Companies should enter into transfer pricing agreements
The Income Tax Amendment Act and the rules enacted thereunder have been the subject of heated debates in the papers in the last weeks. This law attempts to stop base erosion and ensure that multinational enterprises (MNEs) deal with associated enterprises in an arm's length manner in order to ensure that there are no distortions which would reduce the amount available for tax.
The Income Tax Amendment Act places the onus on taxpayers who earn more than J$500 million in a financial year to state in their annual returns the arm's length consideration in respect of connected transactions and the use of arm's length consideration in computing the tax chargeable on the income for that year of assessment.
This legislation is based on the Organisation for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises (MNE's) and Tax Administrations. OECD member countries, in a bid to minimise the risk of double taxation to which MNEs are constantly exposed, adopted the separate entity approach as the principle to use when determining a transfer price (the price of goods and services sold between related entities in a business enterprise). In applying the separate entity approach, the OECD member countries came up with the arm's length principle to use when determining the transfer price on goods.
ARM'S LENGTH PRINCIPLE
The arm's length principle has been accepted by countries because it avoids double taxation while ensuring that each jurisdiction has the appropriate tax base. This principle is also accepted because it gives MNEs and domestic enterprises equal treatment for tax purposes, and effectively removes any advantages and disadvantages that would unfairly accrue to either enterprise. Research has found that the arm's length principle is effective in most cases. This is because when commodities are sold where an arm's length price has been used and a comparison is made with a similar transaction with similar conditions undertaken by a similar independent enterprise, it is easy to prove if the arm's length principle has been used.
However, the practicalities of this principle and the different transfer pricing methods have constantly been questioned. The arm's length principle has conceptual and process related shortcomings. The conceptual problems are that that associated enterprises behave differently from unrelated ones, because their transactional structures are different, the products being exchanged are different and have different functions and risks allocated.
The differences in these transactions is also compounded by the benefits MNEs enjoy because of integration between the different enterprises, the arm's length policy fails to take in account things like economies of scale and other synergies that MNEs enjoy. Therefore, it is not practical to compare unrelated and associated companies.
The process-related shortcomings are the high levels of documentation required as well as the negotiations involved. All of these are cumbersome and do not facilitate international trade, they increase uncertainty and make MNEs reluctant to enter such transactions. In developing countries such as Jamaica, this is compounded by the fact that this information is hard to come by because you have fewer organised operators so finding proper comparable data might be difficult.
The arm's length principle is also difficult to apply to intangibles as these tend to lack suitable comparables. An example is intellectual property, which is unique. Finding a similarity for this can be challenging. Finding comparables is made more complex because dealings with intellectual property can occur in many subtly different ways such as through license agreements for which a royalty is paid, including the price of the intellectual property in the price of goods or package deals that combine different methods. Tracing all these different transactions can be challenging.
Given the complexities in determining arm's length consideration companies should actively seek to enter into transfer pricing agreements. The Income Tax (Transfer Pricing Agreement) Rules 2015 allow companies to request the Commissioner General to enter into a transfer pricing agreement. This will determine in advance the appropriate set of criteria to use when dealing with connected parties, the transfer pricing method, comparables and appropriate adjustments. This will give the taxpayer certainty regarding the outcome of his international transactions, by agreeing on a set of arm's length methods and prices. It will remove the threat of an audit and substantially reduce the cost of compliance while the transfer pricing agreement is in force.
The tax authority also stands to benefit as the transfer pricing agreements will significantly reduce the costs of administration. It is, therefore, in the interest of both the taxpayers and the tax authority to actively seek and encourage transfer pricing agreements as the government embarks on this new policy.
n Christabel Musaazi is an attorney-at-law whose MBA (Birmingham University) thesis was on transfer pricing. Email firstname.lastname@example.org.