Tax payers have only completed their duties in preparing documentation for 2018, and in a moment they will have to analyse their transactions in relation to changes in the transfer pricing rules applicable from 1 January 2019
one from significant changes in transfer prices that entered into force 1 January 2019, the tax authorities obtain tools to challenge settlements between related parties.
The tax authorities should use the transfer pricing verification instruments indicated above with great caution, taking into account the economic rationality considerations that were taken into account when establishing the conditions for cooperation
Since the beginning of this year it has been in force Article 11c Corporate Income Tax Act (hereinafter: CIT Act), which gives a new wording to the primal principle to be followed by entities linked to each other, i.e. the principle of market price and the conditions under which transactions between related parties should be concluded.
In accordance with the applicable rules, the conditions laid down between related parties, already at the time the controlled transaction was concluded, should not deviate from those which would have been established among themselves by reasonable counterparties independent in comparable transactions and circumstances.
Provision Article 11c of the CIT Act indicates that the tax authorities have the power to estimate the income of related parties only through price adjustment, from second Parties by introducing section 4 of Article 11c CIT provides additional tax authorities two Transfer pricing verification instruments according to which the tax authority can:
- • consider that, in comparable circumstances, unrelated parties, which are guided by economic rationality, either would not have entered into the transaction in question (not including the transaction) or
- • would have entered into another transaction, or would have carried out another activity (recharacting).
The tax authority shall take account of:
- •
- the conditions which have been established by the related entities,
- •
the fact that the conditions laid down between related parties make it impossible to determine the transfer price at the level that non-connected entities with economic rationality would agree taking into account the options available at the time of the transaction.
Thus, in the examination of transactions between related parties, the tax authorities shall take into account the actual course of the transaction and the circumstances of its conclusion and the actual behaviour of the parties in the transaction, and not necessarily the contractual or other arrangements between the parties.
The Authority shall not carry out any of the following activities if the rationale for the use of re-sarakterisation tools or omissions of the transaction is solely:
- •
- difficulty in verifying the transfer price,
- •
- the absence of comparable transactions between unrelated parties in comparable circumstances.
The tax authorities assess the marketability of the terms of the transactions between related parties on the basis of their economic rationality, which has no legal definition in the CIT Act. The concept of economic rationality, on the other hand, is used in the OECD Guidelines to verify whether the transaction between related parties would have been carried out in the same way between unrelated parties in comparable economic circumstances.
In the updated OECD Guidelines, 2017 in Part D[2] section 1.122-1.128 there are examples of re characterisation of the transaction or recognition that the transaction should not take place. In particular, section 1.126 Part D[2] The OECD Guidelines indicate the following example of transactions between related parties which could be considered by tax authorities as not occurring between independent entities.
Example 1
Entity 1 has a production plant located in a vulnerable zone to increasingly frequent flooding in recent years. The entity acquires from the related entity the insurance of the property held and pays the relevant premium together with the annual premium constituting the 80% the value of stocks, real estate.
In this example Entity 1 entered into an irrational commercial transaction because there is no insurance market, given the likelihood of material claims, and transfer or non-insurance could be a more attractive realistic alternative.
The transaction is not commercially rational, there are no acceptable prices for both the Entity 1, and the entity associated with their individual perspectives".
In such a situation, the tax authority could omit a transaction between related parties, arguing that the transaction would not have been carried out on the free market because no insurer would have chosen to enter into an agreement with such a high level of insured risk. In that case, the tax authority would determine the taxable person's income without taking into account the burden on the transaction.
In contrast, section 1.128 in Part D[2] OECD Guidelines on 2017 an example of transactions between related parties that could be regarded by tax authorities as inappropriate and tax authorities could identify another transaction between related parties and determine an appropriate transaction price for them.
Example 2
Entity 1 conducts research activities to develop intangible assets used to create new products. The Company intends to transfer to the related entity unlimited rights to all intangible assets that may arise from its future work during the period twenty years, for lump sums.
This agreement is not commercially rational for both parties because neither the Entity 1, neither the related entity has any reliable means to determine whether the payment reflects the appropriate valuation, either because it is not certain what the scope of the activity could be carried out by the Entity 1 during this period and because the valuation of potential outcomes would be entirely speculative.
In line with the guidance given in the OECD Guidelines, the agreement concluded between related parties, including the form of payment, should be modified for the purpose of the transfer pricing analysis.
The replacement structure used by the tax authority should be guided by the characteristics relevant to business activities, including functions, assets used and commercial risks. On the basis of this analysis, the contract could be converted, inter alia, as providing funding by a related entity, as the provision of research services by the Entity 1 or if specific intangible assets can be identified as a conditional license for the development of those specific intangible assets.
As shown in the above examples, the key question that tax authorities should ask themselves when assessing revenue, if any, using the new price verification instruments set out in Article 11c(4) The CIT Act is whether the actual transaction between related parties was concluded from economic rationale that would be taken into account between unrelated parties in comparable economic circumstances.
The tax authorities' recognition of a transaction as non-existent where it has an economic rationality should be assessed as an inappropriate application of the market price principle.
In view of the above, it can be pointed out that it is not only sufficient to reply to the question whether the same transaction involves unrelated entities. The OECD Guidelines also indicate that the mere fact that a transaction is not applied between independent entities does not mean that it should not be recognised.
Indeed, related parties may have significantly greater possibilities for mutual understanding than independent undertakings and may include transactions that do not occur or are very rarely encountered between independent entities.
The tax authorities should use the transfer pricing verification instruments indicated above with great caution, taking into account the economic rationality considerations that were taken into account when establishing the conditions of cooperation.
Bożena Pawłowska, senior tax consultant, Russell bedford Poland office in Katowice