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Managing Partner, Attorney-at-Law, Head of Tax and Customs Practice, Legal Group EUCON
Partner, Auditor, Head of Transfer Pricing Practice, Legal Group EUCON
Transfer Pricing Rules in Ukraine
Transfer pricing rules were implemented in Ukraine in 2013. Since then, many taxpayers have come a long way from trying to avoid recognizing transactions as controlled ones at all costs to regular and timely reporting and preparation of documents.
Moreover, the reality is that executive staff, having studied economic and comparative analysis, have found yet another mechanism for obtaining a true picture of margin distribution across all business transactions that’s useful. While earlier nothing but tax optimization was the main priority for many companies, currently the focus is on building an effective corporate structure in view of a fair assessment of the performance of separate companies of a group. The analysis carried out during preparation of documents provides management with an opportunity to assess the results of division of activities, profitability of goods, products, services broken down by individual customers, market value of attracting/placing financial resources, to compare these with industry results as a whole.
We recommend that you pay attention to certain practical aspects.
1. It is important to keep to the analysis strategy and the chosen pricing method consistently.
Taxpayers have of late often been requested to submit documents for 2-3 or even more reporting periods. By studying the logic of economic analysis over a period of time, regulatory authorities take notice not only of the reasoning in relation to the pricing method choice, but also of the consistency of approaches to such a choice. This is especially true over the years with sharp movements in the exchange rate and falls within the period under review. For importing companies, especially those that had certain deferred payments with their suppliers, the increase in the exchange rate led to foreign exchange loss, which, as a part of other operating expenses, adversely affected the overall financial result from operating activities. Having significant losses over several reporting periods, many taxpayers (their consultants) used methods based on the calculation of a financial indicator, which in its turn is calculated at the level of gross profit margin, to substantiate compliance of controlled transactions with the ’arm’s length’ principle. These methods were applied even for comparison with the operating results of other legal entities. For importers, this is, for example, the resale price method and the gross margin index. Following stabilization of the exchange rate and the impact of exchange differences, there was a transition to the net income method for economic analysis. The change in pricing method is monitored by the regulatory authority when analyzing documentation that covers several years and is the grounds for requests for additional substantiation or even disagreement with the resale price method and appointment of inspection of controlled transactions.
2. It is necessary to proceed with due care in relation to determination of the “net sales income (revenue) volume” criterion when generating a sample from the database.
When generating a sample of legal entities performing comparable activities, it is possible to set a number of criteria in the database, including the revenue amount criterion. Sometimes, the turnover of a company, whose activity is subject to analysis, comes to billions of hryvnias and comparison results of its activities with those of enterprises, whose turnover is at the level of UAH 5-10 million, does not seem to be reasoned. However, the current legislation does not regulate approaches to establishing such comparability criterion and the decision on its application is made on the basis of the opinion of the expert conducting the analysis. In such a situation it is worth remembering that you may set a revenue amount criterion. For example, above UAH 100 million, to select comparable persons, to calculate profitability ranges and to conduct comparison, during the inspection, but the regulatory authority may generate a completely different sample like, for example, above UAH 5 million. Thus, the profitability range for another (extended) sample of companies may be significantly different and the profitability of the company subject to analysis may not fit into it. Therefore, so as to avoid risks, we recommend that you carefully approach the sample criteria and analyze the relevant sample and its results to the maximum extent.
3. Companies that carry out controlled transactions should be aware that the financial results of each controlled transaction are subject to analysis, including the same broken down by contractors. Such analysis may promote proper accounting and software status, provide the possibility to obtain the necessary analytics and to segment the accounting data.
In practice, it is often enough to segment the accounting data and to conduct manual calculations, since the accounting program does not permit obtaining information about the prime cost of a certain volume of goods sold (for example, under any nomenclature) in automatic mode. We often see that the prime cost of services is not accounted at all for those services that are not the main type of activity. Is it accounted, for example, using the concentration method, which does not allow the generation of the prime cost of services under a separate order or a contract.
For financial reporting segmentation procedures, the role of accounting policies, which should regulate approaches to the distribution of overhead and administrative costs, is increasing.
4. The need and importance of a comprehensive and thorough analysis of the economic activity of each enterprise as a whole. When analyzing the conditions for comparability of transactions or activities of legal entities, it is necessary to consider the possible significant impact of business strategies.
We have repeatedly studied a portfolio approach strategy to assessing the overall financial performance that may be inherent. For example, the business activities of companies operating in the engineering field which sell equipment and perform further equipment maintenance, and sell tools and supplies. Such a strategy implies that some goods may be sold by a taxpayer on terms of low rate of return or even at a loss because they create demand for other goods and/or related services of the taxpayer, which are then sold with a higher rate of return (for example, equipment and the related market of services, materials, spare parts). At the same time, all business transactions are closely interconnected and have a single economic logic.
Initial transactions related to the sale of manufacturing equipment, machines are generally not very profitable, since the prices for such equipment are high enough and each buyer makes a purchasing decision very prudently and carefully, analyzing the offers of competing sellers in the market in detail. At the same time, the company-supplier when selling agrees to minimum or even zero mark-up, since it plans to cooperate with the client for a long time in future in terms of the supply of tools, service and maintenance, which are more cost-effective and are the basis for underlying profit. Thus, if these transactions related to core product supply are controlled and have low profitability, it is necessary to prove their compliance with the principle of ’arm’s length’ only in view of the strategy influence. Therefore, to analyze the efficiency/profitability of this type of business activity, we consider it necessary to apply a portfolio approach, combining interconnected transactions with goods and services across the aggregate without segmentation broken down by the supplier. At the same time, the fact is also taken into account that during the comparison with the operating results of legal entities engaged in comparative activities, their total (combined) financial result included in the financial statements will be analyzed. Unfortunately, since 2017 the Tax Code of Ukraine contains a contradictory provision, under which a taxpayer has the right to apply the grouping principle only in terms of the aggregate of several controlled transactions with one person, which does not allow consideration of activity strategy. Therefore, the issue of detailed substantiation of the analysis procedures in view of activity strategies is of special importance in this case, since there are risks of disputes emerging with regulatory bodies.
5. Taxpayers’ own uncontrolled transactions may be considered as comparable ones for conducting economic analysis. Such transactions provide the widest possible opportunity to study financial and business terms, make adjustments to achieve comparability and are recorded in accounting within the same accounting policies as the controlled ones. If there are such transactions available, it is quite possible to do analysis without samples from the database and using the net analysis profit method.
In our opinion, this source of information is undervalued by Ukrainian companies, a fact which in many cases entails certain risks. The absolute comparability of the characteristics of the goods, which is necessary for the application of the comparative uncontrolled price method, is entirely optional. Resale pricing or “cost plus” methods may also be used if a taxpayer imports goods for their resale from other unrelated non-resident contractors or sells goods, works, services to other buyers on a comparable basis in uncontrolled transactions. Such monitoring of transactions is very important as these can be identified by the regulatory authority and, if a comparison study is conducted, may first be subject to additional accrual of tax liabilities during the audit. Comprehensive analysis of the taxpayer’s business activities is required to identify and monitor such in-house comparative transactions. This is the first thing we always get familiar with when we study a client’s activities.
There are many general conclusions that can be drawn from our work, but the main recommendation is probably this: to comply with the requirements for timely declaration of controlled transactions, because currently the fines are extremely high (UAH 630,600 for failing to submit a report for 2020). Monitoring of risks, legislative changes, clarifications, and gathering information for qualitative substantiation of controlled transactions terms should be conducted on a regular basis throughout the year. Quality documentation means quality protection and a way to avoid inspections. After all, all inspections in the field of transfer pricing were initiated after the regulatory authority recognized the reasons in the documentation as being poor or insufficient ones.