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Controlling transfer pricing

Diego Martin-Mejívar

The growing importance of international trade and investment by multinational enterprises has led the government to establish a system of control to improve the reception of income from international transactions. For this reason, the government has taken a few measures to solve the problem of price manipulation by the multinational enterprises when they enter into transactions with their branches, subsidiaries or affiliates. This problem translates in the adoption of a fictitious price between related parties to shift income from a high tax country to a low tax country.

One of the measures to control this problem is to determine the transfer pricing that multinational enterprises considered as related parties use when they deal with each other. The new Article 62-A of the Tax Code regulates that "when taxpayers celebrate deals or transactions with related parties, they will have to determine the prices of those transactions considering the fair market value used in transactions of the same kind between unrelated parties." The same applies when the transactions are done with parties domiciled or constituted in low tax countries or fiscal paradises.

At this moment El Salvador has not adopted the Guidelines established by the Organisation for Economic Co-operation and Development (OECD). But the known arm's length principle is found in the cited Article 62-A. The purpose of the principle is that the results of a transaction between related parties must be consistent with the results of a transaction between unrelated parties. Such result is met if the involved parties adjust the price to the fair market value; thus, eliminating the ability of related parties to fix prices.

Internationally, the term related parties is used when in the existing relationship between enterprises, one of them owns or controls directly or indirectly the direction, organisation or the capital of the other. Our Tax code regulates in Article 199-C the different scenarios where the relationship between enterprises is considered as related. Moreover, Article 62-A and Article 159-D of the Tax Code establishes the legal presumption that when an enterprise deals with another enterprise that is domiciled or constituted in a low tax country or fiscal paradise, they are considered related parties and as a consequence, must use the fair market value in their transactions with one another.

In accordance with the Guide of Transfer Pricing for Multinational Enterprises and Tax Administrations, the practical application of the arm's length principle is done by using a method which provides comparable circumstances – comparing transactions or financial information of controlled entities and non-controlled entities.

Article 119-d of the Tax Code regulates that when comparing transactions "the economic characteristics of the transactions entered by the related parties must be compared with other similar transactions between unrelated parties." Furthermore, similar situations must be used for that purpose and if there are no similar situations, the differences have to be eliminated by using adjustments that allow better comparability.

In El Salvador, the comparability of transactions is to be measured by the following factors: Characteristics of the goods or services; functions of the activities; contractual terms; economic circumstances; business strategies.

El Salvador's legislation has no best method rule like the one in the US Transfer Pricing Rules, nor a list of different methods like the ones the members of the OECD use. It currently has only one method which is similar to the Comparable Uncontrolled Price method (CUP). This method consists in examining comparable prices assigned to properties or services used in transactions where the parties are unrelated. Additional to the price, the economic functions must be taken into account because these conditions will affect the price. If there's a difference between the compared prices, then the transaction was not made under the Arm's Length principle and adjustments will be done to eliminate the resulting differences.

There is an important reporting requirement established by Article 124-A of the Tax Code. When transactions are conducted between related parties or with parties that are domiciled or constituted in low tax countries or fiscal paradises, they must report their operations to the Tax Administration when the transactions are equal or superior to $571,429. This report must be filed within the subsequent three months after the fiscal year has ended. There's also a tax penalty provision for failing to submit the annual report in Article 244L of the Tax Code.

Even though we already have some transfer pricing regulations it feels like the importance of the subject has been overlooked and needs more reinforcement to become a useful tool for the control of international trade. There's a need for the implementation of Advanced Pricing Agreements (APA's), Double Taxation Conventions and a consistent exchange of Information between the tax administration, customs and other tax administrations. We expect more developments in the near future to the current regulations to avoid problems as a result of implementing the Transfer Pricing Regulations.

Juan Ernesto Menjívar

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