Newsletter
NEW TRANSFER PRICING RULES
Article 43-1 of the Income Tax Act provides for an adjustment mechanism for related parties' transaction that do not conform to regular busi-ness practices. However, in the past three dec-ades, this provision has rarely been used, mainly because of a lack of official criteria by which to determine what constitutes irregular business practices. The issue of how profits are distrib-uted between entities in different countries im-pinges on the ability of a state to maintain its sovereign power of taxation. In line with the rapid internationalization of business operations in recent years, the need to establish transfer pricing guidelines has become urgent. Accord-ingly, on 2 January 2004 the Ministry of Finance announced the addition of a new Article 114-1 to its Income Tax Assessment Regulations for Profit-Seeking Enterprises, to stipulate various criteria for judging whether transfer pricing practices conform to the "arm's length" principle. This heralded the coming establishment of a comprehensive regime to regulate transfer pric-ing.
The MOF then actively set about drafting the Income Tax Assessment Rules for Non-Arm's Length Transfer Pricing. A final draft was re-leased on 5 October 2004, and the MOF formally announced the new Assessment Rules on 28 December 2004. The MOF intends to first apply the Assessment Rules to business income tax filings for year 2004. Thus any businesses that have related-party transactions, or controlled transactions under the Corporate Mergers and Acquisitions Act or the Financial Holding Company Act (not limited to those with related parties) need to pay particular attention to the Assessment Rules.
The Assessment Rules comprise 36 articles in seven chapters. The following is a brief over-view of the main points:
Includes all transactions not conforming to the arm's-length principle, as referred to in Article 43-1 of the Income Tax Act, Article 50 Para-graph 1 of the Financial Holding Company Act, and Article 42 Paragraph 1 Subparagraph 1 of the Corporate Mergers and Acquisitions Act. Such transactions are not limited to those between related parties.
The criteria are largely based on those under the Company Act, and the Statements of Fi-nancial Accounting Standards relating to transactions between related parties. The wide-ranging list is as follows:
1.one entity has direct or indirect sharehold-ings in the other of 20% or more;
2.enterprises in which the same persons or entities have direct or indirect sharehold-ings of 20% or more;
3.the largest shareholder holds 10% or more of shares;
4.half or more of the entities' executive shareholders and directors are the same;
5.one entity appoints half or more of the other's directors;
6.senior managers at the level of chairperson and CEO are the same person, spouses, or first- or second-degree relatives (grand-parents, parents, siblings, children, or grandchildren);
7.the relationship between an overseas head office and a Taiwan branch office;
8.where there is direct or indirect control over the other company's human resources, finances, or business operations;
9.where the entities have entered into a joint venture or joint management agreement;
10.where there are other circumstances suffi-cient to show that one of the entities exer-cises major influence over the human re-sources, finances, business operations, or management policies of the other.
With reference to what constitutes direct or indirect control over the other entity, the As-sessment Rules explicitly define five situa-tions:
1.appointment of personnel at the level of CEO or above;
2.loan of funds (except by a financial insti-tution) or provision of guaranty of an amount of 1/3 of the other entity's total asset or more;
3.the entity's production or business activities require the provision by the other entity of patent rights, trademark rights, copyrights, secret methods, specialized technology, or license rights of any kind, in an area of ac-tivity that accounts for half or more of the entity's total output value;
4.controlled purchasing of raw materials or goods accounting for half or more of the total purchased value in a single year;
5.controlled sale of goods accounting for half or more of the total sales value in a single year.
Affiliated enterprises means for-profit enter-prises between which a relationship of subor-dination and control exists. Related parties mean affiliated enterprises plus persons or entities having any of the following relation-ships with a for-profit enterprise:
1.foundation to which the enterprise has do-nated one-third or more of the foundation's paid-in funds;
2.the enterprise's directors and supervisors, and its personnel at the level of CEO, dep-uty CEO and above;
3.spouses of directors, supervisors, and per-sonnel at the level of CEO and above;
4.first- and second-degree relatives of the board chairperson and CEO;
5.other persons or entities that can be ade-quately demonstrated to be able to exercise control or major influence over a for-profit enterprise.
The scope is comprehensive, including trans-fers of both tangible and intangible assets, regardless of the form of the transaction, and making no distinction as to whether valuable consideration is given or not. Relationships of service provision, provision of funds, and other forms of transaction as determined by the MOF, are also included.
Both tax collection authorities and taxpayers should apply the following principles to de-termine whether a transaction complies with the arm's-length principle:
1.assessment should be made by comparison with comparable transactions with non-related parties (comparability);
2.the most appropriate arm's-length business practices should be selected (most appro-priate transaction);
3.the most appropriate transaction mode for individual transactions should be identified (individual transaction assessment), except in the case of connected or successive transactions;
4.determination should be based on data from the same financial year (same-year comparison), except where inadequate data is available, where the sector concerned is affected by the business cycle, where the subject of the transaction is affected by its product life cycle, where the enterprise concerned has adopted a market-share strategy, where profit is used as the basis for determining the outcome of an arm's-length transaction, or in other cir-cumstances approved by the MOF;
5.assessment should be made by comparison with the range of outcomes of two or more uncontrolled transactions applying the same arm's-length transfer pricing method (multiple comparison);
6.if the enterprise declares a loss, but its group is in overall profit worldwide, an analysis should be made of the reasons for the loss and of whether transactions be-tween the enterprise and its group conform to arm's-length practices (analysis of rea-sons for losses);
7.the pricing of transactions in opposite di-rections should be assessed separately (separate assessment of receipts and pay-ments);
8.other principles for determining conformity to arm's-length business practices as ap-proved by the MOF.
The following charts summarizes the applicabil-ity of transfer pricing methodologies to different types of transaction (Articles 10 to 13):
CUP is the most direct method for determining whether the pricing of a transaction conforms to the arm's-length principle. For example, in the case of a sale of tangible assets, there are three types of transaction that can be used for comparison:
1.sale of products by a controlled group company to a non-affiliated enterprise;
2.sale of products by a non-affiliated enter-prise to a controlled group company; and
3.sales activities between non-affiliated companies. Let us consider the following example:
Company A of Taiwan holds 100% of the shares in Company B of the British Virgin Islands. Company A manufactures computer motherboards at a unit cost of NT$650. It sells them to its Korean distributor at a unit price of NT$900, but it also sells them to its subsidiary, Company B, at a unit price of NT$700. Company B sells the motherboards to non-related overseas clients at a unit price of NT$950. The circumstances under which Company A of Taiwan sells its products to Company B and to its overseas distributors can be taken to be the same. Therefore by this method, the arm's-length transfer price is found to be NT$900.
The comparable uncontrolled transaction method is used exclusively for transfers of intangible assets. The difference between this method and CUP lies in the fact that in the case of intangible assets it is more difficult to obtain information on uncontrolled transac-tions as a basis for comparison than in the case of tangible assets. It is therefore necessary to give special consideration to the degree to which transactions are comparable, and the degree to which adjustments can be made to take account of differences. For instance, if it is not possible to make reasonable adjustments to remove differences arising from such fac-tors as whether a license is exclusive, whether there are restrictions on its use, or whether there is a right of alteration, then another more appropriate method should be applied instead.
Using this method, the arm's-length transfer price is found by deducting an estimated margin of gross profit from the price at which an enterprise involved in controlled transac-tions resells goods to non-related parties. The amount to be deducted is calculated on the basis of the gross margin earned in compara-ble uncontrolled transactions. For example:
Company A of Taiwan sells goods at a unit price of NT$200 to its subsidiary, Company B. Without undertaking any further processing of the goods, Company B sells them to non-affiliated Company X at the same price. If the National Tax Administration (NTA) determines that the arm's-length gross profit margin for the sale of such goods, based on the gross margin earned in comparable uncon-trolled transactions, is 30%, then in this ex-ample, the arm's-length transfer price for sales by Company A to Company B is found by subtracting gross profit of NT$60 (200 x 30% = 60) from the price of NT$200 at which the enterprise involved in the controlled transac-tion resold the goods to a non-related party. The result of this calculation is NT$140. Thus the NTA may determine that the arm's-length transfer price for Company A's sale of goods to Company B is NT$140, and may adjust Company B's purchase cost on that basis.
Using this method, the arm's-length transfer price is calculated by taking the cost of pur-chase from a non-related party, or the cost of own manufacture, and adding a percentage mark-up derived from the gross margin over costs that is earned in comparable uncontrolled transactions. For example:
Taiwanese Company B is a manufacturer of machine parts, which it sells to its affiliated distributor, Company C. Company C also buys identical machine parts from Companies D, E, and F, which are not related parties of Company C. Data on the gross profit margins earned by Companies D, E, and F from their sales to Company C can be used as a basis for establishing the arm's-length price for Com-pany B's sales of machine parts to Company C.
MK, a foreign company, manufactures cleaning products that are marketed world-wide. MK's Taiwanese subsidiary MKT, which is MK's only distributor in Taiwan, imports MK's assembled products, and sells them at wholesale in Taiwan in MK's name. Neither MK nor other companies manufac-turing similar products sell their products to independent distributors.
The tax authorities obtain data from a large number of independent distributors, and as a basis for comparison, select from among them a number of companies that play a similar role to MKT, bear a similar level of risk, and are active in the same sector. Suppose that data on the mean annual net profits of Companies A, B, C, D, E, and F in the years 2001–2003 are used to establish that their range of profit in arm's-length trading was NT$20,000–25,000. Suppose too that MKT's mean annual operat-ing profits in the same period were NT$0 (its profits and losses in 2001–2003 were 20,000, -15,000, and -5000). This falls outside the range of profits achieved in arm's-length trading by the uncontrolled distributors. One then takes the median value of the 2003 data on all the selected uncontrolled distributors. Supposing that the median falls at NT$22,500, which is the mean of the 2003 operating profit of distributors C and D, then MKT's operating profit should be adjusted upward to NT$22,500.
Profit split method (Article 19)
The contribution that the activities of each of a number of entities participating in controlled transactions make to the entities' combined operating profit is used to calculate the pro-portion of operating profit attributable to each entity. This method is appropriate for cases where the activities of the participating entities are highly integrated, so that it is not possible to consider the outcomes of their transactions singly. For example:
Taiwanese Company D is a manufacturer of laser-based audio equipment. It manufactures the major components in Taiwan and sells them to its Hong Kong subsidiary Company G, which assembles them into finished products and markets them.
The following profit and loss account filed by Company D is taken as the basis for applying the profit split method:
The tax authorities decide to apply the profit split method to determine the companies' arm's-length trading outcome. The consoli-dated net profit before deduction of sales overhead is 70. Based on a sample of Hong Kong companies that play a similar role to Company D's Hong Kong subsidiary, the au-thorities decide to set the average market rate of return for the subsidiary's operating assets at 10%, so that the subsidiary's routine contribution to gross profit is 5 (operating assets 50 x 10%). This leaves a consolidated residual profit of 65 (70 - 5). Applying the above principles, the tax authorities seek to apportion residual profit between the entities according to their respective contributions to intangible assets.
Suppose that the tax authorities calculate the two companies' annual amortization from the capitalized cost of the research and development by which the two companies maintain their audio products, which is 5 for the Hong Kong subsidiary, and 15 for Taiwan Company D. This gives an apportionment ratio of 1/4 to 3/4. On this basis, the residual profit attributable to the Taiwan parent company is 48.75 (65 x 3/4), and that attributable to the Hong Kong subsidiary is 16.25. From this example one can see that the application of this transfer pricing method would lead to a different apportionment of profits than that declared by Company D.