Recently transfer pricing has become a particularly topical issue due to the increased incidence of adjustments and controversies as a result of the active measures for collection of budget revenue. This is understandable because when associate companies or related parties transact with one another the prices and conditions negotiated between them are generally different from those prevailing on the market – i.e. from the prices and conditions in business transactions between independent companies. In related party transactions buying and selling above or below the market price directly affects the associate companies’ income and is considered profit manipulation. The transfer price is used for comparison and is arrived at through the application of a variety of formulas comparing a number of commercial indices of two types of transactions: transactions between related companies and between independent companies – on comparable market terms. A survey conducted within leading international companies shows that the share of audits leading to adjustment of transfer prices and the imposition of sanctions has gone up world-wide from 5 % in 2005 to 20% in 2010. For Bulgaria the trend is similar.
This paper aims to acquaint the readers with taxation-related issues arising in connection with the auditing of related company transactions.
The requirement for documentary validation of prices in related party transactions – their conformity with market prices and the reasons for the difference is set forth in the Tax and Social Insurance Procedure Code. The tax legislation does not stipulate any special requirements concerning the volume and format of the documents. Consequently, when the firm being audited makes business deals with associate firms, they are obliged to prove conformity with the market price or give reasons for the divergence, including by providing relevant documentation from abroad regarding how the their transfer prices were established.
Broadly defined, associate companies are firms one of which owns the prevailing part of the other firm’s capital or exercises a relatively high degree of control over its activity. Due to the existence of these two factors (capital participation and control), associate firms are able to agree upon commercial and financial terms and conditions different from those agreed between independent firms.
Consequently, the special relationship existing between associate companies frequently finds expression in negotiated prices which differ from established market prices between independent companies trading in goods (including non-material goods) and services on comparable market conditions. The tax effect of the special arrangements between related parties is the possibility for arbitrary adjustment of the gains and income of the participating companies, hence manipulation of their tax liabilities. With a view to repressing such possibilities special rules are set forth for determining the financial tax result in cases where associate companies transact with one another on terms and conditions different from those established between independent firms.
In this connection the so-called „arm’s length principle”requires that the profits and income resulting from deals completed between associate companies correspond to the profits and income that would have been achieved in business transactions between independent firms on comparable market conditions. Seen in this perspective and for tax purposes, the law regulates the prices in related party transactions so that any market price divergence will be eliminated. Within the framework of such auditing, the auditor has the right to demand specific documentary evidence to be provided within a stipulated time limit. If the obligated party fails to present the required written evidence in time, the revenue authorities may assume that the evidence does not exist and hence assess only the evidence gathered in the proceedings. Should the required evidence be presented before the issuance of the tax assessment act, or in the course of the procedure for issuing a tax assessment decision – before expiration of the term for appealing against the audit report (before the final tax assessment decision on the obligations), then the revenue authorities are obliged to take into account the evidence in question.
Below are the cases where the business entity is subject to taxation and the requirement for provision of documentary evidence of the used transfer pricing methods in transactions between related parties:
– between associate companies, local entities for Bulgaria
– between associate companies, only one of which is a local entity for Bulgaria
– transfers between the place of economic activity of a foreign company and its other parts located outside of the country, in accordance with the specificity of the place of economic activity
– the cases as per art. 116, para 3 of the Tax and Social Insurance Procedure Code.
Transfer pricing documenting is applied by persons conducting transactions with related parties. Any taxpayer who makes such transactions has the obligation to prove conformity with the market price and the reasons for the divergence. Market price conformity of controlled transactions is proved with documents evidencing that the principle of independent market relationships has been observed.
Accordingly, with some exceptions for the smaller firms, the taxpayer must prepare a sizable stack of documentation which includes the description of the companies in the group, their business activity, functions and policies of transfer pricing. As well as that, an analysis of the bigger transactions where the Bulgarian company is a participant is submitted. The submitted documents must prove that the profitability achieved by the company conforms to the market levels of profitability of equivalent transactions concluded between unrelated parties. The statistics of such transactions usually can be found at some of the reputable international databases (Аmadeus, Orbis, etc.).
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