Transfer pricing in Ukraine. How to substantiate financial transactions?
The current state of Ukrainian transfer pricing can be characterized as problematic due to uncertainties that taxpayers face as they try to substantiate the controlled transactions conducted. This problem centers around the statutory criteria used to compare controlled and uncontrolled transactions (a transaction that meets the market conditions).
When selecting comparable transactions, the Tax Code governs taxpayers to analyze the following elements of controlled and uncontrolled transactions to determine the arm’s length range:
- Description of goods (works, services) subject to a transaction;
- Parties’ performance of functions, assets involved and risks borne in the transaction;
- Relationship practice between counterparties and terms of agreements concluded;
- Operational conditions of parties to a transaction and their business strategies.
I think these parameters provide no certainty on how to create a methodological framework for comparison since all these criteria contribute to problems when it comes to selecting comparables due to the lack or insufficiency of the information required. Considering the generalized nature of these criteria, they increase the risk of additional tax charge since tax agencies may keep a personal bias on the search and selection of comparable transactions from open sources.
The national regulations include OECD developments on the usage of information sources to substantiate the controlled transaction to be used in search of comparables. These comparables may be taxpayer’s internal uncontrolled transactions and/or related party uncontrolled transactions, as well as external transactions available from public information sources.
The internal comparables can cover most of the needs for comparables specified in the Tax Code.
It is safe to say that financial transactions (lending transactions) are arguably the most exposed today because low comparability is the main reason for tax inspections and additional charges of corporate tax.
At this moment, Thomson Reuters, Bloomberg and the National Bank of Ukraine databases are the most common external sources to substantiate that controlled transactions are arm’s length. As a rule, most taxpayers, who prepare documents for these transactions on their own, use only the databases of the National Bank of Ukraine. These databases do not fully meet the comparability elements. Therefore, the substantiation should be based on the key criteria of lending transactions that affect interest rates in accordance with the loan principal.
As contractual terms are being created to regulate the financial terms of transactions, one can treat the following criteria as the main ones:
- loan disbursement period. The interest will increase if the disbursement period extends;
- subordination (debt repayment priority). Higher subordination means a better interest;
- loan uses. The intended use of borrowed funds aligned with the borrower’s business profile affects the interest;
- security and collateral. These allow to decrease the interest rate when borrowing funds;
- financial statements. Borrower’s financials fail to comply with those specified in the contract, thus, resulting in higher interest rates;
- loan amount. When interest rates are being set, It constitutes a separate determiner causing the interest rate both to decrease and increase;
- acceleration of debt. Agreeing on this option can decrease or increase the interest rate;
- loan type. The type of loan can also decrease or increase the interest rate. For example, clients with a strong credit history will most likely decrease the interest;
- credit rating. A credit rating reflects the borrower’s solvency. This parameter is an inverse of the interest rate set.
That said, I believe that when analyzing this type of financial transactions, the key conditions to study are: duration of loan, borrower’s credit rating, type of credit and subordination. They are to be identical in the analyzed transaction. Resultant differences, if any, are subject to adjustments.
Taking these criteria into account will create a better transparency in legal relations between tax agencies and taxpayers, thus, increasing the investment appeal of Ukraine and enhance the economy.