Maintaining proper accounting on transfer prices and documenting the reasoning for conformity to market value is in the interests of every enterprise, as it avoids tax risks. In preparing documentation, the requirements of legal acts should be considered along with the specific company’s risks and needs.
Transfer prices are the prices at which related persons (companies belonging to the same group or companies with a common economic interest) execute transactions with each other. By law in Estonia and other countries with advanced tax systems, such transactions must take place according to the arm’s length principle. Put simply, the rule means that the prices of a transaction must be identical to the price agreed by mutually unrelated parties under identical circumstances.
If this is not the case, the difference from market value (the amount the taxpayer would have received as gains or the amount of expenses forgone by the taxpayer) is subject to income tax. The idea behind the arm’s length principle is to prevent concealed redistribution of profit among related companies, as this would deprive the state of tax revenue.
What does transfer price documentation mean?
Assessing conformity to market value is not always a simple task – after all, transactions between related persons always have to be analysed in the economic context and all factors that could influence the price of a transaction must be taken into account in comparison with an identical transaction between mutually unrelated persons. For example, the following have to be taken into account:
- object of the transaction
- functions performed in the context of the transaction
- risks assumed
- resources used
- terms of the transaction
- business strategies of the parties.
To make this work easier and avoid drawing conclusions generalised from an incomplete picture (especially important in the case of large international groups of companies), tax rules in developed countries often require larger companies to prepare documentation on transfer prices – a document that describes their business activity, organisational structure and circumstances of transactions with related persons and provides reasoning for the transaction prices – transfer pricing documentation.
Requirements of maintaining such records and the required content and scope of the documentation differ significantly from country to country. What is positive is that on the international level, the OECD is leading a drive to harmonise regulations with regard to methodology for evaluating market value and requirements for documentation.
What are the requirements for documentation in Estonia?
In Estonia, the requirements for documenting transfer prices were set forth in Section 18 of Minister of Finance regulation no. 53 from 2006, “Methods for determining the value of transactions conducted between related persons.”
It is important to stress that although as a rule, Estonia requires documentation of transfer prices to proceed from general requirements for documenting business transactions and the obligation of documentation in accordance to thorough requirements is mainly imposed on large corporate groups in Estonia – persons whose annual turnover for all related persons is at least 50 million euros and have 250 or more employees or a balance sheet volume of 43 million euros or more – all undertakings must in fact conduct transactions with related persons according to the arm’s length principle, and companies must be capable, if prompted by the tax authority, to substantiate the transactions based on the principles set forth in Minister of Finance regulation no. 53.
In other words, although an undertaking may not have the obligation under Estonian legal acts to maintain thorough documentation on transfer prices, the tax authority is always entitled to request additional information and explanations on transactions conducted with related persons (the obligation to taxpayers to cooperate with authorities in tax proceedings). A definite transfer pricing strategy developed beforehand and precisely documenting its correspondence to market value is thus always in the taxpayer’s best interests, to assure the tax authority of the correctness of transfer prices and to hedge a specific type of business risk.
For businesses operating across borders in other tax jurisdictions, it is wise to be aware of local requirements on transfer pricing matters, including documentation requirements.
Considering risks and needs
Although documentation of transfer prices may seem an arduous and costly undertaking (especially if there is no outright obligation to prepare detailed documentation) and unlikely to be economically rewarding, the other side of the coin should be considered. Doing nothing or taking minimal action is cheap in the short run but runs the risk of much more expensive consequences in the form of adjustments of transfer prices and sanctions if the transactions come under the scrutiny of tax authorities.
The need for strongly reasoned transfer pricing policy and corresponding documentation is correlated with the scope, particularities and level of complexity of the transactions between related persons. For example, smaller-scale transactions governed by simple and transparent pricing principles where the market value is supported by evidence of similar transactions with independent persons do not require so much analysis and detailed attention as, say, pricing for goods that pervade a complex value chains and are related to use of intellectual property, where multiple factors influence the market value.
The resources of national tax authorities are also limited and the use of those resources is generally aimed at areas where the state stands to lose the most revenue. The indicators of such a risk are generally large transaction volumes between related parties, regularity of such transactions, constant reporting of losses or significant variations in financial indicators compared to the average for comparable companies or economic sectors.
Certain types of transactions (e.g. financial transactions, payments for use of intellectual property, management services, transfer of company, agreements on sharing of expenses), location of a related party in a tax haven, high loan burden of a company, and deficient documentation and unwillingness to cooperate, signalling the lack of thought-out transfer pricing policy in the company.
A practical approach to the documentation obligation
Practical aspects of documentation of transfer prices should be noted. Understanding the company’s value chain and functions and risk-based analysis could aid in identifying inefficiency, possibilities for optimisation and deviations from established principles or in mapping business risks (including tax risks) threatening the company.
Self-analysis and comparison of profit margins to financial indicators for other market participants is a valuable source of information for companies that helps them make management decisions. It is not infrequent for transfer pricing theory to serve as an effective resource that can be relied on in negotiations with related persons.
Documentation of transfer prices as part of general risk management
Documentation of transfer prices is in truth just one part of a broader risk management process, which is preceded by consideration of risks and practice needs and opportunities, verification of valid principles (conformity to business model and the arm’s length principle) and development and implementation of a corporate transfer price strategy that can be justified to tax authorities.
Following the documentation procedures, it is important from time to time to check the developed approach and whether it is still valid, reassess risks and introduce the required changes into practical business and the documentation. Keeping up to date with changes in valid regulations, including documentation requirements, is also important.
A skilful approach will thus keep transfer pricing documentation from being just a piece of paper in the corporate accounting system but an important tool for organising business activities and keep tax risks minimised.