An expert overview on Transfer Pricing by PwC: Swimming in fresh waters

Transfer Pricing Partner Kuni Vaidya and PwC Director Tax Services Charmaine Tillekeratne 

Transfer Pricing (TP) is not new to the global showground. Despite being in existence for years, TP is still seen as prone to countless complications and is stringently monitored by tax authorities across the globe. Of late, there is a clamour among nations to obtain a greater share of the shrinking economic pie. This has led to organisations operating globally and in turn creating an impetus for regulatory bodies to employ stringent rules and regulations to ensure business entities are paying their due share of taxes.

In Sri Lanka, the Inland Revenue Department has been working towards gradually implementing TP regulations. PwC Sri Lanka primarily known as the Sri Lankan Chapter of one of the ‘Big 4’ auditing firms in the world has partnered with their member firm PwC India with regard to TP in Sri Lanka. Incidentally, TP has been prevalent in India since 2001 and is a highly litigated subject in India.

The Daily FT was able to obtain an exclusive interview with PwC India Partner, Transfer Pricing, Kunj Vaidya who has been involved in providing TP solutions across the world for the past 15 years and PwC Sri Lanka Director, Tax Services, Charmaine Tillekaratne who explained the technical and theoretical aspects of TP. Below are excerpts:

By Shehana Dain

Q: What is transfer pricing in your words?

A: Today, more than 60% of the global cross border trade takes place within multinational enterprises (MNE) which may result in certain complex arrangements between these enterprises belonging to same MNE Group. 

Let us take the example of ABC USA, a globally reputed company having operations across multiple countries. ABC would design its products in USA, manufacture the same in China and sell it across the world. To carry out its operations effectively, ABC USA would establish branches/entities in respective locations. (ABC SL, ABC India, etc.). ABC USA would manufacture and sell its products to ABC SL for sale in the Sri Lankan market. In case the transfer price of the products sold into Sri Lanka is priced low, there would be additional profits which would be parked in ABC SL. 

In such a scenario, the USA revenue authorities would object to such low transfer price as USA would lose out on their due share of tax revenue. Similarly, Sri Lankan revenue would object if the situations were to be reversed. The TP provisions provide a framework to regulate pricing of transactions between related parties to avoid such a situation. 

Q: What do these TP regulations convey to businesses? 

A: In a nutshell, TP regulations create a legal fiction that the transactions between related parties are carried out as if the other party is a third party. This is essentially the arm’s length principle. So if in the above example, if ABC USA is selling to ABC Sri Lanka, it should transact at a price ABC USA would adopt when it transacts with a third party in a similar circumstance situation. This will ensure that each country/ economy receives a fair price on which it would receive its revenue from taxes. 

Q: What sort of connection does the Big 4 have with TP?

A: TP impacts two or more related parties to a transaction who may be in different tax jurisdictions. For example, in our example of ABC USA and ABC SL, both these entities may need to substantiate the pricing of the transactions to their respective tax authorities at different points of time. Fortunately, the core principles of TP are globally consistent. The Big 4 firms, having network offices across the world, having experience and skilled resources are better equipped in assisting businesses in setting up a related party transaction in compliance with the TP principles.

Q: Does Sri Lanka have TP regulations now?

A: Sri Lankan TP provisions were first introduced back in 2008 along with detailed rules. However, in 2013, the latest set of rules was put in place, which superseded everything prior to 2013. In 2015, the policy makers came up with new regulations which require certification to be filed with the income tax returns. As a result, companies filing their income tax returns would be required to include a certification by an approved accountant wherein the said accountant would detail the international/domestic transactions with associated undertakings, the TP method that has been followed and the documentation that has been maintained and whether they are in line with the regulations and whether the end result is that the company has followed the arm’s length principle. 

Such certification has to be done by an approved accountant and is mandatory to be filed with the income tax return for the Y/A 2015/2016 due on or before 30 November 2016. In a nut shell, the approved accountant will certify the absence or the presence of the TP documentation. 

Q: Are Sri Lankan regulations on par with global standards?

A: The Sri Lankan regulations have been drafted very similar to the Indian TP regulations with certain relaxations. In general, however, they are quite consistent with global standards. It is important to note that, per se, there are no global guidelines. However, OECD (Organisation for Economic Corporation and Development), an International economic organisation, has been in existence for a long time and has issued detailed guidelines for TP. A huge proportion of countries having TP regulations are modelled based on such detailed guidelines from OECD for TP.

Q: What are the documentation requirements in the TP regulations?

A: The documentation required for TP legislation can be broadly categorised into three heads. The first head requires details of the transacting entities. The information required would be in the nature of ownership structure, group profile, business carried out by each entity, the industry in which the business operates trends of the industry, etc.

The second head of documentation requirement emphasises on the functional background. In this head, the legislation requires the details of the key functions, assets and risks of the relevant entities of the group and their significance. This analysis would form the basis of evaluating a related party transaction for arm’s length. 

The third head is transaction specific requirements and the basis of establishment of arm’s length. The documentation required under this head would be in the nature of inter-company agreements, invoice copies, selection of a transfer pricing method, rejection of the other methods, benchmarking analysis etc. 

All the above documentation required could be summarised in a form of a single comprehensive document which would also stand the test of time and form the basis of justifying transactions with a related party during the time of the TP audit by the Inland Revenue Department.

Q: Are all tax payers supposed to apply TP regulations?

A: All tax payers are expected to maintain their transactions with related parties at arms’ length. However, the documentation requirements are applicable to companies only where the aggregate value of transaction with an associated undertaking for any year of assessment exceeds LKR 50Mn in case of domestic transactions and Rs. 100 m in case of international transactions.

Q: How do I know if my transaction is expected to comply with TP regulations?

A: The rules prescribe the basis of identifying whether a transaction would require compliance with TP regulations. The identification procedure has two parts. The first is to identify your related parties. The definition of who is a related party is very wide and ideally covers any related party under a normal commercial parlance. Once a related party is identified, any transaction carried out with such related party would fall under the ambit of the TP regulations.

Q: Can a person agree on pricing in advance with the Inland Revenue Department? 

A: While there are provisions in the law to enter into an advanced pricing agreement with the Inland Revenue Department, the same has not been implemented yet. The methods and rules governing the advanced pricing regulations are yet to be prescribed and may take some time.

Q: How will companies select the most appropriate TP method to determine whether transactions with their related parties satisfy the arm’s length principle?

A: For determining the most appropriate method, one should carry out a functional analysis in a very methodical and structured manner to obtain a thorough understanding of the transaction. Based on such understanding, one should evaluate the application of each methods prescribed and select one of the methods after objectively rejecting each of the other methods.

Q: What if there is a group policy in place already, do we need to carry out a TP study again?

A: Considering the fact that TP is globally consistent and a key consideration for cross border transactions, most multinational companies (MNC) would have a group policy which would provide the basis for pricing of any related party transaction.

It is important to evaluate whether the group policy has been effectively applied in Sri Lanka or not because, it is commonly observed that while there is a group policy, the same may not be effectively applied for various reasons. Secondly, it is important to factor as to ‘how old is the policy?’ It is possible that the group policy was put in place long time back and it may not have been updated to factor updates in the business operations.

Post a review, if the answers to these questions are in the affirmative, then the group policy would provide for a significant base to establish arm’s length. However, it is important to consider the fact that there would be some specific requirement that a company may have to carry out from a Sri Lankan regulation perspective which has to be taken care in addition to the information captured in the group policy. However, if there is a group policy, that would be a good starting point for developing TP documentation from a Sri Lankan perspective.

Q: How easily can we obtain information on comparable transactions or companies in order to benchmark our TP with related parties?

A: For benchmarking, there can be internal comparables and external comparables. Internal comparables represent comparable transactions carried out with third party by such company. The company has to determine whether there are internal comparables to a particular transaction or not. If comparability is established, internal comparables are preferred. However, it is possible that some adjustments need to be conducted to account for certain differences between the covered transaction and the internal comparable. 

In case one cannot establish an internal comparable, then external comparables can be identified from various third party databases which provide information of various companies. As Sri Lanka does not have any such databases, the databases containing Indian companies may be considered. However, in such a scenario, an appropriate adjustment for differences in the market conditions of both the countries may need to be factored while determining arm’s length price.

Q: How far back can tax authorities go and request a TP documents or assess a TP adjustment?

A: The new legislation that has been placed before the Parliament would ensure that a tax year would be open for five years for TP purposes. Hence, the documentation that the companies maintain to establish arm’s length should hold good for at least five years.

Q: How has Sri Lankan companies aligned with TP regulations throughout the years?

A: Although the last set of regulations were notified in 2013-14, most companies did not strictly comply with the regulations. While this does not imply that the companies have not been operating at an arm’s length price over the years, it is possible that certain companies may not have adopted a structured approach when dealing with related parties. The mandatory certification has now forced companies to relook at their TP policy and ensure that it is in line with the regulations. 

Q: What are the challenges Sri Lanka is currently facing when it comes to global TP standards and tax regulations?

A: The biggest challenge is to change the mindset of the taxpayer. The taxpayer should appreciate that TP is here to stay and was not introduced with the intention of disrupting normal commercial activities or restricting commercial activities. The requirement is that transactions with related parties should be at arm’s length price and companies establish the same on the basis of certain globally accepted guidelines. Therefore, the tax payer needs to recognise the importance of having the relevant documentation in place well in time before IRD commences its TP audits by when there would be very little time.

The other major challenge is obtaining comparable companies to carry out a benchmarking analysis in the determination of arm’s length price. While India has access to several seasoned databases that have been developed over the years, Sri Lanka has no such databases. 

Q: Has TP and its technical aspect reached the proper audience?

A: At present, TP is the most discussed topic at various forums and as such the importance of TP appears to be reaching a wide audience. TP is no longer looked as compliance but assumes equal importance and is a key consideration for strategic business decisions. More importantly it should reach the boardroom as part of the documentation is to obtain a signed assurance from the company’s director that TP regulations if applicable have been adhered to by the company.

–Pix by Upul Abayasekara