Establishing affiliations for transfer pricing purposes – general remarks, direct and indirect capital affiliations – part 1

Correctly determining the existence of an affiliation under the provisions of income tax laws has been a key issue for correctly identifying documentation obligations for many years. In this article, we will attempt a reliable analysis of the existing legal status at the beginning of 2018 Significant amendments to the transfer pricing provisions, a significant part of which is effective since 1 January 2017, do not directly affect the definitional layer of affiliations, but the proper determination of the scope of affiliations has increasing importance in the context of this amendment due to the fact that the scope of obligations arising on the side of taxpayers for whom such affiliations exist is significantly increasing.

Introduction – how affiliations are defined and types of affiliations

The obligations of affiliated entities are no longer limited to preparing appropriate documentation for their own transactions with an affiliated entity, but also include the necessity of properly identifying affiliations within a capital group (group of affiliated entities) for the purpose of preparing group documentation (including creating a diagram showing affiliations between entities in the group) or properly preparing a simplified report.

This article constitutes first part of an analysis, in which we present general remarks regarding the provisions defining affiliations and specifically address the issue of direct and indirect capital affiliations. The purpose of this paper is to summarize the currently applicable provisions of income tax laws concerning the subject matter and to point out legislative solutions causing interpretational difficulties and any potential need for changes in this area.

The basic provisions defining related parties are Article 11 of the Corporate Income Tax Act (hereinafter: the Corporate Income Tax Act) 1 and Article 25 of the Personal Income Tax Act 2 (hereinafter: PITA) 3 .

The provisions regulating the issue of related parties within the tax acts are not very extensive, but due to the way these provisions are formulated, they create rather vague boundaries for different types of related parties.

The legal definition of related parties, which is important from the perspective of transfer pricing, is constructed by pointing out prerequisites—relationships existing between parties that condition the ability of tax authorities to determine income and due tax for related entities.

The cited provisions capture these prerequisites determining the existence of a related party in a specific way.

“If a natural person, legal person, or organizational unit without legal personality, having its residence, registered office, or management on the territory of the Republic of Poland, hereinafter referred to as the 'domestic entity,' or having its residence, registered office, or management outside the territory of the Republic of Poland, hereinafter referred to as the 'foreign entity,' participates directly or indirectly in the management of an enterprise located outside the territory of the Republic of Poland or controls it, or holds a share in the capital of this enterprise, or if the same person simultaneously participates directly or indirectly in the management of a domestic entity and a foreign entity or controls them, or holds a share in the capital of these entities” – the basic prerequisites for establishing a related party are met.

The remainder of the discussed provisions concern their appropriate application to relationships between domestic entities, family relationships, those arising from employment, property relationships, as well as transactions with entities from so-called "tax havens."

These provisions constitute an independent basis introduced for transfer pricing purposes, autonomous from the regulations of other acts. Therefore, one should not refer to the definitions of related parties contained in other acts, even in the Accounting Act[4].

The mentioned regulations present various types of affiliations in a collective manner; after reading these provisions, international and domestic affiliations emerge for the plan first. The quoted fragment Article 11 the Corporate Income Tax Act specifies what entities should be understood by the terms 'domestic entity' and 'foreign entity'.

It is worth noting that by defining the scope of affiliations that will generate the possibility for tax authorities to estimate the amount of income obtained by the taxpayer and the documentation obligation, the legislator First, pointed to affiliations occurring in international relations.

Such a designation is not accidental, since the system for verifying prices applied between affiliated entities, introduced into Polish law, is based on principles developed by the Organisation for Economic Co-operation and Development (OECD), which were comprehensively presented in the Guidelines on Transfer Pricing for Multinational Enterprises and Tax Administrations (hereinafter: OECD Guidelines) 5 .

The purpose of the transfer of capital monitoring system developed by the OECD is, from the outset, to increase the tax security of individual jurisdictions by limiting the possibility of capital flow between entities operating in different tax systems (it is particularly about protecting the fiscal interest of highly developed economies with a fairly developed fiscal system). Polish law, by introducing regulations concerning the monitoring of capital transfer into the national legal order, will equalize the situation of taxpayers operating in groups of international affiliated entities as well as domestic ones, and it can even be stated that it goes a step further, because the scope of criteria determining the establishment of an affiliation in domestic relations is broader, as shown below.

Types of Affiliations

In an effort to achieve the most transparent division of types of affiliations, the following system can be applied:

1. Capital: a. direct; b. indirect; II. Personal: a. management-control: b. resulting from an employment relationship; c. property-based; d. family-based.

The legislator formulated the cited regulations in a way that allows for recognizing the territorial limitation of individual types of connections, which can be summarized by the statement that foreign relations concern practically only capital and management-control connections. However, in domestic relations, all types of connections mentioned above must be considered.

This is a solution that should be considered practically correct, because examining connections of a personal nature, e.g., family connections in the case of international corporate group structures, would be a very difficult task to implement in practice. Regarding domestic connections, in the wording effective since 1 January 2018, connections by the State Treasury and local government units 6 have been excluded from their scope.

A specific category of prerequisites leading to the emergence of a documentation obligation is conducting transactions with entities from so-called "tax havens." The specific approach to the documentation obligation in the case of these transactions is primarily that the mere fact of conducting a transaction with an entity having its registered office in a given jurisdiction is sufficient prerequisite for the existence of such an obligation, without the need to examine any direct or indirect connections.

Capital connections

Since 1 January 2017, a capital connection depends on holding a share in the capital of another entity at a level no less than 25% (by the end of 2016, this share was only 5%). It was pointed out that holding a share in the capital of another entity can be direct or indirect.

By introducing a regulation concerning indirect participation, the legislator indicated that it concerns a situation where first entity holds a share in the capital of second entity, and the latter second holds a share in the capital of another (third) entity.

If the shares between first and second are at the same level as between second and third, it should be assumed that there is a relationship between first and third of the same materiality.

In a situation where these shares are different, the lower value should be considered to determine the materiality of the relationship between first and third entity.

By the nature of this relationship, it appears that they can only occur in the case of entities holding formalized shares, and therefore, in relation to Polish entities, these may be limited liability companies, joint-stock companies, and limited partnership companies.

Example 1

Company A holds shares in Company B worth 50% – Companies A and B are directly related entities.

Example 2

Company A holds a share in Company B worth 50%, and Company B holds shares in Company C worth 30% – Companies A and C are related entities with an indirect participation value at the level of 30%.

Determining a direct relationship is relatively easy in practice and does not raise major doubts; for its investigation, knowledge of one's own share structure in a given entity is sufficient, which constitutes publicly available information, identifiable also from the perspective of an external observer, even using information provided electronically by the National Court Register. This does not, however, mean that establishing the existence of capital relationships is entirely free from interpretive doubts.

The issue that has been controversial since the effective date of the regulations discussed, and which also has enormous practical significance, is the matter of the so-called “depth of capital connection”.

The above examples present a situation concerning an indirect connection, in which there are three entities – there is no doubt that in such a situation the prerequisite for the existence of an indirect connection, mentioned in under Article 11(5b) the Corporate Income Tax Act (respectively Article 25(5b) u.p.d.o.f.), is met 7 .

However, the question arises how to interpret this provision in a situation where, in addition to these third entities, there are further capital connections at subsequent levels, with a value exceeding the threshold of 25% materiality – should the existence of a connection be established between the first entity holding the shares and subsequent entities beyond these first three units?

This can be illustrated with the following example:

Example 3

Company A holds shares in Company B worth 80%, Company B holds 100% shares in Company C, which in turn holds 50% shares in Company D.

In the above example, it is clear that capital connections exist in the relationships between companies A to B, B to C (direct connection), and A to C (indirect connection). The question that must be asked is whether an indirect connection also exists in the relationships between Company A and D, and also in relationships with subsequent units, should such further relationships regarding owned shares occur.

There may be two interpretations of the provision mentioned, which may lead to different conclusions:

1. literal interpretation.

According to tax law doctrine, literal interpretation has priority significance in the process of interpreting tax law provisions[8].

Literal interpretation in the context of tax law is particularly important because it ensures legal security for the recipients of legal norms, and thus indirectly realizes the principle of trust in the State and established law 9 .

This is especially important in the case of tax law, whose provisions very largely impose obligations on taxpayers (of a strictly fiscal nature, resulting in the obligation to pay tax, or informational and reporting nature).

Literal interpretation should therefore be applied by default for the purpose of determining the meaning of a given tax law provision, provided that unambiguous results regarding the scope of the taxpayer's obligations can be established on this basis.

Teleological interpretation is not the only necessary type of interpretation, but however, other types of interpretation cannot be used to improve or correct the content of normative acts if the given provision would not allow for the establishment of a legal norm through literal interpretation 10 .

By applying the principles of literal interpretation to the provision cited above defining indirect capital connections, the author believes that an unambiguous result can be established. This result is the establishment of a connection in the relationship between these three taxpayers mentioned in the provisions.

Referring therefore to the presented example 3 and applying the rules of literal interpretation, it should be considered that an indirect connection exists between Company A and Company C (as well as between Company B and Company D), while no such connection exists between Companies A and D.

Applying such an approach also allows for the determination of a clear limit regarding the “depth of capital connection,” which is of great significance when analyzing capital connections occurring in relationships between companies operating within complex capital group structures.

It should also be considered whether an approach different from the presented linguistic interpretation, resulting in the recognition that indirect connections also concern subsequent entities located at further levels of the structure, does not constitute an impermissible attempt to improve or correct the content of the normative act using teleological interpretation 11 .

2) Teleological interpretation

Linguistic interpretation, although having priority significance for tax law, is not the only type of interpretation and does not have an absolute character – it is possible to deviate from linguistic interpretation when its results are unambiguous but contradict the hierarchy of values maintained by the interpreter.

An interesting attempt to approach the issue of indirect connections using teleological interpretation was presented in the individual interpretation by the Director of the National Tax Information 12 .

According to this position, if, within the scope of conducting economic activity, Entity U enters into transactions with domestic or foreign entities, between which there is a relationship consisting of the fact that Entity W holds a share in the capital of Entity X of no less than 25%, Entity X holds a share in the capital of Entity Y of no less than 25%, and Entity Y holds a share in the capital of Entity Z of no less than 25%, and simultaneously Entity W holds a share in the capital of Entity U, then a capital connection exists between Entity W and Entity Z.

Furthermore, according to the position of the Director of the National Tax Information contained in the aforementioned interpretation, if Entity U enters into transactions with domestic entities, between which there is a relationship reducing to the fact that Entity A holds a share in the capital of Entity B of no less than 25%, while Entity B holds a share in the capital of Entity C of no less than 25%, and Entity U holds a share in the capital of Entity A of no less than 25%, then an indirect capital connection will occur between Entity U and C.

In the justification for the aforementioned individual interpretation, the authority indicated that the regulation resulting from Article 11(5b) the Corporate Income Tax Act merely indicates a principle governing the approach to determining the indirect share, and its presentation based on third entities results from the fact that it is a construction with a minimal number of entities whose capital dependence must be described[13]. It is possible, in fact, to create longer chains of connections, consisting, for example, of four links (A-B-C-D), provided that an appropriate level of capital involvement is maintained for each subsequent relationship, which allows one to state that entity A is connected to entity D 14 .

Based on the position presented above, it can be concluded that the indirect capital connection, for the purpose of determining documentation obligations, does not actually have a limit in its "depth" within the structure of entities. The interpretative authority proposes referring to the dictionary meaning of the phrase "it is assumed that the principle" (referring the reader to the Polish language internet dictionary www.sjp.pwn.pl), which appears in the commented provision 15 , concluding from a supposedly literal interpretation of this concept that the intention of the legislator was to describe the "manner of procedure" for the purpose of determining whether the given entities are connected entities.

In the author's opinion, such an argument is difficult to consider a correct model for applying literal interpretation, especially since it aims at the actual expansion of the scope of obligations imposed on taxpayers. The attempt to apply literal interpretation in this way seems to contradict the established understanding of this interpretation as an assumption of literal, or even colloquial, understanding of statutory provisions, which was expressed, among others, In one in the judgments of the NSA 16 .

Summary

The approach presented earlier, proposed by interpretative bodies and part of the doctrine, constitutes a worrying solution from the point of view of taxpayers operating in groups of related entities; establishing such an approach can, in many cases, pose a serious difficulty for units operating in international capital groups regarding the ability to reliably determine the scope of their obligations. For example, such a situation can be indicated by a frequently recurring scheme – a Polish limited liability company acts as a contract manufacturer, operating within a large group, whose direct shareholder is a Swiss company, which holds shares in companies operating in the Central and Eastern European region, where, in turn, the shareholder is a Dutch company.

In many such situations, the personnel managing the Polish unit do not possess knowledge of the structure of relationships at the higher levels of the holding, beyond very general information provided by the group management. They may therefore conduct transactions with entities within the group without even being aware of the existence of the relationship. There is thus a risk that they will not properly fulfill the obligation to prepare documentation for these transactions.

However, the parties, and probably the tax authorities, will not possess knowledge of the details of the structure either, regarding second.

In this context, it is also worth mentioning the obligation to identify related parties for the purpose of preparing group documentation. one among the elements of such documentation is the organizational structure of the group of related entities 17 .

The implementing act to this provision specifies that regarding information on the organizational structure, this structure must be presented in the form of a diagram, and information must be provided about related parties holding a share in the capital 18 .

This would mean that when preparing this diagram for group documentation purposes, taxpayers should identify all direct and indirect capital relationships, while the literal wording of this provision excludes relationships of a non-capital nature.

This is undoubtedly a certain simplification for taxpayers, but doubts regarding the proper definition of an indirect capital relationship remain relevant in this regard.

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1 Corporate Income Tax Act of 15 February 1992, i.e. Journal of Laws of 2018, item 1036. as amended 2 Personal Income Tax Act of 26 July 1991, i.e.

Journal of Laws of 2018, item 200 as amended 3 At the time of preparing this paper (July 2018), legislative work is ongoing on the act amending tax laws (a draft from 15 July 2018 amending the Personal Income Tax Act, the Corporate Income Tax Act, and certain other acts, published in the Government Centre of Legislation 16 July 2018, http://legislacja.rcl.gov.pl/docs//2/12313855/12522177/12522178/dokument350013.pdf which will significantly change the statutory regulations regarding the method of identifying related parties for transfer pricing purposes.

Given that the legislative work is still in an early stage, the Author does not refer to it in this part of the paper, considering it an unconfirmed source of information about the future state of legislation.

However, In the second parts of the publication will discuss the considered directions of legislative changes that are significant for the method of defining related parties. 4 i.e. Journal of Laws of 2018, item 395.

5 OECD Guidelines for Transfer Pricing for Multinational Enterprises and Tax Administrations (English: Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations), http://www.oecd.org/tax/transfer-pricing/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-20769717.htm .

6 Article 2(12) point (a) Act of 27 October 2017 amending the Personal Income Tax Act, the Corporate Income Tax Act, and the Act on Lump-Sum Income Tax on Certain Income Obtained by Natural Persons (Journal of Laws of 2017, item 2175) amending the Corporate Income Tax Act with effect from 1 January 2018 7 When determining the size of the indirect share held by an entity in the capital of another entity, the principle is adopted that if one entity holds a specified share in the capital of second entity, and that second entity holds the same share in the capital of another entity, then first entity holds an indirect share in the capital of that other entity of the same amount; if these values are different, the lower value is taken as the indirect share amount.

8 For example, B. Brzeziński, Fundamentals of Tax Law Interpretation, Gdańsk 2008, R. Mastalski, Application of Tax Law, Warsaw 2008, R. Mastalski, The Place of Linguistic Interpretation in the Process of Applying Tax Law, "Przegląd Podatkowy" 2007, no. 8. A. Mariański, Resolving Doubts in Favor of the Taxpayer.

Principle of Tax Law, Chapter 5 Tax Law Interpretation and the Principle of In Dubio Pro Tributario, Warsaw 2009. 9 Article 2 Constitution of the Republic of Poland. 10 B. Brzeziński, Introduction to the Science of Tax Law, Toruń 2003, p. 147.

11 The principle of priority of literal interpretation of tax law has also been confirmed repeatedly in the case law of the Supreme Tax Court (NSA), including in judgments: from 20 October 2016, reference no. II FSK 1582/16; from 19 September 2012, reference no. II FSK 1403/J 2; from 10 November 2011, reference no.

I FSK 1634/10; from 30 March 2011, reference no. II FSK 1925/09; from 25 January 2011, reference no. II FSK 1665/09. 12 Individual interpretation of the Director of the National Tax Information from 18 January 2018, no 523760/I.

13 The interpreting body refers to the rationality of the legislator, arguing that it is irrational to assume that Article 11(5b) the Corporate Income Tax Act (or Article 25(5b) u.p.d.o.f.) would introduce a limitation regarding the number of entities.

14 The position stating the lack of limitation regarding the number of entities in the structure for which the existence of an indirect capital connection must be established appears in the relevant literature, such as J. Mika, Transfer Pricing. Commentary on the Regulation. Methods for Determining and Estimating Transfer Prices.

Comparability Analysis. Examples, Warsaw 2017 and P. Małecki, M. Mazurkiewicz, CIT. Taxes and Accounting. Commentary, Warsaw 2017. 15 When determining the size of the indirect share held by an entity in the capital of another entity, the principle is adopted (...).

16 Supreme Administrative Court Judgment from 16 January 2009, reference no. II FSK 1495/09: "The starting point for all legal interpretation is undoubtedly linguistic interpretation, which simultaneously defines its limits within the possible meaning of the words contained in the legal text.

one among the basic principles of linguistic interpretation is the presumption of colloquial language, which means that, as far as possible – we give legal phrases the meaning found in colloquial language." 17 Article 9a(2d)(2) the Corporate Income Tax Act, or Article 25a(2d)(2) u.p.d.o.f.

18 section 4 Regulation of the Minister of Development and Finance of 12 September 2017 regarding information contained in tax documentation concerning corporate income tax, Journal of Laws of 2017, item 1753.