Investors need guidance on transfer-pricing rules

Recent press reports indicate that Polish tax authorities will increasingly focus attention on the transfer-pricing affairs of taxpayers (particularly foreign-owned taxpayers) to assess their compliance with transfer-pricing rules. Unfortunately, because of the somewhat skeletal nature of transfer-pricing regulations, and the lack of judicial precedents in this area of law, Polish and foreign investors are left without much guidance on how to comply with existing transfer-pricing regulations. To date, taxpayers have lost the majority of transfer-pricing cases in Poland, indicating that sufficient guidance is lacking. This result is somewhat surprising as, for example, U.S. tax authorities have lost (at least in part) almost every single major transfer pricing case litigated so far. Such a difference in the outcomes of the transfer-pricing cases between Poland and the United States can perhaps be explained by the relatively lax enforcement of transfer-pricing rules in Poland. As a result, fairly simple transfer-pricing techniques proliferated that can now be relatively easily challenged by Polish tax authorities. The main practical lesson from the U.S. is that to successfully defend against a proposed transfer-pricing adjustment, taxpayers need to be aggressive and develop defenses against these adjustments, based on a two-fold approach to transfer-pricing issues. The two-fold approach is necessitated by the economic and legal nature of the foundation of transfer-pricing rules - the arm's length standard.

The economic approach The economic approach is fairly obvious since the arm's length standard generally aims at putting the transactions between related parties on the same economic level as the transactions between unrelated parties. This is done by utilizing the methods based on an economic analysis of transactions between unrelated parties. Taxpayers and the Polish tax authorities are guided by three general methods (and supplemented by a fourth) espoused by Polish transfer-pricing rules and by the Organization for Economic Cooperation and Development (OECD) transfer-pricing guidelines, in determining what constitutes the arm's length standard with regard to a particular transaction. Unfortunately, Polish transfer-pricing rules do not contain in-depth guidance regarding the way each method should be applied to any specific type of transaction in a way that, for example, the U.S. transfer pricing regulations do. Because of this lack of guidance, taxpayers in Poland rely mostly on the OECD guidelines but in many areas (for example, with respect to intangibles) the guidelines are still very much a work in progress. More generally, each method suffers from its own inherent limitations. For example, the "comparable uncontrolled price" method is generally unsuitable if no comparable goods (or intangibles) are passed to third parties; the "resale price" method - crafted for the sales of goods - does not really work when services or licenses are involved; and the "cost plus" method, if used with regard to an intangible, would rob the owner of the intangible of an economic entrepreneurial incentive to which the owner, as its creator, should clearly be entitled.

The legal approach The legal approach is as important as the economic approach to the arm's length standard but, while intuitively fairly easy to grasp, has proven extremely difficult to express in legal terms, particularly with respect to more complicated transactions. Indeed, the arm's length standard has been defined and set in the U.S. mainly through the judicial proceedings of taxpayers challenging transfer-pricing adjustments, with the results of the judicial proceedings ultimately reflected in U.S. Treasury regulations defining the arm's length standard for various transactions. Further, from the legal perspective, the issues of who (taxpayers or tax authorities) is presumed to be correct and who has a burden of proof, among other procedural matters, are extremely important. Moreover, in many transfer-pricing cases, taxpayers also face legal challenges related to the valuation of imported property (therefore the application of the customs laws) and challenges related to the regulation of prices by internal laws. Because of the overlapping of the transfer-pricing rules, customs laws and other internal regulations, taxpayers are often faced with conflicting legal rules and duties.

The practical approach On a practical level, to comply with Polish transfer-pricing regulations, taxpayers should: " Properly document and provide evidence of their legitimate reasons for transactions that could attract the attention of tax authorities. " Plan transactions, particularly large ones, with a view to possibly defending their transfer-pricing policies at a later date. " Understand the business and corporate structures that dictate the pricing of various goods, services and intangibles. " And understand what constitutes the arm's length standard with regard to a contemplated transaction.

The first aspect is important not only to avoid the heavy penalties that Polish tax authorities can impose if the required transfer-pricing documentation is not properly maintained but also because proper documentation may support a taxpayer with the evidence that, for example, because of the credit history/financial conditions of the particular borrower, a bank would not lend money to them other than at a rate that is higher than the prevailing lending rate. The second aspect is relatively new, but some U.S. firms carefully plan the ownership and development of intangibles and, anticipating that such structures are likely to be challenged by U.S. tax authorities on the transfer-pricing grounds, they concurrently prepare a litigation blueprint that can be used in any future transfer-pricing trial. The third, business-related, aspect requires the company's counsel to fully understand the role that a Polish affiliate performs in the company's international structure and how that role may affect the transfer-pricing decisions with respect to the flow of goods, services and ownership of intangibles.

The fourth point, understanding what constitutes the arm's length standard, will probably prove the most difficult, simply because the Polish legal system doesn't provide guidance in this area, and both taxpayers and the Polish tax authorities lack the experience necessary to determine the appropriate arm's length standard for more complicated transactions. At the same time, this may prove to be the single most important aspect of transfer-pricing cases, since the details of comparable transactions are indispensable for determining the arm's length standard for a particular transaction. In the adversarial common law legal systems, tax authorities and taxpayers present their own sets of comparables and try to convince the judge that their comparables define the arm's length standard for a particular transaction. But in Poland, at least in theory, judicial proceedings are not conducted in the same adversarial manner, therefore it is not always clear how in the case of more complicated transactions such comparables will be determined.

Increased challenges The legal/economic nature of transfer-pricing cases makes them particularly difficult since lawyers, accountants, economists and other tax advisers must cooperate closely. At the same time, tax authorities and judges also face increased challenges in such cases because of the overlap between economics and the law. Unfortunately, the Polish judicial and legal systems (because of the lack of sufficient guidance and sufficient jurisprudence respectively) do not appear to be prepared well enough to deal with the complicated transfer-pricing cases that are likely to appear as soon as taxpayers realize that the usual simple transfer-pricing techniques no longer work and new, more sophisticated, techniques appear. From the fiscal policy perspective, the current state of transfer-pricing affairs in Poland reflects the fact that Polish companies generally import know-how, capital, goods and intangibles developed by other, mostly foreign, entities. This fact directly clashes with the perception perpetuated in the press and claims made by the Polish tax authorities that foreign investors transfer profits out of Poland by using transfer pricing. In some cases such perception and claims reflect reality but they equally reflect the low competitiveness of Polish companies that often, taking product manufacturing as an example, function as simple contract manufacturers, financed by a foreign parent company, producing goods designed by the parent company, utilizing intangibles developed by foreign parent companies and ultimately sold in foreign markets utilizing the foreign parent distribution networks.

The Polish fiscal policy and its enforcement must balance its legitimate concerns about the use of transfer pricing being used to transfer profits out of Poland, with the steps that are needed to increase the competitiveness of Polish firms. To conclude, Polish transfer-pricing rules need some refinement, particularly with respect to guidance as to what constitutes arm's length for various transactions, and a sensible audit and enforcement approach. Taxpayers must then comply with the rules and adhere to the prescribed guidance. Above all, the Polish economy needs steps to increase its competitiveness; and the claims that the Polish tax authorities will pursue more vigorously transfer-pricing audits seem to clash with the statements that the government intends to make Poland a friendlier place for foreign investors. At a time of rising unemployment, only investments will create jobs in Poland, not vigorous transfer-pricing audits.

Władek Rzycki is an attorney at White & Case W. Daniłowicz, W. Jurcewicz i Wspólnicy - Kancelaria Prawna Sp. komandytowa