Tax administration of transfer pricing. What’s new?

In this alert we comment on the latest letters from the Federal Tax Service regarding transfer pricing regulations for cross-border transactions in the current economic environment and set out our advice on what steps companies might take.

Regulations regarding foreign transactions with unrelated persons that are classed as controlled for taxation purposes

On 25 May 2022 the Federal Tax Service published Letter No. ShYu-4−13/6384@ ("the FTS Letter"), in which guidance was given on proving that prices in controlled transactions with unrelated persons are at arm’s length.

The following conclusions may be drawn from the FTS Letter:

1. From 1 January 2022, transactions involving the commodity groups specified in clause 5 of Article 105.14 of the Tax Code are deemed controlled for taxation purposes.
2. The Federal Tax Service takes the view that the comparable uncontrolled prices method ("CUP method") should, as a rule, be applied in relation to commodity groups such as oil and products manufactured from oil, ferrous metals, non-ferrous metals, mineral fertilisers, precious metals and precious stones. That TP method may be applied using information relating to a company’s own activities (the "internal" CUP method) as well as any other publicly available information sources.
3. However, the FTS Letter acknowledges that objective constraints on the application of transfer pricing methods may arise in transactions with unrelated persons.
4. Where it is impossible to apply the transfer pricing methods provided for in Articles 105.9 to 105.13 of the Tax Code, the arm’s length nature of a controlled transaction may be demonstrated by submitting a set of documents setting out the normal commercial practices of the parties to the transaction, which may include:

• An internal document establishing the principles governing the selection of counterparties, identification of their beneficiaries, setting of the risk level, etc.
• Pricing policies (an internal document establishing acceptable commercial (or financial) terms of transactions).
• Internal documents resulting from the application of policies in a specific transaction.
• Contracts, invoices, and business correspondence relating to the negotiation of transaction terms.
• Other documents that are ordinarily drawn up when entering into a transaction.

What action is advised?

We pointed out objective difficulties in applying TP methods in transactions with unrelated persons in previous alerts devoted to transfer pricing regulations for foreign trade transactions.
Following the logic of the FTS Letter, in terms of reducing TP risks in foreign trade transactions the following priorities may be identified:

1. Developing internal regulations that systematise the processes of the conclusion and performance of export transactions so as to minimise tax and TP risks (interaction protocols, responsibility matrices, job descriptions, etc.).
2. To minimise the risk of an unrelated counterparty being deemed an affiliate or conduit entity, designing the target form of relationship between structural subdivisions of Russian and foreign counterparties based not only on tax considerations but also on business goal-setting and the essential synergy of tax and business functions.
3. Preparing a defence file demonstrating an arm’s length approach to pricing, including: counterparty selection policy (an internal document establishing the principles governing the selection of counterparties, identification of their beneficiaries, setting of the risk level, etc.), pricing policy (an internal document establishing acceptable commercial and (or) financial terms of transactions), and internal documents resulting from the application of those policies.

The value of having uniformly applied pricing/commercial policies and procedural rules is not only observed in the FTS Letter but has also been confirmed by a court ruling on a tax dispute between Voronezhsakhar OOO and a tax authority (case No. A14−4599/2020). The existence of such a document was one of the reasons why the court ruled in the taxpayer’s favour.

Transfer pricing regulations in the context of sanctions

Another two FTS Letters which we regard as important are devoted to transfer pricing in the context of the rising sanctions pressure on Russian companies.

In particular, Federal Tax Service Letter No. ShYu-4−13/2724@ of 5 March 2022 refers to the possibility of discounts being applied in foreign trade transactions in light of sanctions, including in transactions with foreign unrelated entities.
According to the Letter:

• The imposition of sanctions on Russian government authorities, individuals and legal entities by "unfriendly" countries (meaning the United States and those foreign states and international organisations that have aligned themselves with the United States) affect the economic conditions of the activities of parties to transactions.
• It is acknowledged that losses may arise in foreign trade transactions as a result of the actions of "unfriendly" countries, resulting in a situation where taxpayers sell their products at discounted prices.
• When conducting transfer pricing inspections and considering applications for advance pricing agreements, tax authorities will consider those circumstances and their impact on the results of transactions that are classed as controlled in accordance with Article 105.14 of the Tax Code.

Furthermore, in Federal Tax Service Letter No. ShYu-4−13/7523@ of 20 June 2022 the Interregional Inspectorate of the Federal Tax Service for Pricing for Taxation Purposes and Interregional Inspectorates of the Federal Tax Service for Major Taxpayers were informed of the need to take account of circumstances that influence pricing in transactions.

The Federal Tax Service identifies the following objective factors influencing the production and sales activities of companies in the current economic circumstances:

• Measures to prevent surpluses of finished products
• Hold-ups in the manufacturing cycle
• Job cuts
• Forced changes to established arrangements for the sale of products, including changes in logistics chains
• Corresponding changes in sale prices to facilitate sales of products

Further to the above, we are seeing that most companies with cross-border dealings are coming up against the emotional component of sanctions, whereby a particular product or entity may not be formally affected by restrictions, but the following difficulties arise:

• In addition to sanctions, many foreign partners (suppliers, customers, transport and logistics companies, investors, production and distribution partners) are pressured by regulators and growing reputational risks into abandoning ties with Russian companies.
• Difficulties with bank payments.
• Retaliatory measures by Russia also have a major impact on relationships with foreign partners.

As a result of mutual sanctions, many Russian companies have found themselves facing significant problems and risks, such as:

• The risk of the suspension of activities of foreign entities registered in "unfriendly jurisdictions" (including trading and holding entities)
• The risk of the disruption or collapse of supply chains as result of foreign suppliers, customers and transport and logistics companies refusing to deal with Russian entities
• The risk of the refusal by certain banks to service accounts held by Russian companies or persons (including entities in which there is Russian ownership).

What can be done?

At present, we recommend considering the following steps to help maintain business continuity in the current circumstances:

• Re-routing flows of goods and money via "friendly" jurisdictions (including by opening fully functioning bank accounts in those jurisdictions).
• Organising purchases and sales of products via independent entities in "friendly" jurisdictions without a "Russian element" in order to restore broken supply chains.
• Reviewing the transport and logistics component of supply chains and shipping documents.
• Modifying holding structures and considering available government support measures and other potential tax savings to help address the worsening economic situation.
• Concluding advance pricing agreements with the Federal Tax Service to eliminate TP risks in future periods (up to 5 years).