In these times of crisis and sudden changes, countries are looking for innovative and effective measures to improve their fiscal balance, including those related to international taxation and transfer pricing (TP), where the TP Cocktail published by the Inter-American Center of Tax Administrations (CIAT) (see CIAT’s “Cocktail of measures for the control of abusive transfer pricing manipulation, with a contextual focus on low-income and developing countries”) (Cocktail) can be transcendental. This phenomenon is especially critical to underdeveloped countries, such as in the Latin American region.
Experience has shown that the mere enactment of the arm’s-length principle as part of a domestic legislation does not ensure success. Several Latin American tax administrations, despite having implemented rules, must currently overcome numerous obstacles which come from the lack of several desirable conditions: tax culture and state of law, transparency, risk perception, government capacity and technical knowledge.
If base erosion is significantly being caused by transfer mispricing, a broad solution may be explored by policy makers, to move from a complex and subjective interpretation of the arm’s-length principle to a more prescribed but near to arm’s-length approach (policy driven) that would minimise double non-taxation and be in line with double taxation treaties.
In this regard, the Cocktail explains several gradual measures (three ingredients and five condiments) that may be analysed and considered by underdeveloped countries which should allow them to take better control of their TP regime in accordance to their contexts, and without the requisite of an exhaustive group of trained experts in the field.
The ingredients for the Cocktail are:
First ingredient – Best method rule perspectives. Given the complexity to identify the best TP method to implement in an inter-company transaction, as well as the overuse of unilateral approaches such as the transactional net margin method on the domestic party, the proposal is that the ‘best method rule’ should be applied over a targeted functional analysis that emphasises the value drivers, intangibles, and development, enhancement, maintenance, protection and exploitation of intangibles (DEMPE) expenses from a value chain perspective.
Second ingredient – Reference profit margins. For strategic industries, it is proposed that referential financial and tax profit standards should be calculated and desirably published by tax administrations. The proposal foresees routine and non-routine activities benchmarks departing from taxpayers’ data, external comparable references and financial consolidated information of the multinational group, as part of an integral risk assessment system and risk perception driver.
Third ingredient – Raw materials and commodity transactions. In the commodities transactions where a transparent market is recognised – a sensitive issue for many underdeveloped countries regarding its significance – the most appropriate TP method must be the comparable uncontrolled price (CUP) method. However, as many countries have autonomously decided to implement a stricter regulation regarding this type of transactions (so-called ‘sixth method’), the Cocktail provides additional guidance and context, including on how to improve its management and control.
Also, the Cocktail condiments are the following:
First condiment – Risk assessment model for TP. Given that resources of tax administrations are usually scarce, the designing of procedures that may systematically and timely identify TP manipulation risks become crucial. This condiment constitutes an illustrative guide for tax administrations on how to approach this process, since risk management eases decisions such as the selection of taxpayers to be audited, risk level of taxpayers that may be eligible to apply for simplified regimes, and the application of preventive measures, among others.
Second condiment – Geographical market adjustment. Since there are different approaches to improve comparability standards for comparable transactions or companies mainly in developing countries with less domestic data, the proposal of this section encompasses the ‘country risk’ adjustment to the operational assets, as it can be applied in a simple and direct manner, departing from the differential in profitability of capital markets between the territories or economies at issue.
Third condiment – Access to the mutual agreement procedure. This section considers the way in which the Cocktail’s measures may coexist with the international tax treaties and the access to mutual agreement procedures. The objective of these measures is to effectively ensure the fair and timely tax collection for countries, but at the same time preventing an obstruction or set back of the international trade perspective.
Fourth condiment – Alternative mechanisms for dispute resolution. Given the complexity and subjectivity existing in TP, this section explores the implementation of new procedures (e.g. mediation or other mechanisms to solve controversies) that may allow the taxpayers and tax administrations to seek technical agreements in a harmonised and anticipated manner when differences arise. A cooperative and transparent environment has been proven to be useful and effective.
Fifth condiment – Sanction regime for TP. This section provides elements or proposals regarding TP compliance and its sanctioning regime that may allow the tax administrations to obtain sufficient, relevant, reliable and timely information from taxpayers.
Given the regional lack of resources, tax administrations cannot delay the implementation and application of effective measures and controls. In this regard, more accurate, simpler, and manageable measures are essential, so the most relevant economic sectors of any country pay its fair share of taxes.
The proposals foreseen in the Cocktail do not constitute rigid perspectives, but rather flexible approaches on how to deal with known problems. This does not mean that the Cocktail is effortless to implement; however, its implementation and management depends on the intensity, scope and prescription that governments consider as adequate, striking a balance between the legal certainty of the tax system and the purpose to avoid double taxation.
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