Evolution of transfer pricing documentation obligations towards implementation of the action plan on BEPS

One of the aspects considered in the BEPS initiative (Base Erosion and Profit shifting) has been to revisit the aspects of documentation, referred to in action 13 of the Action Plan.  However, in order to have a greater understanding of this new document approach and an idea of the impact of its implementation, it would be interesting to revisit the evolutionary process of transfer pricing documentation obligations and their progressive adoption by jurisdictions on the continent. All this without losing sight of the benefits that are sought with these changes.

The starting point for the definition of transfer pricing documentation obligations, in principle, had to contemplate, among other elements, whether the burden of proof should correspond to the tax administration or to the taxpayer.  In the first case, the tax administration should check whether or not the taxpayer complies with the Arm’s Length Principle by using the information available in its files or obtained in a control process, corresponding to the tax administration to identify the necessary elements to delimit the operation subject to analysis and verify that the taxpayer is in compliance.  In the second case, the taxpayer, who must be the best connoisseur of his business and his operations, should compile and explain each of the relevant elements to apply the most appropriate method allowing to prove that the prices (or margins obtained, depending on the method to be applied) in the operations carried out with related parties were consistent with those that would have been agreed with independent third parties.  In the latter case, the taxpayer’s main instrument to accurately and coherently provide the tax administration with information on their operations with related parties would be a transfer pricing study.

The inconsistency in the different jurisdictions in terms of defining, explicitly through domestic legislation or implicitly through practice, the subject to whom the burden of proof was responsible contributed to the proliferation of different criteria in relation to the type and level of documentation sufficient to determine compliance with the Arm’s Length Principle.  All of this represented a practical difficulty in trying to establish an international documentation standard that was commonly accepted.

The transfer pricing and multinational enterprises report  of the Organization for Economic Co-operation and Development (OECD), published in 1979, established in its chapter I “Summary of Problems,” paragraph 25 concerning the necessary documentation and evidence that:

“The flexibility of the agreements available to MNEs (multinational enterprises) can create a problem for them as well as the tax authorities. If the transactions are not adequately evidenced by contemporary documentation, it will be clearly more difficult for the MNE to convince the tax authorities that they took place in the form and manner claimed or that the transactions compare properly with particular transactions between unrelated parties.  Retroactive agreements would justifiably be rejected moreover as inadequate to explain transactions taking place before the agreements.  This is not to say that the evidence consists only of written contracts or agreements or that documentary evidence should be required in relation to every transaction.  It is clearly desirable to avoid burdening MNEs with unnecessary documentation requirements.  It would be reasonable, however, to require MNEs to provide in support of any important contention either the relevant legal documents and explanatory material or in any rate sufficient information to allow the tax authorities to arrive at an informed judgement in the matter.”

This above mentioned paragraph highlights the importance of documentation and evidence,  the administrative burden that the documentation process can represent.  However, the absence of clear guidelines for documentation can be noted, as well as the responsibilities of the tax administration and taxpayer in this process.

With the update of this report, that would become the OECD transfer pricing guidelines for multinational enterprises and tax administrations (OECD guidelines) published in 1995, which in the 1979 report was a paragraph became a complete chapter in the Guidelines.

The Chapter V Documentation continues to address the issue of the administrative burden of documentation and incorporates some considerations on the exchange of information between the tax administration and the taxpayer but without providing specific requirements on transfer pricing documentation.  It also recommends that the taxpayer should make reasonable efforts to document transactions at the time the transfer pricing is established, if they are appropriate for tax purposes and comply with the Arm’s Length Principle.  On the side of the tax administration, it emphasizes its right to obtain documentation that serves as a means to verify compliance with the Arm’s Length Principle, while on the taxpayer’s side it suggests that the extension of the documentation process be done with the same principles of prudent business management that would govern the assessment process of businesses of similar complexity and importance.

For its part, U.S. regulations on transfer pricing contained in section 482 of the U.S. Tax code (Internal Revenue Code, or IRC) in force on the same date do not establish specific documentation obligations.  Interestingly, it is section 6662 concerning the imposition of sanctions, which has established documentation obligations whose fulfilment implies for the taxpayer the non-application of penalties (penalty relief) in the event of a transfer pricing adjustment.  In this sense, if the taxpayer has documentation (at the date of filing the income tax return) that establishes the pricing and application of the transfer pricing methods (based on the best method rule) and provides such documentation within 30 days of the date on which it is required, it wouldn’t be subject to sanctions.  The principal documents of the taxpayer must describe in a complete and precise way its transfer pricing analysis.  This documentation must include:

  • A general summary of the taxpayer’s business, including an analysis of the economic and legal factors affecting prices;
  • Description of the organizational structure of the taxpayer;
  • Any documentation explicitly required in section 482;
  • Description of the selected method and the respective explanation;
  • Description of alternative methods considered and reasons for rejection;
  • Description of controlled transactions and any internal information used to analyze such transactions;
  • Description of the comparables used and how comparability was assessed and how adjustments were applied (if necessary);
  • Explanation of the economic analysis;
  • Description or summary of any relevant information that the taxpayer obtained after the fiscal year end and before presenting tha income tax return, which could help determine whether the taxpayer selected and applied the method in a reasonable manner; and
  • A general index of the main documentation and support.

These obligations begin to proliferate in Latin America when, as a result of the North American Free Trade Agreement (NAFTA), Mexico included the transfer pricing regime in its legislation.  Similarly, other Latin American countries such as Argentina and Venezuela began to include in their legislation similar obligations of transfer pricing documentation in the late nineties. As the new millennium started, most of the other countries in South America were gradually adopting these obligations.  More recently Central America and the Caribbean have been actively working on the adoption of transfer pricing regulations.

These Latin American jurisdictions tried to adopt these obligations according to their own interpretation of international standards and practices.  However, they have presented two aspects in common: (i) the obligation to prepare a transfer pricing study to be delivered when requested, similar to the one requested to  U.S. taxpayers, but their compliance does not imply the elimination of sanctions; and (ii) the implementation of transfer pricing information returns.

With the recent incorporation of the results of the final report of Action 13 of the BEPS action Plan into the OECD guidelines, the preparation of the master file, local file, and country by country report (CbCr) is established as a documentation approach recommended by the OECD guidelines. This implies for the tax administrations that the pendulum balance of the burden of proof could shift with greater force than ever, as there is an increase in the quantity, quality and diversity of sources of information, where the task of assembling the pieces will require a significant increase in the capacity of the tax administrations to cope with this daunting task.  For their part, business groups must be very efficient and organized, as well as develop initiatives to create organizational structures and technological platforms that allow them to cope with these obligations.  Otherwise, the level of administrative burden for compliance will significantly increase for all those involved in the long term.

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