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COVID-19 and transfer pricing: saving ‘private’ distributor
What steps should the management of distribution companies take today to avoid complications after the year ends
The latest developments in global commodity and stock markets, national currency fluctuations, and introduction by the Ukrainian government of measures to prevent the spread of COVID-19 pose a challenge to the Ukrainian business.
Small and medium-sized businesses are most exposed to current conditions, followed by large companies. Among large business, it is companies with high fixed costs that would be the most sensitive to possible economic instability. First, it would affect manufacturing sector companies.
Current macroeconomic conditions will also affect distributors of multinational corporations that sell products in the Ukrainian market. It may seem that such companies do not have significant fixed costs, but it is not quite so.
Labor legislation of Ukraine allows for changes in working conditions (for example, reduction of working hours or sending employees on compulsory leave). However, in practice, it is difficult for companies to introduce such changes.
As distributors of international groups officially employ workers and pay them salaries, labor costs may be considered as long-term fixed costs.
This is one of key reasons why management of distribution companies is not only expecting for a decline in the profitability of their businesses, but also predicting net losses based on the calendar year results.
Now imagine that the majority of Ukrainian distributors (as will be discussed further below) that will declare losses may be subject to the additional accrual of corporate income tax (CIT) by tax authorities. This tool is defined by the tax code and is called transfer pricing.
According to the tax code requirements, a distributor needs to substantiate that the prices of import deliveries from the related parties (i.e. transfer prices) are not overcharged and correspond to arm’s length prices (accordingly, there is no tax base understatement). Given that a company will receive net losses, the provision of such a substantiation may be complicated.
What steps should the management of distribution companies take today to avoid complications with such substantiation after the year ends?
To substantiate the compliance of import prices to arm’s length, the majority of distributors operating in Ukraine position themselves as limited risk distributors.
According to transfer pricing (TP) concept, such companies should not bear currency, credit, market price, and other commercial risks (though some Ukrainian distributors bear the currency risk, which does not quite correspond to the limited risk distributor concept). This allows them to receive a small but guaranteed profit. Therefore, it is extremely difficult for the limited risk distributors to substantiate their unprofitability.
An example of such a company could be an importer of household appliances.
To substantiate that import prices at which an importer purchases appliances are arm’s length, the transactional net margin method (TNMM) is used. According to this method, if the company’s operating profit margin (i.e. profit to financial expenses ratio and tax to revenue ratio) is not lower than that of similar distributors in the market, then import prices correspond to arm’s length prices. In this case, it will not result in the additional CIT accruals.
In keeping with this approach, it seems like there should not be any difficulties with the substantiation, since negative margin of the household appliances’ importer will be compared with profit margin of comparable companies, which will be at about the same level.
However, there is a limitation for applying this approach envisaged by the legislation. According to the tax code, only companies with positive profit margin could be included in the selection. This means that, in our case, the distributor of household appliances is unlikely to be able to substantiate that its profit margin for 2020 is arm’s length.
This will result in the additional CIT accrual on the importer, while the group will face double taxation (because the supplier will not be able to offset the tax paid by the importer against its liabilities).
In practice, there are two baseline scenarios that can allow the group to avoid double taxation, and minimize the additional CIT accruals to the importer. The first scenario is to use the tools to improve the distributor’s financial result. The second scenario is to change the transfer pricing method used by the distributor to analyze transfer prices.
As regards the first scenario, there are several mechanisms that will allow the distributor to increase its profit margin. Below we are going to explore some of them.
Use of credit notes
The Ukrainian companies quite often use credit notes as a tool for adjusting prices of unpaid deliveries from non-residents. The Ukrainian legislation does not define a credit note and does not regulate the procedure for issuing such notes. Nevertheless, according to current court practice and clarifications from the Ukrainian tax authorities, credit notes are treated as an acceptable instrument.
Using of credit note allows, on the one hand, to increase the Ukrainian company’s profitability, and on the other hand, to reduce the supplier’s profitability. Accordingly, the use of a credit note will allow avoiding double taxation on supply transactions.
To use a credit note, the supply agreement between the supplier and distributor should contain the provisions on terms, form, and possibility of issuing a credit note.
However, there may be some VAT risks associated with the use of credit notes. For example, tax authorities may consider a credit note as a provision of marketing services in favor of non-resident and accrue additional VAT liabilities. To minimize the risk, it is necessary not only to correctly issue a credit note, but also to correctly reflect it in the company’s financial statements.
Receipt of payments from distributors
To increase the distributor’s profitability, the product supplier can make payment to the distributor in several forms, for example, to pay bonuses or make compensating payment in the form of TP adjustment. Similar to credit notes, such transactions can help to avoid double taxation.
The compensating payment made as TP adjustment reflects the substance of transaction more correctly than the bonus. We had a case when a foreign supplier refused to pay a bonus to its distributor. The reason was simple: the distributor operated at a loss, therefore he did not deserve any bonuses.
Both options could lead to certain tax exposure. For example, tax authorities may treat the compensating payment and bonus as a provision of marketing services and accrue additional VAT.
Properly executed compensating payment provides stronger argument for challenging the position of tax authorities. We have a successful experience in challenging the position of tax authorities in court. For example, there was the case when a judge took the side of a taxpayer and confirmed that such payment is not a marketing service.
As for the second scenario (the change of TP method), most Ukrainian distributors use the transactional net margin method and compare their operating profit margin with the same profit level indicator of similar companies. Using of this method may not allow factoring in all market terms and conditions of the transaction, thus leading to negative tax consequences mentioned above.
Therefore, it would be advisable to consider the use of other methods for the analysis purposes. The tax code envisages four more methods, in particular, the resale price method and profit split method. Theoretically, using one of these methods may allow the distributor to substantiate that import prices correspond to arm’s length prices.
However, to do so, the company should have strong arguments in favor of changing the analysis method and for explaining why new method is more appropriate for the analysis.
Based on the above, it is high time for management of distribution companies to think about mechanisms that will allow the group to avoid double taxation, and minimize the additional accrual of CIT to the importer. It should be stressed that there is no one-size-fits-all solution to this issue, since each case is individual and requires a careful and detailed analysis.
This article is co-authored with Maksym Zaichenko, Tax & Legal Senior Consultant at Deloitte Ukraine.