Transfer pricing under Ethiopian Tax Law: Conceptual introduction & comparative analyses

Globalization and economic growth have driven inter-company transactions to new heights. It’s estimated that more than 2/3 of all business transactions worldwide occur within groups. In particular, developing countries are observing immense growth in intra-group transactions because their economies are still in the process of opening up and attracting large amounts of FDI. So, it’s of immense importance to halt challenges posed to both national & world economies through controlled transactions. In this article, I briefly discussed the conceptual introduction of transfer pricing, the arm’s length principle, transfer pricing methods recognized under OECD & UN transfer pricing guidelines, and Ethiopian tax law. Finally, I tried to address whether the Ethiopian Transfer pricing law & regulation accords or contradicts with OECD & UN transfer pricing manual.

 

1. INTRODUCTION TO TRANSFER PRICING

1.1. TRANSFER PRICING

A transfer price is a price established in a transaction between related persons.

Enterprises are treated as being associated or related if one enterprise participates in the management, control, or capital of other or both enterprises or if the same persons participate in the management, control, or capital of both enterprises (sister companies). Likewise, transfer prices might happen in individuals dealing with corporations or other entities under their control and by individuals dealing with their close family members. Thus, unlike the market price, which is a price set in the marketplace for the transfer of goods and services between unrelated persons, the transfer price is a price set by related parties with no conflict of interests. However, the mere fact that Transfer pricing can be established between related persons doesn’t mean that it is an abusive price. Thus, as pointed out by the Tax Justice Network, “Transfer pricing is not, in itself, illegal or abusive. What is illegal or abusive is transfer mispricing, also known as transfer pricing manipulation.”

1.2. TRANSFER MISPRICING

Related persons can manipulate transfer pricing to avoid or lower their tax liability. To exemplify, if Aco, a manufacturing company which engages in transboundary trading, manufactures goods in country A and then sells them to its foreign affiliate Bco, a resident company in country B, at lower /artificial price, which is different from market price, to benefit from low tax rate in country B, then both company can pay little or no tax on their combined profit. This scenario is called Transfer price manipulation. Transfer mispricing arises as a result of abusive transfer pricing practices.

 It ultimately aims at achieving certain outcomes such as avoidance, low or no tax for their company. Thus, to neutralize this abusive act which contradicts existing commercial practices, tax authorities should be given the power to adjust transfer misprice.

 

2. ARMS LENGTH PRINCIPLE AND TRANSFER PRICING METHODS

 

2.1 THE ARMS-LENGTH STANDARD

 

An appropriate transfer price is one that meets the arm’s length standard. Arm’s length price is the market price created by market forces in transactions between unrelated enterprises acting independently. Thus, under Arm’s length standard, the transfer price for national intra-entity transactions, transactions between the head office and a branch of international enterprises, and transactions between associated enterprises must reflect the prices that independent entities would have been used for similar entities.

 

2.2 ARGUMENTS FOR USING ARM’S LENGTH PRICE

 

Under the arm’s length principle, we determine acceptable transfer prices by comparing intra-entity or intra-group transactions with transactions between unrelated entities. The rationale for arm’s length principle is the need to govern all transactions by market. It’s a market that governs all transactions in an economy. Therefore, it’s imperative to treat intra-group transactions as equivalent to transactions done between independent/unrelated entities. Thus, under the arm’s length principle, if the transfer price for a given transaction deviates from the transfer price for comparable arm’s length transactions, the allocation of profit and expenses under intra-entity should be tested and adjusted accordingly.

 

2.3 LEGAL FRAMEWORK FOR ARM’S LENGTH STANDARD

 

Both OECD and UN model conventions on double tax treaties contain an article that deals with international transfer pricing. Both models endorse Arm’s length standards. Article 9(associated enterprises), article 25(mutual agreement procedure), article 26(exchange of information) refers to arm’s length price and are therefore relevant to transfer pricing. Thus, head office and permanent establishment (branches) of an international enterprise doing business in another country can be treated as separate entities for tax purposes and their transaction must be adjusted to arm’s length price.

 

2.4 COMPARABILITY ANALYSIS

 

The essence of transfer pricing is to determine the appropriate price for a non-arm’s length transaction based on a comparable arm’s length transaction. The arm’s length transaction used for comparison may be a transaction between taxpayer and other third parties or the transaction between other independent third parties. To exemplify, If the transaction between Aco, a manufacturer company, and Bco which is Aco’s controlled or affiliated company in country B is suspected as mispriced, then comparable analysis can be done based on Aco’s transaction to another third party or the transaction between other completely different independent & unrelated third party which trades in similar goods (say, for example, Fco manufacturing company & Nco trading). Thus, if an enterprise may sell the same goods to both related and unrelated persons, the price charged for the sales to unrelated persons may provide a good comparable for determining the arm’s length price for related party sales. However, if the enterprise doesn’t sell the same goods to unrelated parties, it would be necessary to search for an independent enterprise operating in the same market or industry that sells the same goods to arms-length parties.

All transfer pricing methods require some type of comparability analysis. It helps to determine the most appropriate transfer pricing method. The comparability of controlled and independent third party transactions is usually based on five factors:

Those include:-

• The characteristics of the transferred property or services,
• Functional analysis of the parties to the transaction,
• The term of the contract,
• The economic circumstances,
• Business strategies pursued by the parties.

Among the above elements, functional analysis is the key to identifying useful comparable transactions. It involves an examination of the functions performed, assets used, and risks assumed by the parties to the relevant transactions.

 

2.5 TRANSFER PRICING METHODS

 

OECD transfer pricing guidelines set out five transfer pricing methods that help to determine whether transfer price between related parties is at arm’s length.

There are three traditional transaction profit methods and two transactional profit methods.

To determine whether the controlled transaction is at arm’s length, the traditional transaction methods compare controlled transfer prices with the uncontrolled transaction, whereas, transactional profit methods focus on net profit from controlled transactions.

• Traditional transaction method

The traditional transaction method is the widely accepted transfer pricing method by the tax community. However, it’s extremely difficult to apply on some cases such as intangible property. There are three methods that can be categorized under this method. Those includes

• Comparable Uncontrolled Price Method
• Resale price method
• Cost-plus method

1. Comparable uncontrolled price method

CUP method establishes an arm’s length price by reference to sales of similar products made between unrelated persons in similar circumstances. CUP method is a preferred method if comparable sales exist.

To Exemplify, if we assume that Dco a country D manufacturing company manufacture watch at a cost of 60 birr and then sell them to an unrelated foreign distributor for 80 birr. Another unrelated foreign distributor Fco then sells nearly identical watch to Eco an affiliate in country E and Eco sells this watch to the unrelated foreign consumers to 120. Then pursuant to CUP, Dco can have a profit of (80-60) which is 20 and Eco would have a profit of (120-80) which is 40. Under this method, we test whether transfer price between related companies is at arm’s length taking uncontrolled transactions as comparable reference.

 

2. Resale Price Method

The resale price method set’s arm’s length price for sales of goods between related parties by subtracting an appropriate markup from the price at which goods are ultimately sold to unrelated parties.

Assume the Fco a hand watch manufacturing company of country F manufactures watch with the cost of 60 and sells this watch to Gco Affiliate Company in country G and Gco sells the watch to an unrelated person with 120. In the above case, as a comparable independent third party doesn’t exist, our only option is to resort to the resale price method. If we assume a 20 percent markup we can get arm’s length price by which Gco buy the watch. That’s 20(120) divided by 100 =24 so the price by which Gco buys is 120-24 which is 86 and the profit of Fco is 86-60 which is 26. So pursuant to the above assumption, the arm’s length price by which Fco sold the watch to Gco is 86 birr.

 

3. Cost-plus method

The cost-plus method uses the manufacturing and other costs of the related seller as the starting point in establishing the arm’s length price. The seller's costs are then multiplied by the appropriate Profit percentage and then the result is added to the sellers cost’s to determine the arm’s length price.

Assume that in the previous example under the resale price method Fco sells the watch to Gco without any brand name and Gco added SEIKO as a brand name and resale it to customers in a foreign country. If we assume the profit is 40 percent then The arm’s length price of Fco’s sell to affiliated company Gco is calculated as –40(60) divided by 100= 24 and we add 24 to 60 which is 84. Thus, pursuant to the Cost plus method Arm’s length price is 84.

 

• Transactional profit methods

Unlike, traditional transaction methods which determine arm’s length price by comparing controlled transfer prices to uncontrolled one, the transactional profit method focuses on net profit from the controlled transaction.

OECD transfer pricing guidelines depict that the transactional profit method is the only profit method that satisfies the arm’s length requirement.

The key feature of the transactional profit method is that the profit from controlled transactions is allocated to associated enterprises instead of checking the actual transfer prices used in each controlled transaction between associated enterprises.

 

• TRANSACTIONAL PROFIT SPLIT METHOD(PSM)

The transactional profit method helps to determine arm’s length prices of transactions between highly integrated associated enterprises. In such cases, it might be impossible to evaluate each transaction separately for transfer pricing purposes. The profit split method is typically applied when both sides of the controlled transaction contribute significant intangible property.

It identifies the profit from controlled transactions between associated enterprises on an economic basis. Accordingly, profits are divided between the associated enterprises based on the relative value of each enterprise's contribution, which should reflect the functions performed, risks incurred, and assets used by each enterprise in the controlled transactions.

• TRANSACTIONAL NET MARGIN METHOD(TNMM)

The transactional net margin method (TNMM) is the most commonly used Transfer pricing method. TNMM tests associated enterprises' net profits from controlled transactions relative to an appropriate base, such as sales, assets, or costs.

The transactional net margin method operates in a manner resale price method and cost-plus method operates. However, unlike those methods which measure gross profits, TNMM measures net profits.

 

3. TRANSFER PRICING UNDER ETHIOPIAN INCOME TAX LAW

Under this section, I will try to expound on some essential concepts of transfer pricing adopted by Ethiopia. As clearly understood, the essence of this section is to discuss whether Ethiopia has body of law regarding transfer pricing. Besides, if Ethiopia has any law regarding transfer pricing, it’s imperative to discuss some comparative analysis of Ethiopian law with other internationally accepted transfer pricing documents, such as OECD &UN transfer is pricing guidelines. Thus, I will try to expound on transfer pricing concepts, methods & other issues of transfer pricing under Ethiopian tax law.

• LEGISLATIVE FRAMEWORK

The concept of transfer pricing was first introduced into the Ethiopian legal system in the 1990’s Ethiopian tax reform. The first Ethiopian law that introduced transfer pricing under its article 29 was Ethiopian income tax law proclamation no-286/94. In Ethiopia, Before 1994 G.C or before the promulgation of income tax proclamation no-286/94, there is nobody in law and literature that directly or indirectly discussed the transfer pricing concept.

Under its article 29, Ethiopian income tax proclamation no-286/94 introduced the transfer pricing concept and authorized the Ethiopian ministry of revenue to adjust transfer prices between associated enterprises, only when it contradicts market price or arm’s length price. Besides, the proclamation clearly indicates the need to have a transfer pricing directive, which should be issued by the ministry of finance and development. Pursuant to article 29/1 of proclamation no-286/94, the Ethiopian ministry of finance and development issued directive no-43/2014 in 2014. The directive contains 19 Articles and discussed the details of Transfer pricing.

Before discussing the details of transfer pricing directive no-43/2014, it’s worth noting that proclamation no-286/94 which enables the promulgation of directive no-43/2014 repealed in 2016 under the second wave of Ethiopian tax reform. Thus, it’s important to discuss the legal basis for continual applicability of directive no-43/2014, if any.

Under the second wave of tax reform in Ethiopia in 2016, Ethiopia introduced “Federal Income Tax Proclamation no-979/2016, which completely repealed its predecessor, income tax proclamation no-286/94.

Despite repealing proclamation no-286/1994, the new Federal Income Tax proclamation no-979/2016 discussed the issue of transfer pricing under its article 79. Thus, it’s of immense importance to discuss whether the new proclamation no-979/2016, clearly repealed directive no-43/2014 which was issued pursuant to article 29/1 of proclamation no-286/94.

Under Article 101/6 of proclamation 979/2016, the new Federal income tax law unequivocally indicates the applicability of regulations and directives issued pursuant to prior income tax law (286/94).

Accordingly, directive no-43/2014 can be applied as a legal transfer pricing document even after the promulgation of the new law. As Ethiopia didn’t enact a new transfer pricing directive so far, directive no-43/2014 will continue to apply as the sole legal document which governs transfer pricing issues in Ethiopia.

 

• TRANSFER PRICING UNDER PROCLAMATION NO-979/2016

Transfer pricing is discussed under article 79 of federal income tax proclamation no-979/20216. Article 79 provides transfer pricing rules. It dictates that transfer pricing transactions must be based on arm’s length principles. Pursuant to this provision Ethiopian ministry of revenue can adjust transfer mispricing through allocating income, gains, losses, deductions, and tax credits between the related parties so that the adjusted transaction reflect the outcome that would have been achieved in an Arm’s length transaction.

Non-resident persons, in particular, may use transfer pricing as a means of reducing Ethiopian source income. To exemplify, a non-resident parent company may supply goods or services to an Ethiopian subsidiary for a price that is greater than arm’s length price so as to reduce the taxable income of the Ethiopian subsidiary.

Similarly, a foreign head office of a non-resident company may allocate income and expenditures to the Ethiopian permanent establishment of the company to reduce the non-resident taxable income in Ethiopia.

It’s because of this that articles 79/ 2 & 3 dictate adjustment of cross-border transfer pricing be made in accordance with a directive issued by the ministry.

Article 79/4 also deals with the application of Ethiopian transfer pricing rules to domestic-related transactions and the necessity of inclusion of details of tax payer’s transaction with related person during tax declaration.

• TRANSFER PRICING UNDER DIRECTIVE NO-43/2014

Ethiopia issued directives that deal with transfer pricing in 2014. This directive is the first of its type to deal with the transfer pricing concept in detail. As seen from the preamble, the directive aims at adjusting transfer pricing between related persons to arm’s length price. At its outset, the directive clearly indicates the importance of facilitating proper arm’s length principle based on international best practices & guidance. In the case where interpretation is needed, the directive clearly recognizes & put OECD transfer pricing guideline at higher hierarchy.

Directive no-43/2014 contains essential concepts of transfer pricing which are also included under both OECD and UN transfer pricing guidelines.

Under article 2, the directive begins with introducing essential definitions of transfer pricing terms such as comparable transactions, controlled & uncontrolled transaction, domestic transactions, functional analysis, related & unrelated persons & tested parties.

Under its article 3, the directive clearly indicates its applicability both to domestic & international transaction between related persons.

It also discussed the arm’s length principle under article 4. Under this article, the directive dictates that transactions between related persons should be adjusted to arm’s length price. Thus, it authorizes tax authority to determine whether transfer price is consistent with arm’s length price based on the directive itself.

The concept of comparability is discussed under article 5 of the directive. Accordingly, the transaction is comparable to a controlled transaction where there is no significant deferences between the comparable.

 Like the OECD model, the directive enlists factors that shall be considered to determine whether two or more transactions are more comparable.

 Those include:-

• The characteristics of the transferred property or services,
• Functional analysis of the parties to the transaction,
• The term of the contract,
• The economic circumstances,
• Business strategies pursued by the parties.

Like the OECD transfer pricing guidelines, the directives recognize 5 transfer pricing methods. This includes:

• Comparable Uncontrolled Price Method
• Resale price method
• Cost-plus method
• Profit split method
• Transactional net margin method

The content of those methods included under directive 43/2014, don’t differ from the OECD and UN transfer pricing guidelines.

The directive also discussed the selection of transfer pricing methods. It unequivocally indicates the need to employ a transfer pricing method that most fit the facts and circumstances of the case.

Under article 8, the directive recognizes the selection of tested parties when applying the Cost plus method, resale price method, and Transactional net margin method.

The issue of the Advanced pricing agreement (APA) is discussed under article 12 of Ethiopian transfer pricing directive 43/2014. Accordingly, taxpayers can in advance agree with the tax authority to enter into an advance pricing agreement to determine the appropriate transfer pricing method in case where adjustment of related party transaction is needed. Like articles 24 and 26 of OECD transfer pricing guidelines the directive, under its articles 15 16 & 17 deals with documentation (art-15) and administrative procedures (16 & 17).

Above all things, the inclusion of interpretative hierarchy, which put interpretation given by OECD at the top under article 18 of proclamation no-43/2014, is catchy and inspiring. It also implies how far Ethiopia opens its door to adopt contemporary legal development in the area.

 

4. CONCLUSION

Under the above paper, I have briefly discussed the transfer pricing concept from both perspectives of international documents such as OECD & UN transfer pricing guidelines and domestic laws of Ethiopia. As one gist of writing this paper is making comparative analysis of concepts of Transfer pricing as dealt under international documents & Ethiopian national law it’s worthy forward my findings as follow.

First, both the content of article 79 of proclamation no-979/2016 & directive no-43/2014, entirely resembles the OECD and UN transfer pricing guidelines. Each content of directive 43/2014 was included under, especially, OECD transfer pricing guidelines. Above and beyond, under article 18 of directive 43/2014, the law equivocally depicts the OECD transfer pricing guideline as an interpretative source. Except in cases of conflict with domestic tax law, which in fact contain transfer pricing provisions copied from the OECD itself, the guideline has a higher source of interpretation.

So, in this regard, Ethiopian domestic transfer pricing law has no difference with that of the developed world or with that of international documents such as OECD and UN.

Secondly, the directive discussed essential issues of Transfer pricing such as transfer pricing documentation, a transaction in service, a transaction involving intangible, administrative procedures, advanced transfer pricing arrangement (APA), etc. Even in this regard, the directive resembles OECD and UN transfer pricing guidelines.

Finally, it’s worth noting that the Ethiopian transfer pricing guideline applies both to domestic and international non-arm’s length priced transactions.

 

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