Colombian tax authorities intensify TP audits on the determination of income tax
Andrés Parra and María Alejandra Cuervo of EY Colombia explore how the international transfer pricing guidelines have influenced regulations in the country.
One of the aspects that demands the most attention from income tax payers in Colombia is related to the intense audit activity that tax authorities are conducting in matters associated to transfer pricing (TP). Any TP adjustment has a direct and exclusive effect in the determination of the income tax.
The TP regime in Colombia has been in force since 2003 and since then, international trends have been incorporated into it, especially the BEPS initiatives on documentation guidelines and commodity transactions evaluation. In the last year, there has been intense activity in matters of audit and controversy related to TP issues that are affecting the taxpayers' income tax return.
For the analysis of certain inter-company transactions, methods that evaluate the gross margin of the operations are used to validate the arm’s-length principle, isolating the effect that operating expenses have on the profit expected for taxpayers subject to the TP regime. The trend that has been seen in the latest audits carried out by Colombian tax authorities is the rejection of the use of these type of methodologies, and the widespread use of methods that evaluate the operating margin, particularly the transactional net margin method (TNMM).
The resale price is one of the methods that evaluates the gross profit of the transactions, mainly those related to purchase of inventory for distribution (therefore is essentially applicable to resellers). The Colombian regulations, as well as the OECD Guidelines on transfer pricing, do not establish a specific functional profile of the reseller or distributor to which this methodology is applicable.
On the contrary, the OECD Guidelines explain the existence of different functional profiles that can be subject to the application of the resale price method. Among these are those who perform functions and assume limited risks, such as commission agents, and those who perform complex functions and assume significant market, credit or product risks, such as full fledge distributors. The resale price method could be applicable to all of them as long as they comply with these three requisites: no transformation of the product purchased to related parties, no addition of value to the product and no substantial contribution to the creation of intangibles.
On the other hand, the application of a methodology that evaluates the operational level is much more flexible in terms of the type of transaction to be evaluated, the applicable functional profile and the selection of the corresponding profit level indicator. Considering operating expenses in the analysis includes other operations with third parties that may change the behaviour of operating profit, without necessarily being a direct effect of the inter-company operations under analysis. For this reason, it is very important to adequately delineate the inter-company transaction, define the functional characterisation of the tested party, appropriately select the method and the comparable transactions to determine compliance with the arm's-length principle.
Despite what is established by the Colombian regulations and the international doctrine on the analyses developed under gross profit methodologies, the Colombian tax authority has a very restricted interpretation of its application. The position of the tax authority is based on the fact that in order to operate and carry out distribution functions in the Colombian market, companies must incur operational expenses such as marketing, sales and management, that are necessary for their operation. Under this logic, the tax authority rejects the use of methods at a gross profit level, because in its interpretation, the resale activity cannot be separated from the items accrued in operational expenses and therefore it is not possible to apply this methodology, despite the taxpayer complying with all the requirements set forth in local and international regulations.
In many cases, using an operational profit methodology results in low profit levels, caused by external factors not related to the operation under analysis, which expose the companies to controversies with tax authorities, if they determine that the methodology at the operational level should be the most appropriate. The transfer price adjustments derived from this change in methodology are directly reflected in the income tax return, affecting the value of the transaction, normally reducing the cost of goods sold, and therefore increasing the taxable income. This, in addition to the penalties for inaccuracy that are normally imposed by the tax authority in the audit process.
Flexibility in the approaches for evaluating the arm's-length principle, particularly at this time of economic turbulence due to the effects of the pandemic, is an invaluable recommendation from the OECD itself that should guide the efforts in TP audits from tax authorities in order to achieve a fair and equitable direct taxation.
Partner, EY Colombia
María Alejandra Cuervo
Senior manager, EY Colombia