New transfer pricing case: Practice is building up steam
The third transfer pricing case has not been long in coming[1], and it is the transactions of PAO Toliattiazot (further “TOAZ”) for supply of ammonia to a Swiss trader Nitrochem Distribution AG (further “Nitrochem”) that were scrutinized by tax authorities this time.
Facts of the case
In 2012, TOAZ sold ammonia for export through a Swiss trader Nitrochem. To this end, TOAZ entered into two contracts with Nitrochem under which TOAZ supplied ammonia in monthly consignments from 5 to 15,000 tons on FCA terms[2] (Incoterms 2000).
The Federal Tax Service (further the “FTS”) picked up on these transactions and initiated an audit of their transfer prices. As a result of this audit, the FTS considered that TOAZ and Nitrochem were related parties and that the transactions between them were therefore controlled transactions for transfer pricing purposes[3]. And, although TOAZ claimed not to be related to Nitrochem, and that the transactions between them are therefore not controlled transactions, TOAZ still submitted to the FTS transfer pricing documentation for these transactions during the audit[4].
TOAZ used the transactional net margin method to justify the arm’s length prices under the transactions with Nitrochem. This method consists in comparing the net margin of a party to a controlled transaction with the net margin of independent companies. In our opinion, the law leaves open the question of which net margin to compare: either the net margin under the controlled transaction or the party’s overall net margin (company-wide data). We will return to this issue below.
Using this method, TOAZ compared Nitrochem’s net profit margin under the two disputed contracts with the arm’s length range of independent companies engaged in the wholesale trade of chemical products. TOAZ also claimed that since it is not related to Nitrochem, Nitrochem’s financial statements were not made available to TOAZ so TOAZ found out about Nitrochem’s net profit margin under the two disputed contracts by receipt of a letter from Swiss tax authorities.
The FTS concluded that TOAZ applied the transactional net margin method incorrectly and estimated arm’s length for transfer prices using the comparable uncontrolled price method (CUP). The FTS obtained arm’s length prices from Argus agency, which we already encountered in Uralkali case, (more information about this case can be found here and here) and concluded that the prices applied by TOAZ under the contracts with Nitrochem are not arm’s length prices so it charged RUB 30 million in additional taxes and RUB 12 million in penalties[5].
Samara Regional Commercial Court ruled in favor of the FTS in this dispute. Below you will find the main and, according to us, most important conclusions of this case.
1. Priority method: All animals are equal, but some more than others
The court considered that the taxpayer should justify why it did not apply the priority method. And, unlike Uralkali case where the court, for some reason, forgot that in case of resale of goods, the resale price method has priority over the CUP method, the court directly indicates here that priority should be given to the resale price method.
But then Samara Court’s reasoning follows the same pattern as Uralkali case: the court agrees with the FTS that the taxpayer made a mistake by applying the “non-priority” transactional net margin method so tax authorities can consider themselves not bound by the method chosen by the taxpayer and must apply the priority method.
This position held by the FTS and court is, in our opinion, fundamentally flawed for at least two reasons.
- First reason. The Tax Code expressly and in no uncertain terms requires tax authorities to use the method chosen by taxpayers in their documentation, and tax authorities are entitled to use another method only if they prove that the method chosen by taxpayers cannot be applied[6]. It is therefore, in our opinion, not sufficient to simply point out the mistake made by taxpayers in applying a particular method. Moreover, this is not a new approach which has been introduced by Russian legislation as it is on the whole based on the OECD Transfer Pricing Guidelines which are widely used internationally as generally accepted approaches for evaluation of transfer prices[7]. In TOAZ case, tax authorities did not even try to apply the transactional net margin method used by TOAZ, and the court considered this approach lawful without citing any significant arguments in its favor.
- Second reason. Taking cue from OECD rules, the Tax Code does not establish a strict method hierarchy so, in our opinion, if the resale price method being the priority method turns out to be inapplicable, then no other method will have priority. The Tax Code expressly states that the comparable uncontrolled price method is “supplanted” by the resale price method and is no longer the priority method for certain transactions[8]. The Tax Code does not, however, provide for a “second priority” method. On the contrary, the Tax Code provides that if it is not possible to apply a priority method, any other method that is more appropriate in specific circumstances will be applicable[9][10]. The comparable uncontrolled price method, therefore, should not have priority.
In our opinion, it would be more appropriate in this situation to apply the transactional net margin method with “net profit margin” indicator than the CUP method as it is economically and methodologically closer to the resale price method designated by the legislator as the priority method in case of resale to independent parties of goods acquired under controlled transactions. It is therefore not clear at all why the court did not insist that the FTS should have tried to obtain data for application of the transactional net margin method.
2. Transactional net margin method: which net margin should be chosen?
When applying the transactional net margin method, TOAZ chose as comparable net margin indicator Nitrochem’s aggregated net profit margin under the two contracts with TOAZ. The FTS and the court considered that such approach was not appropriate. According to the FTS and the court, the transactional net margin method entails determining the net margin for each contract individually. This statement is, in our opinion, highly questionable, all the more so that both disputed contracts provide for the same type of transaction.
First, transfer pricing rules are inherently neutral in as much as they are not intended to combat tax evasions[11]. To put it simply, these rules only delimit the tax scope for various jurisdictions, i.e. they determine the part of an international group’s aggregate profit that will be taxed in each of the countries in which the group operates. This profit share is determined based on the functions, assets and risks that the group companies have and assume in their respective country, in other words, based on the group company’s functional profile. Moreover, if a company engages only in a single type of activity, the company’s functional profile may, in our opinion, be determined for the company as a whole rather than for each transaction.
Second, the FTS holds that net profit margin should be determined for each individual contract as the functions performed by the parties under different contracts may slightly differ. But this is quite literally not a problem at all because the net profit margin of the party to a transaction under analysis is to be compared with the net profit margin of independent companies which is determined on the basis of financial statements of comparable organizations as a whole rather than for specific transactions [12]. So it is, in our opinion, inappropriate to compare a taxpayer’s net profit margin indicators under a controlled transaction with net profit margin indicators of comparable organizations as a whole as this could result in significant data misstatement stemming from the comparison of different net profit margin indicators. It is appropriate and sufficient to remember that a company’s net profit margin as a whole consists of a number of completely different net profit margins for specific transactions.
Third, the OECD transfer pricing guidelines also allow the aggregation of transactions to determine a taxpayer’s net profit margin if these transactions are united by a single business logic.[13] Judging by the court ruling, the transactions between TOAZ and Nitrochem were almost identical with one objective so they were indeed united by a single business and economic logic.
Fourth, the Ministry of Finance did comment on the question of which net profit margin indicator to apply under the transactional net margin method. So, in its opinion, the taxpayer determines the appropriate number of net profit indicators necessary for comparison depending on the number of types of activity performed[14]. It is possible to conclude from this statement that if the party to a controlled transaction performs only one type of activity, then net profit margin should be determined on the basis of the reporting data (financial statements) for such party as a whole.
3. Comparability of companies for transactional net margin method purposes: Let’s get a magnifying glass
The court rejected all the companies selected by TOAZ as comparable with Nitrochem on grounds that the products they trade are not identical (similar) to the ammonia traded between TOAZ and Nitrochem. This position held by the court sets unreasonably high requirements for comparable companies.
Prices for different goods obviously are usually different so the similarity of goods is important when using the comparable uncontrolled price method. As for the methods based on net profit margin comparison, they in fact compare the return for functions performed. In a market economy, the compensation for performance of similar functions will be more or less the same even if these functions are performed for different goods. In support of this idea, the OECD provides a textbook example: a distribution company sells blenders and toasters and performs the same functions to sell both. In a market economy, the distribution company can expect the same compensation for the functions performed and therefore the same net profit margin upon sale of both blenders and toasters although the prices for blenders and toasters will obviously be different[15].
TOAZ selected companies engaging in the wholesale of chemical products, including chemical fertilizers. The companies selected by TOAZ seem, in our opinion, sufficiently comparable for transactional net margin method purposes.
Although we do not agree with the court’s position, we recommend reconsidering the selection of comparable organizations in the transfer pricing documentation, taking into account the approaches specified by the court.
4. Argus is our everything
Like in Ulralkali case, tax authorities used in TOAZ case data from Argus and Ferticon agencies to determine the arm’s length range.
TOAZ objected to Argus data, arguing that it does not reflect the terms and conditions of the actual transactions. Based on the methodology used by Argus as cited by the FTS, published price ranges reflect the prices of the transactions that took place and also the transactions that could be concluded if the buyer and seller want to. When sales decline on the market, Argus may determine the price range based on conclusions drawn from communication with buyers and sellers. A price quotation reflects the price that is, in Argus’s opinion, achievable.
We think that the CUP method does not involve the use of “possible” or “achievable” prices but should be based on real transactions. Otherwise, the price under a controlled transaction will be compared with prices that do not actually exist.
5. Conclusion and recommendation
Overall, the emerging practice on transfer pricing cases shows that a simplified approach to the evaluation of transfer prices is still used and consists in only comparing transaction prices with data from price agencies. Moreover, internationally recognized approaches are not always well received and applied in Russian practice so, in view of Uralkali and Toliattiazot case, we recommend:
- Justifying the inapplicability of priority methods very thoroughly;
- Using, where possible, verification methods to support conclusions about the compliance of transfer prices with arm’s length principle;
- Very carefully selecting comparable organizations for transactional net margin method.
If you have any questions, require further information or would like to discuss our conclusions, please do not hesitate to contact Anton Kabakov.
Truly yours,
[1] Samara Regional Commercial Court Ruling dated September 06, 2018 Case No. А55-1621/2018
[2] FCA (Free Carrier) means that the seller transfers products that have been cleared at customs for export to a carrier specified by the buyer at a named placed.
[3] Article 105.14(1) Tax Code provides that all transactions between related parties are recognized as controlled transactions.
[4] It is important to note that the absence of relatedness between parties does not mean that a transaction cannot be recognized as a controlled transaction for transfer pricing purposes. Foreign trade transactions with traded commodities are controlled transactions even if they are completed with independent parties (Article 105.14(1(2)) Tax Code). Mineral fertilizers are among those traded commodities (Article 105.14(5) Tax Code). The Tax Code also sets out that the Ministry of Industry and Trade must provide a list of specific customs classification codes for such “controlled” commodities (Article 105.14(6) Tax Code), but this has not yet been done for mineral fertilizers. The Ministry of Finance therefore considers that transactions with mineral fertilizers are not controlled foreign trade transactions (Ministry of Finance Letters N 03-01-18/2657 dated January 27, 2015 and N 03-12-11/1/16985 dated March 19, 2018). This, however, does not mean that they cannot be recognized as controlled transactions on other grounds such as, for example, on the ground that they are concluded with a related party. This is exactly what the FTS did with TOAZ in this case.
[5] The FTS has also initiated several other transfer pricing lawsuits against TOAZ with a substantially large “bill”.
[6] Article 105.17(4) Tax Code
[7] Paragraphs 2.2, 2.8 and 2.9 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations
[8] Article 105.7(3) and Article 105.10(2) Tax Code
[9] Article 105.7(4) of the Tax Code
[10] On the other hand, Article 105.7(4) of the Tax Code also states that it is possible to use the most suitable method only if it is not possible to apply the comparable uncontrolled price method. However, we believe that according to the spirit of the Tax Code this provision should be applied only if the priority method is the comparable uncontrolled price method. And, accordingly, this rule should not apply if the comparable uncontrolled price method is not the priority method as per the rules of the Tax Code.
[11]Item 3.2.1 United Nations Practical Manual on Transfer Pricing for Developing Countries (2013)
[12] Article 105.8(2) Tax Code
[13] Items 3.9 – 3.10 OECD Transfer Pricing Guidelines
[14] Ministry of Finance Letter N 03-01-18/5294 dated February 25, 2013
[15] Item 2.30 OECD Transfer Pricing Guidelines