Mutual agreement procedures on transfer pricing between Russia and South Korea
16 November 2022
Tax Messenger
Tax Messenger
In this alert we discuss the recent letter issued by the Ministry of Finance of Russia regarding a taxpayer’s request for the initiation of a mutual agreement procedure on transfer pricing between the governments of Russia and South Korea and we set out recommended next steps for taxpayers involved in cross-border intra-group transactions.
Background
Letter No. 03−08−05/88 695 of the Ministry of Finance of Russia ("the Finance Ministry’s Letter"), published on 12 September 2022, was issued in response to an application filed by a taxpayer on 9 June 2022 for the initiation of a mutual agreement procedure in accordance with Article 24 of the Convention between the Governments of Russia and South Korea for the Avoidance of Double Taxation with Respect to Taxes on Income of 19 November 1992 ("the Convention").
It follows from the application that the National Tax Service of the Republic of Korea ("NTS") carried out a TP audit for 2014−2016 in relation to transactions involving the sale of cold rolled steel in rolls by a Korean company to a Russian related entity ("the Russian Company") and concluded that the prices used were not consistent with market prices.
The NTS adjusted the tax base using the transactional net margin method ("TNMM") based on operating profit margin (separately for the "Production" and "Distribution" segments") with the Russian Company taken as the tested party.
In order to review the matter thoroughly and reach a decision on whether to initiate a mutual agreement procedure, the Ministry of Finance asked the Russian Company to provide additional information on the results of the TP audit, and in particular:
Letter No. 03−08−05/88 695 of the Ministry of Finance of Russia ("the Finance Ministry’s Letter"), published on 12 September 2022, was issued in response to an application filed by a taxpayer on 9 June 2022 for the initiation of a mutual agreement procedure in accordance with Article 24 of the Convention between the Governments of Russia and South Korea for the Avoidance of Double Taxation with Respect to Taxes on Income of 19 November 1992 ("the Convention").
It follows from the application that the National Tax Service of the Republic of Korea ("NTS") carried out a TP audit for 2014−2016 in relation to transactions involving the sale of cold rolled steel in rolls by a Korean company to a Russian related entity ("the Russian Company") and concluded that the prices used were not consistent with market prices.
The NTS adjusted the tax base using the transactional net margin method ("TNMM") based on operating profit margin (separately for the "Production" and "Distribution" segments") with the Russian Company taken as the tested party.
In order to review the matter thoroughly and reach a decision on whether to initiate a mutual agreement procedure, the Ministry of Finance asked the Russian Company to provide additional information on the results of the TP audit, and in particular:
- The functional analysis of the parties to the transaction carried out by the NTS, including analysis of the characteristics of functions performed by the parties to the transaction and in accordance with customary business practice.
- A statement of the principles underlying the segmentation of the Russian Company’s reports into "Production" and "Distribution".
- The methodology for determining the profit margin range based on data of comparable companies, details of the search strategy used to identify comparable companies, the list of comparable companies and the accounting/financial statement data based on which the profit margins of comparable companies were calculated.
- Reasoning for the profit level indicator used based on the provisions of clause 4 of Article 105.12 of the Tax Code.
- Information on the evaluation by the NTS of the applicability of other price adjustment methods, including the comparable uncontrolled prices (CUP) method.
Recommendations of the Ministry of Finance
According to the Finance Ministry’s Letter, the following factors should be taken into account in deciding whether to apply for the initiation of a mutual agreement procedure:
According to the Finance Ministry’s Letter, the following factors should be taken into account in deciding whether to apply for the initiation of a mutual agreement procedure:
For the purpose of determining the market range, the NTS searched for comparable companies operating in the European region, i.e., the search results could include not only companies operating in Russia but also companies that operate in European countries and therefore keep accounting/financial records in accordance with the laws of foreign states.
However, according to clause 2 of Article 105.8 of the Tax Code, the indicators referred to in clause 1 of Article 105.8 of the Tax Code and other financial indicators for the purposes of Section V.1 of the Tax Code must be determined for Russian entities based on accounting/financial statements prepared in accordance with Russian accounting law.
In addition, according to subsection 2 of clause 2 of Article 105.6 of the Tax Code, information obtained from the accounting/financial statements of foreign entities may be used to determine the profit margin range for Russian entities (or foreign entities whose activities in Russia give rise to a permanent establishment) only if it is impossible for that profit margin range to be determined based on the accounting/financial statements of Russian entities that have concluded comparable transactions.
Thus, the information used by the Korean tax authorities may not comply with the requirements of Section V.1 of the Tax Code.
However, according to clause 2 of Article 105.8 of the Tax Code, the indicators referred to in clause 1 of Article 105.8 of the Tax Code and other financial indicators for the purposes of Section V.1 of the Tax Code must be determined for Russian entities based on accounting/financial statements prepared in accordance with Russian accounting law.
In addition, according to subsection 2 of clause 2 of Article 105.6 of the Tax Code, information obtained from the accounting/financial statements of foreign entities may be used to determine the profit margin range for Russian entities (or foreign entities whose activities in Russia give rise to a permanent establishment) only if it is impossible for that profit margin range to be determined based on the accounting/financial statements of Russian entities that have concluded comparable transactions.
Thus, the information used by the Korean tax authorities may not comply with the requirements of Section V.1 of the Tax Code.
The Tax Code does not provide for the use of the median value of the market profit margin range for the purpose of making adjustments.
If the highest value of the market profit margin range were used, as prescribed by paragraph 2 of clause 9 of Article 105.12 of the Tax Code, based on the ranges determined by the NTS, additional assessments:
If the highest value of the market profit margin range were used, as prescribed by paragraph 2 of clause 9 of Article 105.12 of the Tax Code, based on the ranges determined by the NTS, additional assessments:
- for the "Production" sector would be substantially lower for 2015 and negligible for 2016;
- for the "Distribution" sector would not arise for 2015 and would be lower for 2016.
The Tax Code lays down a hierarchy for the application of TP methods.
The CUP method has top priority, followed by the resale price or cost plus method, and if these cannot be used then the TNMM is applied. The profit split method is applied if it is impossible to use any of the other methods.
The CUP method has top priority, followed by the resale price or cost plus method, and if these cannot be used then the TNMM is applied. The profit split method is applied if it is impossible to use any of the other methods.
What conclusions can be drawn and what action is recommended?
In terms of reducing TP risks in cross-border transactions, the following conclusions can be drawn from the Finance Ministry’s Letter, which should be borne in mind both when developing TP methodologies and in the context of initiating mutual agreement procedures, as well as when concluding unilateral or bilateral advance pricing agreements:
In terms of reducing TP risks in cross-border transactions, the following conclusions can be drawn from the Finance Ministry’s Letter, which should be borne in mind both when developing TP methodologies and in the context of initiating mutual agreement procedures, as well as when concluding unilateral or bilateral advance pricing agreements:
- The prices or profit margins of controlled transactions must be compared with the market price or profit margin ranges for individual business segments (i.e., lines of business) rather than the profit margins for all business segments taken together.
- Particular attention must be paid to the market or country in which the taxpayer operates when deciding on the information sources to be used in calculating market price or profit margin ranges. For instance, the fact that the Russian Company operated in Russia led to conclusions about the need to use Russian accounting/financial statements / Russian information sources in calculating market profit margin ranges.
- In testing whether transaction prices are consistent with the market level, it is essential to observe the strict hierarchy of TP methods laid down in the Tax Code and to provide detailed reasoning as to why individual TP methods can or cannot be used.
Authors:
- Tatiana TarmanovaSeniorTransfer Pricing & Operating model effectiveness group
Tatiana.Tarmanova@b1.by
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