. Distinction between trading in and trading with a country
When an individual, or a business, is trading there are two possibilities: Either the trade is carried out within their own country:
i.e. both supplier and customer are in the same country – “domestic” trade
Or the trade is carried out with another country:
i.e. the supplier is in one country, and the customer is in another – “international” trade.
When the goods or services are supplied to a customer in another country, the supplier exports to that country. When goods or services are bought from a supplier in another country, the customer imports from that country.
Both goods and services can be exported and imported. Goods are self-evident – food, minerals, raw materials etc. Examples of the export of services are a designer in country A producing designs for a customer in country B, or an accountant in one country advising a client in another.
Every trading transaction gives rise to tax issues, but the tax issues will differ depending on whether the trade is domestic or international.
A key feature of international trade is import taxes. This is where a country decides to impose import taxes (also known as custom duties) on various products on arrival into a country. The duties will vary depending on the actual product. So, for example, a country which has a vibrant steel business may impose relatively high import duties on steel in order to protect the domestic steel industry from cheap imports.
The duties will also depend on the origin of the imports. Thus imports from Country A may carry higher import duties than those from Country B.
In Appendix I is an extract from the East African Community legislation –
The East African Community Customs Management Act, 2004 incorporating all amendments up to 8th December, 2008
An additional feature of international trade is the emergence of trading blocs of countries such as the EAC.
These typically involve groups of countries coming together and agreeing to cooperate closely on trade. The degree of cooperation can vary, and the countries involved are usually ones that have close links with each other for geographic, historical or cultural reasons.
A good example of a bloc with geographic links is the East African Community (EAC) Common Market. Another good example is the European Union (formerly the European Common Market) – which was formed for historical and geographic reasons.
Generally speaking such blocs evolve over time. They can start with an agreement to simplify trade administration between two or more countries and to reduce tariffs, customs duties etc on goods and services traded between the countries.
The ultimate aim of such partnerships is to abolish commercial borders between member states, thus pushing the commercial borders to the periphery of a trading bloc. Thus, goods imported into country A of a trading bloc are deemed to be imported into all the countries.
So, in the case of the EU, when goods are imported into Belgium, they are also deemed to be imported into France. This means if the goods are subsequently sold from Belgium into France, they are not classified as either a Belgian export or a French import. Neither are there any tariffs, duties etc. payable. Such a transaction is in essence a trading bloc domestic transaction, and is known formally as “intra-community trade”.
Double Taxation Agreements
International Taxation involves taxation which is cross border. It can arise from an individual having taxable income or assets in two countries, or a business operating in two (or more) countries. Due to increased globalisation, the growing level of businesses trading internationally around the globe, and increased personal mobility, international taxation is becoming more and more prevalent. Travel restrictions are less onerous, and it is no longer difficult for people to move from one state to another to carry out businesses or to seek employment opportunities. Capital is more mobile and with advances in e commerce and e banking it moves more swiftly than ever before. Such activities are all likely to attract tax liabilities.
To take a simple example. Joe is a citizen of and lives in Country A. He has a home there, and lives there with his wife and family. Thus, in the normal scheme of things, Joe would be taxed on his income in Country A, in common with all other residents and citizens who live there, and who use the roads, sanitation systems and other public services there.
However Joe is slightly unusual. Every Tuesday morning Joe flies to Country B, works there until Thursday afternoon and then flies home again. He gets paid in Country B.
The dilemma however, is – in what country does the tax liability fall, and how is that decided? And a further issue that may arise is that if an individual or a business is taxed in
Country A and in Country B, then that person or entity has effectively been taxed twice on the same income or transaction. If such a situation were to prevail, it could materially inhibit the development of international trade.
So, for example, Country A will argue that Joe is a citizen and a resident, he lives with his wife and family there, and every citizen is expected to make their contribution to the various public services they enjoy. Thus, they will argue, Joe should be taxed on his income in Country A, according to the rules that prevail there.
But Country B will argue that Joe should pay his income tax in their country, because the income originated there, and their rules state that anyone earning an income in their country should be taxed there.
The dilemma for Joe is that he could end up being taxed in both countries on the same income – which is a bit unfair on Joe. The dilemma for both Countries is that they could end up not taxing Joe in either country. And if it is to be only one – which one, and how is that decided?
So a system of double taxation agreements has evolved to deal with this type of situation. The taxpayer does not have to be an individual – it could be a company, or a business operating in both countries.
There are two principal scenarios to be considered:
- Where there is a double taxation agreement in place
- Where there is not
In scenario (A) (where there is a tax treaty, on avoidance of double tax and prevention of fiscal evasion), between Country A and Country B, the treaty generally will specify in a clear wording that the right to tax is with state Country B, because this is the country in which the income arises – i.e. the “source” country. Country A, which taxes on worldwide incomes, i.e. income arising from Country A and Country B, will then compute tax payable. Country A will provide credit for the tax paid to Country B i.e. the country where the incomes were sourced. It is thus, through this arrangement that double taxation is avoided. Scenario (B)
In Scenario (B) (where there is no existing tax treaty on avoidance of double tax and prevention of fiscal evasion) country B will to tax Joe on incomes arising from country B, because that is the source of the incomes. When he goes back to country A, country A may give Joe credit for the tax paid in country B. However, country A may only do this on a unilateral basis, and is not obliged to do so. Thus the certainty created for Joe, and other taxpayers in Scenario a is absent here.
Under Rwanda’s income tax law (Law No.16/2005 OF 18/08/2005, On Direct Taxes on Incomes as modified and complemented to date), this is indicated in article 6, regarding foreign tax credit. Note: foreign tax credit provision exists in almost all tax laws(Acts).
It is desirable, and indeed necessary, in the field of international taxation, that there are rules agreed between different countries as to which tax jurisdiction takes what portion of tax, and why a given tax jurisdiction should forego in whole or in part what it considers to be its revenues. Having such agreements creates taxation certainty for businesses and individuals who operate internationally. Also, such agreements can include provision for cooperation and sharing of information which can assist in tackling tax evasion.
Various countries have concluded and ratified tax treaties with other countries. Typically these tend to start with a country’s major trading partners. Rwanda has signed and ratified tax treaties with Mauritius, South Africa and Belgium. The East African Tax Treaty on Avoidance of Double Tax and Prevention of Fiscal Evasion, is also on the horizon and it is likely that, in time Rwanda will adopt and ratify this. Key to all such treaties is that the business community (and other taxpayers) will be provided with certainty in cross border taxation issues.
A typical Double Taxation Agreement (DTA) will address key issues. Each agreement may differ depending on the prevailing circumstances, and the participating countries. However, a typical DTA would be likely to include provisions for some or all of the following:
This provision defines who the treaty will apply to, and specifically if it will apply to persons who are residents of either State or both. This is a central concept in all double taxation treaties. Benefits are only extended by one State to “residents” of the other State.
This provision article sets out the taxes to which the treaty will apply. In some cases this may apply only to taxes on income, (personal and corporate); in other cases it may also apply to Capital taxes.
It is very important that there is clarity around precisely what taxes are included in the treaty, and which are not included.
This provision sets out the rules for determining whether a person is a resident of of one State or a resident of the other State for the purposes of the treaty. Only residents of the
Contracting States can claim the benefits of the treaty. A resident of a Contracting State is a person who is subject to comprehensive taxation in that State.
The provision can contain tie-breaker provisions to resolve cases where an individual would be regarded as a resident of both Contracting States.
A treaty will also normally contain a tie-breaker test for corporate entities. Where the entity is a resident of both States it will normally be deemed to be a resident of the State in which it is effectively managed.
This provision defines the term “permanent establishment”. The concept of a permanent establishment is important generally but is of primary importance for the purposes of Business Profits. Only when an enterprise of one of the Contracting States carries on business through a permanent establishment in the other State is its presence regarded as sufficiently substantial to allow that State to tax the business profits attributable to the permanent establishment.
A “permanent establishment” is defined as a fixed place of business through which the business of an enterprise is wholly or partly carried on.
INCOME FROM IMMOVABLE PROPERTY
This provision defines the rules relating to taxation of income from immovable property, including income from agriculture or forestry.
The term “immovable property” is defined by reference to the domestic law of the Contracting State in which the property is situated.
Under this provision, each Contracting State agrees to rules for the taxation of Business Profits. The rules tend to revolve around whether an enterprise has a permanent establishment in a State. The provision can also set out the rules by which the profits of a permanent establishment are to be attributed.
This provision deals with transfer pricing.
Generally such a provision determines that the profits made by an enterprise from dealings with an associated enterprise in the other Contracting State may be increased to the level they would have been if the enterprises had been independent and dealing at arms-length. This is known as the “arm’s length” principle.
It may also provide for the adjustment of profits of the associated enterprise in the other State as a consequence of an adjustment in the first State.
This provision is concerned with the taxation of dividends paid by a distributing company resident in one Contracting State to a shareholder resident in the other State. The term “dividends” will be defined in the article.
This provision provides rules for the taxation of interest arising in one Contracting State and paid to a resident of the other State.
The provision normally provides that the interest may be taxed in the State in which it arises but if the beneficial owner of the interest is a resident of the other State the rate of tax is limited to a specified percentage of the gross interest payment. This will normally be lower than the tax rate that would otherwise apply.
The provision will also include a comprehensive definition of the term “interest”.
This provision provides rules for the taxation of royalties. It may limit the taxation in the source State of royalties paid to a resident of the other State.
The term “royalties” is defined and can covers payments in respect of copyright of literary, artistic or scientific work as well as patents and trademarks. Some treaties also cover leasing payments – “payments for the use of, or the right to use, industrial, commercial or scientific equipment” – which would otherwise normally come under Business Profits.
INCOME FROM EMPLOYMENT
This provides for the taxation of income from employment.
It generally provides that remuneration in respect of an employment derived by an individual who is a resident of a Contracting State may be taxed only in that State unless the employment is exercised in the other Contracting State. In that event, the other State may tax the remuneration derived from the exercise of the employment in it.
ARTISTES AND SPORTSPERSONS
This deals with the taxation of entertainers and sportspersons resident in one of the Contracting States and performing services in the other State.
PENSIONS and ANNUITIES
This provides a general rule for the taxation of pensions and annuities.
It normally provides that a pension arising in a Contracting State and paid in consideration of past employment to a resident of the other Contracting State will be taxed only in that other State. In some treaties, the source country retains the right to tax pensions.
ELIMINATION OF DOUBLE TAXATION
This provision is relevant where both Contracting States retain taxing rights on items of income or gains. Double taxation is relieved in such cases by the State of residence of the taxpayer either exempting the income or gains from further taxation or granting credit for the tax paid in the other State.
EXCHANGE OF INFORMATION
This provides for the exchange of information that is relevant for the carrying out of the provisions of the treaty or of the domestic laws of the Contracting States concerning taxes covered by the treaty. All information so exchanged is to be treated as secret and disclosed only to persons concerned with the administration of the taxes to which the treaty applies. There is no obligation to act or supply information other than in accordance with domestic law or normal administrative practice, or to supply information which would disclose trade secrets or would be contrary to public policy.
In East Africa, the EAC Partner States commenced implementing the EAC Common Market Protocol in July 2009. This means that Rwanda, Uganda, Kenya, Tanzania and Burundi entered into a single market with free movement of factors of production based on the principles of non discrimination, most favoured nation and transparency.
Some of these rights include free movement of goods, persons and labour.
The EAC citizens also have the rights of establishment (i.e. a Ugandan citizen can set up a business in Rwanda, and vice versa) as well as rights of residence. There is also provision for free movement of services and capital.
It is important to note that taxes on international trade will remain as is, except for import duty which will be at 0% on imports from the EAC that comply with the rules of origin criteria.
If a trader for example imports juice or biscuits that are manufactured in Uganda (an EAC member state) and have a valid certificate of origin, the Rwandan Revenue Authorities (RRA) will not collect import duty (a tax levied on goods imported into the country) on such goods as long as it is proved the goods are originating from the region.
In Rwanda, issuance of certificates of origin has been decentralized to the RRA Gikondo
Customs department and at all border posts including, Gatuna (Rwanda-Uganda border) and Rusumo (Rwanda-Tanzania border). It is intended that this service will be introduced at the Rwanda-Burundi border.
While import duty was abolished for such trade, traders will continue to pay other domestic taxes due on goods including Value Added Tax (VAT) of 18 percent, consumption tax (excise duty) as well as withholding tax of 5 percent.
However, the withholding tax mentioned above is exempt for people who have a tax clearance certificate (Quitus Fiscale).
Free movement of goods under the Common Market is provided for under the protocol (Article 39).
On 1st July, 2009, Rwanda commenced the implementation of the EAC Customs Union and started levying zero percent import duty tariff on goods originating from the Partner States, applying the Common External Tariff and the East African Customs Management Act and Regulations.
Implementation of the Customs Union is progressive. For example, the internal tariff elimination on intra regional trade took 5 years.
Removal of VAT, Consumption tax (excise duty) and Withholding tax will be implemented when a fully fledged customs union is established.
Such a union will also include the following:
- Shifting of borders between Partner States to the peripheral
- Collection of duties and taxes at the point of entry into the Customs Union Territory
- Agreeing on the revenue sharing mechanism;
- Establishment of a regional authority to administer the Customs Union
- Elimination of rules of origin on intra regional trade. In a fully fledged Customs Union, goods from Nairobi to Kigali will not attract any duties and taxes will be considered just as goods coming from Huye, Southern Province or Musanze, Northern Province.
Harmonization of tax policies and laws
The EAC Common Market Protocol provides that the Partner States will progressively harmonize their tax policies and laws to remove tax distortions. This will be done to facilitate the free movement of goods, services and capital and to promote investment within the Community.
It is important to note that the implementation of the EAC Common Market has not changed the existing fiscal regime and the anticipated changes will progressively be realized as Rwanda enters into a fully fledged Customs Union and the harmonization of tax policies and laws finalized.
Harmonization of domestic taxes is being handled under EAC Framework by the Fiscal
Affairs Committee(Technical Committee on tax harmonization) and Fiscal Affairs
Committee has established Technical Working Groups on Value Added Tax, Excise Tax and Income Tax develop a harmonized legal framework on tax laws and a roadmap for the harmonization process.
It should also be noted that the double taxation and the prevention of fiscal evasion with respect to taxes on income (DTA) was agreed upon by the Partner States and is awaiting legal input from the Attorney Generals Before approval by Council.
This will all take time to achieve. It may be further complicated by the admission of new member states to the Common Market. And it is possible that there may be a deeper strengthening of trade ties. For example in the EU, the arrangements have moved on from being a pure trading bloc to a group of countries who have some common laws, and in some cases a common currency.
Countries can also involve themselves in wider, but looser associations for international cooperation. Such an example is COMESA (the Common Market for Eastern and Southern Africa). The benefits of COMESA are:
- A wider, harmonised and more competitive market
- Greater industrial productivity and competitiveness
- Increased agricultural production and food security
- A more rational exploitation of natural resources
- More harmonised monetary, banking and financial policies
- More reliable transport and communications infrastructure
19 countries – including Rwanda – are members of COMESA, and the agreed activities cover more than just taxation issues.
. Most Favoured Nation
Most Favoured Nation (MFN) is a status or level of treatment accorded by one state to another in international trade. This means that the country which is the recipient of this treatment must, nominally, receive equal trade advantages as the “most favoured nation” by the country granting such treatment.
Such advantages would include such things as low tariffs or high import quotas. It effectively means that a country that has been accorded MFN status may not be treated less advantageously than any other country with MFN status by the country granting MFN status. MFN status is accorded by members of the World Trade Organization (WTO) to each other. Preferential treatment of developing countries, regional free trade areas and customs unions is permitted by exception.
Some of the benefits conferred by MFN status are:
- As a consequence of MFN, smaller countries can participate in the advantages that larger countries often grant to each other. In the absence of an MFN, smaller countries would often not be powerful enough to negotiate such advantages by themselves.
- MFN provides domestic benefits: Administration is simplified. By having one set of tariffs for all countries the rules are simplified and made more transparent. It also lessens the frustrating problem of having to establish rules of origin to determine which country a product (that may contain parts from all over the world) must be attributed to for customs purposes.
- MFN restrains domestic special interests from obtaining protectionist measures. For example, butter producers in country A may not be able to lobby for high tariffs on butter to prevent cheap imports from developing country B, because, as the higher tariffs would apply to every country, the interests of A’s principal ally C might get impaired.
- As MFN clauses promote non-discrimination among countries, they also tend to promote the objective of free trade in general.
There is, however, a recognition that the MFN rule should be relaxed to accommodate the needs of developing countries.
The emergence of powerful trade blocs (e.g the EU, or the North American Free trade Agreement (NAFTA) has presented challenges to the MFN concept. In these blocs, tarriffs have been lowered or eliminated among the members while maintaining tariff walls between member nations and the rest of the world.
Withholding Tax Provisions
Withholding tax, also called retention tax, is where a government requires the payer of an item of income to withhold or deduct tax from the payment, and pay that tax directly to the government.
In most jurisdictions, withholding tax applies to employment income. Thus employers deduct the appropriate tax, pay the employee the net amount, and pay the balance (i.e. tax) over to the government.
Rwanda operates a PAYE (pay as you earn) withholding tax system:
Rwandan tax law requires that when an employer makes available employment income to an employee the employer must withhold, declare, and pay the PAYE tax to the Rwanda Revenue Authority within 15 days following the end of the month for which the tax was due.
In the case of engaging a casual labourer for less than 30 days during a particular tax year, the employer shall withhold 15% of the taxable employment income of the casual labourer. The employer is personally responsible for the correct withholding, declaration and the timely payment to the Rwanda Revenue Authority.
The employer is personally responsible for keeping proper books of account to prove that the tax has been correctly withheld, paid, and accounted for. Under those circumstances where, the employer is not required to withhold and pay the tax, the employee is responsible for registering, declaring, accounting, and paying the tax.
Many jurisdictions also require withholding tax on payments of interest or dividends. In most jurisdictions, there are additional withholding tax obligations if the recipient of the income is resident in a different jurisdiction, and in those circumstances withholding tax sometimes applies to royalties, rent or sale of property. Withholding tax enables Governments to combat tax evasion, and sometimes impose additional withholding tax requirements if the recipient has been delinquent in filing tax returns, or in industries where tax evasion is perceived to be common.
Withholding Tax on other payments in Rwanda
A withholding tax of 15% is levied on the following payments made by resident individuals or resident entities including tax-exempt entities:
Dividends, except those governed by Article 45 of this law; Interest payments;
Service fees including management and technical service fees;
Performance payments made to an artist, a musician or an athlete irrespective of whether paid directly or through an entity that is not resident in Rwanda; Lottery and other gambling proceeds.
Withholding Tax on Imports and Public Tenders
A withholding tax of five percent (5%) of the value of goods imported for commercial use shall be paid at custom on the CIF (cost insurance and freight value) value before the goods are released by customs.
A withholding tax of three percent (3%) on the sum of invoice, excluding the value added tax, is retained on payments Or by public institutions to those who supply goods and services based on public tenders.
Typically the withholding tax is treated as a payment on account of the recipient’s final tax liability. It may be refunded if it is determined, when a tax return is filed, that the recipient’s tax liability to the government which received the withholding tax is less than the tax withheld, or additional tax may be due if it is determined that the recipient’s tax liability is more than the withholding tax. In some cases the withholding tax is treated as discharging the recipient’s tax liability, and no tax return or additional tax is required.
The amount of withholding tax on income payments other than employment income is usually a fixed percentage. In the case of employment income the amount of withholding tax is often based on an estimate of the employee’s final tax liability, determined either by the employee or by the government.
Some governments have written laws which require taxes to be paid before the money can be spent for any other purpose. This ensures the taxes will be paid first, and will be paid on time as the government needs the funding to meet its obligations.
Most countries require that payers of certain amounts, especially interest, dividends, and royalties, to foreign payees withhold income tax from such payment and pay it to the government. Payments of rent may be subject to withholding tax or may be taxed as business income. The amounts may vary by type of income. A few jurisdictions treat fees paid for technical consulting services as royalties subject to withholding of tax. Tax treaties may reduce the amount of tax for particular types of income paid from one country to residents of the other country.
Some countries require withholding by the purchaser of real property.
Taxes withheld may be eligible for a foreign tax credit in the payee’s home country.
Transfer pricing refers to:
- the setting,
- and adjustment
of charges made between related parties for goods, services, or use of property. Transfer prices among components of an enterprise may be used to reflect allocation of resources among such components, or for other purposes. OECD Transfer Pricing Guidelines state,
“Transfer prices are significant for both taxpayers and tax administrations because they determine in large part the income and expenses, and therefore taxable profits, of associated enterprises in different tax jurisdictions.”
Over 60 governments have adopted transfer pricing rules.
Transfer pricing rules in most countries are based on what is referred to as the “arm’s length principle” – that is to establish transfer prices based on analysis of pricing in comparable transactions between two or more unrelated parties dealing at arm’s length. The OECD has published guidelines based on the arm’s length principle, which are followed, in whole or in part, by many of its member countries in adopting rules. The United States and Canadian rules are similar in many respects to the OECD guidelines, with certain points of material difference. A few countries, such as Brazil and Kazakhstan, follow rules that are materially different overall.
The rules of nearly all countries permit related parties to set prices in any manner, but permit the tax authorities to adjust those prices where the prices charged are outside an arm’s length range. Rules are generally provided for determining what constitutes such arm’s length prices. Prices actually charged are compared to prices or measures of profitability for unrelated transactions and parties. The rules generally require that market level, functions, risks, and terms of sale of unrelated party transactions or activities be reasonably comparable to such items with respect to the related party transactions or profitability being tested.
Most tax treaties and many tax systems provide mechanisms for resolving disputes among taxpayers and governments in a manner designed to reduce the potential for double taxation. Many systems also permit advance agreement between taxpayers and one or more governments regarding mechanisms for setting related party prices.
Many systems impose penalties where the tax authority has adjusted related party prices. Some tax systems provide that taxpayers may avoid such penalties by preparing documentation in advance regarding prices charged between the taxpayer and related parties. Some systems require that such documentation be prepared in advance in all cases.
The OECD system provides that prices may be set by the component members of an enterprise in any manner, but may be adjusted to conform to an arm’s length standard. The system provides for several approved methods of testing prices, and allows the government to adjust prices to the midpoint of an arm’s length range. Both systems provide for standards for comparing third party transactions or other measures to tested prices, based on comparability and reliability criteria. Significant exceptions are noted below.
Most governments have granted authorization to their tax authorities to adjust prices charged between related parties. Some authorizations, (e.g. the United States, United Kingdom, Canada, and Rwanda – Law 16/2005 DTI), allow domestic as well as international adjustments. Some authorizations apply only internationally. Most, if not all, governments permit adjustments by the tax authority even where there is no intent to avoid or evade tax. Adjustment of prices is generally made by adjusting taxable income of all involved related parties within the jurisdiction, as well as adjusting any withholding or other taxes imposed on parties outside the jurisdiction. Such adjustments generally are made after filing of tax returns Nearly all systems require that prices be tested using an “arm’s length” standard. Under this approach, a price is considered appropriate if it is within a range of prices that would be charged by independent parties dealing at arm’s length. This is generally defined as a price that an independent buyer would pay an independent seller for an identical item under identical terms and conditions, where neither is under any compulsion to act.
There are clear practical difficulties in implementing the arm’s length standard. For items other than goods, there are rarely identical items. Terms of sale may vary from transaction to transaction. Market and other conditions may vary geographically or over time. Some systems give a preference to certain transactional methods over other methods for testing prices.
In addition, most systems recognize that an arm’s length price may not be a particular price point but rather a range of prices.
The OECD rules require that reliable adjustments must be made for all differences (if any) between related party items and purported comparatives that could materially affect the condition being examined.
Transactions not undertaken in the ordinary course of business generally are not considered to be comparable to those taken in the ordinary course of business. Among the factors that must be considered in determining comparability are:
- the nature of the property or services provided between the parties,
- functional analysis of the transactions and parties,
- comparison of contractual terms (whether written, verbal, or implied from conduct of the parties),and
- comparison of significant economic conditions that could affect prices, including the effects of different market levels and geographic markets.
Comparability is best achieved where identical items are compared. However, in some cases it is possible to make reliable adjustments for differences in the particular items, such as differences in features or quality.
Buyers and sellers may perform different functions related to the exchange and undertake different risks. For example, a seller of a machine may or may not provide a warranty. The price a buyer would pay will be affected by this difference. Among the functions and risks that may impact prices are:
- Product development
- Manufacturing and assembly
- Marketing and advertising
- Transportation and warehousing
- Credit risk
- Product obsolescence risk
- Market and entrepreneurial risks
- Collection risk
- Financial and currency risks
- Company- or industry-specific items
Manner and terms of sale may have a material impact on price. For example, buyers will pay more if they can defer payment and buy in smaller quantities. Terms that may impact price include payment timing, warranty, volume discounts, duration of rights to use of the product, form of consideration, etc.
Goods, services, or property may be provided to different levels of buyers or users: producer to wholesaler, wholesaler to wholesaler, wholesaler to retailer, or for ultimate consumption. Market conditions, and thus prices, vary greatly at these levels. In addition, prices may vary greatly between different economies or geographies.
Most systems provide variations of the basic rules for characteristics unique to particular types of transactions. The potentially tested transactions include:
- Sale of goods. Identical or nearly identical goods may be available. Product-related differences are often covered by patents.
- Provision of services. Identical services, other than routine services, often do not exist.
- License of intangibles. The basic nature precludes a claim that another product is identical. However, licenses may be granted to independent licensees for the same product in different markets.
- Use of money. Comparable interest rates may be readily available. Some systems provide safe haven rates based on published indices.
- Use of tangible property. Independent comparatives may or may not exist, but reliable data may not be available.
Tax authorities generally examine prices actually charged between related parties to determine whether adjustments are appropriate. Such examination is by comparison (testing) of such prices to comparable prices charged among unrelated parties. Such testing may occur only on examination of tax returns by the tax authority, or taxpayers may be required to conduct such testing themselves in advance or filing tax returns. Such testing requires a determination of how the testing must be conducted, referred to as a transfer pricing method. Most systems consider a third party price for identical goods, services, or property under identical conditions, called a comparable uncontrolled price (CUP), to be the most reliable indicator of an arm’s length price. All systems permit testing using this method, but it is not always applicable.
Among other methods relying on actual transactions (generally between one tested party and third parties) and not indices, aggregates, or market surveys are:
- Cost plus (C+) method: goods or services provided to unrelated parties are consistently priced at actual cost plus a fixed mark-up. Testing is by comparison of the mark-up percentages.
- Resale price method (RPM): goods are regularly offered by a seller or purchased by a retailer to/from unrelated parties at a standard “list” price less a fixed discount. Testing is by comparison of the discount percentages.
- Gross margin method: similar to resale price method, recognised in a few systems.
Some methods of testing prices do not rely on actual transactions. Use of these methods may be necessary due to the lack of reliable data for transactional methods. In some cases, nontransactional methods may be more reliable than transactional methods because market and economic adjustments to transactions may not be reliable.
These methods may include:
- Comparable profits method (CPM): profit levels of similarly situated companies in similarly industries may be compared to an appropriate tested party.
- Transactional net margin method (TNMM): while called a transactional method, the testing is based on profitability of similar businesses.
- Profit split method: total enterprise profits are split in a formulary manner based on econometric analyses.
- CPM and TNMM have a practical advantage in ease of implementation. Both methods rely on microeconomic analysis of data rather than specific transactions. These methods are discussed further with respect to the U.S. and OECD systems.
Two methods are often provided for splitting profits:] comparable profit split and residual profit split. The former requires that profit split be derived from the combined operating profit of uncontrolled taxpayers whose transactions and activities are comparable to the transactions and activities being tested. The residual profit split method requires a two step process: first profits are allocated to routine operations, then the residual profit is allocated based on non-routine contributions of the parties. The residual allocation may be based on external market benchmarks or estimation based on capitalised costs.
Where testing of prices occurs on other than a purely transactional basis, such as CPM or
TNMM, it may be necessary to determine which of the two related parties should be tested.
Testing is to be done of that party testing of which will produce the most reliable results. Generally, this means that the tested party is that party with the most easily compared functions and risks. Comparing the tested party’s results to those of comparable parties may require adjustments to results of the tested party or the comparatives for such items as levels of inventory or receivables.
Testing requires determination of what indication of profitability should be used. This may be net profit on the transaction, return on assets employed, or some other measure. Reliability is generally improved for TNMM and CPM by using a range of results and multiple year data.
Valuable intangible property tends to be unique. Often there are no comparable items. The value added by use of intangibles may be represented in prices of goods or services, or by payment of fees (royalties) for use of the intangible property. Licensing of intangibles thus presents difficulties in identifying comparable items for testing. However, where the same property is licensed to independent parties, such license may provide comparable transactional prices. The profit split method specifically attempts to take value of intangibles into account.
Enterprises may engage related or unrelated parties to provide services they need. Where the required services are available within a multinational group, there may be significant advantages to the enterprise as a whole for components of the group to perform those services. Two issues exist with respect to charges between related parties for services: whether services were actually performed which warrant payment, and the price charged for such services. Tax authorities in most major countries have, either formally or in practice, incorporated these queries into their examination of related party services transactions.
There may be tax advantages obtained for the group if one member charges another member for services, even where the member bearing the charge derives no benefit. To combat this, the rules of most systems allow the tax authorities to challenge whether the services allegedly performed actually benefit the member charged. The inquiry may focus on whether services were indeed performed as well as who benefited from the services. For this purpose, some rules differentiate stewardship services from other services. Stewardship services are generally those that an investor would incur for its own benefit in managing its investments. Charges to the investee for such services are generally inappropriate. Where services were not performed or where the related party bearing the charge derived no direct benefit, tax authorities may disallow the charge altogether.
Some jurisdictions impose significant penalties relating to transfer pricing adjustments by tax authorities. These penalties may have thresholds for the basic imposition of penalty, and the penalty may be increased at other thresholds. For example, U.S. rules impose a 20% penalty where the adjustment exceeds USD 5 million, increased to 40% of the additional tax where the adjustment exceeds USD 20 million.[
The rules of many countries require taxpayers to document that prices charged are within the prices permitted under the transfer pricing rules. Where such documentation is not timely prepared, penalties may be imposed, as above. Documentation may be required to be in place prior to filing a tax return in order to avoid these penalties. Documentation by a taxpayer need not be relied upon by the tax authority in any jurisdiction permitting adjustment of prices. Some systems allow the tax authority to disregard information not timely provided by taxpayers, including such advance documentation. India requires that documentation not only be in place prior to filing a return, but also that the documentation be certified by the chartered accountant preparing a company return.
Results of the tested party or comparable enterprises may require adjustment to achieve comparability. Such adjustments may include effective interest adjustments for customer financing or debt levels, inventory adjustments, etc.
Tax authorities of most major countries have entered into unilateral or multilateral agreements between taxpayers and other governments regarding the setting or testing of related party prices. These agreements are referred to as advance pricing agreements or advance pricing arrangements (APAs). Under an APA, the taxpayer and one or more governments agree on the methodology used to test prices. APAs are generally based on transfer pricing documentation prepared by the taxpayer and presented to the government(s).
Multilateral agreements require negotiations between the governments, conducted through their designated competent authority groups. The agreements are generally for some period of years, and may have retroactive effect. Most such agreements are not subject to public disclosure rules. Rules controlling how and when a taxpayer or tax authority may commence APA proceedings vary by jurisdiction.