Second round of Uralkali case and risk of its relegation to an unjustified tax benefit case
Moscow District Commercial Court (cassation court) has referred Uralkali case on transfer pricing for reconsideration by the court of first instance [1]. It seems is that the reason for such referral is that the cassation court failed to grasp the reason for the difference in arm’s length prices calculated by tax authorities and those calculated by the taxpayer, which amounted to almost one billion rubles. The court considered that arm’s length prices are objective, and if calculated as prescribed by the Russian Tax Code, they should be roughly the same regardless of the transfer pricing method used by tax authorities or taxpayers to establish such arm’s length prices. The cassation court thereby drew an obvious conclusion: a significant difference in results indicates either that the calculations are incorrect, or the wrong method was applied, or other objective reasons. And it is precisely these reasons that the court of first instance has to clarify in a new round of case examination.
Interestingly, the court chose not to look deeply into the legal intricacies of transfer pricing and indicated that such matter requires specialized knowledge. It should be noted that the court has neither resolved the legal issues identified in the decisions rendered by the courts of first and second instance, nor has it figured out to resolve them. We have described these issues in our alert on the outcome of Uralkali case in appellate instance which you can read here.
Gist of the case. The dispute is about supply transactions concluded between Uralkali and a related Swiss trader who resold the goods delivered by Uralkali to independent customers. The taxpayer, Uralkali, used the Transactional Net Margin Method to support arm’s length prices, but tax authorities considered that the Comparable Uncontrolled Price Method should have been applied in priority and that prices should have been compared with the data from Argus agency. After applying this method, tax authorities imposed on Uralkali almost one billion rubles in additional taxes.
Although the cassation court has not offered a clear legal position on the case, it nevertheless picked up on several points.
Which method has higher priority?
The first thing that should be noted is that the position held by the court on the priority of transfer pricing methods is a compromise. The court pointed out that the Comparable Uncontrolled Price Method should be used in priority by both taxpayers and tax authorities. The court also noted that the other 4 transfer pricing methods provided by Article 105.7(1) of the Russian Tax Code do not take precedence over each other. And if the Comparable Uncontrolled Price Method cannot be applied to calculate arm’s length prices, other methods should be applied not in the order listed in Article 105.7(1) of the Russian Tax Code, but depending on which method gives a more accurate result in view of actual circumstances. This approach seems to correspond both to the letter and the meaning of Russian transfer pricing regulations, and it is also overall consistent with the OECD Guidelines on Transfer Pricing for Multinational Enterprises and Tax Administrations[2].
Furthermore, the court noted that transfer pricing methods are intended to achieve objective arm’s length price level so, regardless of the method used, the result should be approximately the same. Such statement could probably be true when all the data for application of any of the methods is fully available to taxpayers. However, such situation hardly ever occurs, and that is why the OECD Guidelines explicitly state: “No one method is suitable in every possible situation”[3].
Yet, in expressing its position on method priority, the court steered cleared of the most prominent question, i.e. should tax authorities first try to apply the method used by taxpayers and apply another method only if this attempt fails, or can a higher-priority method be applied immediately? In other words, are tax authorities bound by the method chosen by taxpayers?
We firmly believe that tax authorities should be bound by the choice of method made by taxpayers, and in case of disagreement, they should demonstrate why the chosen method results in inaccurate figures. If a method has been incorrectly selected, surely it should not be difficult for tax authorities to make such demonstration. However, if a taxpayer has obtained accurate results, the fact that a lower-priority method has been used should not be particularly relevant.
How to select an information base?
The court’s approach that tax authorities should not blindly rely on data from price information agency when calculating arm’s length price is another positive point. The court pointed out that it is necessary to consider in each specific case whether the data from price information agency on arm’s length prices is accurate and comparable with the transaction under review regardless of the agency’s credibility and similar factors. The appellate court upheld the position held by tax authorities and ruled that the data from the information and advisory agency Argus should be applied. Also, it seems that the appellate court’s main argument was that state authorities, including the Russian government have always relied on the data from this agency.
Russian general anti-avoidance doctrine of unjustified tax benefit and transfer pricing rules
One of the most significant points is the court’s instruction to the court of first instance to consider, when reexamining the case, the facts and circumstances that could indicate that the taxpayer has derived unjustified tax benefit. The court invites not to limit the verification to arm’s length price level, but also to check the availability of a business purpose. We note that in support of its decision the court refers to the position on uncontrolled transactions (i.e. transactions not subject to transfer pricing regulations) held by the Supreme Court[4]. In our opinion, these references have nothing to do with Uralkali dispute and raise the following logical question: is the court trying to bypass the application of transfer pricing rules by establishing unjustified tax benefit for the taxpayer? And is the court trying to raise the question of whether the transactions with the Swiss company were necessary at all?
The court’s reference to the concept of unjustified tax benefit seems ambiguous and raises the question of correspondence between transfer pricing rules and unjustified tax benefit as a general anti-avoidance rule. In our opinion, attempting to find unjustified tax benefit in parallel with the application of transfer pricing rules could be highly risky for taxpayers. In particular, instead of applying complex transfer pricing rules with their “check-and-balance system” and guarantees, tax authorities and courts could start applying unjustified tax benefit rules. In such case the whole process of application of transfer pricing rules will be reduced solely to whether or not there is a business purpose in taxpayers’ actions, and in its absence, the impossibility to deduct for profit tax purposes the expenses incurred for such actions. On the other hand, the court’s position is not absolutely groundless and could be applied in cases where taxpayers pretend to carry out business activities and hide behind transfer pricing rules to double back tax authorities.
In any case, the approach chosen by the court leaves so far more questions than it provides answers and makes the application of transfer pricing rules even more unclear.
***
Transfer pricing rules are fairly new so their application is not yet uniform and consistent. In our opinion, taxpayers should currently pay special attention to the preparation of transfer pricing documentation for controlled transactions.
If you have any questions about this alert or require assistance in preparing transfer pricing documentation, we will be happy to help.
If you would like to discuss this matter further or have any questions, please write to Anton Kabakov.
Faithfully yours,
[1] Moscow District Commercial Court Ruling dated March 14, 2018 Case No. А40-29025/201
[2] OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 (these provisions are similar to the guidelines of 2010) http://www.keepeek.com/Digital-Asset-Management/oecd/taxation/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-2017_tpg-2017-en#.WpAP5GJuz58#page39
[3] Item 2.2 OECD Guideline
[4] Items 3, 6, 8 Review of Court Examination of Cases Related to the Application of Certain Provisions of Section V.1 and Article 269 of the Russian Tax Code approved by the Supreme Court Presidium on February 16, 2017