It’s been more than two years since the Russian government promised to align the country’s economy with global trends and introduce transfer pricing reform. In July 2011, Russia finally adopted new transfer pricing rules, bringing the country’s tax legislation closer to international standards.

Like any transfer pricing reform, the main idea behind the law is to prevent aggressive profit-shifting between a chain of companies inside and outside Russia, and to ensure there is no profit outflow to low-tax or offshore jurisdictions. The changes will become effective on 1 January 2012 and will significantly affect both local companies and international corporations in the Russian market.

A transfer pricing concept was first introduced in Russia in 1998, but it proved rather ineffective. This was primarily because of poor enforcement related to rigid and outdated legislation, but also due to the absence of clear guidance in terms of applicable transfer pricing methods, lack of comparable data and a requirement to use only official sources of information. The previous rules consistently proved to be inefficient, and an urgent need for more advanced transfer pricing regulations was evident.

The changes proposed to the transfer pricing laws were regularly and severely criticised, and the Russian Ministry of Finance and State Duma faced numerous objections from the local business community, especially related to the need for transfer pricing control of domestic transactions. Despite all the obstacles, the transfer pricing law managed to be finally accepted and passed through the Russian Duma.
The new transfer pricing law fundamentally improves the previous rules and brings them more in line with the OECD principles – but it still leaves room for future improvement.

What to expect
Improving the definition of related parties is one of the most important and significant changes introduced in the law. Previously, only parent companies and their direct and indirect subsidiaries qualified as related parties for transfer pricing purposes under previous rules. The law takes a significant step forward by extending the control over other affiliated companies including but not limited to sister companies, companies under common management and subordinated entities. The percentage of ownership in the related party companies based on the direct or indirect shareholding was increased from 20 to 25 percent. The list of related parties is not exhaustive, since the transfer pricing law preserved a discretionary provision allowing a Russian court to recognise parties as related if relationships between them are proven to influence the commercial or financial results of their transactions between each other.

Another critical change relates to the list of controlled transactions. To ensure that the proper portion of income is taxed in Russia (or a region in Russia) the scope of controlled transactions was extended. Now it includes transactions within Russia if they exceed approximately $35m (although this threshold will be introduced gradually, starting at $105m in 2012 and dropping to $70m in 2013 – the general threshold will come into effect from 2014) or involve taxpayers with reduced tax rates or special tax regimes. Cross-border transactions between related parties and transactions with commodities remain under transfer pricing control. All transactions with offshore companies qualify as controlled as well, irrespective of the relationships between the parties. It’s worth noting that the list of jurisdictions that Russia treats as offshore has not been updated since 2009, and still includes countries that are not necessarily considered low tax jurisdictions, such as Cyprus (although there are plans to remove Cyprus from the list).

What it practically means for taxpayers is that many of them will have to reconsider their ongoing transactions and determine if these are covered by the new transfer pricing law. Taxpayers will also need to review the applicable pricing mechanism to ensure that prices in intergroup transactions are established at arm’s length.

Overhaul for pricing methods
The previous transfer pricing rules provided for three transfer pricing methods: compared uncontrolled price (CUP), cost plus, and resale minus. The tax authorities, however, tended to apply only CUP – more often than not disregarding the unique nature of the audited transaction as well as the absence of fair comparables. The other two methods are rarely used in practice, mainly because the information needed to apply them is difficult to obtain. Moreover, since the description of the transfer pricing methods in the tax code was limited to a few brief and very general principles with no precise formula, there was little understanding how the methods should be applied. Nevertheless, even with that limited guidance in the current rules we now see more and more cases when the tax authorities successfully applied the resale minus and the cost plus methods in practice.
Under the new transfer pricing rules, the definition of each transfer pricing method is very descriptive. Furthermore, the law introduces new transfer pricing methods. To determine the arm’s length price, taxpayers will be able to apply transactional net margin (TNMM) and profit split methods previously unfamiliar in Russia, although the resale minus and the cost plus methods existing under the previous rules were very much akin to the TNMM under the new rules (testing the operating profit level of a taxpayer). The priority of the methods has changed as well: CUP remains the preferred method, while the profit split has the lowest priority. The order of applying the other methods is discretionary as long as the ‘best fit’ principle is followed. An official independent evaluation can also confirm the reasonableness of the prices if performed with respect to a single transaction considered unusual for the taxpayer’s business.

Another progressive and positive development related to the definition of arm’s length prices is the introduction of an interquartile range of prices. Basically, the interquartile price range is the middle 50 percent of the arm’s length prices range. Under the new law, prices in controlled transactions should be within this range. Previous legislation allowed a 20 percent deviation from the arm’s length price– the so-called ‘safe harbour’ rule, which was abused by both taxpayers and the tax authorities. Taxpayers used it as a tax optimisation technique while the tax authorities applied it to take advantage of bone-fide taxpayers providing services or selling products with discounts. The new rules are certainly more appropriate. The only downside is that the transfer pricing rules still might require special regulations to prevent improper range adjusting techniques.

The law also solves another major problem in Russian transfer pricing. Bona-fide taxpayers in many cases were unable to determine the arm’s length price because they could not find relevant comparable information. The previous transfer pricing rules contained outdated and highly formalistic requirements to use only official sources of information for transfer pricing purposes. Unfortunately, no definition of official sources of information was provided. In practice this meant that only data originated in Russia and coming from the state authorities could be used for benchmarking.

Obviously, the content of local or official information is very limited and unreliable, and its quality is poor. In addition, the data is extremely difficult to access. In most cases it is impossible to verify whether the available information is in fact comparable to the tested transaction or price. Use of foreign sources of information and databases, no matter how relevant and accurate, was not allowed.

All of the above often resulted in a practical impossibility to apply the transfer pricing rules and calculate the actual arm’s length price. And if the fair price was determined based on data from commercial and reliable foreign sources, the taxpayers could not defend the price to the tax authorities because the data it was based on did not formally satisfy the requirement of being official.

The new rules are much more advanced in this respect. The reference to official information is removed. The list of acceptable data is quite extensive and includes open databases and foreign sources. However, foreign sources, although in many cases considered more reliable and complete than Russian sources, can be used only in the absence of local sources. Nevertheless, this is a huge step for Russian transfer pricing.

Documentation review
Another revolutionary change – and arguably one of the most important – is establishing a transfer pricing documentation requirement. Taxpayers with controlled transactions (with certain exceptions) are required to maintain transfer pricing documentation and provide it to the tax authorities within 30 days of the relevant request. The transfer pricing documentation may be requested not earlier than 1 June of the year following the calendar year in which the relevant transactions took place (i.e. not earlier than 1 June 2013).

By introducing the documentation requirement, the legislator de facto shifted the initial burden of proof in transfer pricing cases to taxpayers. Obviously, this does not mean that the tax authorities will always accept the position documented by taxpayers. But in cases of disagreement the burden of proof will be transferred back to the tax authorities, as long as the taxpayer met the proposed standard of documentation.

The proposed set of transfer pricing documentation contains a few key sections: description of the company and the inter-company transaction(s), functional analysis, financial results, the choice of the transfer pricing method and the economic analysis supporting the arm’s length prices (margins). Once taxpayers fulfil the proposed documentation requirements, they will not be subject to liability for penalties.

It is likely that the documentation requirement will not significantly increase the administrative burden of multinational companies in Russia. Many of them prepared and maintained the transfer pricing documentation needed for group purposes or required under foreign legislation before the transfer pricing law was enacted. Adaptation of the documentation template with the Russian transfer pricing law however is likely to be required.

Another way to shield taxpayers from liability from penalties as well as from transfer pricing tax reassessments will be for Russian companies to use an Advance Pricing Agreement (“APA”). Following the best transfer pricing practices, the new transfer pricing law introduces the APA concept which might be used by the largest taxpayers (legally defined as a large taxpayer). The APA will fix the pricing in controlled transactions and can become an effective protective measure against the challenges of pricing policies and tax assessments.

The APAs will be concluded for a three year period with a possible extension for two more years. The Russian tax authorities are committed to consider an APA application within nine months. Because the APA application process may start immediately after the new transfer pricing law comes into force, the first APAs may be expected to be concluded in late 2012. However, the nine month period for considering an APA appears to be quite optimistic as compared to practices of other countries and it is yet to be seen whether the nine month deadline is realistic to meet in practice.

Audit questions remain
Starting in 2013, compliance with the transfer pricing rules will be audited during transfer pricing audits. These audits will be performed by a special department in the Federal Tax Service separate from the regular tax audit process. The event triggering an audit will be information obtained about the controlled transaction by the tax authorities either via obligatory transfer pricing reporting or during a regular tax audit. So far there are more questions than answers about the process of transfer pricing audits. The procedure of further tax reassessments is also not clear apart from the fact that a 40 percent tax penalty will apply if a transfer pricing assessment is made by the tax authorities and if the taxpayer fails to submit the transfer pricing documentation to the tax authorities.

According to the new transfer pricing law, if the tax authorities perform an upward income adjustment, the corresponding downward adjustment should be available to the other party of the transaction. The problem is that the law is designed in a way to prevent any outflows from the Russian treasury. It means that only Russian resident taxpayers under certain conditions will be able to receive downward adjustments. Foreign companies will not have this privilege and therefore double taxation is inevitable. The only feasible option to implement an income adjustment between the Russian and foreign companies seems to be through the use of bilateral double tax treaties, although the chances to succeed in Russia with this issue are highly uncertain.

Transitional period
To ease taxpayers into the new transfer pricing laws and prepare taxpayers for the changes, the law includes certain transition provisions. Specifically, there will be no tax penalty on transfer pricing adjustments for the tax periods from 2012-13. For tax periods from 2014-16 the tax penalty will be 20 percent only. Starting from 2017, a standard 40 percent tax penalty will apply. Transition provisions also exist with respect to documentation requirements and certain controlled transactions.

The transfer pricing law will have a huge impact on Russian taxpayers, and significant preparations must be made before it comes into force on 1 January 2012. These should include diagnostics of intergroup transactions, existing transfer pricing policies and business resources. Specific attention should be paid to preparation of transfer pricing documentation and adjusting business processes to ensure constant monitoring of the internal transfer pricing situation.

With the new transfer pricing law available, Russian tax authorities will have heightened interest on the tax effect of intercompany transactions. The tax authorities will be more focused in business activities of taxpayers, supply chain operations and transfer pricing strategies than ever before. New realities mean that taxpayers will constantly need to monitor, document and often defend pricing in intercompany transactions.

Evgenia Veter is Partner and Head of Transfer Pricing Services at Ernst & Young, Russia. Anna Johnson is a Transfer Pricing Services Senior at Ernst & Young.