/esed-2-05-26-11

ISSN 1684-9833 • Year 2 / Especial Edition / May 26, 2011

The Executive Secretariat Informs CIAT updates its “Analysis of the legal framework for the control of transfer pricing in Latin America” report Author: Isaác Gonzalo Arias Esteban

Analysis of the legal framework for the control of transfer pricing in Latin America may 2011

CIAT is a public international organization which groups the tax administrations of 40 countries, (31 Amarican countries, 6 European countries, 2 African countries and one Asian country), for the purpose of providing an integral service for the modernization of those administrations, by promoting their evolution, social acceptance and consolidation through the exchange of knowledge, experiences and the rendering of specialized technical assistance.

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The CIAT Executive Secretariat is pleased to provide hereby the latest update of the “Analysis of the legal framework for the control of transfer pricing in Latin America” report, prepared by the International Cooperation Management Office with the valuable support of officials from the tax administrations of Argentina, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Mexico, Panama, Peru, Uruguay and Venezuela.

The objective of the aforementioned report is to make known, in a relatively simple and schematic manner, the provisions for the control of existing transfer prices in the Latin American countries. Accordingly, in order to simplify the analysis and comparability of the information, it is possible that all of the information included in the legal provisions is not available for certain aspects considered in the report. For this reason, the criterion adopted was to identify a series of aspects considered critical for analyzing each of the legislations, to then determine whether those aspects were totally or partially, explicitly or implicitly considered considered in the text of the regulation.

The aspects dealt with in the report are the following: • Differences in corporate income tax rates in the Central American, Mercosur and Andean Community countries.

• Evolution of legislations through time for controlling the manipulation of transfer prices in Latin America • Drafts, projects and reforms in the process of elaboration or discussion in Latin America • Individuals and operations subject to the transfer pricing systems • Related party concept • Methods for determining transfer prices • Criterion for determining the hierarchy of the methods • “Safe Harbors” in Latin America • Advance Pricing Agreements in Latin America • Adoption of official reports for interpretation purposes or as a complement to legal provisions.

• Information systems • Specific sanctions for formal or significant noncompliances within the framework of international operations • Structures adopted by the tax administrations of Latin America for controlling the manipulation of transfer prices or international operations.

The report indicates that, in the past 15 years Latin America has significantly evolved in the implementation of the legal framework for regulating transfer prices, having begun first in Mexico, in 1995, then in the South American countries and finally in Central America, with Panama being the last one to

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implement it in 2010. On the other hand, except for Mexico and some South American countries, for many years there has been no significant progress in the application of such legal frameworks.

Approximately in the past 3 years, the Latin American countries have begun generating their own experiences on the subject. The recent “Seminar-Workshop on Transfer Pricing and Information Exchange”, which was held in the city of Guatemala on May 2 through 5, was a unique opportunity in the history of CIAT to learn about the experiences of the Latin American countries. This was an atypical event, in the sense that it was carried out mainly with experiences presented by experts from Latin America (Argentina, Brazil, Chile, Colombia, Ecuador, Uruguay and Venezuela), something which had not been possible some years ago. Likewise, on said occasion, a high level of knowledge has been observed in CIAT developing member countries such as the Dominican Republic and Kenya.

At present, there are almost no Latin American countries that have not considered the need to implement this type of provisions and improve the capabilities of their tax administrations given that, due to varying reasons, the current context in Latin America favors those businesses wishing to abusively manipulate their transfer prices. For example, exclusively from the taxation standpoint, one may find significant differences in the corporate income tax rates, with the approximate standard deviation of general rates considered in the Report being equivalent to 6.12 points. The differences would be greater if we were to evaluate the special rates, aspects dealing with the composition of the tax base as well as others linked to the effectiveness of the tax administration, all of which influence the actual tax burden. From another standpoint, businesses could be motivated to manipulate transfer prices in order to reduce customs tariffs payments, avoid legal restrictions for sending remittances abroad and the distribution of dividends, and accessing new markets, among others.

As stated in the aforementioned report, among the Latin American countries there is a certain legal uniformity with respect to the application of the “Arms Length” principle, but such uniformity is not perceived with respect to the methodologies for applying this principle. For example, Argentina, Uruguay and Ecuador have implemented an alternative method within the sphere of CUP which presents certain differences, although based on a similar mechanics: Brazil implemented the already known “traditional methods”, although using fixed margins; Mexico has a special regime for maquilas; Mexico, Uruguay and Ecuador count on “Safe Harbor”, etc.

Likewise, there are numerous divergences in other relevant aspects. For example, although most of the countries consider direct and indirect “relations”, the minimum percentages of participation for determining the existence of a relation and the various factors that comprise the “related party” concept vary considerably from one country to another. On the other hand, not all countries establish minimum revenue or net worth thresholds for an individual to apply the transfer pricing system, which implies that in certain countries, the small and medium businesses would be obliged to comply with transfer pricing systems. In almost all cases, enterprises carrying out operations with countries or jurisdictions considered as “tax havens”, are subject to the transfer pricing system, by virtue of the presumption that there is a relation. In this respect, the Colombian law admits evidence to the contrary to nullify the presumption of relation in this type of operations.

Another aspect where there are wide divergences is the determination of hierarchy for using the methods established in the regulation. Although several countries had already adopted the OECD’s criterion promoted in the last version of the transfer pricing guidelines (2010), which involves the use of the most appropriate method according to the circumstances and operation evaluated, there are differences in the case of Mexico, which applies the criterion proposed in the OECD guidelines of 1995 and in the cases of Brazil, Panama, Venezuela, Dominican Republic and Chile, which establish different original procedures. In those countries applying the so-called “6th. Method”, when there are appropriate conditions for its application, this method always has priority.

Although 7 of the 12 countries evaluated provide for the possibility of formalizing APAs in their legislations, except for Mexico, no other Latin American country has been able to enter into one. Perhaps one of the main reasons is the taxpayers’ reluctance for providing additional documentation and being more transparent in the relationship with the tax administration. This situation could result from several factors, such as: low perception of risk by tax evaders, which fails to create motivation for entering in a negotiation process with the treasury and lack of taxpayer trust regarding the use which the tax administration may make of the information they may contribute when negotiating an APA. In any of these situations, there is a clear need for strengthening the relationship between large enterprises and the tax administrations. In this sense, we believe that as experience evolves in this sphere, legal reforms will be generated for

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adjusting the procedures which currently pose divergences with respect to their nature, duration, term of resolution and level of confidentiality.

An aspect worth revising, given the significant differences, is that relative to information systems. While some countries provide for the obligation to include fields for information in the income tax return or implemented transfer pricing information returns, others have implemented alternative formats. On the other hand, in most cases there is the obligation to preserve and submit information at the tax administration’s request and in 7 of the 12 countries analyzed, the submission of a technical study is obligatory.

With respect to penalties for formal or significant noncompliance of obligations derived from international operations, there are very specific differences. Seven countries have different special regimes, although with a common denominator, and it is that in all cases penalties are more burdensome than those of the general regime. Bearing in mind, the disproportion existing in terms of possibilities for evasion and tax fraud among taxpayers operating in the international sphere and local taxpayers, it is advisable to apply more severe penalties to irregular behaviors generating within the framework of this type of operations. Obviously, tax evaders will be motivated to incur in illegal behaviors in those countries with insignificant penalties and deficient controls.

One of the aspects where the greatest uniformity has been perceived is in the determination of comparability criteria since, except for Brazil, Chile and the Dominican Republic, all legislations analyzed consider the possibilities for adjustments to eliminate differences as well as the following criteria: characteristics of the transaction, functions or activities, contractual terms and economic circumstances. All the countries analyzed, except for Argentina, Brazil, Chile, Dominican Republic and Panama, consider in their legislation the business strategy as a comparability criterion. On its part, although Chile does not provide for these criteria in its legislation, the tax administration does consider them.

Finally, all the tax administrations of the countries that have implemented transfer pricing regulations have likewise implemented in their respective tax administration structures, specific areas for applying these rules. In general terms, the tax administrations have adopted one or several of the following options: normative area on international taxation, normative area on transfer pricing, transfer pricing examination office and/or transfer pricing teams in the sphere of auditing areas.