Transfer Pricing in Kazakhstan
BILL PAGE, Partner, Director of Tax Services ERNST & YOUNG KAZAKHSTAN
What is Transfer Pricing?
A transfer price may be defined as the price charged when an entity supplies goods, services or finance to another entity to which it is related in some way. Tax authorities are interested in transfer pricing because the relationship that exists between the two entities enables them to manipulate the price charged in order to minimise their overall tax liability.
Company A is resident in a high tax jurisdiction. It manufactures goods and sells them to Company B. Company B is resident in a low tax jurisdiction. Company B retails the good it purchases from A. Company A and Company B are both 100% owned by Company C. If the cost of manufacture is USD 100 per item and the retail sale price is USD 150, it is easy to see that the C group can minimise its overall tax liability by compelling A to sell its goods to B at cost so that all the profits on the combined activity are generated in the low tax jurisdiction where B operates.
Clearly the tax authorities in A’s jurisdiction will not wish to see profits shifted in this way. Transfer pricing rules usually operate to enable the tax authorities to adjust for tax purposes pricing in transactions between related parties. A country’s transfer pricing regulations normally require that such adjustments are made in accordance with the arm’s length principle, ie based on the price which would have been charged between independent parties acting at arm’s length.
History of Transfer Pricing in Kazakhstan
The current Kazakhstan Tax Law does not include any transfer pricing rules. Instead a separate piece of legislation entitled State Control over Transfer Pricing governs transfer pricing in Kazakhstan. This came into force on 1 January, 2001. This law is discussed in more detail below.
Prior to January 2001, the Tax Law had included detailed provisions on transfer pricing since 1 January 1999. A much briefer rule preceded this.
In addition to general legislation, sub-surface use contracts for mineral extraction or the production of hydrocarbons normally include specific transfer pricing rules which apply to transactions with related parties, instead of the provisions in general law. The provisions of such contracts are beyond the scope of this article.
It is expected that the new Tax Code of Kazakhstan will include transfer pricing provisions identical to those in the current Law. The new Code is expected to come into force on 1 January 2002. At this point presumably the current law will be withdrawn.
The 1995 Rule
The current Tax Law came into force on 1 July, 1995. Article 138 originally contained a provision giving the tax authorities the power to adjust a taxpayer’s income to reflect arm’s length prices in the case of transactions with related parties that were on non-arm’s length terms. This provision was amended with effect from 1 July 1998 to apply to transactions with non-residents or organizations enjoying tax concessions. It was not necessary for there to be any other relationship between the parties.
This provision was not widely applied in practice.
The 1999 Rules
The transfer pricing legislation was significantly expanded in 1999 to give the tax authorities the power to challenge prices in case of related-party transactions, barter operations, transactions involving importation or the provision of services by non-residents. The legislation also provided a “safe harbour” rule: only sales at a price that varied by more than 20% from the market price for identical goods, works and services were subject to adjustment by the tax authorities. Related parties were defined as individuals or legal entities whose relations could directly affect the conditions, economic results or activities of the taxpayer - in particular, an entity owning at least 33% of another entity or individuals with a familial or guardian relationship.
These rules apply for 1999 and 2000.
The normal means of determining the arm’s length price for goods and services under the 1999 rules is to look for the comparable transactions between unrelated parties. The use of “comparable uncontrolled transactions” to benchmark arm’s length prices is widely applied by tax jurisdictions around the World. When no transactions are conducted with similar goods or services in a particular market or if there is a deficit of these goods or services on the market or if it is impossible to determine appropriate prices, the following methods may be used by the tax authorities to determine applicable prices:
• the “subsequent selling price” method, whereby the market price of goods or services subsequently sold by the purchaser is deemed to be the subsequent sale price less reasonable marketing costs and a reasonable and usual profit for this sphere of activity;
• the “cost plus” method, whereby the market price of goods or services is deemed to be the sum of direct and indirect costs incurred for the production/acquisition and/or sale of goods or services, transportation, storage, insurance and other similar costs plus a reasonable and usual profit for this sphere of activity. These options are also widely applied by tax authorities in other jurisdictions.
The 1999 rules are comparatively recent but there have already been a number cases where the tax authorities have sought to apply them in practice.
The 2001 Rules
During 2000 the Government and the National Bank became increasingly concerned by loss of tax revenues and the flight of capital from Kazakhstan. Transfer pricing policies of exporters were seen as a major cause of both phenomena and the need for more stringent transfer pricing regulation identified. In particular the 20% “safe harbour” created in the 1999 rules was no longer regarded as acceptable.
Discussions of a new Transfer Pricing Law began in the government in 2000 and draft legislation was first issued in August of that year. A significantly amended version was signed by the President in December 2000 and came into force on 1 January 2001.
Under this Law, the tax authorities have extremely wide powers to review transfer prices adopted in respect of transactions for goods, works and services.
Any deviation detected between the transfer price and the deemed “market price” for imported or exported goods, works and services may trigger additional taxes and penalties in accordance with Kazakhstan tax legislation. All taxes may be affected including profits tax, VAT, excise and customs duties and royalties for subsurface users.
The new Law expressly recognises that a taxpayer shall have the right to provide any relevant information pertaining to the market price or the appropriate method to be adopted in determining the market price. This is a significant improvement was earlier versions of the draft law which referred only to the imposition of market prices in accordance with “official sources of information”.
Analysis of the 2001 Law
The following types of transactions are subject to transfer pricing scrutiny:
1. transactions between mutually dependent parties (as extensively defined in the draft Law);
2. barter transactions;
3. offset claims;
4. transactions with residents of foreign states which are covered by a concessionary tax regime, including offshore zones which are defined on a list to be prepared by the Kazakhstan Government;
5. transactions with legal entities which have tax concessions or for whom a special tax rate has been legally established;
6. transactions with legal entities which have declared losses in their tax declarations for the immediately preceding 2 year period.
In addition, any other international business transactions not covered by Items 1-6, may be subject to transfer pricing scrutiny, if the transfer price adopted for the transaction deviates by more than 10% from the market price.
The term “international business transactions” is defined as the export or import of goods, works and services.
In addition, domestic transactions covered by Items 5 and 6 may also be reviewed, if such transactions are also intimately connected with international business transactions.
The concept of mutual dependency is much wider that that of related parties found in the previous law. The definition (in Article 6 of the Law) states that mutually dependent parties include any legal entities or individuals “who are specifically inter-related and may influence the economic results of transactions or operations between them”. Whilst the language is not very clear, the list of examples which follow indicates that the law has a very wide scope indeed, much wider than usually found in transfer pricing rules of other countries.
Under the Law, the tax authorities are empowered to use the following methods for determining the market price:
• comparable uncontrolled price method;
• cost plus method;
• resale price method.
In this respect the new rules are similar to the 1999 regulations.
The first method is to be adopted when there is a corresponding market for similar goods, works or services. In such circumstances, the market price shall be the price for similar goods, works or services sold in comparable conditions between parties acting at arm’s length.
The second and third methods are to be adopted when there is no such corresponding market for similar goods, works or services. These methods shall also be adopted if it is not possible to determine an appropriate market price due to the lack of information sources.
The Law acknowledges that certain factors may result in price deviations, and that such factors should not be considered as a basis for adjusting the transfer price. These include:
• volume of goods supplied, or works performed;
• seasonal fluctuations;
• varying quality in goods sold; and other consumer characteristics;
• marketing policies for promoting new products for the market;
• samples and specimens;
• terms of payment;
• period of fulfiment of obligations.
The following sources of information may be used to determine the market price for goods, works or services:
• officially recognised sources of information; and
• information provided to the tax authorities by taxpayers.
The New Law in Practice
The tax authorities are currently working on an instruction that will set out in more detail how the law is to be applied. Minister of State Revenue Kakimzhanov has indicated that the tax authorities will focus their attention primarily on export transactions related to commodities. The scope of the law is, of course, far more wide-ranging.
Taxpayers in Kazakhstan have a number of concerns about the new law. In particular, it applies to many types of transactions with unrelated parties. In addition it does not provide a mechanism for making compensating adjustments where both parties to a transaction are taxpayers in Kazakhstan. This could result in economic double taxation as illustrated in following example.
Company X and Company Y are under common ownership. X is a manufacturing company and Y is a retailer. X sells goods to Y for USD 100. Subsequently a tax audit determines that X sold the goods for USD 20 less than an arm’s length price. X is taxed now on a sale price of USD 120. Y on the other hand can still only deduct a cost of sales of USD 100. USD 20 of income is effectively twice: once in X’s hands and once in Y’s.
Another major concern for taxpayers is documentation. In other tax regimes with more mature transfer pricing regulations, the tax authorities expectations with regard to documentation are reasonably clear in law and practice. Kazakh tax officials traditionally require very significant amounts of documentation, however although taxpayers are now under the new law, it is not yet dear what the tax authorities will expect from taxpayers by way of support for their pricing policies.
Kazakhstan is a society in transition. Normal business practices that are a matter of course in more mature markets are still a novelty for the tax authorities in Kazakhstan, particularly at the region and local level. One of the major challenges to the tax authorities and for taxpayers will be to agree on the distinction between the reasonable and the unreasonable so far as pricing is concerned. This process of mutual education and understanding is likely to take some time and one of the most important tools on both sides will be patience.
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