comparability.

​​​​​​The Indian transfer pricing administration has come across cases of outbound loan transactions where the Indian parent has advanced to its associated enterprises in a foreign jurisdiction interest free loans or loans either at LIBOR (London Interbank Offered Rate) or EURIBOR (Euro Interbank Offered Rate). The main issue before the transfer pricing administration is the benchmarking of these loan transactions to arrive at the ALP of the rates of interest applicable on these loans.

​​​​​​A further issue in financial transactions is credit guarantee fees. With the increase in outbound investments, the Indian transfer pricing administration has come across cases of corporate guarantees extended by Indian parents to their associated enterprises abroad, where the Indian parent as guarantor agrees to pay the entire amount due on a loan instrument on default by the borrower. The guarantee helps an associated enterprise of the Indian parent to secure a loan from the bank. The Indian transfer pricing administration generally determines the ALP of such guarantees under the CUP Method. In most cases, guarantee rate quotes available from banking companies are taken as the benchmark rate to arrive at the ALP. The Transfer Pricing Officers sometimes also use the yield approach, wherein the benefit from the guarantee received by the guaranteed party in terms of lower inter-est rates is quantified and is used to benchmark the guarantee fee.

However, the Indian transfer pricing administration is facing a challenge due to the non-availability of specialized tools and of comparable prices for cases of complex inter-company loans and mergers and acquisitions that involve complex inter-company loan instruments as well as an implicit element of guarantee from the parent company in securing debt.

​​​​​​A comprehensive dispute resolution mechanism is available to taxpayers in India facing transfer pricing adjustments. As a part of the legal process in all cases, the Assessing Officer incorporates the order of the Transfer Pricing Officer in his own draft order and issues that to the taxpayer. The taxpayer has the option to file an objection against the draft order before the Dispute Resolution Panel which is a panel comprising three Commissioners of Income Tax. The Assessing Officer issues a final order in compliance with the Dispute Resolution Panel’s directions. At present, the direction of the Panel is final for the tax administration and it cannot appeal further against the Panel’s order. The taxpayer can challenge the direction of the Panel in appellate forums.

The sequence and availability of dispute resolution forums to the taxpayer in India is depicted in the flow chart below.

The Indian tax administration is aware of the problem of increasing transfer pricing disputes and the impact on the investment climate in India. Therefore, the Government of India has taken several steps to reduce litigation and the time needed to resolve tax disputes. Some of the steps taken in this direction are the following:

1. risk-based selection of cases for transfer pricing audit instead of selecting all cases above a particular monetary limit of the value of international transactions for audit;
2. introduction of the “range” concept in the Transfer Pricing Law along with the use of multiple-year data;
3. use of the MAP provision in tax treaties for speedier resolution of pending cases;
4. introduction of APA provisions in the law; and
5. introduction of safe harbour provisions in the transfer pricing law

Tax Disputes Resolution Flow Chart (India)

​​​​​​​

India introduced the APA provisions in its legislation in 2012. An APA is an agreement between the Central Board of Direct Taxes (CBDT) and any person, to determine, in advance, the ALP or specify the manner of determination of the ALP (or both), in relation to an international transaction. Once an APA has been entered into, the ALP of the international transaction will be determined in accordance with the terms of the APA for the period specified therein. An APA can be entered into for a maximum period of five years and can be renewed thereafter. The APA process is voluntary but once an APA is entered into, it becomes binding for both the taxpayer and the CBDT.

APAs can be unilateral, bilateral or multilateral. An applicant may request a particular type of APA while making the application. The scheme provides for an optional pre-filing consultation between the taxpayer and the APA team before filing a formal application. Such consultation can be on anonymous basis. The application is to be filed along with the specified fee. The Indian APA Scheme also provides for a rollback of the APA for a period of four years prior to the first year of the APA period. Therefore, the combined impact of an APA with rollback provisions is tax certainty for nine years. Rollback is not available for a year in which the Income Tax Appellate Tribunal (ITAT) has pronounced its decision on the issues proposed to be covered under the APA including the proposed APA Rollback. All the procedures relating to the APA Scheme have been prescribed in detail under the APA Scheme in the Income Tax Rules and certain issues have also been clarified by the CBDT through various Circulars and Frequently Asked Questions (FAQs).

​​​​​​​Recently, the scope of APA provisions has been widened and APAs signed after 1 April 2020 can include agreement on profit attributable to a permanent establishment (PE) in India. This change is expected to reduce disputes and to bring certainty to non-residents doing business in India through a PE.

​​​​​​India accepts bilateral APA applications (besides transfer pricing MAP applications) regardless of the presence or otherwise of Paragraph 2 of Article 9, which provides for “corresponding adjustments”, in the applicable Double Taxation Avoidance Agreement (DTAA).

​​​​​The Indian APA programme has been well-received by taxpayers and about 1,300 applications have been filed so far. More than 350 APAs have already been entered into by the CBDT. The APAs signed so far cover various sectors of the Indian economy including information technology, automobiles, telecommunications, steel, shipping, general trading, banking, pharmaceuticals, etc. It is expected that the robust APA programme in India would go a long way in reducing transfer pricing disputes and providing certainty to MNEs in such matters.

India introduced safe harbour provision in its legislation in 2009. Rules for administering the provision were subsequently notified.

Safe harbour provisions are intended to reduce the compliance burden for small taxpayers with regard to transfer pricing issues. Sectors/transactions covered under safe harbour rules are the following:

• • •  
• software development;
• IT enabled services;
• knowledge process outsourcing services;
• outbound intragroup loans;
• corporate guarantees;
• contract R&D services in software;
• contract R&D Services in pharmaceuticals;
• manufacture and export of core auto components;
• manufacture and export of non-core auto components; and
• receipt of low value-adding intragroup services.

In 2020, the law was amended to expand the scope of safe harbour rules, to include determination of profit attributable to a PE in India.

India has endorsed the Final Report of the BEPS project on Actions 8 to 10 dealing with various transfer pricing issues. Some of the issues addressed in the BEPS reports are in conformity with long standing views of the Indian transfer pricing administration. These include:

• the broad objective of aligning transfer pricing outcomes with value creation;
• giving importance to the Development, Enhancement, Maintenance, Protection and Exploitation (DEMPE) functions in respect of intangibles for remunerating the group entities of MNEs;
• testing of contractual allocation or contractual assumption of risk on the parameters of exercising control over risk and/or the financial capacity to bear the risk, and disregarding such con-tractual allocation or assumption of risk;
• harmonizing contracts with the conduct of parties;
• identifying and accurately delineating the transaction (i.e. iden-tifying the “real deal”) by analyzing the economically relevant characteristics;
• preventing the capital-rich but low-functioning entities (“cash box” entities) from contributing to base-erosion or profit-stripping; and
• non-recognition of commercially irrational transactions that cannot be seen between independent parties, etc.

Accordingly, the Indian tax administration is of the view that the guidance flowing from the Final Report of the BEPS project on Actions 8 to 10 should be utilized by both Transfer Pricing Officers and taxpayers in situations of ambiguity in interpretation of the law. However, India has not endorsed the guidance in the BEPS report pertaining to Low Value-Adding Intra Group Services (LVAIGS) under Action 10 and has not opted for the simplified approach.

​​​​​​India has also endorsed the recommendations contained in the BEPS Final Report on Action 13, which attempts to completely change the trans-fer pricing documentation standards. India has supported the three-tiered documentation regime comprising a Local File, a Master File and a Country-by-Country (CbC) Report and has already carried out legislative changes in its domestic law. Appropriate use of CbC Reports and maintenance of their confidentiality is ensured by the Indian tax administration through administrative instructions and guidance. India has been peer reviewed under guidelines laid down in the final report on Action 13 of the BEPS project without any major recommendations.

​​​​​​Mexico introduced transfer pricing rules in 1997 by including the arm’s length principle in the Mexican Income Tax Law (MITL). Since fiscal year 2014, the transfer pricing rules are found in Articles 76-IX, 76-X, 76-XII, 110-X, 110-XI, 179, 180, 181 and 182; and regulate both cross-border and domestic intercompany transactions. The Transfer Pricing Guidelines for Multinational Companies and Tax Administrations as approved by the Council of the OECD are referred to as applicable in the MITL, for interpretation of the provisions in transfer pricing matters, to the extent that said guidelines are consistent with the provisions of the MITL and the treaties entered into by Mexico. The transfer pricing regulations are complemented by rules on their application by taxpayers regarding transfer pricing adjustments, interpretation criteria (e.g. comparability adjustments and interviews during APA processes) and undue fiscal practices (e.g. identification of unique and valuable contributions in comparability analysis).

In 2016, Article 76-A was incorporated in the MITL, mandating taxpayers to submit the following annual informative returns: (i) master file, (ii) local file and (iii) country-by-country report.

​​​​​​Tax audits in Mexico may be conducted through on-site inspection of taxpayers to review their accounting, goods and merchandise, or through desk reviews, in which the tax authorities may require that taxpayers submit their accounting records, data and other required documents and information at the offices of the tax authorities. In practice, most of the transfer pricing audits are conducted through desk reviews. In certain cases, Mexican taxpayers may receive a non-binding “invitation letter” sent by the Mexican Tax Authorities, raising questions as to specific risk indicators that could cause concerns to the risk assessment department, which has contributed in taxpayers solving tax issues before performing a tax audit or in rejecting preliminary candidates for further review.

In Mexico two or more individuals or legal entities are deemed as related parties when one of them has a direct or indirect participation in the management, control, or capital of the other, or when a person or a group of persons participate directly or indirectly in the management, control, or capital of such persons. There is no specific threshold for the entities to be considered related parties.

In addition, since 2002 members of joint ventures, as well as permanent establishments with regard to their central office or other permanent establishments, are considered related parties. This is in accordance with the provisions of Article 179 of the MITL.

​​​​​​It is assumed that any transaction performed with companies that are resident for tax purposes in preferential tax regimes (low or no income tax) will be considered to be carried out between related companies at values other than arm’s length. In addition, it is established that the payments made to residents in such regimes are not deductible unless it can be proven that the price or consideration amount was at arm’s length.

The law in force requires all taxpayers to prepare and keep documentation that proves that all the transactions carried out with related parties are conducted pursuant to the arm’s length principle. The transfer pricing docu-mentation must be prepared for each tax year and should have an evaluation per type of transaction and per related party.

In addition, certain taxpayers (e.g. large taxpayers) must also disclose information regarding the conclusions of the transfer pricing documentation as part of the appendixes of the statutory tax audit report, or the informative statutory report (ISSIF), along with the sign-off of the expert who prepared the referred documentation. The transfer pricing documentation must contain the following specific requirements:

1. Name or firm name of the related company residing abroad, tax address and jurisdiction;
2. Documentation that shows the direct or indirect participation among related parties;
3. Information regarding assets, functions and risks per type of transaction;
4. Information and documentation with the detail of each transaction performed with related parties and their amounts per type of transaction; and
5. Transfer pricing method applied, as well as the documentation of comparable companies or transactions per type of transaction. An interquartile range of the results obtained from comparable transactions/companies must be used.

Taxpayers whose income for the immediately preceding tax year was under 13 million pesos for business activities, or 3 million for the provision of services, have no obligation to prepare and keep the documentation referred to in the law. This benefit does not apply in the case of transactions with companies residing in preferential tax regimes (low or no income tax), contractors or assignees under the terms of the Hydrocarbons Revenue Law, or in the case of having to prepare the transfer pricing informative return (Article 76-X of the MITL).

Such documentation should be recorded in account books, specifying that the transactions were performed with related parties residing abroad.

The MITL in force establishes that when using financial information to demonstrate that inter-company transactions were performed at arm’s length, taxpayers must prepare such information in accordance with the accounting standard in order to calculate the income, cost, gross profit, net income, expenses and operating profit, as well as assets and liabilities.

​​​​​​Through an informative return (DIM Annex 9), taxpayers are also required to submit information regarding transactions with foreign-resident related parties. Said information includes among other data, a summary of the intercompany transactions results, elements of the economic analysis and the arm’s length ranges. The non-compliance with the submission of this informative return results in penalties for the taxpayer.

In addition, companies that are required to file a statutory tax audit report (due on June 30) must also submit the following appendices with regard to transfer pricing:

1. Type and amount of intragroup transactions by related party, transfer pricing method used, whether the intragroup transaction is at arm’s length, and amount of the adjustment if so applied to comply with the arm’s length principle;
2. Taxpayer’s business activity, ownership of intangible assets used or contributed, date on which the informative return was submitted and whether the taxpayer has supporting documentation of the arm’s length nature of intragroup transactions, advance pricing agreements (APAs) under negotiation, Tax ID of transfer pricing advisors, interest deemed to be dividends, pro rata expenses, financial derivative transactions with related parties, thin capitalization, corresponding adjustments, whether the taxpayer must submit the master file, local file or Country-by-Country report; and
3. The external auditors of the Mexican taxpayer filing the statutory tax audit report will also have to complete a transfer pricing questionnaire confirming that all transactions were performed at arm’s length and the documentation requirements that were met.

The documentation substantiating transfer pricing matters must be prepared every year no later than the date when the annual tax return is filed. In the case of an informative tax return, it must be filed not later than the date when the statutory tax report is filed.The documentation substantiating transfer pricing matters must be prepared every year no later than the date when the annual tax return is filed. In the case of an informative tax return, it must be filed not later than the date when the statutory tax report is filed.

​​​​​​The Mexican tax authorities conduct audits based on information provided by the taxpayer and other data, including information obtained from:

1. Commercial databases; and
2. Exchange of information mechanisms with treaty partners. 

A key issue is that this information must be consistent and verifiable for purposes of the review.

Failing to keep documentary support will result in the external auditor’s mentioning of such failure in his report and, in case of an audit, the authority may determine the method and comparable companies it deems appropriate in the application of the arm’s length principle, and an adjustment to the income or deductions may be determined. This may result in a new taxable basis and consequently in a new tax charge including inflation, surcharges and penalties, in addition to the potential double taxation resulting from the payment made in the other country. The fine shall range from 55 to 75 per cent of the historical omitted tax (first and penultimate paragraphs of Article 76 of the Federal Tax Code), in the case of improper tax loss, the penalty shall range from 30 to 40 per cent of the difference between the filed tax loss and the loss actually incurred, both of these penalties can be reduced 50 per cent if the transfer pricing study requirement has been met (eight and penultimate paragraphs of Article 76 of the Federal Tax Code).

Article 76-A of the MITL establishes the general contents of the master file, local file and country-by-country report, and which taxpayers must file such annual informative returns. Submission of master file, local file and country-by-country report is regulated in Article 76-A and miscellaneous tax rules 3.9.11 through 3.9.17. Within this context, there is a penalty in case of failing to file the (i) master file, (ii) local file and (iii) country-by-coun-try report, or submitting them incomplete, with mistakes, inconsistencies or differently from what is indicated in the tax provisions, the penalty shall range from MXN $154,800.00 to MXN $220,400.00, and is annually updated according to inflation.

​​​​​​The following comparability factors are included in the MITL for purposes of the application of the arm’s length principle:

1. The characteristics of the goods and services;
2. The functional analysis;
3. The contractual terms;
4. The economic circumstances; and
5. The business strategies.

The MITL establishes the possibility of applying reasonable adjustments to eliminate differences between the comparable transactions or companies. Such adjustments must consider the aforementioned comparability factors. The application of this comparability adjustment follows the arm’s length principle, and can be implemented, for instance, as a capital adjustment.

Public financial information for local comparables is limited in Mexico. Therefore, taxpayers may use adjusted foreign comparable data, as long as said adjustments are reasonable.

Under Article 69 of the Federal Tax Code (Código Fiscal de la Federación or FFC), the Mexican Tax Authority may use confidential information obtained from third parties to determine revenues and deductions of taxpayers that have not performed their transactions at arm’s length.

1. Comparable Uncontrolled Price (CUP) Method;
2. Resale Price Method (RPM);
3. Cost Plus Method (CPM);
4. Profit Split Method (PSM);
5. Residual PSM; and
6. Transactional Net Margin Method (TNMM).

​​​​​​In 2006, resulting from a recommendation from the OECD (as part of the Peer Review of the Mexican Transfer Pricing Legislation and Practices of March 2003), the MITL introduced a hierarchy for the application of trans-fer pricing methods. In particular, Article 180 of the MITL establishes that taxpayers may use another method only when the CUP Method as outlined in the OECD Transfer Pricing Guidelines is not appropriate to determine the arm’s length nature of the tested transaction. The taxpayer must demonstrate that the method used is the most appropriate or most reliable pursuant to all available information, giving preference to the RPM or CPM over the PSM or TNMM.

​​​​​​To determine the price that should be used between independent parties, Article 180 of the MITL allows the use of a range of prices or profit margins resulting from the application of a method with two or more comparable transactions. Such range may be adjusted through statistical methods (specifically the interquartile range).

​​​​​​The MITL accepts multiple year data only for comparables, and provided that taxpayers must demonstrate that the business cycle or the commercial acceptance of the products cover more than one year. The MITL does not allow the use of multiple years if this is only applied as a statistical tool to mitigate changes and trends in the financial indicators of the comparables.

The MITL transfer pricing rules for inter-company financing focus on the characteristics to consider in applying proper comparability factors with uncontrolled transactions. These characteristics include the principal amount, payment period, guarantees, debtor’s solvency and interest rate.

Payments made abroad for interest paid to related parties may be deemed as dividends if they arise from an unconditional promise of payment agreement involving the total or partial payment of credit received, of standby credit, or of a profit-related payment condition; or from the management of the business.

​​​​​​Thin capitalization rules are established in Article 28, Section XXVII of the MITL, which states that the interest paid to related parties will not be deductible in amounts exceeding the 3:1 ratio of liabilities to the equity of the company. The rule does not apply to entities that are part of the financial system (as defined in the MITL) and those taxpayers that assumed for the construction, operation or maintenance of productive infrastructure related to strategic areas of the country or electric power generation. Other exemptions and waivers regarding thin capitalization rules may apply. For example, taxpayers who obtain an APA for inter-company loan transactions are not subject to this limitation.

In the case of transactions related to the sale or purchase of stocks, the taxpayer must consider elements such as: (i) the equity value of the issuer’s stockholders as of the transaction date; (ii) the present value of its profits or cash flows; or (iii) the last published market price of the stock.

In Mexico, taxpayers must allow inspections to verify tax compliance and provide all documentation requested by the tax authorities. If the tax authority considers that the taxpayer has not complied with its obligations adequately, the taxpayer must provide all evidence demonstrating such compliance.

The burden of proof resides with the taxpayer, who must prepare transfer pricing documentation to demonstrate that its intercompany trans-actions were performed at arm’s length. If the tax authorities review this information and find that the taxpayer is not in compliance, the tax authorities are liable to determine arm’s length prices, considering the information available or otherwise identified for such purposes. If the dispute goes to the tax court, the taxpayer and the tax authorities must present all evidence they deem appropriate to defend their respective positions.

​​​​​​Currently, different audit units of the Large Taxpayers Division of the Mexican Tax Administration conduct audits with a holistic approach, which includes transfer pricing along with other taxes such as VAT, withholding taxes, customs and other local tax provisions, with the coordination and advice of the Transfer Pricing unit.

​​​​​​One of the objectives of this audit programme is to focus revisions on the most recent tax years and, if possible, in real time, taking advantage of recently assembled information, experienced staff and resources to stream-line the capacity of the tax administration to address tax issues and ensure that the business operations of the taxpayers are in compliance with the tax regime. The tax administration can also monitor the performance of the taxpayers in the post-audit stage and for more recent tax years it is much easier to understand and outline a value chain analysis of the business for a better resolution of the case.

Mexico has a cooperative compliance programme whereby based on principles of trust, transparency and mutual understanding the tax administration looks to improve voluntary compliance by taxpayers with their tax obligations. Applying an objective interpretative (“substance over form”) criterion, which would facilitate and simplify the application of tax provisions, the tax administration aims to establish effective long-term, trustful relationships with taxpayers to identify risk areas and use its resources and capacity to find a successful solution. This programme is in line with international best practices.

Owing to the significant increase of audits (including transfer pricing) and the increase in tax controversies, and the long process for resolving disputes in tax courts, coupled with the high cost thereof, the Conclusive Agreement was created as an alternative for solving controversies during the audit process without the need of recurring to appeals or litigation. This mediation process can be considered as a domestic supplementary dispute mechanism that allows tax authorities and taxpayers alike to cope with the complexities of tax (including transfer pricing) disputes by providing the chance to solve the controversy at the audit stage.

The Conclusive Agreements are handled by the Tax Ombudsman Agency (Prodecon), which acts as an independent impartial official mediator between the taxpayer and the tax authorities.

The mediation begins with the request of the taxpayer which must contain the reasons for his dissent and the tax treatment that he believes should apply to the findings detected by the authority during the tax audit, accompanied of all the necessary documentation supporting his position. The filing of the Conclusive Agreement suspends legal deadlines, including the audit and collection procedures, which allows the parties to discuss and analyze the controversy in a detailed manner with no time constraints. However, the Conclusive Agreement is an effective and efficient mechanism when the taxpayer is aware of adjustments that must be performed to his tax position; for cases where the taxpayer is convinced that his tax position is correct it might represent an extended and inefficient use of resources.

​​​​​​The core of the mediation is the tax treatment that the tax administration is giving to the tax situation detected during an audit and can involve aspects related to the interpretation of the law, formal issues and/or assessment of evidence presented during the audit, as well as relieving associated penalties if the agreement is reached.

No tax debts are addressed during the mediation, since the procedure can only be initiated during the audit but not after the tax authority has issued a tax assessment. This encourages consensus since discussions between the parties take place before there is a final decision of the tax authority.

This procedure is optional for the taxpayer but it is mandatory for the tax authority to attend the mediation. However, as it is common in most alternative dispute resolution procedures, it is optional for the tax authority to finally accept or refuse the proposals to reach a solution to the dispute.

Meetings with the taxpayer and tax authorities can be set to discuss the specific tax controversy. The meetings are held in a neutral environment that encourages addressing technical issues through the exchange of points of view and documentation regarding tax law, accounting issues or tax specific situations, with the input and active participation of the representatives of Prodecon.

Once the Conclusive Agreement is signed, the tax effects agreed therein apply immediately and the tax audit is definitively closed. The parties are legally unable to challenge the result of a Conclusive Agreement by any domes-tic mean or modify the results of the agreement through negotiation in a MAP. Additionally, according to the Federal Tax Code, the Conclusive Agreement creates no legal precedent, which provides certainty to the tax authority that any agreed issues cannot be raised in a different or new tax controversy.

If no agreement is reached between the tax authority and the taxpayer the suspension of the audit concludes and all legal procedures are continued (i.e. by the issuance of a tax assessment). In this case, the taxpayer will still be able to file the corresponding legal defense, i.e. administrative appeal or tax litigation against the tax assessment.

​​​​​​Article 34-A of the Federal Tax Code enables taxpayers to submit unilateral, bilateral or multilateral APA requests. Unilateral APAs may cover the tax year of submission, the preceding tax year and the following three tax years. APAs may be valid for a longer period if an agreement is reached with the competent authority (authorities) of the Contacting State(s) under a Convention to which Mexico is party.

The Maquiladora Program started in the late 1960s as a direct response to the cancellation of the US Bracero Program that had allowed temporary Mexican migrant agricultural workers into the United States for seasonal employment. The Mexican and United States Governments agreed to the maquiladora programme whose immediate purpose was to provide employment in Mexico and generate economic activity in the manufacturing industry. It was not originally envisaged for taxation purposes, multilateral trade treaties or long-term foreign direct investment.

In 1989 the Mexican Government issued a decree to adapt and expand the maquiladora programme, with the intention of moving beyond simple job creation into a more meaningful economic development of the Mexican manufacturing and export generation base. The expansion programme was intended to develop a local supply chain for US manufacturers and to include a qualification programme (PITEX Program) for Mexican companies to produce and supply some of the inputs for the US companies (unlike maquiladoras that import all inputs).

A maquiladora is a Mexican subsidiary company, usually 100 per cent foreign-owned, whose primary role is assembly. Maquiladoras are defined in the Presidential Decree (Decrees for the Fostering and Operation of the Maquiladora Industry for Export) as assembly plants undertaking maquiladora activities under a permit issued by the Ministry of Economy.

​​​​​​Maquiladoras are usually structured as cost centres, with marginal profits. Their activities include the maintenance of assets and inventories provided by foreign residents for their transformation (production, sub-assembly and assembly) into semi-finished and finished goods destined for export (mainly for the United States market). Typically, foreign parent companies own inventories, equipment and machinery, provide the maquiladora with all the input, technology and know-how to carry out the manufacturing process, and allow the maquiladora the use of patents and technical assistance free of charge. Maquiladoras usually own or lease few assets, including a physical facility in Mexico; they hire and manage the labour pool required, and use capital free loaned by the parent company to transform inputs into products for export to the parent company or another related party. Many maquiladoras actually perform some additional functions for the parent company that must be identified and pay taxes apart from the maquiladora services. However, maquiladoras are generally treated as “contract” companies since it is considered that they perform functions requiring no valuable intangibles and very few routine intangibles.

Parties residing abroad may constitute a permanent establishment in Mexico arising from the legal or economic relations with Maquila export companies.

​​​​​​Entities carrying out maquila operations will comply with the arm’s length principle, and it will not be considered that the foreign residents for which the maquila operates will have a PE regarding the foreign assets being used if the maquiladoras determine their taxable profit according to “safe harbour” rules. Under this measure, the Maquila companies have to obtain a taxable profit that represents at least the larger of the values of:

1. 6.9 per cent on the assets used in the Maquila activity, both its own and those of the party residing abroad; or
2. 6.5 per cent on the costs and expenses incurred by the Maquila company.

​​​​​This option has remained the same since the year 2000. For purposes of this option, the obligation to the Tax Administration Service (SAT) is to file an informative return stating that the taxable profit obtained represents at least the greater amount resulting from applying the 6.9 per cent or 6.5 per cent calculations as referred to above, corresponding to the safe harbour option.

These rules include several provisions for existing and newly organized maquiladoras with respect to the determination and valuation of the asset base and cost base (i.e. adjustments for inflation, amortization, inventory and currency conversion; exclusion for shelter activities, time frames, documentation requirements, conditions for changing options etc.).

Also, the entity resident in Mexico can submit an APA application to confirm compliance with the arm’s length principle, and that foreign residents would not constitute a PE. The APA must be requested under the rules of Article 34-A of the Federal Tax Code.

Regarding the APA maquila programme, since the vast majority of cases dealt with US principals, in 2016 the Mexican tax authorities and the United States Internal Revenue Service (IRS) reached a technical agreement and established administrative measures so that U.S. taxpayers with maquiladora operations in Mexico will not be exposed to double taxation if they enter into a unilateral APA with Mexico, under terms agreed in advance between the U.S. and Mexican competent authorities.

​​​​​​The agreement between the competent authorities provides the Mexican Tax Authority the approach to be followed for qualifying taxpayers that have requested a unilateral APA. These taxpayers may apply a transfer pricing framework that the U.S. and Mexican competent authorities have agreed in advance will produce arm’s length results.

Determinations done by the tax authority of a jurisdiction regarding the compliance with the arm’s length principle that represent a modification of revenues or deductions of a Mexican taxpayer may be performed solely by filing an amended tax return, providing that the SAT has accepted such adjustment, validated through a competent authority procedure under the tax treaty in place.

The tax authorities may totally or partially condone the surcharges resulting from an adjustment to prices or to consideration amounts in the case of transactions between related parties, provided that said condoning arises from an agreement with a competent authority, based on reciprocity, between the competent authorities of Mexico and those of a country with which Mexico has entered into a double tax convention, and provided that said authorities have refunded the corresponding tax without the payment of any amounts corresponding to interest.

The main pillars of an effective implementation of the arm’s length standard are comprehensive legislation, trained and adequate personnel, control procedures and a robust, systematic and precise risk assessment system.

​​​​​​Mexico recognizes that a well-founded risk assessment system is the correct starting point of an effective tax audit cycle, and in this regard a series of tax structures and arrangements have been identified by the Mexican Tax Administration and tackled by implementing specific audit programmes. This relates to the causes and effects of eroding structures, which from a transfer pricing perspective have an impact on operating results, net results and tax results of non-reported inter-company income, involving base eroding payments (including those settled with low-tax jurisdictions or with no economic sense, such as royalties, interests, intra-group services, among others) and business restructurings (assets and risk reallocations).

​​​​​​It has been recurrently noted by Mexican tax officials that intragroup service transactions are a risk area, and in 1981 the Mexican Income Tax Law was reformed to include a limitation of the deduction of prorated expenses. Nonetheless in 2014, the Mexican Supreme Court ruled that the limitation of the deduction of prorated expenses is neither absolute nor unrestricted, thus the deduction may be permitted if certain conditions are fulfilled, namely that the service transaction has been rendered, that it provides a benefit to the recipient and that it conforms to the arm’s length principle.

Information asymmetry is a critical issue in effectively documenting an intragroup service transaction so it is crucial that taxpayers provide appropriate information on the service rendered, the service provider entity (even if it is a foreign entity), and the benefit test. It would also be useful to make a general assessment of the financial status of the service recipient entity, which must have the financial capacity to bear the expense; and it has been important to clarify to taxpayers in Mexico that in the absence of the appropriate information that demonstrates an intragroup service transaction the expenses can be non-deductible under the Income Tax Law.

Royalties paid by a taxpayer to nonresident related parties for the temporary use of intangible assets are likely to be challenged when such royalties are from a Mexican source and were previously owned by such taxpayer or any related party thereof residing in Mexico, when the transfer of the intangible assets was made without receiving any consideration or at a non-arm’s length price.

The SAT has challenged the fact pattern where there are advertising and marketing expenses incurred by Mexican subsidiaries along with royalties paid to their related parties abroad for marketing intangibles, since the legitimate owners of the intangibles surplus are the ones creating them. These are mostly the entities in charge of the development of brand awareness, brand positioning, and brand prestige adding value to the business cycle.

Mexican subsidiaries should be compensated based on the value they create through functions performed, assets used and risks assumed in the development, enhancement, maintenance, protection and exploitation of intangibles.

Two of the key components of the aforementioned transactions are the economic valuation of the intangible assets and the amount of the royalty payments arising from the use of such assets. Both elements should be analyzed under the tax regulations on transfer pricing in force since 1997.

​​​​​​In Mexico, as in many countries, taxpayers tend to over-utilize net margin TP methods to support the Mexican taxpayer’s financial results (regardless of a careful review in establishing the tested party), collecting external comparables operating in the same industry from commercial data-bases, mostly from developed countries such as United States and Canada, since public data from local comparables is scarce due to the low market capitalization in Mexico. Since in most industries the macroeconomic conditions between Mexico and developed countries such as the United States and Canada differ, it is necessary to perform comparability adjustments to the financial results of the comparables.

The application of a comparability adjustment follows the arm’s length principle, and this can be implemented as a capital adjustment taking into account the inherent differences between the sovereign bond yields of the two countries— the country of residence of the tested party and the country of residence of the comparable— and applying it as a factor in the invested capital or operating assets of the companies. Even though a country risk adjustment would generally improve the comparability of the companies in this situation, there can be specific industrial differences among countries which must be evaluated independently. Another separate comparability adjustment may come from local saving advantages.

An aggressive tax planning structure found in Mexico relates to full manufacturing companies performing all productive processes from purchase of raw materials, manufacturing the products, product development and incorporation of intangibles, searching for clients, selling the finished products to the clients, and assuming all related risks in the Mexican market; and suddenly the manufacturing activities turn into maquila services and presumably acts as a limited risk entity only receiving compensation through a mark-up over salaries, and a minimal commission for the sales to the retailers, despite having the same functions as before the reorganization.

These reorganizations are being challenged following the 2014 tax reform under which maquila companies must export all of the products they produce, and if the products are found to be sold in Mexico, the value chain, even if fragmented, would be assessed and taxed in its entirety in Mexico, including the manufacturing and distribution portions of the business performed in Mexico.

The SAT is committed to implementing the Base Erosion and Profit Shifting (BEPS) initiatives. Within this context, the 2020 tax reform (in effect for fiscal year 2021) establishes the implementation of Action 4 (Limitation on Interest Deductions; establishing a limit of 30% of EBITDA, contained in Article 28 —XXXII of the MITL).

• Transmission of Hard to Value Intangibles;
• Business restructurings;
• Non-remunerated services or functions, as well as non-compensated transmission of goods and rights;
• Transactions for which there are no reliable comparables; and
• Application of foreign safe harbours.

In the other Parts of this Manual, the Subcommittee has sought to provide practical guidance on the application of transfer pricing rules based on Article 9(1) of the UN Model Tax Convention and the arm’s length principle embodied in that Article. With regard to Parts A through C, the Subcommittee has discussed and debated the merits of the guidance that is provided and, while there may be some disagreement on certain points, for the most part the Subcommittee is in agreement that the guidance in those chapters reflects the application of the arm’s length principle as embodied in the UN Model Tax Convention.

The Subcommittee recognizes that individual countries, particularly developing and emerging economies, struggle at times with the details of applying these treatybased principles in a wide variety of practical situations. It therefore remains appropriate and instructive to allow representatives of individual countries an opportunity to set out their individual country viewpoints and experiences for the information of readers. Those individual country views are contained in this Part.

It should be emphasized that, with this background, this Part of the Manual does not reflect a consistent or consensus view of the Subcommittee. How it should be read is reflected in the Foreword to this edition of the Manual:

The Foreword to the First Edition of this Manual, remains relevant as to its substance. In particular, its recognition that: “While consensus has been sought as far as possible, it was considered most in accord with a practical manual to include some elements where consensus could not be reached, and it follows that specific views expressed in this Manual should not be ascribed to any particular persons involved in its drafting. [Part D] is different from other chapters in its conception, however. It represents an outline of particular country administrative practices as described in some detail by representatives from those countries, and it was not considered feasible or appropriate to seek a consensus on how such country practices were described. [Part D] should be read with that difference in mind.”

In cases where countries provide updated versions of their country practices following publication of this edition of the Manual, they will be made available on the Tax Committee’s website:

https://www.un.org/development/desa/financing/whatwedo/ECOSOC/  taxcommittee/taxcommitteehome

Brazil introduced a law on transfer pricing, through Law n. 9,430/1996, in 1996.¹⁴⁸ The bill was proposed to deal with tax evasion through transfer pricing schemes, and in line with this proposal it adopted the arm´s length principle.

The methodology introduced by the law listed the traditional transaction methods (CPM and RPM) but denied the use of transactional profit methods (the PSM and TNMM) and formulary apportionment. Regarding the CUP Method, for exports or imports, the law introduced a methodology that is similar to OECD practices; and in addition Brazil also adopted the socalled Sixth Method (which is the CUP Method applied specifically for commodities). However, with regard to the CPM and RPM, instead of making use of comparable transactions, the law established fixed margins for gross profits and markup.

In 2012 the law was changed by adopting different margins for certain specific sectors as applicable to the RPM. The Brazilian perspective is that the conventional use of the RPM and the CPM implies some uncertainty and juridical instability, since they are implemented by the taxpayer without previous consent or summary review by the tax authorities. This affects stability and expectations in economic and fiscal relations.

Brazil’s RPM and CPM with fixed margins are applicable to both export and import operations. In order to make them easier to understand they are presented in the following paragraphs disregarding practical distinctions. A more detailed explanation to differentiate the application to imports and to exports and how to deal with that will be discussed separately. This is because the Brazilian transfer pricing law details the application of the two methods (RPM and CPM) for exports and imports in separate sets of rules. There are also specific methods for tradable commodities and interest that are addressed in paragraph 1.8.2 and following of this Chapter.

Brazil’s RPM and CPM with fixed margins are not “safe harbour” methods. For these purposes, safe harbours mean provisions that apply to a defined category of taxpayers or transactions that relieve eligible taxpayers, at their own option, from certain obligations in pricing controlled transactions otherwise applicable under the arm’s length standard. The RPM and CPM with fixed margins can be applied by the taxpayers as regular methods, not as safe harbours. The fixed margins are subject to modifications authorized by the Minister of Finance, based on the taxpayer´s request or ex officio, as discussed below.

The mechanism of the RPM using fixed gross profit margins is considered by Brazil to be similar to the conventional RPM with margins, except that the gross margins are set out in the rules, rather than being based on comparables (see Figure 1.1 below). In order to determine the transfer price (deemed arm´s length price, or parameter price, as it is called in Brazilian transfer pricing laws), the resale price that the reselling company (Associated Enterprise 2) charges to an unrelated customer (Independent Enterprise) is reduced by a fixed gross profit margin. The remainder is the acceptable transfer price between the associated parties (Associated Enterprise 1 and Associated Enterprise 2), which is the parameter price.

Reference is made below to two applications of how this method could be implemented for transfer pricing of products, including cases where the product is subject to manufacturing activities (valueadded costs) before it is resold.

The method is based on the participation of transferred goods in the product that is resold (which is 100 per cent in a simple resale). Then the parameter price will be the resale price participation less a profit margin, fixed by law. Therefore, this methodology is also feasible to apply when other inputs (bought from independent companies) are combined with the inputs traded between associated enterprises and the final goods, manufactured from these different sources of inputs, are resold by a Brazilian enterprise.

If the product traded between related parties is not subject to any manufacturing modifications the formula adopted will be the same and the participation ratio will be 100 per cent, since the price of Product A1 will be equal to the resale cost of Product A’:
Figure 1.1
Resale Price Method (RPM) (without manufacturing)

screenshot gambar

ppropriate price? Price is given

In this case the calculation is simple as the parameter price (deemed arm´s length price) is the resale price of the same product (charged between independent parties) reduced by: unconditional discounts granted; taxes and contributions on sales; commissions and brokerage fees paid; and a fixed profit margin of, for example, 20 per cent (according to current Brazilian law as at September 2016).
TP (parameter price) = NRP— GPM x NRP, Where:
►    TP (parameter price) = transfer price determined by Brazilian law. The maximum price on imports or the minimum price on exports;
►    NRP = net resale price;
►    GPM = gross profit margin = the value of gross profit margin ratio, as determined by law or tax regulations (20% in this simplified example); and
►    TP (parameter price) = NRP—GPM x NRP = NRP—20% x NRP
= 80% NRP.

Hence:
►    (Net) Resale price    $ 10 000
►    – Resale price margin (20%)    $ 2 000
►    = A1 Transfer price under Brazilian law =    $ 8 000

In this methodology the transfer price would be calculated having regard to the proportional participation of the goods negotiated between associated parties (Product A + input) in the goods resold to an independent enterprise (Product B). This methodology reduces the weakness of using the RPM when the reseller adds substantial costs to the product traded between associated parties. The resale price to be considered shall be that price agreed upon by the reselling company with an independent enterprise. More details are given below.

In this more elaborate approach the parameter price (deemed to be the arm´s length price) would be the difference between the participation value of the sale price of goods (Product A) in the net resale price (Product B) less its “gross profit margin” participation. For this purpose, the participation value of Product A in the net resale price (Product B) would be: the application of the participation ratio of the input (Product A) to the total cost of Product B multiplied by the net resale price (of Product B).¹⁴⁹

The abovementioned participation ratio is determined as follows: the ratio of the price of Product A (input) to the total cost of the goods resold (Product B), calculated according to the company’s cost spreadsheet. The net resale price is the weighted average price of sales of the goods resold (Product B), less unconditional discounts granted, indirect taxes on sales, and commissions and brokerage fees paid. “Unconditional discounts” are those that do not depend on future events and that are detailed in the invoice.

The gross profit of Product A (in the resale of Product B) is the application of, for example, a 30 per cent (gross profit margin) on the participation value referred to above. As mentioned before, in this approach the gross profit margin will be provided by law. See Figure 1.1. The 30 per cent margin may vary depending on the economic sector of the activity performed by Associated Enterprise 2.

Figure 1.2
Resale Price Method (RPM) (with manufacturing)

Appropriate price? Price is given

(Where Product A is an input for Product B)

In order to avoid distortions between companies operating within Brazil it is necessary to ensure accounting uniformity between taxpayers in the country. If certain expenses are characterized as operating expenses by some companies and costs of goods sold by others the system will not be satisfactorily implemented.
The general formula for the intercompany transfer price would be (for a 30 per cent margin):
TP (parameter price) = PV— GPMV, Where:
►    TP (parameter price) = deemed arm´s length transfer price determined under Brazilian law. The maximum price on imports or the minimum price on exports;
►    PV = participation value of the goods transferred to the associated enterprise in the net resale price = (price of Product A ÷ total cost of Product B) x (net resale price of Product B);
►    GPM = gross profit margin = the value of gross profit margin ratio, as determined by law or tax regulations (30% in
this example);
►    GPMV = GPM x PV = GPM x (price of Product A ÷ total cost of Product B) x (net resale price of Product B) = 30% (price
of Product A ÷ total cost of Product B) x (net resale price of Product B); and
►    TP (parameter price) = PV—GPMV = ((price of Product A ÷ total cost of Product B) x (net resale price Product B))–30% x ((price of Product A ÷ total cost of Product B) x (net resale price Product B)) = PV (1—GPM).

Brazilian transfer pricing legislation establishes different margins for specific economic sectors regarding the RPM for imports as follows (including simple resale operations and manufacturing operations):
1.    40 per cent, for the following sectors:
■    Pharmaceutical chemicals and pharmaceuticals;
■    Tobacco products;
■    Equipment and optical instruments, photographic and cinematographic;
■    Machinery, apparatus and equipment for use in dental, medical and hospital;
■    Petroleum, and natural gas (mining industry); and
■    Petroleum products (derived from oil refineries and the like);
2.    30 per cent for the following sectors:
■    Chemicals (other than pharmaceutical chemicals and pharmaceuticals);
■    Glass and glass products;
■    Pulp, paper and paper products; and
■    Metallurgy;
3.    20 per cent for the remaining sectors.

In order to apply such margins, the law also states that in the event that the company engages in activities described in more than one of the categories mentioned above (13), the margin that should be adopted to apply the RPM is the margin corresponding to the activity sector in which the imported goods are intended to be used. In the event of the same imported goods being sold and applied in the production of one or more products, or if the imported goods are subjected to different manufacturing processes in Brazil, the final price parameter is the weighted average of the values found by applying the RPM, according to their respective destinations.

For exports the applicable margins in the foreign country are: 15 per cent for wholesale and 30 per cent for retail sales.

The Minister of Finance, ex officio (that is, by his or her own volition), or by request, is authorized by law to modify these margins. A request for modification presented by a taxpayer must be fully justified, and supplied with the proper documentation as established in the law.

Important note: This applies only to intangibles that are imported for resale; for other import operations with intangibles see 1.8.2.

Explanation of the methodology: Similar to the RPM with fixed margins, the CPM may be used with a predetermined gross profit markup. The basic functionality of this method is similar to the nonpredetermined margin (or traditional) CPM except that the gross margins are set out in the rules rather than based on comparables. The method focuses on the related product manufacturing or service providing company determining transfer pricing for transactions with associated enterprises. As explained above, the parameter price (deemed to be the arm´s length price) is reached by adding a predetermined cost plus markup to the cost of the product or service. This will be a maximum value on imports or a minimum value on exports.

1.3.2    Unlike the RPM, the CPM with predetermined fixed gross profit markups does not require the taxpayer to calculate the ratio of certain inputs to the final product. Thus, the gross profit markup is applied to the costs as a whole to determine the parameter price. See Figure 1.3 below.
The calculation formula is:
TP (parameter price, which is deemed to be the arm´s length price) = PC + GPM x PC = PC x (1 + GPM)
Where:

►    TP (parameter price) = transfer price determined by Brazilian law. The maximum price on imports or the minimum price on exports;
►    PC = product cost; and
►    GPM = gross profit markup, as determined by law or tax regulations (20% in this simplified example, which is the fixed gross profit markup for export operations according to Brazilian law).
This method may also be applied in cases where the product is not subject to substantial modification, that is, where Associated Enterprise 1 merely resells the product to Associated Enterprise 2. This method can also be used for services and intangibles; however, the existence of cost sharing agreements in the latter case will make it more complex to apply.

Figure 1.3
Cost Plus Method (CPM)
 

take a screenshot

Fixed Margins for the Cost Plus Method (CPM)
Brazilian transfer pricing law provides two fixed gross profit markups for the CPM, depending on whether import or export operations are being addressed. For export operations from Brazil the fixed gross profit markup is 15 per cent, and for imports it is 20 per cent (which is the required gross profit markup for the export country).

The Minister of Finance, ex officio, or by request, is authorized by law to modify these margins. A request presented by a taxpayer must be fully justified, and supplied with the proper documentation as established in the law.

The RPM and CPM methods with fixed margins are applicable both to export and import operations.¹⁵⁰ Considering the RPM with fixed margins, depicted in Figures 1.1 and 1.2 of this Chapter, it would be applicable in the country of Enterprise 1 for export operations, and in the country of Enterprise 2 for import operations, hence:

►    For exports: TP (parameter price) > PV–GPM, which means that (PV–GPM) is the minimum acceptable transfer price for the tax basis calculation; and
►    For imports: TP (parameter price) < PV–GPM, which means that (PV–GPM) is the maximum acceptable transfer price for the tax basis calculation.

Considering the CPM with fixed margins, in Figure 1.3 of this section, it would be applicable in the country of Enterprise 1 for export operations, and in the country of Enterprise 2 for import operations, hence:
►    For exports: TP (parameter price) > PC (1 + GPM), which means that PC (1 + GPM) is the minimum acceptable transfer price for tax basis calculation; and
►    For imports: TP (parameter price) < PC (1 + GPM), which means that PC (1 + GPM) is the maximum acceptable transfer price for tax basis calculation.
However, due to information accessibility the RPM is usually more suitable when the Brazilian company imports and the CPM is usually more suitable when the Brazilian company exports, as explained below.

Considering the case where the product resold is subject to valueadded costs or manufacturing by the reselling associated enterprise, the RPM is normally more useful for imports than for exports. The reason for this is that companies may not disclose their production or manufacturing costs, even to other associated companies located in Brazil. This aspect would jeopardize the method’s applicability for exports, because the necessary manufacturing cost data incurred by the associated importing enterprise would be unavailable for the associated Brazilian exporting enterprise and the Brazilian tax administration. Even if the enterprises involved have complete access to each other’s books there is still the problem of information availability to the Brazilian tax administration. In addition, the transfer pricing regulations allow the use of a comparable by applying necessary adjustments.

If the RPM is applied for import transfer pricing, the manufacturing importer uses its own accounting book costs to calculate the correct transfer price, with no need to request the cost data incurred by the exporting associated enterprise. Furthermore, in the case of imports the tax administration has full access to evaluate the uncontrolled operations (with independent enterprises). As a result, the RPM with fixed margins is recommended for import operations.

For the corresponding reasons mentioned above as regards the RPM, the CPM is more practical for exports than for imports. Companies may not disclose their production or manufacturing costs, even to other associated companies located in Brazil, which jeopardizes the method’s applicability for imports, because the necessary manufacturing cost data incurred by the associated exporting enterprise may be unavailable for the associated Brazilian importing enterprise. Even if the enterprises involved have complete access to each other’s books there is still a problem of information accessibility to the Brazilian tax administration.

If the CPM is applied for determining the export transfer price the Brazilian manufacturing exporter uses its own booked costs to calculate the correct transfer price, with no need to request any data from the nonBrazilian affiliate. Furthermore, in the case of exports, all necessary information can be accessed and verified by the Brazilian tax administration. As a result, the CPM with fixed margins is typically applied for Brazilian export operations.

The strengths of Brazil’s predetermined profit margins when using the RPM and CPM, which focus on simplicity, include:
►    Avoiding the need for specific comparables;
►    The use of the conventional RPM and CPM depends on the availability of certain data, databases or reports to empirically determine the gross profit margin and gross profit markup. In general, these elements are not easy to find;
►    Freeing scarce human resources and being able to be applied without technical knowledge of specific transfer pricing issues;
►    Stabilizing the expectations of taxpayers with respect to their Brazilian tax liability associated with intercompany transactions;
►    Providing a lowcost system for companies and the tax administration by doing away with one aspect of a transfer pricing analysis, the need to empirically determine gross margins;
►    Including a strong emphasis on practicality;
►    Not distorting competition among enterprises located where the methodology is applied, since they are subject to the same tax burden, and they are not benefitting from asymmetry of information;
►    Allowing for simple implementation by tax authorities when auditing taxpayers; and
►    Simplicity of application for taxpayers.

The weaknesses of Brazil’s predetermined profit margins when using the RPM and Cost Plus Method include:
►    The approach may lead to double taxation if there is no access to competent authorities to negotiate relief from double taxation;
►    These methods require clear classifications and accounting conformity with respect to the allocation of expenses between COGS and operating expenses; and
►    It is unavoidable that some Brazilian enterprises will be taxed at (higher or lower) profit margins not compatible with their profitability. This is because the fixed margin method applies regardless of the cost structures of taxpayers. For example, otherwise economically identical taxpayers with large COGS relative to operating costs will face higher tax burdens than taxpayers with low COGS relative to operating costs.

The law and regulations set a precise number of methods for import and export transactions that are, in fact, specific methodologies for CUP, CPM and RPM, as follows:
►    For import transactions:
       - Comparable Uncontrolled Price (CUP) (PIC and PCI used for transactions in commodities) (equivalent to CUP Method);
       - Resale Price Method (RPM) (generally 20% gross profit margin (PRL) (equivalent to RPM) + other margins for specific sectors (see above section 1.2.11); or
       - Cost Plus Method (CPM) (20% markup margin) (CPL) (equivalent to CPM).
►    For export transactions:
       - Comparable Uncontrolled Price (CUP) (PVEx and PECEX used for transactions in commodities) (equivalent to
CUP Methods);
       - Wholesale Price in the Country of Destination Less Profit Method (15% margin) (PVA) (equivalent to RPM);
       - Retail Price in the Country of Destination Less Profit Method (30% margin) (PVV) (equivalent to RPM); or
       - Cost Plus Method (CPM) (15% profit margin) (CAP) (equivalent to CPM).

In the case of the import or export of commodities subject to trading in internationally recognized mercantile and futures exchanges the method that should be used for imports is the Imports with Price under Quotation (PCI) Method, which is a simplified version of the CUP Method for imports, as defined in the law, and for exports is the Export with Price under Quotation (PECEX) Method, which is a simplified version of the CUP Method for exports, as defined in the law. This mandatory methodology for such products considers the average quotation price on the global market as the arm´s length price. The law has established that the price to be considered is the average daily price of goods or rights subject to public prices in commodities futures on internationally recognized exchange markets (quoted price). However, the law allows for adjustment of the price for the market premium at the date of the transaction, and other adjustments such as quality of goods traded and terms of payment. If there is no transaction in the organized market on a specific date the price to be taken into consideration is the last price information available in the market. If no price is available at all the taxpayer and tax authority may consider an internationally recognized database as a means of establishing a price. This approach for commodities is in line with the updated version of the OECD Transfer Pricing Guidelines after BEPS.¹⁵¹

Brazilian transfer pricing legislation does not apply to payments of royalties and technical, scientific, administrative assistance or similar activities (on imports), which remain subject to the conditions for deductibility set out in the tax legislation. In this regard the transfer pricing legislation applies, in general, only on export operations, and, in a limited way, on intangibles that are imported for resale (see Example 1.2.17 above).

Under Brazilian transfer pricing legislation there are special rules for interest (paid or credited), which are similar to the fixed margin approach if one considers the issue of predictability and clarity. Current legislation states that in the case of a controlled loan transaction (between related parties), or similar transaction, the interest rate to be applied to the transaction is:
(i)    In the case of transactions in US dollars with a prefixed rate: market rate of the sovereign bonds of the Federal Republic of Brazil issued in the foreign market in US dollars;
(ii)    In the case of transactions in Brazilian reals with a prefixed rate: market rate of the sovereign bonds of the Federal Republic of Brazil issued in the foreign market in reals; and
(iii)    In all other cases, the LIBOR rate for 6month deposits;
plus a spread as determined by a tax administrative rule issued by the Minister of Finance. If the actual interest rate of the transaction is different, it is subject to adjustment accordingly. With respect to interest expenses, the spread to be added to the interest rates as mentioned above is 3.5 per cent; with respect to interest credited (received from abroad), the spread to be added to the interest rates as mentioned above is 2.5 per cent.

The interest rate calculated in accordance with these rules is deemed to be the arm´s length rate. The rules also apply to transactions between a resident company and a resident in a noncooperative/lowtax jurisdiction as defined by the law, regardless of whether the resident abroad is a related party.

The Brazilian transfer pricing regulations establish that if the taxpayer finds a deviation of 5 per cent, or less, between the actual transfer price and parameter price calculated in accordance with the Brazilian transfer pricing legislation, the taxpayer is not requested to make any adjustment. Thus, in practice there is a range for each price. This allowance rate is only 3 per cent when the method is the CUP for commodities (the socalled 6th method, which corresponds to PCI, for imports, and PECEX, for imports, in Brazilian nomenclature).

Brazilian transfer pricing legislation also establishes a broad definition of related parties, which is intended to counter tax planning schemes (as a specific antiavoidance rule), and this also affects transactions between individuals and companies and some specific transactions (back to back transactions, interposed persons). The transfer pricing legislation also applies to all transactions with Brazilian residents and residents in lowtax jurisdictions, as defined in the law, regardless of whether the persons and companies performing the transaction are related. Brazil adopts a list of jurisdictions as prescribed by law and detailed through administrative regulations that encompass lowtax jurisdictions, noncooperative jurisdictions and also privileged tax regimes.

Countries may establish different profit margins per economic sector, line of business or even more specifically according to the kind of goods or services dealt with, to calculate the parameter price (deemed arm’s length price). The more accurately these are computed and the more margins are established, the more likely it is that the use of the margins will neither distort the system nor the decisions of the players involved.

It may not be possible to justify establishing many different margins, depending on the actual amount and types of goods and services exported and imported by a country. This is because it is possible that the country does not export or import a sufficiently large amount or many types of those goods and services and the determination of such margins, or even their applicability, could lead to some difficulties.

If a country opts for the application of different margins these may be established at different levels of specificity. In other words, such margins could be determined by the economic sector (e.g. the primary sector, i.e. the extraction or production of raw materials; secondary sectors such as manufacturing; and tertiary sectors such as services). A country may differentiate further, so that the margins could be determined by line of business at different levels of specificity according to the necessity and ability of a country to determine them. For example, the country could use a margin for the chemical industry as a whole, or different margins for different types of products of the chemical industry (agrochemical, petrochemical, explosives, cosmetics etc.). The possibilities are nearly limitless. The differentiation per industry into types of products is adopted by Brazil, where, for the RPM for imports, the margin for the chemicals sector in general is 30 per cent, while the margin for pharmaceutical chemicals and pharmaceuticals is 40 per cent. See paragraph 1.1.3. above.

Each country should determine, according to its specific circumstances, the amounts involved and types of goods and services, how specific the margins should be and whether more margins are merited. Also a country may combine different levels of margin specifications if it seems appropriate; it may set forth some general margins for a line of business in addition to more specific margins for some goods.

In order to determine such fixed margins, the tax authorities will need to do pricing research or purchase such information from existing (public) databases, in order to find appropriate prices that could be used as a comparable. Then, if it seems necessary to specify more profit margins, the tax authorities will need to determine a range of profit margins, that is, a maximum and a minimum profit margin that statistically corresponds to relevant data from uncontrolled transactions. The maximum and minimum profit margins simply represent an acceptable margin of divergence.

It is recommended that relevant taxpayers or groups that represent them verify the research, and that the margin found for each sector, line of business, product or service could be applicable to any or the vast majority of transactions in that situation. In short, this method suggests that a margin that is used for a sector, line of business or specific goods and services can be used for similar situations in the same business sector.

It is important to emphasize that what will be applied, in practical terms, are not “margins” but “ranges”. As a result, what will be identified for a specific sector is an average. Thus, some companies may understand that they will fall below the average number, while others will fall above that number. For example, it is assumed that based on market research in a specific country the average market gross profit for resale transactions in the pharmaceutical sector is 30 per cent. It may well be established that some companies have a 25 per cent margin and others a 38 per cent margin. Thus it would be advisable to have a range— in this case say 28 per cent to 35 per cent— that is regarded as acceptable. The exact calculation of the range will depend on the distribution of the margins; in any case, the fixed margin should be inside the range. The details depend on the market, and if the range is very wide, that in itself indicates the need for further specification to a line of products, or even to a specific product.

Transfer pricing remains a strategic focus area for the South African Revenue Service (SARS), forming an integral part of SARS’ compliance programme. As South Africa has gone through low economic growth in recent years and the global COVID 19 pandemic, the focus remains on identifying and challenging structures that lead to profit shifting and mispricing.

The fundamental principle underpinning South African transfer pricing legislation, since inception, has been the arm’s length principle as set out in Article 9 of both the UN Model Double Taxation Convention between Developed and Developing Countries and the OECD Model Tax Convention on Income and on Capital. This UN Practical Manual on Transfer Pricing reinforces this principle for Developing Countries and the OECD Transfer Pricing Guidelines.

​​​​​South Africa’s transfer pricing legislation is set out in Section 31 of Income Tax Act (Act No. 58 of 1962) (Income Tax Act), and came into effect on 1 July 1995. This was followed by Practice Note 7 dealing with transfer pricing (published on 6 August 1999) which serves to provide taxpayers with guidance on how SARS interprets the legislation.

In 2012, South Africa introduced the Tax Administration Act (Act No. 28 of 2011) (Tax Administration Act), which was to incorporate in a single piece of legislation certain generic tax administrative provisions, which were duplicated in different tax Acts. The Tax Administration Act is therefore applicable for compliance and administration of the transfer pricing legislation.

Important legislative amendments to both the Income Tax Act and the Tax Administration Act are highlighted in 5.4 below.

​​​​​South Africa’s Minister of Finance announced in February 2013 that the government would initiate a tax review to assess South Africa’s tax policy framework and its role in supporting the objectives of inclusive growth, employment, development and fiscal sustainability. A committee known as the “Davis Tax Committee” (DTC) was inaugurated and the Committee’s Terms of Reference were announced in July 2015.

​​​​​​The OECD/G20 BEPS Project was launched in September 2013 with South Africa participating as an equal partner. As a result, the DTC set up a BEPS Sub-Committee to address its concerns around base erosion and profit shifting and to formulate the DTC’s position in this regard. The DTC consulted with various stakeholders from business representatives, trade unions, civil society organizations, tax practitioners, SARS, National Treasury, the South African Reserve Bank, members of international bodies and academics, in releasing its “BEPS First Interim Report” for public comment by 31 March 2015. The final report was released in July 2016.

After review and evaluation, SARS has implemented certain of the DTC’s recommendations relating to documentation, tax returns and building capacity in the transfer pricing division.

South Africa is not a member of the OECD but has the status of being a participant in the Committee on Fiscal Affairs and as an associate to the Base Erosion Profit Shifting (BEPS) project for the G20 in 2013. South Africa is thus an associate to the Inclusive Framework on BEPS from 2016. However, as part of the OECD/G20 BEPS Project, South Africa was an associate on equal footing alongside OECD member countries. The BEPS Project raised areas of improvement for South Africa, especially in relation to asymmetry of information, resulting in legislative and administrative changes.

The ambit of Section 31 was widened to consider any transaction, operation, scheme, agreement or understanding that was entered into between a South African resident and an offshore-connected person (including permanent establishments and controlled foreign companies) for the benefit of a South African resident.

With the overhaul of the transfer pricing legislation, taxpayers bear the onus of demonstrating that the transactions entered into are at arm’s length.

​​​​​​One of the requirements for the transfer pricing provisions to apply, is a connection between the entities. Section 1 of the Income Tax Act defines this connection as a “connected person”.

With effect from 1 January 2022, the connection requirement is further widened by the inclusion of associated enterprises, defined as an associated enterprise as contemplated in Article 9 of the Model Tax Convention on Income and on Capital of the OECD.

From 2015, the secondary adjustment provision was amended and the difference between taxable income on an arm’s length basis and taxable income on the non-arm’s length basis is deemed to be a distribution of an asset in specie in the case of a company and a donation in the case of any other type of taxpayer.

​​​​​​No treaty relief is available for dividends tax as a deemed dividend in specie for transfer pricing purposes has been specifically excluded from the definition of dividend in Section 1 of the Income Tax Act.

As the taxpayer bears the onus to demonstrate that it transacted at arm’s length, voluntary adjustments made after a tax return has been filed will also incur the secondary adjustment.

As the taxpayer bears the onus to demonstrate that it transacted at arm’s length, voluntary adjustments made after a tax return has been filed will also incur the secondary adjustment.

The financial transactions paper issued by the OECD in February 2020 furthermore guides SARS on financial transactions.

​​​​​​Section 23M of the Income Tax Act provides a limitation on the deduction of excessive interest, which is also applicable to cross border financial assistance transactions between certain connected persons.

National Treasury is currently undertaking further work on the limitation of excessive debt and has published a paper titled “Reviewing the tax treatment of excessive debt financing, interest deductions and other financing payments” for public consultation on 26 February 2020. The deadline for submission of public comments on the draft paper is 30 September 2020.

In order to eliminate the potential for double taxation described above, it was legislated that the transfer pricing provisions would not apply to certain cross-border financial assistance transactions (e.g. loans) and certain cross-border uses of intellectual property. More specifically, transfer pricing will not apply to holders (i.e. creditors) of a loan or holders of intellectual property if:

• The holder is a South African company;
• The obligor is a controlled foreign company (CFC) in relation to the South African holder and 10 per cent of the equity shares and voting rights in the obligor is directly owned by that holder (whether alone or together with any other company forming part of the same group of companies as the holder);
• The CFC has a foreign business establishment; and
• The CFC is taxed at a comparable rate (an aggregate effective rate of 67.5 per cent of the South African rate that would otherwise be imposed). For purposes of this 67.5 per cent threshold, foreign taxes on income imposed by all foreign spheres of government (national, provincial and local) must be taken into account. The calculation of the aggregate effective rate also takes into account all income tax treaties, rebates, credits or other rights of recovery. Lastly, the rate is calculated after disregarding carryover losses as well as group losses.

With regard to the provision of financial assistance and licensing of intellectual property to a controlled foreign company, the Explanatory Memorandum¹⁵⁷ explains the reason for the introduction of the provisions mentioned above: “South African companies often make interest-free loans to controlled foreign subsidiaries for non-tax reasons. These soft-loans often operate as an implicit form of share capital (i.e. lacking interest and fixed dates of repayment). The purpose of these loans is mainly to allow for the seamless withdrawal of funds for foreign company law and to alleviate certain adverse impacts of foreign exchange controls. As such, these soft loans are an important method of indirectly funding offshore start-up operations. South African companies may also provide yield-free licenses (and other forms of yield-free intellectual property) to controlled foreign subsidiaries for similar non-tax reasons. The lack of yield for these instruments unfortunately has undesirable side-effects for tax purposes. The South African holder may be subject to transfer pricing concerns, thereby being subject to tax based on a higher notional yield. On the other hand, the foreign company obligor will often be allowed a foreign deduction only for actual cross-border payments to the South African company (as opposed to a foreign deduction for the higher notional payments). The net result is a potential de facto double taxation; a result that reduces the international competitiveness of South African multinationals.”.

Furthermore, where a South African resident company (or any company that forms part of the same group of companies as the South African resident company) grants financial assistance to a foreign company in which the South African resident (whether alone or together with any other company that forms part of the same group of companies as the South African resident company) constitutes a debt owed by that foreign company to that resident company (or any company that forms part of the same group of companies as the South African resident company), the foreign company:

• is not obliged to redeem that debt in full within 30 years from the date the debt is incurred;
• the redemption of the debt in full by the foreign company is con-ditional upon the market value of the assets of the foreign com-pany not being less than its market value of the liabilities; and
• no interest accrued during the year of assessment.

Substantial improvements to increase disclosure requirements of transfer pricing and other BEPS related transactions have been made to the corporate income tax return.

Prior to 2016, South Africa did not have specific statutory transfer pricing documentation requirements. Following the BEPS project and the recommendations made by the DTC, the specific statutory documentation retention requirements set out below were introduced by public notice¹⁵⁸ in terms of Section 29 of the Tax Administration Act in 2016 for transfer pricing. The extent of the documentation to be kept is tiered according to the reasonably expected value of the transaction:

• • •  
• Records, books of account or documents in respect of the structure and business operations; and
• Records, books of account or documents to be kept in respect of the affected transactions.

Country-by-Country reporting, master file and local file requirements for large multinational enterprises were also introduced by public notice¹⁵⁹ in terms of Section 25 of the Tax Administration Act in 2016.

One of the key challenges in any transfer pricing analysis is access to information. This is a widespread problem not unique to South Africa and indeed was also acknowledged in the BEPS project. Over the years SARS had been challenged on a number of fronts regarding its information requests including, inter alia:

• • • • SARS’ right to certain categories of information. Taxpayers have argued for the non-submission of information on the basis that such information is commercially sensitive, irrelevant and out of scope, not accessible, or legally privileged;
      • taxpayers requesting numerous extensions of time within which to comply with a SARS information request to the point that the statute of limitation runs out for SARS or that it becomes almost impossible for SARS to review such information before the statute of limitations runs out; and
      • taxpayers have challenged SARS’s powers to interview persons and personnel that may have information relevant to the trans-action under audit.

To address the above information related challenges, the following legislative amendments have been effected to the Tax Administration Act:

The overarching provisions of Section 46 clarifying the information gathering powers of SARS to be that SARS can request information that is relevant or foreseeably relevant. There is no onus on SARS to explain or justify information requests. However, it was acknowledged that legal professional privilege was an exceptional situation. For this reason, Section 42A of the Tax Administration Act was introduced clarifying the requirements to be met by taxpayers failing to submit relevant information to SARS on the basis of legal professional privilege and the process to be followed to resolve the issue;

Amendment to Section 46 with respect to access to foreign based information and to ensure that, where a matter progresses to dispute resolution, taxpayers are held to any assertions that they were unable to access information located offshore. Where a taxpayer makes such an assertion, the taxpayer may, under certain circumstances, be prohibited from submitting such information at a later stage;

There is a general three-year statute of limitation for assessments by SARS to execute and conclude any audit. The statute of limitations may be further extended in terms of Section 99 of the Tax Administration Act:

• The statute of limitation may be extended by agreement between SARS and the taxpayer;
• SARS may extend the statute of limitations by prior notice by a period approximate to the delay of the taxpayer in providing relevant material within the required time period; and​​​​​​​
• This statute of limitations period can also be extended by SARS, with prior notice to the taxpayer, for a period of three years where an audit or investigation relate to transfer pricing, the application of substance over form, the general anti-avoidance rule or the taxation of hybrid entities or hybrid instruments.

There appears to be an increasing tendency for parent companies of South African subsidiaries to shift profits via a year-end adjustment to either the cost of goods imported by the South African subsidiary or directly to the operating margin, to bring the South African subsidiary in line with “comparable companies”. What occurs is usually a global policy change by the parent company aimed at limiting the return of its subsidiaries (including those based in South Africa) to a guaranteed return (determined by way of a comparable search). The change in policy is often followed by an introduction of year-end transfer pricing adjustments to ensure that South African entities achieve the often low targeted net margin while the residual profit is returned to the parent or holding company.

​​​​​​There is little or no regard for the drivers of higher profits attained in South Africa when comparing them to comparable companies in foreign markets (given there are no local comparables for South Africa) or consideration for the actual functional and risk profile of the South African subsidiary. South African subsidiaries of multinational companies are frequently classified as limited risk distributors or limited risk manufacturers when in actual fact they assume much more than just limited risk.

Further, there are many instances where unique dynamics exist within the South African market that enable South African subsidiaries to realize higher profits than their connected party counterparts in other parts of the world or than is evidenced by comparable data obtained from foreign databases. The increased participation and spending power of the middle class segment in the economy also offers a new market opportunity for certain industries.

Further, there are many instances where unique dynamics exist within the South African market that enable South African subsidiaries to realize higher profits than their connected party counterparts in other parts of the world or than is evidenced by comparable data obtained from foreign databases. The increased participation and spending power of the middle class segment in the economy also offers a new market opportunity for certain industries.

The main challenge that South Africa has in determining arm’s length profits has been the lack of domestic comparables. It is thus accepted that the most reliable comparables will suffice. The problem in South Africa is that this compromise is exacerbated even further given that databases contain extremely limited South African specific, or for that matter, Africa specific, comparable data. As a result, both the tax administration and taxpayers often rely on European databases to establish arm’s length levels of profitability.

​​​​​​Instituting comparability adjustments to account for geographical differences (for example, market, economic and political differences) in order to improve the degree of reliability of the comparable data, is often extremely complex and can in some instances have the reverse effect, i.e. where the comparable data is no longer comparable.

In practice, SARS has attempted to make comparability adjustments, for example, country risk adjustments based on publicly available country risk ratings and government bond rates (sometimes referred to as the risk free rate). However, these have been applied with caution and in specific circumstances.

Whilst South Africa may be worse off than some countries in having extremely limited domestic comparable data, many other countries are likely to be in a similar position. As multinationals become more and more complex in their business models, and as more widespread industry consolidation is achieved, finding comparable data and achieving reliability may not be South Africa’s problem alone. It is perhaps already true that for certain types of large scale manufacturing and distribution activities, for example in the automotive industry there is no independent comparable data available anywhere.

​​​​​​It is for this reason, amongst others, that SARS favours a more holistic approach to establishing whether or not the arm’s length principle has been complied with. By seeking to understand the business model of taxpayers across the whole value chain, gaining an in-depth understanding of the commercial sensibilities and rationalities governing intragroup transactions and agreements, it is evident that SARS does not look to comparable data alone or in isolation from other relevant economic factors in deter-mining whether or not the appropriate or arm’s length level of profit has been achieved.

​​​​​​As intangibles are often “unique” in nature they raise unique transfer pricing challenges for both multinationals and tax administrations. Disputes that arise in South Africa relate to the existence of local marketing intangibles, issues of economic versus legal ownership and the valuation of intangibles. The revised guidance in Chapter 6 of the OECD Transfer Pricing Guidelines as a result of the BEPS Project was welcome and provides helpful guidance for developing countries.

In the South African experience, the sale of South African developed intangibles presents a somewhat exceptional situation compared to the rest of the world, as exchange control regulations prohibit the export of South Africa developed intangibles, in the absence of approval by the Financial Surveillance Department of the South African Reserve Bank. Once the worldwide (excluding South Africa) intangible property is sold to an offshore connected party, usually in a low tax jurisdiction, the connected party becomes the legal owner of the intangible property for the rest of the world, excluding South Africa. This connected party then licences out the intangible property worldwide (excluding South Africa) earning royalties. In addition, terms and conditions of the original sale may dictate that the South African entity will continue to perform certain functions toward the enhancement and further development of the intangible property for which it earns a cost plus return. The connected party, that is now the legal owner, in essence merely carries out activities relating to registration and maintenance of the intangible property and earns an intangible connected return (in the form of royalties). Furthermore, if such intangible property were ever sold outside of the group, the South African entity would have no participation in any profits that may be realized.

South Africa has enacted anti-avoidance provisions to limit BEPS in relation to IP payments. This is in the form of Section 23I of the Income Tax Act that denies a general deduction in respect of fees paid for the use of IP where the IP was originally developed in SA and subsequently migrated to a foreign jurisdiction for licensing back to SA.

​​​​​​As a result of an increase in globalization, in order to achieve economies of scale and optimize efficiencies, it is becoming commonplace for multinationals to centralize the provision of certain services in a single entity, generally in a tax advantaged jurisdiction.

South Africa has consistently stated that it will not be applying the simplified approach to low value-adding services, as outlined in the final BEPS report.

In essence, Chapter 7 of the OECD Transfer Pricing Guidelines set out the approach that in establishing the arm’s length nature of intragroup services, the test is twofold. Firstly, it must be determined if a service has been rendered and secondly it must be determined if the charge for such service is arm’s length (paragraph 7.5 of the OECD Transfer Pricing Guidelines). As relates to the first part of the test, the approach followed is to determine if the services:

• provide the recipient with economic and commercial benefit (now called the “Benefits Test” in the revision to Chapter 7);
• are not services that the recipient is already performing for itself (duplicate service test); and
• are not shareholder services.

As regards the second part of the test, the audit approach seeks to confirm the following:

• that the cost base is appropriate to the services provided;
• that the mark-up is arm’s length; and
• that the allocation keys applied are commensurate to the services provided.

​​​​​​​In particular, paragraph 7.29 of the OECD Transfer Pricing Guidelines states that in determining the arm’s length price for intragroup services, the matter should be considered from the perspective of the service provider and the recipient. Relevant considerations include the value of the service to the recipient as well as the costs to the service provider.

SARS is currently taking a pragmatic but firm approach to evaluating payments for intragroup services and where clear commercial justification or reasonableness for those payments is lacking, the payments are disallowed.

Once an assessment has been raised, the taxpayer may lodge an objection against such assessment.

​​​​​Currently the Alternative Dispute Resolution (“ADR”) mechanism allows for resolving a dispute other than through litigation. The ADR process is governed by the rules promulgated under Section 103 of the Tax Administration Act.

SARS and the taxpayer can initiate the ADR mechanism once the taxpayer has lodged an Appeal against the disallowance of an objection against an assessment. SARS, however makes the final decision as to whether a matter is suitable for ADR.

A facilitator, who will endeavour to resolve the dispute, facilitates the ADR meeting between the taxpayer and SARS. The taxpayer and SARS may agree in certain instances not to use a facilitator, in which case the taxpayer and SARS will endeavour to resolve the dispute.

If a matter is not resolved during ADR, the litigation route may be followed.

The majority of South Africa’s Double Taxation Agreements (“DTA”) contain an Article dealing with the exchange of information.

In addition, South Africa has entered into the following categories of Exchange of Information Conventions/Agreements:¹⁶⁰

• • • • USA FATCA Intergovernmental Agreement—The USA FATCA Intergovernmental Agreement is an agreement between the governments (tax administrations) of the United States of America and the Republic of South Africa to exchange information automatically under the provisions of the double taxation agreement between these countries. The Standard for Automatic Exchange of Financial

Account Information (the Standard or the CRS) is a standardized automatic exchange model, which builds on the FATCA IGA to maximize efficiency and minimize costs, except that the ambit is now extended to all foreign held accounts and not only those of US citizens. South Africa is also one of the early adopters of the CRS;

• • • • Multilateral Mutual Administrative Assistance (“MAA”) Conventions / Agreements—agreements between the governments (tax administrations) of two or more jurisdictions to enable them to exchange tax information on request, spontaneously or automatically, as well as to provide assistance in the collection of taxes;
      • Bilateral Tax Information Exchange Agreements (“TIEAs”)—agreements between the governments (tax administrations) of two jurisdictions to enable them to exchange tax information upon request;
      • Double Taxation Agreements (“DTA”)—agreements between two tax administrations to two countries to enable the administrations to eliminate double taxation;
      • Bilateral Common Reporting Standard Competent Authority Agreements (“CRS CAAs”) / MoUs—bilateral agreements between the Competent Authorities of two jurisdictions to enable them to exchange information under the CRS; and
      • Bilateral Country-by-Country Competent Authority Agreements (CbC CAAs) / MoUs—bilateral agreements between the Competent Authorities of two jurisdictions to enable them to exchange CbC reports.

Different positions taken by two or more administrations, on what constitutes arm’s length conditions for a transaction between associated enterprises, can lead to economic double taxation. Article 25 OECD Model Tax Convention enables competent authorities to consult with each other with the view to resolve taxation not in accordance with the Convention. This also applies in the context of transfer pricing problems relating to economic double taxation. South Africa provides access to MAP in trans-fer pricing cases in particular. DTA provisions such as Article 9(2) of the OECD Model Tax Convention or, in the absence of Article 9(2) of the OECD Model Tax Convention, provisions of domestic law enable contracting juris-dictions to provide for a corresponding adjustment with the aim of avoiding double taxation.

A MAP case is a transfer pricing MAP case where the taxpayer’s MAP request relates to:

• the attribution of profits to a permanent establishment (Article 7 of the OECD Model Tax Convention)¹⁶², including the determination of whether a permanent establishment exist in a contracting jurisdiction (Article 5 of the OECD Model Tax Convention); or
• the determination of profits between associated enterprises (paragraph 1 of Article 9 of the Model Tax Convention) and the corresponding adjustments to be made in pursuance of paragraph 2 Article 9 of the OECD Model Tax Convention and assessing whether they are well founded and for determining the amount.

Under normal circumstances, secondary adjustments (discussed at paragraphs 4.6 to 4.8 above) are reversed if the primary adjustment is reversed or, if the taxpayer repatriates funds from the non-resident equivalent to the amount of the transfer pricing adjustment. In these two instances, relief from the secondary adjustment should be a consequence of the MAP settlement.

A transfer pricing MAP case does not include a request for an APA.

In determining if taxation of relevant transactions satisfies the arm’s length principle, and thus result in taxation in accordance with the provisions of a DTA, South Africa is guided by the OECD Transfer Pricing Guidelines and this UN Practical Manual on Transfer Pricing for Developing Countries.

A person can pursue the MAP and domestic legal remedies (See 5.9 on Dispute Resolution above) simultaneously. SARS may concurrently consider a case presented to the competent authority for MAP and the objection lodged by the taxpayer under domestic tax provisions against the assessment. Depending on the circumstances, the competent authorities may defer the MAP until a decision has been reached on the objection or if a taxpayer has requested a settlement.

MAP does not automatically suspend the payment of taxes. Therefore, it is advisable that taxpayers lodge an objection or appeal concurrently with the MAP process.

​​​​​​South Africa has not committed to MAP arbitration under BEPS Action 14 and the majority of South Africa’s DTAs do not contain this provision. A MAP arbitration provision is included in the DTAs with Canada (1997), Netherlands (2008) and Switzerland (2009).

South Africa currently does not have an APA programme due to the scarcity of resources. However, The South African Revenue Service Strategic Plan 2020/21–2024/25 states as its “Strategic objective 1: Provide clarity and certainty for taxpayers and traders of their obligations” that “… Taxpayers and traders proactively receive clarity guidance, and where required, have easily accessible additional customized support. Certain segments of taxpayers and traders may also access leverage products such as advance pricing agreements, advance rulings (inclusive of VAT rulings and Binding General Rulings) and cooperative compliance programmes.”

Owing to the rapid evolution in the international tax landscape and the change in the mode of doing business by South African multinationals, South Africa continues to explore new ways of protecting its tax base through participation in international fora (such as the OECD, ATAF and the UN).

​​​​​​Transfer pricing refers to the setting of prices for transactions occurring between associated entities. It is a common practice with globalization and growth in international trade. Transfer pricing manipulation increases the risk of capital flight and shifting of profits by multinational enterprises. Kenya has put up measures to protect her tax base from transfer pricing risks posed by cross-border transactions between related entities, through enactment and enhancement of tax legislation and administration.

Section 18(3) of Income Tax Act, Chapter 470, Laws of Kenya, is the basic legislation governing transfer pricing in Kenya. The Section requires that the business income from dealings between a resident person or a permanent establishment with a related non-resident person, be determined as if the parties are independent persons dealing at arm’s length. The Income Tax (Transfer Pricing) Rules, 2006, provide guidelines to be applied by related enterprises in determining the arm’s length prices of goods and service in transactions involving them. The Income Tax (Transfer Pricing Rules) 2006 heavily borrows from the OECD Transfer Pricing Guidelines.

​​​​​​Kenya’s transfer pricing legislation has been enhanced over the years. Section 18(3) of the Income Tax Act has been in the Act since its enactment in 1973, but remained largely untested for several years until the hallmark transfer pricing case of Unilever (Kenya) Limited that was ruled in 2005. The audit conducted on Unilever (Kenya) Limited in 1998, revealed that Unilever (Kenya) charged lower prices to Unilever (Uganda) than those charged both to customers in Kenya and to unrelated parties in the export market both in Uganda and elsewhere. This led to a dispute that went to the courts of law. The case was ruled in favour of Unilever, based on two main reasons: that there were no regulations to guide the application of Section 18(3) at the time; and Section 18(3) was itself unclear, placing the burden of proof on the Commissioner and not on the taxpayer. Following the judgment in the case of Unilever Kenya Ltd v Commissioner of Domestic Taxes in 2005,¹⁶³ Kenya issued the Income Tax (Transfer Pricing Rules) 2006.

There have been subsequent legislation amendments on section 18(3) and other related sections:

• In 2010, the section was amended to get rid of the statement that required the Commissioner to prove that the transactions were arranged in such a way to reduce taxable profit;
• To minimize tax leakage through transfer pricing, section 18(6) was also amended in 2010 to include transactions between individuals who are related by consanguinity or affinity;
• Through Legal Notice No. 54 of 2012, the Commissioner may issue guidelines on application of the transfer pricing methods set out in the Transfer Pricing Rules;
• The Finance Act 2014 expanded the scope to include the dealings between a non-resident and its permanent establishment (PE); and
• The Finance Act 2017, introduced section 18A, that brought transactions with taxpayers in preferential regimes within the scope of Transfer pricing (in line with BEPS action 5 on Harmful Tax practices).

​​​​​​These amendments have eased the practical application of the transfer pricing legislation in Kenya. The transfer pricing legislation is now widely applied by both Kenya Revenue Authority (KRA) and the taxpayers in the determination of arm’s length price. Several transfer pricing audits have since been conducted and disputes resolved, raising substantial revenues. Many companies with related party cross-border transactions have now registered their transfer pricing policies with the Commissioner.

​​​​​​Kenya has embraced internationally recognized guidelines namely UN and OECD Transfer Pricing Guidelines and the OECD Base Erosion and Profit Shifting (BEPS) project outcomes.

Kenya has embraced the BEPS outcomes and has gone ahead to imple-ment some of the recommendations contained in the BEPS reports. Kenya is in the process of reviewing the Income Tax Act and KRA has proposed several amendments to be included in the revised Act to address BEPS issues. Some of the developments include:

1. Transactions with Companies in Low Tax Jurisdictions

The widening the definition of related parties within the mean-ing of international transactions to include companies in low tax jurisdictions, or tax havens to give lee way to transfer pric-ing review of transactions entered into with a company in a tax heaven even in situations where no relationship between the two companies is seen.

2. Preferential Tax Regimes

Kenya has expanded the scope of transfer pricing legislation to include transactions with related resident entities operating in preferential tax regimes, in line with BEPS action 5 on Harmful Tax practices.

3. Transfer Pricing Documentation

Kenya is in the process of enacting rules regarding transfer pricing documentation to enhance transparency. It has already developed a tax return that is meant to ensure that all the required information is disclosed. This is proposed to cover:

3. • CbC reporting;
   • Disclosure of beneficial ownership;
   • Domestic operations disclosures; and
   • Imposition of penalties on failure to maintain and or avail transfer pricing documentation.
4. Widening the Scope of Permanent Establishment (PE)

Kenya is in the process of widening the scope of PEs to include activities that were omitted previously, for instance dependent agents, commissionaire agents among others. This is in line with BEPS Action 6.

5. Pricing of Commodities

Proposal to have an additional method for benchmarking com-modities using data from international or domestic commodi-ties markets. This is in addition to the conventional methods.

6. Enhancement of Dispute Resolution Under Mutual Agreement Procedure (MAP)

Kenya is open to resolving tax disputes with countries which it has tax treaties with in line with BEPS Action 14.

7. Development of a Multilateral Instrument

Kenya is already in the process of reviewing existing Double Tax Treaties (DTAs), identifying gaps within the DTAs to propose measures to address the gaps identified in the DTAs, In line with the outcome of BEPS Action 15.

Other enhancements in tax legislation and administration to protect against base erosion and profit shifting from cross-border transactions include:

1. Mutual Administrative Assistance in Tax Matters (MAC)

Kenya has ratified the Mutual Administrative Assistance in Tax Matters (MAC) agreement which is to be deposited with the OECD, promoting the ability to exchange tax information with other jurisdictions globally; upon request and later to

enter into process of exchange of information automatically and spontaneously.

2. Management of Treaties

Kenya is in the process of preparing a treaty policy and a treaty negotiation strategy which is meant to secure and safeguard taxing rights.

3. Proposal to Anchor Advance Pricing Arrangements (APA) in the Legislation

Kenya has a framework for APA and has also made proposals to have APA anchored in law.

4. Kenya has already joined the Global Forum on Exchange of Information and Transparency.

​​​​​The Unilever (Kenya) Limited case was among the first transfer pricing audit cases conducted by KRA. Kenya Revenue Authority’s (KRA) instituted the transfer pricing audit unit in 2009. This unit specialized in transfer pricing audits and has grown to what is now the International Tax Office (ITO) with trained and dedicated staff, from less than 10 officers to the current level of about 40 officers. The unit has ensured adequate training of its staff through in-house training and collaboration with international organizations like the World Bank Group funded training programmes, among others.

​​​​​​KRA has committed resources to support transfer pricing audits through procurement of transfer pricing database for benchmarking studies and providing office equipment and facilities.

KRA has been engaged in many international platforms on transfer pricing and international tax matters, including active participation in regional bodies like the Africa Tax Administrators Forum (ATAF) and the East Africa Revenue Authorities Technical Committee (EARTC); participation in international transfer pricing seminars; having her staff take part in supporting transfer pricing audits in other countries under the OECD’s Tax Inspectors Without Borders initiative; and having membership and participating in the OECD Working Parties under the OECD BEPS Inclusive Framework. Kenya has membership to OECD working parties such as:

• Action 1 Address the tax challenges of the digital economy;
• Action 5 Counter harmful tax practices more effectively, taking into account transparency and substance; and
• Actions 8, 9, 10 Assure that transfer pricing outcomes are in line with value creation.

​​​​​​Kenya has enhanced its tax legislation and worked towards aligning it with international practices to safeguard its revenue by sealing avenues that have caused revenue leakages. KRA’s ITO is dedicated to keeping pace with the changing landscape in the taxation of cross border transactions.