NEWS

TRANSFER PRICING: PROHIBITED USE?
Ec. Jorge Ayala Romero
jayala@tpa.ec

Most states or countries, through their legislative and tax administration bodies, have established a series of mechanisms to strengthen and improve the levels of tax collection. In developed countries, the most commonly-used instruments are those that are intended to combat international tax evasion, primarily through practices like:

* The abusive use of agreements or treaty shopping
* Undercapitalization or thin capitalization

Transfer Pricing

According to surveys conducted by different international organizations, the issue of greatest concern for companies operating internationally is the tax authority's ability to control prices that are set for transactions carried out between related parties, called Transfer Pricing Policy. While the issue isn't new, most tax administration bodies have tightened their controls in this area due primarily to two factors:

The first is the rapid growth in international trade over the past 50 years, at rates even faster than those of global production growth and the significant variation in the way in which this kind of trade is being carried out, as the processes of integration and globalization have hastened the processes of business internationalization, with the result that two-thirds of international trade is carried out by transnational firms and 50% of these transactions are carried out between related or linked companies within the same group.

The second factors that obliged tax authorities to implement greater controls in this area is the excessive use of this mechanism by multinational firms, which, characterized by the relocation of certain production or service activities from industrialized countries to developing countries with significantly lower labor costs, began to relocate activities toward those countries where there are tax incentives for foreign investment or minimal or null effective tax rates, the most commonly used of which are called tax havens. In this way, by carrying out transactions with their affiliates in those countries, they managed to transfer profits from a high-tax country to a low or no-tax one.

Currently, over 140 countries have laws that regulate transfer pricing and all countries which have income taxes in one form or another have regulated cross-border operations between related parties.

Nevertheless, the issue that should be highlighted, which is really the main point of this document, is that having operations with internal or external related parties is not prohibited by law in any countries, nor does it constitute a problem in and of itself for the tax authority, as long as the transfer prices for those operations comply with the market or arm's length principle , which is codified in the tax law of all countries which have these kinds of controls. The key to proving that the prices agreed upon comply with this principle is conducting a technical study in which, using a globally standard methodology, one can demonstrate tat the prices of said operations are similar to those which would have been negotiated between independent parties in similar conditions. To the extent that the study is not done or is not up to the required technical specifications, a business can be very vulnerable to tax inspections or audits by the tax administration as well as possible price adjustments and fines for fraud or failure to comply with formal obligations, as the case may be.

The benefits of doing a Transfer Pricing Study are not only related to avoiding litigation with the tax authority, but the study can serve as a instrument to ensure an appropriate intra-group pricing policy and transparent and reliable financial statements, which is indispensable for good corporate governance.

What operations or transactions can lead to a transfer pricing policy?

Transactions involving tangible goods
These can be inventory or machinery or equipment, and can be transferred in the following way:
Sales
Leasing: Operational, Financial, Lease Back, Real Estate Leasing, Leasing of Moveable Goods, or Keys in Hand.

Transactions involving intangible goods
These can be manufactured intangibles, market intangibles, or super intangibles and can be transferred in the following ways:
Sales of intangibles
Licenses
Service provision
Routine nature
Technical Assistance
Technical Nature
Human Resources / Personnel]
Financial Transactions
Short-term: payments and collections between companies, capital advances, collateral for bank loans (back to back, swaps, Bonds)

1-The Arm's Length Principle is contained in the OECD Transfer Pricing Guidelines (Organization for Economic Cooperation and Development) and is in general the central element in Transfer Pricing rules.

These can be manufactured intangibles, market intangibles, or super intangibles and can be transferred in the following ways:
Sales of intangibles
Licenses
Service provision
Routine nature
Technical Assistance
Technical Nature
Human Resources / Personnel]
Financial Transactions

Short-term: payments and collections between companies, capital advances, collateral for bank loans (back to back, swaps, Bonds).

Long-term: Mortgages, leasing, capital contributions, long-term loans, bond issues and other instruments.

Despite this very complete detail, it should be clarified that the transfer pricing policy is not only limited to transactions that affect profit or loss; any balance sheet transaction between related parties can be called into question by the fiscal authority.

ECUADORIAN TAX LAW IN THE AREA OF TRANSFER PRICING

In Ecuador, beginning in 1999, the IRS has had the ability and jurisdiction to regulate transfer pricing between related parties. The key criteria for determining whether the issue of transfer pricing applies to a person or business and therefore they must comply with the controls in place is establishing whether or not their transactions, of any kind, are carried out with local or foreign companies with whom they have a connection. For this purpose it is necessary to be very aware of the criteria that the IRS uses to establish whether or not there is a relationship, which can be summed up as follows:

Direct or indirect ownership stake greater than 25%.
Decision-making authority in two or more companies.
A share of transactions with a single supplier or customer that accounts for more than 50% of all said transactions.
Transactions made with a tax haven or preferential tax regime.

As mentioned above, the fact that a company has operations with related parties is not a problem in and of itself for the tax authority. In this sense, it should be emphasized that transfer pricing rules do not forbid operations with related parties, nor do they prohibit making transactions with tax havens or preferential tax regimes. Transfer pricing enforcement in Ecuador has reversed the burden of proof, which now falls on the taxpayer, who has to justify their operations with related parties and prove that they fulfill the arm's length principle through a Transfer Pricing Study.
The authority to regulate and set transfer prices, contained in the Tax Code and through the Equity Act, appearing in the Organic Tax Regime Law, together with other laws, regulations and resolutions allows the Tax Administration to exercise control over taxpayers, primarily in the following areas:

Requiring companies to comply with the arm's length principle in local as well as international operations via the transfer pricing regime.
Requiring the fulfillment of formal obligations
Submission of the Transfer Pricing Annex
Submission of the Integral Transfer Pricing Study

Compliance with these obligations on the part of the taxpayer requires a study to demonstrate the application of transfer pricing policies that are in line with the technical requirements issued by the IFS and that do not differ from those established in the OECD Guidelines. Therefore, those who conduct these studies must have the necessary expertise, and have multidisciplinary teams which know Ecuadorian reality.

Conclusion

The use of Transfer Pricing by companies cannot be avoided, since it has been shown to be an essential part of the new organizational structures of multinational companies. The important thing for correctly applying the transfer pricing policy is to have proper advice in this area, and to comply with the formal obligations that the tax administration demands, thus avoiding unnecessary risks and being able to justify one's pricing policy.

.:TRANSFER PRICING OBLIGATIONS :.
Eng. Mauricio García Espinel

Acting National Head of International
Taxation and Transfer Pricing at the IRS

Decree No. 2430 published in the Official Registry No. 494 dated December 31, 2004, included various reforms to the Regulations for the Enforcement of the Internal Taxation Regime Act (RLRTI), which represented a new mechanism in the country for determining tax obligations in operations which taxpayers make with related parties.

This Decree redefined the concept of related parties, and includes other criteria for determining related status such as volumes of transactions, ownership stakes, and effective administration of the business (Art. 4 of the RLRTI).

According to these new rules, taxpaying companies which carry out operations with related parties in the accumulated amount of over US$300,000 must submit to the Internal Revenue Service, five days after filing their tax return, an annex detailing such transactions and up to six months later, a report that evaluates whether or not these transactions were made according to the "arm's length" principle, understood to mean that they were conducted under the same conditions that would have held for similar transactions with non-related parties. This threshold was in place for fiscal years 2005 and 2006, while for FY2007 and beyond, IRS resolution 464 applies, which states that taxpayers who carry out operations with related parties abroad worth more than US$ 1 million must submit the transfer pricing annex, and those companies who conduct these kinds of operations in the amount of US$ 5 million or more must also submit their comprehensive transfer pricing report.

In order to determine whether or not operations between related parties are done at arm's length prices, the reform establishes first of all criteria for comparing transactions, in order to ensure that they are similar and can therefore be considered comparable, and secondly, sets forth the following six methods for calculating the benchmark price:

Uncontrolled Comparable Pricing Method
Resale Pricing Method
Cost Plus Method
Profit Split Method
Residual Profit Split Method
Transactional Net Margin Method .

Based on the annex and report submitted by the taxpaying company, the Tax Administration, by the authority vested in it to determine transfer pricing (Art. 66-5, RLRTI) can determine a new tax base, when it believes that the prices declared as the basis for calculating that base or as a price for determining an expense or income, are not of "arm's length", that is that they are different from what they would have been in transactions with independent third parties.

As a technical reference, the "Transfer Pricing Guidelines for Multi-national Enterprises and Tax Administrations", approved by the Council of the Organization for Economic Cooperation and Development (OECD) in 1995, to the extent that they are congruent with the mandate of article 91 of the Tax Code, the provisions of Decree 2430 and the treaties signed by Ecuador.

REFORM

With the passage of the Tax Equity Reform Act in Ecuador, published in the third supplement of Official Registry 242 dated December 29, 2007, a number of changes were made to Transfer Pricing regime. First of all, it was established within the Internal Tax Regime Act that the Transfer Pricing regime would apply to all transactions carried out with related parties, and all obligations that this implies, as for example the presentation of a report and transfer pricing annex. In addition, a specific penalty schedule was established for violations of these obligations, which states that in the event that a company fails to submit the transfer pricing annex or report, or if the information presented contains errors or is different from its income tax declaration, the Tax Authority can levy a fine of up to US$15,000.

Within the Regulations for the Application of the Internal Taxation Regime Act, the methods used to determine whether or not operations between related parties are at market prices were maintained.

The reform also allows taxpayers to consult with the Tax Administration about the methodology that they are using to determine transfer prices, by supplying all of the information, data and documentation necessary for the granting of absolution, which is binding for the current fiscal year, the one immediately prior, and the three following years.

FINAL REFLECTIONS

Control over transfer pricing is particularly important for Ecuador, in light of the significant increase in the flow of operations made between related companies and the effects that the manipulation of those prices can have.

Among the different ways to manipulate transfer prices, those which are intended to evade the payment of taxes are of growing concern in industrialized countries, as exporters of capital.

The main objective of a business is to maximize profit, not only in terms of revenues but also in terms of costs and expenses, which include paying taxes.

The problem posed by pricing operations between related companies is very complex, and the methods designed to address this problem only enhance this complexity.

The methods used to determine arm's length transfer pricing should be applied so that:

They achieve a result that is fair for the taxpayer as well as the tax authority, reflecting the economic reality and the real profit made in each jurisdiction.

They provide precise guidelines for the company and promote voluntary compliance.

They are reasonably easy to apply for the tax administration.

They help to reduce conflicts between the treasury and the taxpayer.