Issue 6, 2013. December-January

   

TRANSFER PRICING PROSPECTS IN GEORGIA

Taxation of Multinational Enterprises (MNEs) has always been an important challenge for governments and they try to overcome it through various instruments, most notably double tax agreements and transfer pricing rules. The Georgian government is grappling with how to create a transfer pricing model that fits the country's needs. Lawyer and tax specialist Giorgi Narmania looks at international best practices and how they could be used in Georgia.

Giorgi Narmania

Introduction

Due to globalization and increased economic integration, it is estimated that more than 30 percent of all international business transactions take place between multinational enterprises (MNEs) and their own constituent members. In order to control the transfer price for goods and services in the intragroup transactions,tax authorities regulate prices for transactions involving the transfer of property or services between the members of same MNE (referred as associated enterprises or related parties), known as transfer pricing. The goal of such legislation is to protect the country's tax base and tackle tax evasion or avoidance by channeling revenues to low- or no-tax jurisdictions.

Transfer Pricing in Georgia and Abroad

Currently the issue of transfer pricing is very high on the global agenda. Prominent corporations, such as Apple, Amazon, Starbucks, and Google have been accused of using gaps in transfer pricing rules to avoid paying tax. The cost to economies has not gone unnoticed: Starbucks, for example, has not reported taxable profits in the UK for the last five years, despite sales of £400 million only in 2012.

During the recent G-20 summit in Moscow, the world's richest economies decided to take action. The OECD is working on an Action Plan on Base Erosion and Profit Shifting (BEPS) which will tackle tax planning strategies that exploit gaps and mismatches in the tax rules.

For Georgia, however, transfer pricing is a relatively new concept. While it was introduced in the 2011 tax code, no detailed regulations to implement it were developed. Application of transfer pricing rules is limited to cross-border transactions under Georgia law.

Now, however, the Revenue Service (RS) is working on a draft order to outline how transfer pricing will be regulated in Georgia. In addition, the RS now recognizes OECD Guidelines for transfer pricing, so any issue not addressed in the Draft Order can be interpreted on the basis of international rules.

After adoption of the Draft Order, Georgian companies and representative offices will have to comply with transfer pricing rules when they undertake international transactions with related entities. As the RS constructs a strategy, it is vital it follow the international best practices that allow the government to protect its interests without obstructing the flow of business and capital into and out of the country.

Transfer pricing is considered to be a major international taxation issue and a difficult challenge faced by both governments and companies today. It usually requires significant resources, including skilled human resources and costs of compliance. Therefore, the Georgian government should adopt regulations that will ensure effective administration by the government and minimize compliance costs for taxpayers, including implementing "Arm's Length Standards" and other proven methodologies.

Transfer Pricing: International Best Practices

Arm's Length Standard

The principle of transfer pricing is based on an "arm's length" standard for the pricing of inter-company transactions. Included in the legislation of most countries, it is essentially the market price. Under the arm's length principle, transactions between associated enterprises are compared to transactions between unrelated entities under comparable circumstances to determine acceptable transfer prices. Arm's length price is the price for goods or services to which unrelated parties would agree. It is acomplex task to identify this price and transfer pricing rules provide guidance in this process.

Comparability Analysis

The first step to determine the arm's length price is to locate a comparable transaction between independent parties (an uncontrolled transaction). Finding comparable transactions is an important practical challenge in developing countries, like Georgia, since there is lack of comparable agreements and necessary data. This process is sometimes equated to finding a needle in a haystack.

The comparability between controlled and uncontrolled transactions is mainly determined on the basis of following five factors adopted by OECD Guidelines:

1. Characteristics of the property or service transferred;
2. Functions performed by the parties taking into account assets employed and risks assumed;
3. Contractual terms;
4. Economic circumstances; and
5. Business strategies of the companies.

If the above factors are similar, anuncontrolled transaction is comparable to a controlled transaction and the relevant arm's length price can be determined. Subsequent to the comparability analysis, transfer pricing methods are used to determine the arm's length price of a transaction. Georgian legislation follows the approach of OECD Guidelines and recognizes five methods to determine arm's length price.

Documentation Requirements

Tax authorities need a number of business documents to determine the arm's length price of a transaction between related parties.

These documents are typically prepared by the taxpayers in the process of comparability analysis. The requirement to produce and maintain necessary documents constitutes one of the most expensive compliance costs for taxpayers. Under the OECD Guidelines the following documents must be prepared: information about the associated enterprises; business structure of the group; description of the controlled transaction; information on pricing, etc. The Georgian Draft Order follows this approach and the list of required documents is comparable to the list provided in the OECD Guidelines.

While adopting themandatory documentation list, tax authorities usually pay attention to the similar requirements of other countries, especially in the same region. Different and inconsistent rules increase the compliance burden for the taxpayers operating in these countries.Besides, several countries-including France, the Netherlands,and Germany-apply simplified documentation requirements for smaller enterprises. Such a flexible approach is used to reduce the compliance burden.

Creating Efficient Transfer Pricing System

In order to create efficient transfer pricing systems, governments employ various instruments, such as Safe Harbor rules and Advance Pricing Agreements (APAs). Safe Harbor rules provide that ifa taxpayer's profits are within a certain percentage or under a certain amount, the taxpayer is not required to follow the complex transfer pricing regulations. The goal of such a provision is to provide certainty and reduce compliance costs for smaller taxpayers, as well as to ensure administrative simplicity for tax authorities. The Georgian Draft Order does not include Safe Harbor rules. The RS should work on this topic as such rules provide an advantage for developing countries to design a transfer pricing compliance environment that makes optimal use of the limited resources available.

Advance Pricing Agreements (APAs) provide the possibility for taxpayers and tax authorities to agree in advanceon the transfer pricing methodologies of forthcoming transactions. Such a regime leads to greater certainty for the taxpayer and it is considered as the safest way to establish the arm's length price.The Georgian Tax Code envisages the APA procedure, which is a legally binding agremenetbetween taxpayer and tax authorities.

Giorgi Narmania is a lawyer and tax specialist.

He holds a position of an Adjunct Lecturer at Ilia State University. Giorgi Narmania graduated from Tbilisi State University with a Bachelor of Laws Degree and received LL.M. in Commercial Law from Erasmus University Rotterdam.

Transfer Pricing Methods

Comparable Uncontrolled Price Method - this transfer-pricing method compares the price charged for goods or services transferred in a controlled transaction to the price charged for comparable goods or services transferred in a comparable uncontrolled transaction;

Resale Price Method - it compares the resale margin in a controlled transaction with the resale margin earned in a comparable uncontrolled resale transaction;

Cost Plus Method - this method compares the mark-up on the costs incurred for the supply of goods or services in a controlled transaction with the mark-up charged in a comparable uncontrolled transaction;

Transactional Net Margin Method - it compares the net profit margin gained by a taxpayer in a controlled transaction with the net profit margin received in a comparable uncontrolled transaction;

Profit Split Method - under this method combined profit of associated enterprises is split between them as it would be divided between independent parties in a comparable transaction.