TRANSFER PRICING UNDER ETHIOPIAN TAX LAW AND A CRITICAL EXAMINATION |
TRANSFER PRICING UNDER ETHIOPIAN TAX LAW AND A CRITICAL EXAMINATION
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Written By: - Bedatu Kumsa Dibaba
INTRODUCTION
1. Concept and Definition of Transfer pPricing
Transfer pricing is a profit allocation method used to attribute a multi-national enterprises net income (profit loss) to the tax jurisdictions where it operates its subsidiary controlled foreign corporations.It’s also defined as the price changed between related corporate entities for goods and services in an intercompany transaction. Transfer pricing refers to the mechanism by which cross boarder intra-group transactions are paid. It’s an accounting practice that represents the price one division in a company charges another division for goods and services provided and allows for the establishment of prices for goods and services exchanged between subsidiaries ,affiliates or commonly controlled companies that are part of the same larger enterprises, by doing this transfer pricing can lead to tax savings for corporations ,though the tax authorities may contest their claims. In addition it allows Multi National Enterprises to determine which parts of the group are profit or loss making and by doing this it has brought the distant parts of the world closer than before.
The transfer price is used to determine the cost, to charge another division ,subsidiary or holding company for services rendered. It can also be applied to intellectual property such as research ,patents and royalties. Multi-National Corporations (MNC) are legally allowed to use the transfer pricing method to allocate earnings among their subsidiary and affiliate companies that are part of the parent organization. However, Companies sometimes can also use this practice of altering their taxable incomes ,thus reducing their taxable income, thus reducing their over all taxes. The transfer pricing mechanisms isa way that companies can shift tax liabilities to low-cost tax jurisdictions.
1.1 Transfer Pricing Basic methods and Concepts
The organization for Economic co-operation and Development (OECD) is responsible for regulating transfer pricing guidelines for multinational organizations. Those guidelines which are accepted by nearly all tax authorities, outline the rules and regulations on transfer pricing to ensure accuracy and fairness. They specify that the price of controlled transaction one made intentionally between related companies
1.2 Arms Length Strength Principle/Method
It is the market price created by market forces in transaction between un related enterprises acting independently. In this approach the transfer price for national entity transactions, transactions between the head of office and branch of international enterprises and associated enterprises must reflect the prices that independent entities would have been used for similar entities. As provided in art.29 of Ethiopian Income Tax proclamation no.286/2002 the arms length strength approach is the primary approach that would be made applicable in case of multinational company intratrade.1 This arms length strength approach is enunciated in the OECD and the UN guidelines is the most widely practiced method around the world. It states that the amount charged by related party to another for a given product must be the same as if the parties were not related. An arms strength price for a transaction is therefore, the price of that transaction on the open market. The principle prohibits the regulation of the price for a particular item by any thing other than market forces. There are two main methods of transfer pricing, thus are traditional transaction and transactional profit methods
2.Traditional Transaction Method
It is the method examine the terms and conditions of un controlled transactions made by third party organizations and compared with controlled transactions between related companies to ensure they are operating at arm’s length. This methods are divided into three.
2.1.Comparable Uncontrolled Price Method(CUP)
This method orchestrates a parallel between prices observed in controlled and uncontrolled transactions. This CUP method establishes an arms length price by reference to sales of similar products made between unrelated persons in similar circumstances. This method compares the price and conditions of products or services in controlled transaction with those of an uncontrolled transactions between unrelated parties. To make this comparison the CUP method requires comparable data. In order to be considered a comparable price the uncontrolled transaction has to meet high standards of comparability. This method considered the most frequent ,preferred ,effective and reliable way to apply the arms length principle to a controlled transactionif comparable sales exist.There are two ways of applying CUP method. The internal method that relies on examples of comparable transactions the company has made with unrelated third parties and the external CUP method looks at pricing of comparable transactions made between two unrelated third parties.
2.2 The Resale Price Method (RPM)
This method also called the resale price . It set the arms length price for sales of goods between related parties by subtracting an appropriate markup from the price at which goods are ultimately sold to unrelated parties. Its is reduced with a gross margin determined by comparing the gross margins in comparable transactions made by similar but unrelated organizations. Then the costs associated with purchasing the product such as custom duties are deducted from the total. The final number is considered an arms length price for a controlled transaction made between affiliated companies. 1..EthiopianIncome tax proclamation No286/2002
When appropriately comparable transaction are available ,the resale price method can be a very useful way to determine transfer prices, because third party sale prices may be relativelyeasy to access .However, the resale price method requires comparable with consistent economic circumstances and accounting methods. There fore, the uniqueness of each transaction makes it very difficult to meet resale price method requirements.
2.3. Cost-plus method
The cost-plus method uses the manufacturing and other costs of the related seller as the starting point in establishing the arm’s length price. The seller's costs are then multiplied by the appropriate Profit percentage and then the result is added to the sellers cost’s to determine the arm’s length price.The cost plus method works by comparing a company’s gross profits to the overall cost of sales. It starts by figuring out the costs incurred by the supplier in a controlled transaction between affiliated companies. Then, a market-based markup—the plus in cost plus—is added to the total to account for an appropriate profit. In order to use the cost plus method, a company must identify the markup costs for comparable transactions between unrelated organizations.
The cost plus method is very useful for assessing transfer prices for routine, low-risk activities, such as the manufacturing of tangible goods. For many organizations, this method is both easy to implement and to understand. The downside of the cost plus method (and really, all the transactional methods) is the availability of comparable data and accounting consistency. In many cases, there are simply no comparable companies and transactions—or at least not comparable enough to get an accurate, reliable result. If it’s not an apples to apples comparison, the results will be distorted and another method must used.
2.4Transactional Profit Method
Unlike traditional transaction methods which determine arm’s length price by comparing controlled transfer prices to uncontrolled one, the transactional profit method focuses on net profit from the controlled transaction. OECD transfer pricing guidelines depict that the transactional profit method is the only profit method that satisfies the arm’s length requirement. The key feature of the transactional profit method is that the profit from controlled transactions is allocated to associated enterprises instead of checking the actual transfer prices used in each controlled transaction between associated enterprises. Thus transactional profit method are also divided in to two.
2.5.Transactional Price Split Method(TPSM)
The transactional profit method helps to determine arm’s length prices of transactions between highly integrated associated enterprises. In such cases, it might be impossible to evaluate each transaction separately for transfer pricing purposes. The profit split method is typically applied when both sides of the controlled transaction contribute significant intangible property. This approach examines the terms and conditions of interrelated, controlled transactions by figuring out how profits would be divided between third parties making similar transactions. One of the main benefits of the PSM is that it looks at profit allocation in a holistic way, rather than on a transactional basis. This can help provide a broader, more accurate assessment of the company’s financial performance. This is especially useful when dealing with intangible assets, such as intellectual property, or in situations where there are multiple controlled transactions happening at a time.
However, the PSM is often seen as a last resort because it only applies to highly integrated organizations equally contributing value and assuming risk. Because the profit allocation criteria for this method is so subjective, it poses more risk of being considered a non-arm’s length outcome and being disputed by the appropriate tax authorities. It identifies the profit from controlled transactions between associated enterprises on an economic basis. Accordingly, profits are divided between the associated enterprises based on the relative value of each enterprise's contribution, which should reflect the functions performed, risks incurred, and assets used by each enterprise in the controlled transactions.
2.6 Transactional Net Margin Method (TNMM)
The transactional net margin method (TNMM) is the most commonly used Transfer pricing method and it also called Comparable Profit method. TNMM tests associated enterprises' net profits from controlled transactions relative to an appropriate base, such as sales, assets, or costs. It helps to determine transfer prices by looking at the net profit of a controlled transaction between associated enterprises. This net profit is then compared to the net profits in comparable uncontrolled transactions of independent enterprises.
The transactional net margin method operates in a manner resale price method and cost-plus method operates. However, unlike those methods which measure gross profits, TNMM measures net profits.As far as benefits go, the CPM is fairly easy to implement because it only requires financial data. This method is really effective for product manufacturers with relatively straightforward transactions, as it’s not difficult to find comparable data.The CPM is a one-sided method that often ignores information on the counterparty to the transaction. Tax authorities are increasingly likely to take the position that the CPM is not a good match for organizations with complex business models, such as high-tech companies with intellectual
property. Using data from companies who do not meet the OECD’s standards of comparability creates audit risk for organizations.
3. TRANSFER PRICING UNDER ETHIOPIAN INCOME TAX LAW AND ITS LEGAL FRAME WORK.
Under this section I would try to explain whether Ethiopia has the body of law regarding transfer pricing ,its imperative analysis with other internationally accepted transfer pricing documents such as OECD and UN transfer pricing guidelines. Ethiopia is relatively new for transfer pricing. The concept of transfer pricing was first introduced into the Ethiopian legal system in the 1990’s Ethiopian tax reform. The first Ethiopian law that introduced transfer pricing under its article 29 was Ethiopian income tax law proclamation no-286/94. In Ethiopia, Before 1994 G.C or before the promulgation of income tax proclamation no-286/94, there is nobody in law and literature that directly or indirectly discussed the transfer pricing concept.
Under its article 29, Ethiopian income tax proclamation no-286/94 introduced the transfer pricing concept and authorized the Ethiopian ministry of revenue to adjust transfer prices between associated enterprises, only when it contradicts market price or arm’s length price. Besides, the proclamation clearly indicates the need to have a transfer pricing directive, which should be issued by the ministry of finance and development. Pursuant to article 29/1 of proclamation no-286/94, the Ethiopian ministry of finance and development issued directive no-43/2014 in 2014. The directive contains 19 Articles and discussed the details of Transfer pricing.
Before discussing the details of transfer pricing directive no-43/2014, it’s worth noting that proclamation no-286/94 which enables the promulgation of directive no-43/2014 repealed in 2016 under the second wave of Ethiopian tax reform. Thus, it’s important to discuss the legal basis for continual applicability of directive no-43/2014, if any. So The Ministry of Revenue has since restructured the organization and set up the Transfer Pricing unit under the General Tax Audit Directive. Under the second wave of tax reform in Ethiopia in 2016, Ethiopia introduced “Federal Income Tax Proclamation no-979/2016. thenew Federal Income Tax proclamation no-979/2016 discussed the issue of transfer pricing under its article 79. Thus, it’s of immense importance to discuss whether the new proclamation no-979/2016, clearly repealed directive no-43/2014 which was issued pursuant to article 29/1 of proclamation no-286/94.Under Article 101/6 of proclamation 979/2016, the new Federal income tax law unequivocally indicates the applicability of regulations and directives issued pursuant to prior income tax law (286/94).Accordingly, Directive no-43/2014 can be applied as a legal transfer pricing document even after the promulgation of the new law. As Ethiopia didn’t enact a new transfer pricing directive so far, directive no-43/2014 will continue to apply as the sole legal document which governs transfer pricing issues in Ethiopia.
The Federal Income tax proclamation No.979/2016 under art. 79 provides that transfer pricing transactions must be based on arm’s length principles.2 Pursuant to this provision Ethiopian ministry of revenue can adjust transfer mispricing through allocating income, gains, losses, deductions, and tax credits between the related parties so that the adjusted transaction reflect the outcome that would have been achieved in an Arm’s length transaction.Non-resident persons, in particular, may use transfer pricing as a means of reducing Ethiopian source income. To exemplify, a non-resident parent company may supply goods or services to an Ethiopian subsidiary for a price that is greater than arm’s length price so as to reduce the taxable income of the Ethiopian subsidiary.Similarly, a foreign head office of a non-resident company may allocate income and expenditures to the Ethiopian permanent establishment of the company to reduce the non-resident taxable income in Ethiopia. It’s because of this that articles 79/2 &3 dictate adjustment of cross-border transfer pricing be made in accordance with a directive issued by the ministry.Article 79/4 also deals with the application of Ethiopian transfer pricing rules to domestic-related transactions and the necessity of inclusion of details of tax payer’s transaction with related person during tax declaration.
Additionally Ethiopia issued directives that deal with transfer pricing in 2014. This directive is the first of its type to deal with the transfer pricing concept in detail. As seen from the preamble, the directive aims at adjusting transfer pricing between related persons to arm’s length price. At its outset, the directive clearly indicates the importance of facilitating proper arm’s length principle based on international best practices & guidance. In the case where interpretation is needed, the directive clearly recognizes & put OECD transfer pricing guideline at higher hierarchy.Directive no-43/2014 contains essential concepts of transfer pricing which are also included under both OECD and UN transfer pricing guidelines.
Under article 2, the directive begins with introducing essential definitions of transfer pricing terms such as comparable transactions, controlled & uncontrolled transaction, domestic transactions, functional analysis, related & unrelated persons & tested parties. Under its article 3, the directive clearly indicates its applicability both to domestic & international transaction between related persons.
2.The Federal Income tax proclamation No.979/2016 under art. 79
Under art.4 of directive dictates that transactions between related persons should be adjusted to arm’s length price. Thus, it authorizes tax authority to determine whether transfer price is consistent with arm’s length price based on the directive itself.The concept of comparability is discussed under article 5 of the directive. Accordingly, the transaction is comparable to a controlled transaction where there is no significant difference between the comparable.
Like the OECD model, the directive enlists factors that shall be considered to determine whether two or more transactions are more comparable. Those factors include:-The characteristics of the transferred property or services, functional analysis of the parties to the transaction, The term of the contract, the economic circumstances and business strategies pursued by the parties. Also Like the OECD transfer pricing guidelines, the directives recognize 5 transfer pricing methods stated aboveincluded under Directive no.43/2014, which is the same with OECD and UN transfer pricing guidelines.
The issue of Advanced Pricing Agreement (APA) is discussed under article 12 of Ethiopian transfer pricing directive 43/2014.3Accordingly, taxpayers can in advance agree with the tax authority to enter into an advance pricing agreement to determine the appropriate transfer pricing method in case where adjustment of related party transaction is needed and this shows inclusion of interpretative hierarchy, which put interpretation given by OECD at the top under article 18 of proclamation no-43/2014, is catchy and inspiring. It also implies how far Ethiopia opens its door to adopt contemporary legal development in the area.
3.1Challenges of Transfer Pricing In Ethiopia
The flow of Foreign Direct Investment(FDI) into the country every year, with the increase in investment, the volume of import into the country is increasing. These two factors make income and customs transfer pricing at a huge risk to the national revenue unless tackled by appropriate legislative and administrative measures. Currently, the tax machinery failed to address due to the following reasons.
*The customs proclamation has incorporated detail provisions governing transfer pricing.which require further clarity. The Income Tax Proclamations has also entrusted the Ministry of Finance andEconomic Development the power of legislating a directive to further implement transfer pricing provisions which the ministry failed to come up with detailed directives governing this.
3.Ethiopian Transfer Pricing Directive No. 43/2014 art.12
* Controlling transfer pricing requires well-trained expertise and organized system for documentation, but there is no such trend in Ethiopia. The Income Tax Proclamation has not incorporated a single provision that requires companies to keep and submit document when they transact with related parties.
*Transfer Pricing approach incorporated in the Income Tax Proclamation requires the availability of a comparable data, But In this country due to absence competing market forces there is no comparable data.
CONCLUSION
The Ethiopian government has done the remarkable work in dealing the country’s desirable destination of investment. By doing this the flow of foreign investment in the country is rising with this international trade and the revenue is also increasing from international trade. However, the absence of clear transferpricing rules and non-implementation of those provisions has bring huge loss in local revenue. In this paper I also try to discuss both content of Ethiopian Income Tax proclamation and Directives adopted in legislative frame work whether they are comply with OECD and UN guidelines of transfer pricing.
RECOMMENDATIONS
As a researcher I would like to give the following recommendations on Ethiopian transfer pricing: