On Transfer Pricing by Permanent Representative Offices of Non-resident Pharm Companies

Oleksii Bezhevets, Partner with Legal Alliance Company

Oleksii Shmatko, the president of "Axioma Consulting Group"

The problem of taxation of permanent representative offices of non-residents (including multinational pharmaceutical companies) has recently gained considerable importance, not least of all due to the attempts on behalf of the tax authorities to make such permanent representative offices pay the taxes in Ukraine. Such attempts of the tax authorities have several times been backed up by the courts, thus the debate to define the “tax nature” of representative offices has become a pressing issue.

Let us be reminded that legal disputes related to the taxation of permanent representative offices of non-residents are all based on resolving the legal collision of the following two competing provisions of the Tax Code of Ukraine (hereinafter referred to as the TCU):

• paragraph 1 of clause 160.9 of the TCU, which states that the total income of non-residents that carry out their activities in Ukraine through a permanent representative office shall be subject to taxation on general basis; for the taxation purposes a permanent representative office shall be treated identically to a taxpayer who carries out its activities independently from such non-resident (so-called “commercial” representative office);
• paragraph 3 of clause 14.1.193 of the TCU and similar by their essence provisions of the Conventions for the avoidance of double taxation, which states that a permanent representative office shall maintain a permanent place of operation solely to conduct the activities for non-residents of preparatory or auxiliary nature (so-called “non-profit” representation).

Due to the aforementioned collision between certain legal regulations, the common form of relations between a “non-profit” representative office and the state is when the permanent representative office is registered with the tax authorities and submits tax reports, however without accruing or paying the income tax based on the respective provisions of the Conventions for the avoidance of double taxation. The issue of whether to submit other reports (e.g. tax deduction report or taxable items notice) or not is resolved by each representative office individually based on its respective history of relations with the local tax authority it is registered with.

Upon the amendments to the TCU which relate to transfer pricing becoming effective on September 1 of this year, the relations between permanent representative offices and tax authorities have become more vague yet due to the following issues:

• Can permanent representative office of non-resident and non-resident be deemed affiliated entities?
• Is receipt of funding by a permanent representative office of non-resident from non-resident a controlled transaction?
• Should a permanent representative office of non-resident report controlled transactions to the tax authority?
• In what manner should a permanent representative office of non-resident define the price in a controlled transaction?

There is an opinion that transfer pricing is in no way related to the relations between permanent representative office of non-resident and non-resident. Such an opinion is based on the provisions of clause 14.1.159 which define the term “affiliated entities” as a derivative from legal entity or individual, neither of which applies to a permanent representative office.

However, such a position is not strong enough and would be hard to defend; also we should in no way exclude the possibility of a different interpretation of the tax legislation (on legal grounds) on behalf of tax authorities.

Firstly, we should keep in mind that the term “controlled transactions” includes several options, one of which involves transactions where one of the parties thereto is a non-resident registered in the “low tax” jurisdictions. A transaction between such non-resident and its permanent representative office even formally shows the signs of a controlled transaction.

Secondly, we should keep in mind that the legislation on transfer pricing and taxation of income of non-residents is traditionally interpreted not only based on the norms of the domestic law, yet also based on the Conventions for the avoidance of double taxation and the respective OECD comments.

In its turn, the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations stipulates that the activities of a permanent representative office are also subject to transfer pricing, thus refers to OECD Report on the Attribution of Profits to Permanent Establishments for practical mechanisms.

OECD Report on the Attribution of Profits to Permanent Establishments itself states that the income of permanent representative office shall be determined based on fair market price principle (arm length) based on assumption of how would a representative office be taxed if it was an independent business rendering services to a non-resident.

The aforementioned paragraph of clause160.9 in its essence is focused on establishing the same approach in Ukraine as indicated OECD Report on the Attribution of Profits to Permanent Establishments.

Thus, despite the fact that according to the letter of the law a permanent representative office is not a legal entity, and respectively cannot be deemed an affiliated entity, we cannot deny that according to the spirit of the law / intention of the legislator, representative office and non-resident are in fact affiliated entities, thus resulting in the necessity to submit the reports on controlled transactions to the tax authority.

In this situation it would be relevant to calculate the income of a permanent representative office of non-resident under either “cost plus” or net income method. The information could be collected from public data about profitability of businesses that are engaged in the activities similar to those of a permanent representative office if it was an independent business.

We ought to understand that the application of these methods is unlikely to result in adjustment of tax liabilities of a permanent representative office, when the chance of significant fines for non-reporting controlled transactions (5% of the transaction amount) imposed by tax authorities is high.

We should also remember that these methods of transfer pricing can serve as alternatives to setting the expenses of a representative office at 70% of its income as indicated in paragraph 3 of clause 160.8 of the TCU. If a permanent representative office of non-resident de facto submits its tax reports as a “non-profit” one while showing the signs of a “commercial” one, the use of transfer pricing can be a way to move to a relatively risk-free system of paying the taxes (however, consultations with the tax authority or the Ministry of Income and Charges are advisable).