Sergey Zhavoronkov, Ph.D. Economics, Senior researcher at the Gaidar Institute for Economic Policy
The shortcomings of pricing regulations are giving rise to litigation and threatening businesses with billions in losses.
Amid crisis and foreign policy challenges, the Russian authorities have declared their answer: improving Russia’s investment climate and openness to business. For many years the impermissibility of nightmarizing business has been talked about, about life under simple and understandable laws. Simplicity is, in part, the presumption of innocence, both in criminal and tax matters. First and foremost, this concerns the “tax amnesty”. All transactions should be executed at market prices; to that end provisions have been made for special rules for transfer pricing, and the state represented by the tax service controls the transactions, ordering companies to pay additional taxes when prices deviate from the market. In 2014, 1.4 billion additional rubles were added to the budget as part of the implementation of transfer pricing rules. And that is just the beginning: the results of the first assessments of the “new” price control regulations that went into effect in 2012 are just around the corner.
However, litigation under the “old” transfer pricing regulations has yet to die down. The result of one such case - a dispute between OAO TogliattiAzot (TOAZ) and the Russian Federal Tax Service’s Interregional Inspectorate for Large Taxpayers N 3 in the sum of more than 0.5 billion rubles - could strike down the principle of legality in price controls for tax purposes for many years to come, threatening multibillion losses for the entire Russian businesses community. In the framework of the dispute, the courts have distorted the key principle of price controls—measuring price deviations from the market level. The next hearing in the TOAZ case will be held on Tuesday June 30, 2015.
Everything should be in accordance with the law
Until 2012, Russian transfer pricing regulations were composed of only two articles of the Tax Code. Article 20 specifies which companies are recognized as interdependent, and Article 40 permitted prices to be controlled in transactions between them. When a price deviated by more than 20% from the market price, the tax inspectorate had the right to recalculate the price of the transaction and assess additional tax.
As for Article 40 of the Tax Code of the Russian Federation, price control regulations that have been in force for nearly ten years, lawmakers managed to find room for 14 clauses. Each clause is a direct instruction for action. The wording of the article was partially inaccurate as the law lacked several terms, which, however, did not significantly hinder the tax authorities in carrying out inspections, filling in the gaps by means of interpretation. According to the Accounts Chamber, in 2010-2013 alone the total additional taxes from non-market pricing amounted to about 18 billion rubles. Claims were presented to many companies: big oil companies, gas traders, distributors of foreign cars, big tobacco and beer producers, small retail outlets, and many others.
The “new” price control regulations (section V.1 of the Tax Code of the Russian Federation) have been in force since 2012, which were developed taking into account recommendations from the Organization for Economic Co-operation and Development. The tax law significantly increased in size from two articles that, in small print, fit on one page, to heavy stacks of printed documents. But it must not be forgotten that the basic principles and methods provided for in Article 40 differ only slightly in their economic essence from the new regulations. With reasonable certainty it can be asserted that the existing approaches in the courts will not be overlooked in considering disputes under the “new” regulations.
A key principle of price controls is the necessity of calculating a 20% deviation of the transaction price from the market price. Simply put, if a transaction price deviates from the market price by 20%, then the tax inspectorate can assess additional tax based on that market price. And each time the market price should be determined by the tax inspector thoughtfully and meticulously based on the law. Wouldn’t this seem axiomatic?! But the Moscow District arbitration courts suddenly saw the problem differently…
OAO TogliattiAzot dispute
Over the past decade the courts repeatedly set aside the claims by the tax authorities of non-market pricing for different reasons. Among this mass of cases unusual was a dispute concerning the incorrect calculation of a 20% deviation. The blame lay with the law’s direct reference to the fact that the inspectorate has the right to assess additional tax only if the transaction price deviates by more than 20% from the market price. Over all these years, it never came into someone’s head to directly contradict the law by calculating a 20% deviation corridor from some other indicator: the contract price, an abstract price—any price, except the market price. That was the situation right up to the tax inspection of TogliattiAzot for 2010.
OAO TogliattiAzot is the largest Russian producer of ammonia. Up to 90% of the plant’s production is exported through the unique 2,417-kilometer Tolyatti-Odessa pipeline, through which the ammonia enters the Ukrainian port of Yuzhny (Odessa Region), and is further reloaded onto tanker ships and delivered to customers in more than 100 countries.
The tax authorities have regularly checked the market basis of prices of products exported through the pipeline since the 1990s. And each time the claims were held to be legally invalid by the arbitration courts. In all these years, the tax authorities did not determine the market prices by a correct calculation, as indicated by the Ninth Arbitration Appellate Court in a ruling under appeal on June 30, 2015 in cassation hearings. And the tax inspection for 2010 was no exception or reason for trying to respect the law and thoroughly observe its requirements.
The tax inspectorate did not take into account the Russian Ministry of Justice’s methodology for determining the price of ammonia and the Russian Federal Antimonopoly Service’s clarification pertaining to the factory, and without a reasonable basis placed an equal sign between the spot and long-term contracts, permitting mass procedural violations. Unfortunately, the courts did not succeed in evaluating the circumstances, having been distracted by the appointment of additional expert examinations. It is surprising that in all the expert examinations, including those of the court, the 20% transaction price deviation was calculated specifically from the market price. In the judicial act it was calculated from the contract price.
What is significant in this case for business at large? No matter what prices are set as market prices—prices, determined by the tax authorities themselves, or defined as market prices by experts engaged by the tax authorities—the business’s prices in selling ammonia cannot pass beyond the range of market prices, i.e. they will not deviate from them by more than 20%. It seems this was exactly the cause of the peculiar approach of the tax authorities in calculating the 20% deviation. In order to receive the desired tax claims, the deviation was calculated not from the market price, as required by the law, but by the prices of the taxpayer. However, the mathematical error in the calculation formula that accidentally found its way into the judgment of the appellate court from the decision of the tax inspectorate, besides the additional half billion rubles in tax assessments for a particular taxpayer, promises serious problems for the entire Russian business community.
Consequences and outlook
Since 2012, an “interval of market prices” has taken the place of the 20% deviation, which now requires the transaction price be included in calculating the market price. But the legacy of the TogliattiAzot dispute threatens to become the first major “time bomb” for the new Russian transfer pricing regulations. Theoretically, hypothetical inspectors could attempt to apply any article of the Tax Code toward any of the 5,900 related-party transactions disclosed by taxpayers in 2013 in a totally incorrect manner, hoping for the courts to be inattentive. In addition, when using the method of comparing market prices, some representatives of the tax authorities will get a chance to ignore the demands of the “comparability” of transaction conditions in analogous situations, comparing blue to warm, quiet to bitter, completely forgetting about implementing rational corrections. It is in fact in the TogliattiAzot case that for the first time a nearly three-fold difference in product delivery volumes between comparable transactions was recognized by the tax authorities as an insignificant difference. And this happened even when the expert witness called by the tax agency itself indicated that the differences in supply volumes between comparable transactions are significant and should be considered with the help of adjustments, i.e. putting it down to volume price. The tax agency’s expert did it, but the tax agency, rewriting the expert opinion in its decision, did not correct the figures. Or maybe it ignored the obvious differences in the transaction conditions just as it ignored its expert examination?
Another “time bomb” for the entire business community of course will be the approach taken in the present case, when the taxes due for any enterprise or individual can be increased on the basis of secret information. What do we mean by secret information? It’s when they tell you that another business has closed a transaction under the same conditions as you, but the sales price of the goods was higher. But no one will show you this deal, because it is a tax secret. It turns out that no one has ever seen this “analogous deal”, including the court, but everyone has acknowledged that the conditions of closing and fulfilling this “phantom transaction”, by which additional taxes are levied on the taxpayer, was analogous, comparable. The tax agency simply says “I saw this deal, so take my statements on faith”. But showing the documents is forbidden, as it is a tax secret. The result is that it is possible to assess additional taxes and hold someone publicly accountable based on secret information, in contradiction of the Constitution.
In the final analysis, additional charges for transfer prices can touch every law-abiding taxpayer, and appealing to the Tax Code will be useless. There can be no “fair prices”, prices can only be set by the market, and if there are doubts about their validity, it is necessary to use a rigorous mathematical formula rather than abstract deductions.