Vicente Duran Rodriguez

Victor Mendoza

Marcelo Castillo

This article sets out an overview of the current transfer pricing situation in Spain and Latin America and compares the current position with the Spanish tax authorities' potential future position as set out in new draft regulations. Following the comparison, the article discusses the impact of the changing transfer pricing regulations on Spanish financial institutions with a presence in Latin America.

Although the article concentrates on Spain and Latin America, the issues discussed will be relevant to multinational enterprises (MNEs) in other jurisdictions, and illustrate the difficulty faced by such businesses in dealing with national tax authorities' approaches to transfer pricing, which, while generally adhering to the OECD's Transfer Pricing Guidelines (the OECD Guidelines), display material differences in terms of legislation, interpretation or practice. Dealing with such differences can cause MNEs significant difficulty, either through increased tax burdens or increased administration costs.

Following the tendency of international economic expansion and the introduction of the European single market, Spanish banks have constantly increased their presence abroad. Rather than expand into Europe, in the mid-1980s Spanish banks began to privatize and open Latin American bank systems, as fewer linguistic and cultural barriers existed. The expansion was welcomed by Latin American governments, since it introduced new technology, financial management skills, and capital to their existing domestic banking industries. Spanish banks, which are mainly focused in commercial banking, private banking and asset management, are present in, among other countries, Mexico, Brazil, Chile, Argentina, Colombia, Venezuela, Puerto Rico, Ecuador, and the Dominican Republic. In fact, at the start of 2004, according to the US Embassy in Madrid, Spanish-owned banks accounted for 19% of the collective bank assets of the top six Latin American countries, or 40% of the total for all foreign-owned banks in these same countries.

On the business side, as described above, there has been a parallel and interactive relationship benefiting both the Latin American and the Spanish financial institutions involved, but on the transfer pricing side, there has been an asymmetric development of the Latin American and Spanish tax and legal framework. While many Latin American countries have introduced strict and detailed transfer pricing rules (including legal documentation requirements), until recently the Spanish transfer pricing system has, from a practical perspective, remained dormant.

However, on January 3 2006, the Spanish Ministry of Economy and Finance issued draft transfer pricing regulations, introducing new documentation requirements in the Draft Law on Measures for Preventing Tax Fraud (the Draft Law). Following this Draft Law, on March 10 2006 the ministry released revisions to the original text published in January, incorporating, for transfer pricing purposes, a specific reference to stiff penalties for non-compliance with the new documentation requirements, and for non-arm's-length transfer prices. If finally approved, the newly issued draft article 16 will shift the burden of providing evidence relating to the arm's-length nature of the related-party transactions performed, to the Spanish taxpayers rather than the Spanish tax authorities. Consequently, Spanish financial institutions with a presence in Latin America may potentially face an array of transfer pricing issues and need to re-analyze and document their arm's-length transfer pricing compliance, from both sides of their international inter-company transactions.

Transfer pricing now

The Spanish transfer pricing regulations are contained in article 16 of the Spanish Corporate Income Tax Law's (CITL's) Royal Legislative Decree 4/2004, of March 5 2004. In similar manner to the OECD Guidelines, article 16 endorses the Spanish tax authorities' application of the general arm's-length principle, when valuing transactions performed between related persons or entities for tax purposes.

In fact, since 1996, Spain has broadly adopted the Guidelines in implementing its regulations (this is confirmed by the tax courts and jurisprudence) although, in practice, certain differences exist. For example, unlike the Guidelines, the Spanish CITL follows a hierarchy for transfer pricing methodology that gives preference to the comparable uncontrolled price (CUP) method, followed by the cost-plus method (CPM) and resale price method (RPM), which may be used as alternatives only if the CUP method is not applicable. If the CUP, RPM or CPM methodologies are rationally refused, the profit split method (PSM) could be applied as a last resort. Unlike the OECD Guidelines, the Spanish CITL does not recognize the transactional net margin method (TNMM). While this methodology is not mentioned in the Spanish law, in practice, the Spanish tax authorities have accepted in the past the TNMM as a recognized OECD methodology in certain circumstances (in principle, whenever a double tax treaty signed between Spain and the Latin American country considered exists). As in some other jurisdictions, there are no specific references in the CITL to valuation methodologies for financial transactions.

In addition to the above, Spanish law has not established specific Spanish transfer pricing documentation requirements, except for the deduction of expenses derived from management fees and cost contributions to R&D activities.

Finally, because of the original drafting of article 16 (which only empowered the Spanish tax administration to value the transactions made by related parties following the arm's-length principle), no penalties have been imposed so far on transfer pricing adjustments proposed by the Spanish tax administration (only the quota and delayed payment interest have being applied when tax assessments have been proposed).

Several Latin American countries, such as Argentina, Brazil, Colombia, Ecuador, Mexico, Peru, Portugal and Venezuela, have introduced specific transfer pricing regulations and documentation requirements. Aside from Brazil, the above countries' transfer pricing regulations are in general alignment with the OECD Guidelines. Similar to the Spanish transfer pricing regulations, the OECD Guidelines also endorse the arm's-length principle to evaluate the transfer pricing policy followed by associated enterprises. To evaluate the arm's-length nature of a transfer pricing result, the OECD Guidelines discuss the preferred use of a traditional transaction-based method (CUP, RPM, and CPM) over other accepted methods (PSM and TNMM). Unlike the Spanish transfer pricing regulations, the OECD Guidelines state no specific preference for the CUP method over the RPM and CPM.

The current transfer pricing situation is already complicated, given the differences in transfer pricing regulations (mainly, the existence of legal documentation requirements in many Latin American countries and the specific penalty regime linked to both the absence of supporting transfer pricing documentation and transfer pricing adjustments). However, it is likely it will get more complicated with the potential enactment of the draft Spanish transfer pricing regulations and the introduction of documentation requirements in the Spanish market.

Transfer pricing in the future

The March 2006 proposals include significant changes to the current transfer pricing legislation, including the following measures:

• General alignment of Spain's transfer pricing rules with the general principles set out in the OECD Guidelines and the EU Joint Transfer Pricing Forum (EUJTPF).

• General alignment of the hierarchy of Spanish transfer pricing methodologies with the OECD Guidelines - the CUP method, CPM and RPM would all be equally preferred methods. If one of these three could not be applied, then the PSM or TNMM could be used.

• A requirement to provide the Spanish tax authorities with evidence (transfer pricing documentation report) that the related-party transactions comply with the arm's-length principle. This formal requirement applies to both domestic and international related-party transactions and should be in line with the content already proposed by the EUJTPF (the 'master file' concept).

• Introduction of formal rules that would permit the tax authorities to make 'secondary adjustments'.

• Application of penalties if transfer pricing adjustments are proposed by the tax authorities, or if the taxpayer fails to prepare the required documentation, does not maintain the documentation, or maintains incomplete, inaccurate or fallacious information. In addition, if the taxpayer's transfer prices or margins, as stated in the tax returns, are not considered by the tax administration to be arm's length, the taxpayer would be subject to further penalties. The penalties would consist of:

• • €15,000 ($19,310) for each omitted data specified within the documentation requirements, and for each inaccurate or misleading data included in the transfer pricing documentation files.

  • If a transfer pricing adjustment for non-arm's length intercompany pricing is proposed, the greater of either (i) €30,000 or (ii) 15% of the transfer pricing adjustment being proposed.

It is not known if any Latin American countries that have draft regulations may be enacted in the near future. However, more transfer pricing regulatory changes can be expected to follow in Latin America in due course.

Impact of changing regulations

The impact of changing transfer pricing regulations presents potential issues that Spanish financial institutions with a presence in Latin America must face, to mitigate any potential transfer pricing risks. Below, the potential impact of the enactment of Spanish regulatory changes are discussed, on:

• global documentation requirements;

• (selection of the "tested party" (that is, the related party whose compliance with the arm's-length principle is being tested) for documentation purposes and as part of the global functional analysis which has to be performed in a typical transfer pricing exercise; and

• selection of the most appropriate transfer pricing methodology to be used to define or test the arm's length nature of the transaction considered.

As already mentioned, the newly issued draft regulations shift the burden of providing evidence that a company's related-party transactions are arm's length to the Spanish taxpayer, rather than the Spanish tax authorities. As such, financial institutions with a presence in Latin America will be required to prepare Spanish transfer pricing documentation in addition to any previously maintained local documentation. This development obliges multinational companies to analyze and document their arm's-length transfer pricing compliance from both sides of the international inter-company transaction (Latin American countries plus Spain), assuming of course that the Spanish entity has related-party transactions in countries with transfer pricing regulations and legal documentation requirements. The requirements on each side may differ and therefore need reconciliation.

The reviews necessary as a result of the above may of course bring about changes to the pricing of related-party transactions, as well as to the documentation thereof. Whereas in the past, a financial institution may not have been unduly concerned with its Latin American affiliates or branches earning a return above the arm's-length range on transactions with their Spanish related party, it will now have to consider the Spanish tax authorities' position and possibly adjust its inter-company pricing policies.

As Spain's draft transfer pricing law is generally in line with the OECD Guidelines, the transition to include Spain in a global "master file" transfer pricing documentation report may be more difficult to manage in cases where the Latin American country concerned has transfer pricing requirements that vary significantly from the OECD guidelines and EUJTPF (master file concept) or, for example, in cases where the related party concept is treated on a different basis. Brazilian transfer pricing legislation highlights differences from the OECD guidelines, since the taxpayer is allowed to choose the method that proves to be the most beneficial to the Brazilian entity. Argentine and Portuguese regulations also provide good examples of potential differences, in the way in which the related-party concept is approached. In both cases, the local rules use a broader concept which may treat an entity as a related party for local purposes (even though not part of the financial institution's group) purely on the basis of the dependency derived from specific commercial or financial relations. The "special relation" concept is contained in the Portuguese and Argentinean transfer pricing regulations.

In every case, Spanish financial institutions with Latin American affiliates will need to determine how to link their current local documentation report(s) with their future global documentation report ("master file" plus country-specific information), and address how to handle any potential changes to their current presentation of facts, selected transfer pricing methodologies, and results.

Furthermore, the taxpayer will need to include a full functional, market and risk analysis of both the Spanish and Latin American entities/branches involved, so as to identify the most appropriate entity (tested party) to validate the company's global transfer pricing policy. This is to facilitate comparison with uncontrolled transactions (where the parties are unrelated). While the OECD guidelines do not introduce the concept of a "tested party" on an isolated basis, as discussed in the US Treasury Regulation section 1.482-5(b)(2), the Guidelines discuss that when selecting "the associated enterprise to which the TNMM is applied [it] should be the enterprise for which reliable data on the most closely comparable transactions can be identified." The Guidelines go on to state

this will often entail selecting the associated enterprise that is the least complex of the enterprises involved in the controlled transaction and that does not own valuable intangible property or unique assets.

In many transfer pricing documentation studies performed for financial institutions, the TNMM has been selected to test the arm's-length nature of the analyzed inter-company transactions. As the majority of Latin American countries generally follow the OECD Guidelines, it is quite possible that the majority of Latin American transfer pricing documentation reports of Spanish financial institutions' affiliates/branches selected the correspondent Latin American company/branch as the tested party. In some cases, it would apparently be the simpler entity from a functional perspective. and in others, it will be the entity that the taxpayer is obliged to test, in accordance with local country regulations. The latter is the case in Argentina, where the General Resolution No 1.122 AFIP, article 9o states, "for the application of the selection of transfer pricing methodology, the pricing comparability and justification analysis should take place directly at the local level". In other words, the prescribed Argentinean norms establish that the "tested party" should, in any case, be the Argentinean entity.

If Spain's draft transfer pricing documentation requirements are enacted, the selection of the tested party may need to be re-evaluated to test the inter-company transactions between Spanish financial institutions with Latin American affiliates. This is the case where the inter-company transaction involves the Spanish headquarter company providing management services to the different Latin American entities involved, which, if deemed beneficial, should receive an arm's-length remuneration. Generally speaking, routine management services would be remunerated on a (net) cost-plus basis. As the Spanish financial institution would in most cases be incurring the management costs to be marked up, the Spanish company would ideally be the more appropriate tested party to be selected. However, given certain Latin America countries' preference to test the local entity's profit margin, for example, in Argentina, Spanish financial institutions with Latin America affiliates may need to test their inter-company transactions from both national perspectives to satisfy the Spanish and certain Latin American tax authorities' requirements.

As the transfer pricing methodology selection criteria in the Spanish Draft Law and the OECD Guidelines are generally consistent, the enactment of the Spanish Draft Law may not significantly affect financial institutions' selection of a transfer pricing methodology.

Latin American subsidiaries, branches or permanent establishments of Spanish financial institutions often perform multifaceted functions, such as sales and marketing, creating and cultivating client relationships, negotiating contractual terms, evaluating the client's risk profile, pricing the loan, raising funds, drafting or checking the contract, resolving potential legal issues, managing and monitoring the financial asset, and possibly refinancing loans. As certain Latin American financial affiliates perform complex functions, the entities concerned bear significant risks, which may have been remunerated with healthy profit margins. In some cases, the Latin American affiliate may have actually earned a profit margin above the documented arm's-length range of results. Whereas Latin American financial companies were probably not as concerned with the Latin American tax authorities complaining on being over-compensated, the Spanish tax authorities will certainly be concerned about being under-compensated.

Spanish and Latin American taxpayers may need to manage any changes to previous transfer pricing methodologies with great care. Any change from past precedent could raise a 'red flag' with both the Latin American and Spanish tax authorities, who could potentially challenge deviations from the previous 'arm's length' inter-company price, especially if neither the Spanish financial institution nor the Latin American affiliate's functions, assets, or risks have changed.

Furthermore, in inter-company transactions involving Spain and Brazil (given Brazil's unique transfer pricing regulations) the Spanish and Brazilian taxpayers may have to re-evaluate the selected methodology to make sure that their results are within an arm's-length range from both national transfer pricing perspectives.

Looking forward

Spanish financial institutions with Latin American affiliates need to be cognizant of the newly issued Spanish draft transfer pricing regulations, which are certain to impact their transfer pricing policy procedures and documentation, once enacted. Given the globalization of the world economy and the ease with which related companies can transact, tax authorities are increasingly monitoring and challenging any potential non-arm's length inter-company transaction. As such, it is critical that companies plan, implement, test and support the arm's-length nature of their inter-company transactions, according to the transfer pricing regulations and documentation requirements of each relevant tax jurisdiction, in accordance with a transfer pricing documentation report(s), to mitigate any potential transfer pricing risk.

Vicente Duran Rodriguez

KPMG in Spain

Tel: +34 9 1456 3400

Email: vduran@kpmg.es

Victor Mendoza

KPMG in Spain

Tel: +34 9 1456 3400

Email: vmendoza@kpmg.es

Marcelo Castillo

KPMG in Argentina

Tel: +54 11 4316 5834

Email: mcastillo@kpmg.com.ar