The Arms Length Standard April 2006

In this issue:Vietnam Issues Circular on Transfer Pricing Regulations (1)Spanish Government Issues Draft TP Rules to be Presented to Parliament (3)Sweden’s New Documentation Requirements Up for Vote in Parliament (4)Deadline for Hungarian Transfer Pricing Documentation Looming (5)Japan Introduces Cost Contribution Agreement Guidelines (6)IRS Issues Seventh Annual APA Report (8)New Zealand Tax Authorities Launch “Financing Costs” Project (8)Mexico’s Tax Authorities Scrutinizing New Business Models (9)Vietnam Issues Circular on Transfer Pricing RegulationsUntil recently, the concept of transfer pricing was relatively new and undeveloped in Vietnam. Circular 13/2001/TT-BCT of 8 March 20011 briefly mentioned basic transfer pricing rules, but the practical application and impact of the transfer pricing provisions of Circular 13 during its effective period were minimal, and it was abolished and replaced by Circular 128/2003/TT-BTC dated 22 December 2003. Unlike Circular 13, which applied only to foreign invested enterprises in Vietnam, Circular 128 is applicable to all business establishments in Vietnam. However, the specific transfer pricing provisions detailed in Circular 13 are no longer included in Circular 128.After approximately two years of preparation, the Ministry of Finance on 19 December 2005 issued detailed transfer pricing regulations under Circular 117/2005/TT-BTC. The circular will be effective 15 days after its publication in the Official Gazette. Practically, the new regulations may be applicable for all or part of the 2006 year, and arguably may even be applicable to the 2005 calendar tax year, as the final annual tax return for 2005 is due on 31 March 2006 for most companies with 31 December year-ends.Unlike the old transfer pricing rules provided under Circular 13, which applied only to transactions between entities with foreign investment capital in Vietnam and their related parties, the new regulations are applicable to transactions between both domestic and foreign related parties.The definition of related parties is very broad, and includes a control threshold of as low as 20 percent, which may be much lower than in many other countries. More important, the definition also covers significant supply, purchase, and lending relationships between otherwise unrelated parties.The circular defines the following acceptable transfer pricing methods:1 Circular 13 provided implementing guidance on the overall taxation of foreign invested•Comparable uncontrolled price;•Resale price;•Cost plus;•Comparable profits; and•Profit split.No method is preferable over the others. However, the chosen method must be “most suitable to the conditions surrounding the transactions with the most complete and reliable source of information and data for analysis and comparison.”Information and data from the following sources only may be acceptable for transfer pricing study analysis and comparison (other unlisted sources may be used only for reference purposes):•State bodies, research institutes, associations, and other recognized international organizations;•Independent authorized professional service organizations (such as independent auditors, business rating organizations, etc.);•Business financial statements; and•Tax returns.Vietnam’s new transfer pricing regulations impose a heavy and onerous compliance burden on businesses with related-party transactions in Vietnam. Related-party transactions must be identified and declared annually following prescribed forms that must be submitted together with the taxpayer’s annual corporate income tax return. Businesses are required to make full self-assessment of their profits calculated on an arm’s length basis. In doing so, taxpayers have the obligation to prove that the pricing adopted is on “arm’s length” terms. Businesses are also required to maintain “contemporaneous” records —that is, records obtained and prepared at the time the related-party transactions took place, which serve as the basis for application of the methods of determining the arm’s length price. The contemporaneous records must include general information on the related-party relationships, transactional descriptions and diagrams, product technical specifications, contractual terms and conditions, and pricing methodology. These documents must be available in Vietnamese and submitted to the tax authorities within 30 days of request.When a business enterprise does not follow the required transfer pricing provisions set out in the circular, the tax authorities are given, under certain circumstances, the right to impose a deemed appropriate pricing, or deemed taxable profits or even a deemed tax. However, the circular does not provide any general administrative or specific transfer pricing penalties. There is also no mention of the possibility to apply and obtain an advance pricing agreements, which are common in other jurisdictions.Because the new transfer pricing regulations were issued without much warning or consultation with the business community, and because Vietnam has chosen a somewhat more stringent transfer pricing regime than other more developed tax jurisdictions, the application (and to some extent the enforcement) of the new transfer pricing regulations are expected to give rise a number of difficulties for both taxpayers and the tax authorities. These obstacles include:•Broad application because of the broad definition of related parties and transactions. Most businesses in Vietnam will be subject to the new rules.•Limited resources, experience, training and guidance on the part of both the tax authorities and taxpayers to effectively apply and enforce the new rules.•Heavy burden on businesses in preparing and submitting declarations and maintaining “contemporaneous” documentation.•Availability, access, and acceptance of comparables.Despite these setbacks and difficulties, the new transfer pricing regulations are now in place, andnoncompliance may lead to heavy costs and penalties. Businesses should consider taking immediate action to understand the new requirements of the transfer pricing circular, put in placean appropriate and supportable transfer pricing strategy, review and analyze all the company’s related-party transactions, and prepare the required transfer pricing documentation together with necessary data/evidence to support the company’s transfer pricing position.— Ninh van Hien (Ho Chi Minh City)PartnerVietnam Auditing Company+84 (09) 0800 8834hninh@Spanish Government Issues Draft TP Rules to be Presented to ParliamentThe Spanish government on March 10 published the final draft of the Tax Fraud Prevention Act, which includes a reform of Spain’s transfer pricing rules. This draft supersedes the initial draft published on December 30, 2006 (see TP Alert 06-001).The revised draft of the Tax Fraud Prevention Act has been published following a consultation with taxpayers and professional firms, including Deloitte. The content regarding transfer pricing remains unchanged (that is, the introduction of the obligation to carry out related-party transactions at an arm’s length price, together with formal documentation requirements). However, the Tax Administration has made some changes to define more precisely taxpayer obligations and the powers of tax inspectors. The most important changes, in comparison to the version published in December 2005, are as follows.Transfer Pricing Penalty RegimeAlthough not expressly mentioned in the text, when the taxpayer prepares documentation that is complete, correct, and truthful, and has applied its transfer pricing policy in accordance with the documentation, the Spanish tax authorities should not impose penalties.When the above-mentioned requirement has not been fulfilled or the taxable base declared is not consistent with the transfer pricing documentation prepared, the following penalties will apply:•When a transfer pricing adjustment is performed, a penalty equal to 15 percent of the adjustment, with a minimum penalty of €30,000.•If no transfer pricing adjustment is applied, a penalty of €15,000 for each incomplete, inexact, or false datum or set of data, for each of the documentation requirementsestablished.•For taxpayers that resist, obstruct, or respond negatively in the event of a transfer pricing audit, the Tax Administration may impose an additional penalty of 3 percent of thecompany’s turnover, with a maximum penalty of €600,000.Secondary AdjustmentsIn the event of a transfer pricing adjustment with a parent company, overpayments will generally be considered dividends and underpayments capital contributions. Secondary tax adjustments will be applied to these transactions.Transactions with Tax HavensDocumentation requirements will apply to transactions between Spanish residents and tax havens, even when the contracting parties are unrelated.The preamble to the draft act highlights that the new transfer pricing rules should be interpreted in the context of the OECD Transfer Pricing Guidelines and the publications of the EU Joint Transfer Pricing Forum, a development we consider to be very positive and that in some circumstances will contribute to the harmonization of technical criteria with other OECD countries.The draft act will be presented to the Spanish Parliament and is expected to enter into force in September. For Spanish resident companies with a tax year ending December 31, the new legislation will apply for periods commencing January 1, 2007.— Ignacio Longarte (Madrid)PartnerDeloitte Asesores Tributarios S.L.+34 (91) 443 2953ilongarte@deloitte.es Chris Wix (Madrid)ManagerDeloitte Asesores Tributarios S.L. +34 (91) 438 1090cwix@deloitte.esSweden’s New Documentation Requirements Up for Vote in Parliament The Swedish Council of Legislation on March 20 presented a government bill to the Swedish parliament for a vote. The bill contains proposed legislation on documentation requirements fortransfer pricing purposes for Swedish resident companies engaged in intragroup cross-border transactions. The legislation is proposed to enter into force January 1, 2007.The Swedish Council on Legislation has reviewed an exposure draft presented by the Swedish Ministry of Finance from an overall legal perspective and thereafter provided comments. The voting by the Swedish parliament is planned to be held in early summer. A short summary of the proposed legislation is presented below.The proposed legislation will be part of chapter 19 of the Swedish Act (2001:1227) on Income Tax Returns and Statement of Income (§§2a - 2b). Proposed paragraphs 2a and 2b read as follows:Chapter 19Documentation requirements regarding transfer pricing.§2 aA person taxable for income of a business shall, in regard to transactions with a nonresidentcompany according to the rules of the Income Tax Act (1999:1229), draft writtendocumentation with respect to these transactions.The first paragraph is applicable only if such financial community of interest as defined inchapter 14, §20 of the Income Tax Act is present. If the financial community of interestexclusively relates to a company’s direct or indirect ownership in one or several othercompanies, documentation is required only if the capital shares in each tier exceeds 50percent.§2 bDocumentation according to §2 a shall consist of1. A description of the company, organization, and business,rmation about the nature and size of the transactions,3. A functional analysis,4. A description of selected price method, and5. A comparability analysis.The Government or the authority selected by the Government will announce more detailed instructions on what information shall be included in the documentation.Paragraph 2 a deals with the companies covered by the proposed legislation. Chapter 14, §20 of the Income Tax Act states that a “financial community of interest” exists if one company owns shares in another company, or in other ways participates in the management of that other company. In theory, then, a shareholding of one share would be enough to create a financial community of interest. Documentation of transactions between such companies would be of little or no value. Therefore, a limitation has been added to §2a, stating that for the proposed documentation requirements to apply, a shareholding of more than 50 percent is required if the financial community of interest exists only because of direct or indirect ownership in the other company.The government bill is based on the report drafted by the National Tax Board in 2003, but in some respects it is more limited in scope. For instance, the bill does not include a requirement to file information with the annual corporate tax return, as the National Tax Board initially proposed. The documentation requirements apply to all types of transactions, regardless of size. There will be no relief for small or medium-sized companies.The complete content of the documentation required is to be announced by a competent authority (most likely the Swedish Tax Authority) at a later time. However, from the exposure draft it is clear that documentation prepared in accordance with the OECD Transfer Pricing Guidelines and the EU Code of Conduct will be accepted. So will documentation drafted in accordance with accepted principles of documentation of other EU member states, assuming the information reliably shows whether the applied transfer pricing policy, in the individual case, is in line with the arm’s length principle.The proposed legislation will not apply for the time being to permanent establishments in Sweden or abroad, because of the ongoing discussions within the OECD regarding the allocation of profitsto permanent establishments.Documentation is to be provided upon request by the Swedish tax authority and will be accepted if drafted in Swedish or English. There will be no requirement for contemporaneous documentation, and there will also be no special sanctions for noncompliance. In case of an adjustment, the normal tax penalty is 40 percent of the tax on the adjustment. In certain cases, the tax authorities may request information under penalty of a fine, already the normal procedure in tax investigations.— Mats Emanuelson (Stockholm) Senior ManagerDeloitte AB+46 (8) 506 721 90memanuelsson@deloitte.se Lars Jernkrok (Stockholm) ManagerDeloitte AB+46 (8) 506 713 38 ljernkrok@deloitte.seDeadline for Hungarian Transfer Pricing Documentation LoomingHungarian transfer pricing documentation must be prepared by May 31 for entities with calendar-year tax years.Hungary introduced transfer pricing documentation requirements in 2003. After a short transition period, and beginning with the 2005 tax year, transfer pricing documentation must be prepared for all contracts entered into with related parties based on which performance took place in the givenyear. The documentation requirements apply to all kinds of related-party transactions, includingdomestic and cross-border transactions such as management services, cost recharge, free-of-charge services, etc. Oral agreements are also subject to documentation obligation. In the courseof tax audits, the Hungarian tax authorities pay particular attention to management fees and royalties paid.The deadline for preparing the documentation coincides with the deadline for filing corporate income tax returns. Thus, transfer pricing documentation pertaining to related-party transactions conducted in 2005 must be prepared by most entities (whose tax year coincides with the calendar year) by May 31.Transfer pricing documentation should be prepared separately for each contract. However, in specific cases, it is possible to document contracts in a consolidated manner, whereby one set of documentation can cover several contracts. For contracts whose arm's length value does not exceed HUF 50 million, it is sufficient to prepare simplified documentation. However, the above rule does not imply an annual limit of HUF 50 million but a total contractual value for the entire term of the contract. Any potential consolidations should also be taken into account when determining whether the above limit has been exceeded, to avoid cases in which companies split one contract into several contracts.If a company fails to have the appropriate transfer pricing documentation by the May 31 deadline (for transactions in 2005), it can be fined up to HUF 2,000,000. This penalty can be imposed not only if the documentation is missing, but also if the documentation does not fully meet the formal requirements set forth in the decree issued by the Ministry of Finance. Besides the formal requirements, the TP rules deal with the arm’s length nature of the prices from a substance point of view. If the related parties do not trade at arm’s length, the tax authorities can challenge the practice and assess tax default and legal consequences (a tax penalty equal to 50 percent of the tax default, late payment interest equal to double of the prime rate of the Hungarian National Bank).— Peter Gemesi, Partner (Budapest)Deloitte Advisory and Management Consulting Ltd.+36 (1) 428 6904pgemesi@Japan Introduces Cost Contribution Agreement GuidelinesJapan’s National Tax Administration (NTA) on March 20 issued a Commissioner’s directive outlining revisions to the Transfer Pricing Administrative Guidelines. The directive adds new guidelines for the treatment of intangible property during the transfer pricing audit process, and introduces for the first time in Japan guidelines on cost contribution agreements (CCAs).Intangible PropertyThe new revisions to the Guidelines make clear that the scope of intangible property is broad, including not only intangibles related to technical innovation, such as patents and trade secrets, but also:•Human resources-based intangibles such as skills and knowledge of employees obtained through management, sales, production, or research and development; and •Organization-related intangibles such as networks and processes.Paragraph 2-11 of the prior Japanese Guidelines stated that the auditor should take into account not only the legal ownership of the intangible property but also contributions by each related partyto establish, maintain, and develop the property. The new guidelines regarding intangible property state that decision-making, services, costs and risk management functions of all related parties involved should be examined when considering the extent of their contribution.Whenever intangible property held by one party is shared with a related party without a formal royalty agreement, the transaction is deemed to be a license agreement, and royalties should be calculated in accordance with the arm’s length principle.CCA GuidelinesThe newly introduced CCA guidelines regard a CCA as a contract under which the parties agree to share the costs of a joint activity (such as development of intangible property) in proportion to their share of expected benefits from the outcome. Furthermore, when a taxpayer’s contribution is considered inappropriately high compared to its proportion of expected benefit, the excess contribution should not be regarded as a cost for tax purposes.The new CCA guidelines provide a list of items to be considered when examining CCAs, as well as a sample list of documents to be examined during the audit. Specifically, auditors should check whether:•The scope of R&D or other activities in the CCA are clearly determined;•Each participant receives benefits directly from the outcome;•The expected-benefit ratio used is reasonable;•Factors for measuring expected benefit (used when direct measurement is difficult) are appropriate;•The share of expected benefit is revised when the factors for measurement fluctuate;•The expected-benefit ratio is reasonable when it differs significantly from the actual share of benefit; and•The interest in the intangible or other outcome was evaluated at the arm’s length price at the time a buy-in or buy-out occurred.Documents to be examined include the actual cost contribution agreement, relevant background documents such as evidence of negotiations and/or computations of expected benefits, background data on valuation of buy-in or buy-out payments, and evidence of actual cost and benefit data after implementation of the CCA.Key PointsJapan’s NTA has been intensifying its focus on intangible property in TP audits recently, and has made clear in these new revisions to the Guidelines that the scope of intangible property is broad. There are three points worth noting regarding the addition of CCA guidelines. First, Japanese TP legislation (Special Taxation Measure Law (STML) Article 66-4, and 68-88) includes no reference to CCAs. This reflects the unique nature of Japanese TP legislation, which defines only basic rules and concepts. Second, revisions to the Guidelines are not limited to “intangible properties” but could include other activities in which the participants engage. This is in line with the OECD Guidelines, which state that a “CCA could exist for any joint funding or sharing of costs and risks, for developing or acquiring property or for obtaining service.” Third, unlike the OECD Guidelines, the revised Japanese Guidelines state that each participant must enjoy benefits directly, and indirect enjoyment is not included.Taxpayers considering entering into a CCA, or that have already entered into such an agreement, should confirm that they have prepared the CCA-related documents the Guidelines instruct auditors to review.— Setsuko Fukushima (Tokyo)PartnerTohmatsu Tax Co.+81 (3) 6213 3976sfukushima@IRS Issues Seventh Annual APA ReportThe Internal Revenue Service on March 31, 2006, released Announcement 2006-22, its Advance Pricing Agreement (APA) annual report covering the activities of the APA program during calendar year 2005. The annual report is issued under §521(b) of Pub. L. 106-170, the Ticket to Work and Work Incentives Improvement Act of 1999, which requires the Secretary of the Treasury to report annually to the public on APAs and the APA program.The annual report provides a brief summary of recent developments in the APA program and a statistical snapshot of the APA program’s activities during 2005. Highlights of the APA annual report are as follows:•Completed APAs – The IRS executed 53 APAs (28 unilateral and 25 bilateral), renewed 16 APAs (seven unilateral and nine bilateral), and amended one APA in 2005, a decrease from the 65 APAs executed in 2004 and the four amended APAs in 2004.•Small Business Taxpayer APAs – Ten small business taxpayer APAs were executed in 2005, up from nine in 2004.•Months to complete APAs – In 2005, the median time to complete a unilateral APA was17.9 months, and 49.3 months for a bilateral APA, compared to 18.4 months for a unilateralAPA and 43 months for a bilateral APA in 2004.•Requests for APAs – The IRS received 82 APA applications (21 unilateral and 61 bilateral) in 2005, slightly up from 80 in 2004.•Inbound v Outbound – Continuing the trend established in previous years, inbound cases accounted for the majority of the APA program’s caseload in 2005, with 64 percent of theAPAs executed involving foreign multinationals with U.S. subsidiaries. This number hasincreased slightly from 62 percent in 2004 and 53 percent in 2003.•Boilerplate and Balance Sheet Adjustments – The annual report also includes the latest versions of the APA program’s boilerplate APA agreement and formulas for balance sheetadjustments.— Alexey Manasuev (Washington, DC)ManagerDeloitte Tax LLP+1 (202) 879 4961amanasuev@New Zealand Tax Authorities Launch “Financing Costs” ProjectThe New Zealand tax authorities' International Audit Unit recently launched a “financing costs” project whereby it contacted 50 New Zealand companies to request transfer pricing details relating to financing. The project focuses on alleged abuses relating to related-party interest and guarantee fees.The broad, sweeping request seeks details concerning the composition of interest rates, related financing fees, and foreign exchange gains and losses. Although taxpayers are not legally required to maintain such documentation, in practice, they must do so to respond to such requests and avoid potentially expensive tax audits.Most taxpayers currently apply a standard global group interest rate spread to a selected baserate. Typically, the group approach focuses on minimizing the risk and impact of a transfer pricing adjustment rather than establishing a robust interest rate. The tax authorities have signaled that amore sophisticated and scientific approach is required. Broadly, that approach requires the borrower’s credit rating to be established and an interest rate to be set by reference to comparable arm's length market data.Establishing a credit rating for multinationals can be challenging, because it requires the assessment of one company within the multinational group as if it were a hypothetical stand-alone entity. This approach requires a raft of difficult assumptions and adjustments, and is a costly process. The fact that most New Zealand-based multinational subsidiaries are not rateable is also cause for concern, particularly given that most intercompany arrangements are longer-term propositions or perpetual arrangements. Additionally, intercompany funding is often required for special-purpose companies with only one underlying asset. In these situations, it would often not be feasible to raise funds in the open market. In the absence of a market rating, generally accepted pricing practices are not relevant, and taxpayers have little choice but to rely on judgment and industry rules of thumb. Further, New Zealand’s financial market is too small to provide taxpayers with robust arm's length data across a full range of instruments.Another method commonly applied by small/medium-sized enterprises and large enterprises with lower value transactions is to request bank quotes from their bankers. However, opinion letters from banks are not acceptable because the tax authorities consider a banker's ongoing relationship with its client an influence on the rate provided. The tax authorities also are concerned that bank quotes do not represent the final position that may be negotiated. Banks are increasingly weary of assisting clients with their tax compliance, and bank quotes are often difficult to obtain. Given this, taxpayers must resort to bankers that have a relationship with the taxpayer. Finally, a quoted rate is useful only when the banker has a full appreciation of the taxpayer's business and is able to provide an accurate credit rating assessment.The enhanced focus on the transfer pricing of financing transactions considerably raises the stakes for New Zealand businesses structuring into overseas jurisdictions and the complexities that arise when those investments are not stand-alone and, thus are unable to meet the comparable market data requirements.— Robyn Russell (Auckland)PartnerDeloitte+64 (9) 303-0902robrussell@Mexico’s Tax Authorities Scrutinizing New Business ModelsThe Mexican Tax Administration Service (SAT) recently conducted several examinations and has taken actions indicating that the agency is adopting a much stricter attitude in cases in which taxpayers and external auditors fail to properly document the application of the arm’s length principle in their transactions with nonresident related parties.Roberto Schatán Pérez, Central Administrator of Transfer Pricing Audits at the SAT, announced that the SAT would be directing resources to focus on new business models that have as their main objective the shifting of complex functions and risks to jurisdictions with significantly lower tax rates than Mexican rates, when those transactions lack business substance.In a simplification of actual cases, Schatán Pérez referred to current examinations whereby a taxpayer with manufacturing and distribution operations in Mexico was restructured so that the。