Chapter Twenty-Nine
Sri Lanka Transfer Pricing
The Sri Lanka ministry of Finance promulgated transfer pricing regulations on April 22, 2008, through the issuance of Gazette Order 1546/10. The Gazette Order does not specifically address the effective date of these transfer pricing regulations. Sri Lanka introduced transfer pricing legislation two years earlier, in April 2006. The 2008 transfer pricing regulations implement that statute.
Sri Lanka’s transfer pricing regulations are quite brief but they include six annexes that address transfer pricing concerns:
Annex 1: Test of Control—Associated Undertaking
Annex 2: Arm’s Length Pricing Methodologies
Annex 3: Appropriate Pricing Methodology—Factors to Consider
Annex 4: Comparability of an Uncontrolled Transaction—Factors to Consider
Annex 5: Prescribed Documentation
Annex 6: Suggested Supporting Documents
ASSOCIATED UNDERTAKINGS
Sri Lanka’s transfer pricing provisions apply to transactions between “associated undertakings,” which, in essence, are transactions between related parties. The Sri Lanka law treats such an “undertaking” to be an associate of the other party if the first undertaking party participates in the control of the second undertaking party. This undertaking process can be direct or indirect, or can occur through one or more intermediaries. The associated undertaking process necessitates that the first party exercises control over the second party in such a manner or to such an extent that the regulations prescribe.
Sri Lanka’s transfer pricing provisions set out conditions that meet Sri Lanka’s control test. The reader should be aware that Sri Lanka’s control requirements are pervasive, viewing “control” from an operating standpoint as well as from a formalistic viewpoint. Such a “control” standard might encompass relationships that might in general not be viewed as being controlled activities. As a general matter, Sri Lanka’s Ministry of Finance views any two undertakings as being associated if, at any time during the previous year, the companies meet any one of the standards for control specified in Annex 1.
ARM’S LENGTH PRICE
Sri Lanka’s transfer pricing provisions define the term “arm’s length price” to mean a price that applies in uncontrolled conditions between persons other than through associated undertaking. Sri Lanka’s Ministry of Finance assumes that market forces determine the terms of the contract when independent undertakings deal with each other. Sri Lanka’s Ministry of Finance assumes that the terms of the contract may deviate from open market norms when a transaction is between associated undertakings. Such deviation may give rise to tax leakages owing to the relationship between the parties. The Ministry of Finance views the application of arm’s length transfer pricing as a means of removing these distortions.
The Ministry of Finance views the arm’s length pricing methods as being the pricing methodologies prescribed by the regulations in the gazette together with the comments by Sri Lanka’s Ministry of Finance on the underlying rationale of each methodology. Annex 2 states that Sri Lanka’s Ministry of Finance expects the taxpayer to apply the “most appropriate” transfer pricing method. The most appropriate transfer pricing method is the method that:
- Is best suited to the facts and circumstances of each particular transaction
- Provides the “most reliable measure” of arm’s length price in relation to the transaction
Annex 3 provides the factors that the taxpayer should consider in selecting a transfer pricing method.
The comparability of an uncontrolled transaction depends on these factors. The taxpayer is to consider an uncontrolled transaction as being a comparable transaction if:
- A difference arises from the transaction but that difference in the transaction will not materially affect the price or cost being charged. Alternatively, comparability can be based on the profit arising from such a transaction in the open market.
- If the taxpayer can make reasonably accurate adjustments to eliminate the material effects of such differences.
Annex 4 provides the factors that a taxpayer should consider in selecting a transfer pricing method.
Sri Lanka’s Ministry of Finance provides guidance to the taxpayer in selecting data to evaluate comparability. The taxpayer should obtain data from the same financial year as the year under review in analyzing the comparability of an uncontrolled transaction. Nevertheless, the Sri Lanka transfer pricing regulations contain an overriding provision that permits the taxpayer to submit data from a two-year period preceding the taxpayer’s financial year. The taxpayer can take data from those years into account if the taxpayer can establish that such data for such years reveal facts that could have an influence on the determination of transfer prices relative to the transactions the taxpayer is comparing.
DOCUMENTATION
Gazette Order 1546/10 requires a taxpayer that must undertake a transfer pricing analysis must maintain specified information and documents, as specified in Annex 5. The taxpayer must retain these documents for a period of five years after the relevant assessment year. The transfer pricing regulations further prescribe the availability of authentic documents to support the above-mentioned information. Annex 6 contains the suggested documents, which documents include public information.
THRESHOLD FOR APPLYING SRI LANKA TRANSFER PRICING
Sri Lanka’s Ministry of Finance, in issuing these transfer pricing regulations, contains a de minimis rule. The threshold is Rs. 100 million, which the taxpayer is to determine by reference to aggregate values, as recorded in the taxpayer’s books of account. At the time of this writing, the rate of exchange from the Sri Lanka rupee to the U.S. dollar is 114:1. The small taxpayer might have to retain its documentation to substantiate its small business exemption. Although the Sri Lanka regulations are not clear on this point, it appears that the taxpayer must aggregate transactions in considering whether the de minimis rule applies.
ADVANCE PRICING AGREEMENTS
The transfer pricing regulations permit the taxpayer to enter into an advance pricing agreement (APA). Sri Lanka’s Ministry of Finance views the APA as an arrangement that determines, in advance of controlled transactions, an appropriate set of criteria. Such criteria might include the transfer pricing method, comparables and adjustments thereto, and critical assumptions as to future events. The APA applies to the transfer pricing determination for these transactions over a fixed period of time.
The APA is a procedural arrangement between the taxpayer and tax administrations (whether unilateral or bilateral) intended to resolve potential transfer pricing disputes in advance. APAs would provide the taxpayer with some degree of certainty regarding how governments would apply transfer pricing in a given set of circumstances. Thus, the legal consequences of the proposed APA are determined in advance, based on assumptions and facts. The validity of the APA depends on the assumptions and on facts occurring when the actual transactions take place.
The APA provisions provide for both:
- Unilateral arrangements between the Sri Lanka tax administration and the taxpayer. Other tax administrations are not involved in this particular APA.
- Bilateral arrangements in which two or more tax administrations concur in regard to the pricing methodology being adopted.
BURDEN OF PROOF
The Commissioner General of Inland Revenue (CGIR) has the power to call on taxpayers to prove their transactions with associated persons as being arm’s length. The taxpayer has the burden of proof. The CGIR can assess the taxpayer if the taxpayer fails to satisfy the CGIR that the terms of the contract are at arm’s length.
IMPLEMENTATION
The Sri Lanka transfer pricing regulations apply to both domestic and international transactions. Sri Lanka is a relatively small country. The country’s database more likely can be found outside the country.
ANNEX 1: TEST OF CONTROL—ASSOCIATED UNDERTAKING
Gazette Order 1546/10 Annex 1 provides an expansive definition of “control” for transfer pricing purposes, in terms of operational issues. However, the control test provides a narrow definition of “control” from a voting power standpoint. Annex 1 provides nine specific activities that indicate control:
1. Control exists where one enterprise holds, directly or indirectly, shares that carry 50% or more of the voting power in each such undertaking.
2. Control exists where any person or undertaking holds, directly or indirectly, shares that carry 50% or more of the voting power in each such undertaking.
3. The primary lender has control over the borrower. Control exists when loans by one undertaking to another undertaking constitute 51% or more of the book value of the total assets of the other undertaking. Note that provision compares loans compared to assets; this control test does not compare one asset to another. The book value concept presumably does not reflect mark to market adjustments.
4. Primary guarantors are in a control relationship. Control exists when one party guarantees 25% or more of the other undertaking.
5. Directors can cause the undertaking to have control in the first of two situations: Control exists when the same person or persons appoint more than half of the directors or appoint more than half of the members of the governing board.
6. Directors can cause the undertaking to have control in the second of two situations: Control exists when more than half of the directors, or members of the governing board, of each of the two undertakings are appointed by the same person or persons.
7. Contractual relationships can determine the presence of control. Manufacturing activities or the maintaining of business might be “wholly dependent” on an intangible, such as the use of know-how, patents, copyrights, trademarks, licenses, and franchises. Similarly, the presence of other intangible property might determine control. Such intangible property includes other businesses or commercial rights of a similar nature. This intangible property also includes any data, documentation, drawing, or other specification relating to any patent, invention, model, design, secret formula, or process. The threshold for determining control is that the other undertaking is the owner or has exclusive rights as to that intangible. Gazette Order 1546/10 Annex 1 fails to define the term “wholly dependent.”
8. Control over raw materials or control over consumables can prove control for transfer pricing purposes. Control exists when one undertaking requires 90% or more of the raw materials and consumables for the manufacturing or processing of goods or articles. Similarly, the undertaking has a controlled relationship when one undertaking supplies the raw materials or consumables, or when one undertaking specifies the raw materials or consumables, or when the prices and other conditions relating to supply influence the undertaking.
9. A catchall provision enables the Ministry of Finance to determine that a control relationship exists between two undertakings if there is “any relationship of mutual interest.”
ANNEX 2: ARM’S LENGTH PRICING METHODOLOGIES
Annex 2 specifically addresses five transfer pricing methodologies:
1. Comparable uncontrolled price (CUP) method
2. Resale price method
3. Cost plus method
4. Profit split method
5. Transactional net margin method (TNMM)
Comparable Uncontrolled Price Method
The CUP method applies to property transactions and to service transactions:
- The CUP method compares the price being charged for property being transferred in a controlled transaction to the price being charged for property transferred in a comparable controlled transaction in comparable circumstances.
- The CUP method compares the price being charged for services being transferred in a controlled transaction to the price being charged for services transferred in a comparable controlled transaction in comparable circumstances.
The CUP method is the most direct and reliable way to apply the arm’s length principle when it is possible for the taxpayer to locate a comparable uncontrolled transaction. The taxpayer might need to make adjustments to bring the controlled transaction to a comparable base. In the event that the taxpayer must make such adjustments, the extent and reliability of these adjustments will affect the relative reliability of the analysis under the CUP method.
Gazette Order 1546/10 Annex 2 provides a three-step calculation methodology as to the CUP method. The taxpayer is to:
1. Identify the price charged or paid for property transferred. Alternatively, the taxpayer is to identify the price charged or paid for services transferred. This transaction under review is to take place in a comparable uncontrolled transaction or in a number of such comparable uncontrolled transactions.
2. Adjust the price to account for differences, if any, between the transaction and the comparable uncontrolled transaction. Alternatively, the taxpayer is to adjust these amounts between the undertakings entering into such transactions. The taxpayer is to take these adjustments into account when these adjustments would materially affect the price in the open market.
3. Adjust the price to account for these differences. The taxpayer is to use an arm’s length amount to make that adjustment to the property transferred or services provided in the transaction.
Resale Price Method
The resale price method addresses a situation in which:
- The first associated enterprise sells the product to the second associated enterprise.
- The second associated enterprise then sells the product to the independent enterprise.
The resale price begins with the amount that the second associated enterprise (the reseller) charges the independent enterprise for the product. In determining the profitability of the second associated enterprise under the resale price method, the second enterprise reduces its gross margin from its sales price of the product it sold to the independent enterprise. The reseller’s gross margin represents the amount the reseller would need to cover its selling and other operating expenses, including the reseller’s profit. The reseller would make an “appropriate profit” determined in light of the functions the reseller performs, taking into account its assets used and risks assumed.
The residual price for the product, from the standpoint of the reseller, after deducing the gross margin from the sales price to the independent enterprise, is the intercompany sales price between the first associated enterprise and the second associated enterprise. Taxes and levies are included in the residual amount. That residual amount is then the arm’s length amount.
Gazette Order 1546/10 Annex 2 provides a five-step calculation methodology as to the resale price method. The taxpayer is to:
1. Identify the price at which it purchases property or services from an associated undertaking and then resells that property to an unrelated enterprise.
2. Reduce such sales price by the amount of normal gross margin accruing to the undertaking or to an unrelated enterprise from the purchase and resale of the same or similar property, or from obtaining and providing the same or similar services. The taxpayer would determine this amount through a comparable transaction or through a number of such transactions.
3. Further reduce the price it had arrived at by the undertaking in connection with the purchase of property or the obtaining of services.
4. Adjust the price so arrived at to take into account functional and other differences, including differences in accounting practices, if any. These differences pertain to the transaction and to comparable uncontrolled transactions, or between the undertakings entering into such transactions. The taxpayer is to take these adjustments into account when these adjustments would materially affect the amount of gross profit margin in the open market.
5. Take the adjusted price into account as being the arm’s length price concerning the purchase of the property or the obtaining of services by the enterprise from the associated enterprise.
Cost Plus Method
The supplier of property or services in a controlled transaction transfers the property or services to the related purchaser. The transferor of the property adds an appropriate gross markup to the transferor’s cost. Under the cost plus method, the taxpayer adds the appropriate cost plus markup to the taxpayer’s original cost. The taxpayer’s appropriate cost plus markup takes into account the taxpayer’s profit in light of the taxpayer’s functions performed and the taxpayer’s market conditions. The arm’s length price is original cost plus the cost plus markup.
Gazette Order 1546/10 Annex 2 provides a five-step calculation methodology as to the cost plus method. The taxpayer:
1. Determines the direct costs of production and the indirect costs of production the enterprise incurs as to property the taxpayer transfers or services the taxpayer provides to an associated undertaking.
2. Determines the amount of the normal gross profit markup as to these costs. The taxpayer is to determine the normal gross profit markup by using the same accounting norms for comparative purposes. The taxpayer is to determine the normal gross profit markup arising from the transfer of the same or similar property or service by the enterprise, or by an unrelated enterprise, in a controlled transaction or in a number of such transactions.
3. Adjusts the preceding gross profit markup to adjust for functional differences and for other differences. These differences can occur between the transaction and the comparable uncontrolled transactions. These differences can occur between the undertakings entering into such transactions. This difference analysis applies to transactions that could materially affect such profit markup in the open market.
4. Increases its direct costs of production and the indirect costs of production by the adjusted profit markup as determined above.
5. The arm’s length price is the sum of the direct costs of production and the indirect costs of production plus the adjusted profit markup, determined in relation to the supply of the property or the provision of services pertaining to the undertaking.
Profit Split Method
The profit split method splits profits between associated enterprises on an “economically valid basis.” Such a profit split method uses a “valid” method that approximates the division of profits that the parties would anticipate and reflect in an agreement made at arm’s length. The profit split method seeks to eliminate the effect of profits on special considerations made or imposed in a controlled transaction. The taxpayer applies the profit split method by determining the division of profits that independent enterprises would have expected to realize from engaging in the transaction or transactions.
Gazette Order 1546/10 Annex 2 provides that the profit split method may be applicable primarily to international transactions where these international transactions involve the transfer of unique intangibles, or applies in multiple international transactions where these international transactions are so interrelated that the taxpayer cannot evaluate each facet separately for the purpose of determining the arm’s length price of any one transaction. Gazette Order 1546/10 Annex 2 provides a four-step calculation methodology as to the profit split method. The taxpayer:
1. Determines the combined net profit of the associated undertaking that arises from the international transaction in which these parties are engaged.
2. Determines the relative contribution that each of the associated parties provides. The taxpayer evaluates the relative contribution based on the functions performed, assets employed or to be employed, and risks assumed by each enterprise. The taxpayer then evaluates the relative contribution based on reliable external market data that indicate how such a contribution would be evaluated by unrelated undertakings, performing comparable functions in similar circumstances.
3. Splits the combined net profit among the undertakings, making that split in proportion to their relative contributions, as evaluated under 2, previously.
4. Assesses the profits to arrive at an arm’s length price. The Sri Lanka profit split method also permits the residual profit split method when the taxpayer can initially allocate the combined net profit amount to each undertaking. This initial allocation might provide the undertaking with a basic return that is appropriate for the type of transaction in which the taxpayer is engaged. The taxpayer needs to make this allocation by reference to market returns achieved for similar types of transactions by independent enterprises. Thereafter, the taxpayer is to apply the residual profit split remaining after the first allocation. The taxpayer can split the residual profit among the enterprise in proportion to their relative contributions. In such a case, the net profit is the summation of the profits attributable to the basic return amount plus the profits attributable to the residual amount.
Transaction Net Margin Method
The TNMM examines the net profit margin relative to an appropriate base that the taxpayer realizes from a controlled transaction. Such a base might include costs, sales, or assets. The analysis looks to the amounts that the same taxpayer would earn in a comparable uncontrolled transaction. The Sri Lanka provisions recognize that such data might not be obtainable and suggest that the taxpayer use as a guide the net margin earned by an independent enterprise on a comparable transaction.
Gazette Order 1546/10 Annex 2 provides a five-step calculation methodology as to the TNMM. The taxpayer:
1. Ascertains the net profit margin it realized by the undertaking from transactions entered into with an associated undertaking. The taxpayer is to compute these profitability amounts in relation to costs incurred, or sales affected, or assets employed or to be employed by the undertaking, or through any other relevant base.
2. Ascertains the net profit margin realized by the undertaking, or by an unrelated undertaking, from a comparable uncontrolled transaction or a number of such transactions. The taxpayer is to compute these amounts by using the same basis.
3. Adjusts the net profit margin arising in comparable uncontrolled transactions to take into account the difference, if any, between the transaction and the comparable uncontrolled transactions. Alternatively, the taxpayer is to adjust the net profit margin arising in comparable uncontrolled transactions to take into account the difference, if any, between the undertakings entering into such transactions. The taxpayer is to take into account transactions that materially affect the amount of net profit margin in the open market.
4. Calculates the net profit, which is the net profit margin realized by the undertaking.
5. Takes into account the net profit margin it establishes to arrive at the arm’s length price in relation to the transaction.
ANNEX 3: APPROPRIATE PRICING METHODOLOGY—FACTORS TO CONSIDER
Gazette Order 1546/10 provides six specific factors that the taxpayer is to consider in developing its transfer pricing methodology:
1. Nature and class of the transaction. Gazette Order 1546/10 fails to define the term “class of the transaction.”
2. Class or classes of the associated undertaking as entering into the transaction. The taxpayer is to consider the functions performed by the class or classes, taking into account the assets they employ or to be employed and the risks that each enterprise assumes.
3. Availability, coverage, and reliability of the data the taxpayer would need to apply the transfer pricing method.
4. Degree of comparability that exists between the transaction and the uncontrolled transaction, and between the undertaking entering into such transactions.
5. Extent to which it can make reliable and accurate adjustments to account for the differences, if any, between the transaction and the comparable uncontrolled transaction, or between the enterprises entering into such transactions.
6. Nature, extent, and reliability of the assumptions the taxpayer makes in applying the transfer pricing method.
ANNEX 4: COMPARABILITY OF AN UNCONTROLLED TRANSACTION—FACTORS TO CONSIDER
Gazette Order 1546/10 provides four specific factors that the taxpayer is to consider in comparing an uncontrolled transaction:
1. Specific characteristics of the property the taxpayer transfers or the services the taxpayer provided, in either transaction.
2. Functions performed by the respective parties to the transaction, taking into account the assets employed or to be employed by the respective parties to the transaction and the risks assumed by the respective parties to the transaction.
3. The contractual terms of the transactions that lay down explicitly or implicitly how the taxpayer and its respective parties are to divide the responsibilities, risks, and benefits. The contractual terms might or might not be formal or in writing.
4. Conditions prevailing in the markets in which the respective parties to the transactions operate. These conditions include the geographic location and size of the markets, the laws and governmental orders in force, cost of labor, and cost of capital in the markets, overall economic development, level of competition, and whether the markets are wholesale or retail.
ANNEX 5: PRESCRIBED DOCUMENTATION
Gazette Order 1546/10 lists 13 aspects of documentation that the taxpayer is to supply:
1. Documentation concerning the ownership structure of the associated undertakings, including share ownership or other ownership interests.
2. A profile of the multinational company or group to which the company is a member. This information is required for companies for which the taxpayer has transactions. This profile is to include, for each member, the name, address, legal status, and country of tax residence. The taxpayer is to provide the ownership linkages.
3. A broad description of its business and the industry in which the taxpayer operates. The taxpayer is to provide this information for its affiliates with which it does business.
4. Details of its group or international transactions. This information is to include the nature and terms of the arrangement, including prices, details of the property being transferred or the services being provided, and the quantum and value of each such transaction or class of such transaction.
5. A description of the functions the taxpayer performs, the risks the taxpayer assumes, and the assets the taxpayer employs or will employ. The taxpayer is also to provide this information for its associated undertakings involved in the transaction.
6. Economic data that the taxpayer prepared. Such data include a record of the economic and marketing analysis, forecasts, budgets, or any other financial estimates. That data might be prepared for the business as whole and for each division or product separately. This economic data requirement applies to transactions that might be relevant to its pricing.
7. A record of uncontrolled transactions the taxpayer takes into account for analyzing their comparability with the transactions the taxpayer undertakes. Such documentation includes a record of the nature, terms, and conditions relating to any controlled transaction with third parties that might be relevant to the pricing of the transaction.
8. The analysis the taxpayer performed to evaluate the comparability of uncontrolled transactions with the taxpayer’s own relevant transactions.
9. The methods it considered in determining its arm’s length price. The taxpayer is to provide this arm’s length analysis for each transaction or class of transaction. The taxpayer is to provide information as to the method the taxpayer selects as being the most appropriate transfer pricing method. The taxpayer should also provide explanations as to why the taxpayer selected that transfer pricing method. The taxpayer should additionally provide information to quantify the methods involved.
10. Records that demonstrate the taxpayer’s working out the determination of the arm’s length price. The taxpayer is to provide the details of the comparable data and financial data the taxpayer uses in applying the most appropriate transfer pricing method. The taxpayer is also to provide the adjustments the taxpayer has made to account for differences between the transaction and comparable transactions, or between the undertaking associates entering into these transactions.
11. The assumptions, policies, and price negotiations, if any, that have critically affected the taxpayer’s determination of the arm’s length price.
12. Details of the adjustments, if any, the taxpayer makes to its transfer prices to align them with arm’s length prices under these provisions. The taxpayer is also to provide its consequent adjustments it made to the total income for tax purposes.
13. Further information, data, or document as requested by the Sri Lanka Ministry of Finance. Such information includes information or data relating to the associated undertaking that might be relevant in the determination of the arm’s length price.
SUGGESTED SUPPORTING DOCUMENTS
Gazette Order 1546/10 suggests that the taxpayer provide six additional documentation facets:
1. The government of the taxpayer’s country of residence of the associated enterprise, or any other country, might issue official publications, reports, studies, and databases. Gazette Order 1546/10 suggests that the taxpayer provide that information to the Sri Lanka Ministry of Finance when the Ministry requests that information.
2. Institutions of national repute might provide market study reports and technical publications. Gazette Order 1546/10 suggests that the taxpayer provide that information to the Sri Lanka Ministry of Finance when the Ministry requests that information.
3. Stock exchanges and commodity markets might provide market quotations. Gazette Order 1546/10 suggests that the taxpayer provide that information to the Sri Lanka Ministry of Finance when the Ministry requests that information.
4. Agreements and contracts entered into with associated undertakings or with unrelated enterprises as to similar transactions might be relevant to the situation. Gazette Order 1546/10 suggests that the taxpayer provide that information to the Sri Lanka Ministry of Finance when the Ministry requests that information.
5. The taxpayer and the associated enterprise might have undertaken letters or other correspondence as part of their negotiation process, documenting their terms. Gazette Order 1546/10 suggests that the taxpayer provide that information to the Sri Lanka Ministry of Finance when the Ministry requests that information.
6. The taxpayer might have issued documents in connection with transactions that reflect their accounting practices. Gazette Order 1546/10 suggests that the taxpayer provide that information to the Sri Lanka Ministry of Finance when the Ministry requests that information.
