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Maliyat journal (Iranian Tax Review)
No. 43, winter 2005-2006
IN THE NAME
OF ALLAH
FROM THE PRESIDENT
The success of tax measures and policies would depend on
whether they have been planned for achieving certain clear aims and objectives.
The objectives of tax policies and amendments are to be determined carefully
and in a proper way. The policy makers should focus on possibility of achieving
the desired purposes on basis of adopted policies. Studies in this respect are
of utmost importance and would greatly effect on overall result of respective
measures. To take the job easy and adopting decisions on basis of superficial
perception of main factors of the issue may divert the outcome of policies from
what the policy makers had in mind at the beginning. A prerequisite for
embarking on the said studies is the sufficient knowledge of the conditions
that prevail in economic relations and social atmosphere of the society.
Experiences gained in the past regarding the probable reactions of the economy
as a whole, and taxpayers in particular, towards the similar tax measures,
shall be of special importance and has to be taken into consideration as a
critical factor.
Economic theory can play a valuable role in this
connection, but on the condition that this aspect of the matter is dealt with
very prudently and in an all-embracing way. Reliance on this or that economic
belief or dogma, without scrutinizing all angles and details of the issue, may
not only prevent the desired results from being realized, but it may also cause
various losses, including the loss of some tax revenues, to be sustained.
For instance, if a tax exemption is granted in a way to
include all, or overwhelming majority of, relevant taxpayers, such abatement
may not necessarily lead to achievement of planned results. Even the social
objectives may not be realized through a tax policy of this kind. But the loss
of a part of tax revenue would certainly take place.
A similar situation may arise in connection with tax
measures that are taken on basis of superficial understanding of economic
opinions, while no attention is paid to other various aspects of the matter.
For example, it may seem economically logical to believe that if the element of
tax is removed, or decreased considerably, from the overall costs of an
economic activity, that would encourage the same activity on one hand and the
produce thereof would be supplied to needy strata of the society chipper and
easier on the other hand. In spite of this justifiable appearance, a strong
possibility would also exist that the market forces and the law of supply and
demand enter into action and have their impact on prices in a way to offset the
effects of the adopted tax policy. Then the only consequence of the tax
abatement will be the loss of revenue, while no appreciable result is achieved
in favor of people or the country.
A side effect of that situation relates to psychological
hindrance that would impede the reversion of the state of affairs. To restore
the exempted taxes is not an easy job from psychological and social points of
view. Suppose that the rate of taxation is considerably reduced in favor of an
important group of taxpayers. Then not only are the expected results of such
considerable abatement not achieved, but certain negative impacts have also
been observed in the same connection. Now, imagine what grave reactions might
be shown if decision is taken for cancellation of the same abatement. The
discontent may be so high that the authorities would prefer to leave the case
as it is. This undeniable fact is of such importance to induce the policy makers
to be cautious, especially when deciding on grant of extensive tax abatements.
In such occasions much deeper and wider studies will be expedient and really
advisable.
Verification and checking of the outcome would also
constitute an important stage of the tax amendments. When considerable changes
are introduced into tax regulations with the aim of achieving certain economic
results, it would logically necessitate checking, after elapse of a reasonable
length of time, whether and to what extent the expected results are realized.
That would show the correctness of initial estimations. If the same process is
repeated in respect of further cases of tax amendments, can provide us with a
clear picture of the fact that how inadvisable is to rely hastily on outward
aspects of economic beliefs. Instead, we would be directed to take every angle
of relevant factors, and especially the previous experiences, into
consideration.
Dr. Aliakbar Arabmazar
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Concepts of Transfer Pricing
Comment on a Circular Letter of the
Tax Administration
By: Dr. Mohammad Tavakkol
A circular letter has been recently issued from the State Tax Organization
with the aim of providing a consistent and uniform approach in respect of
taxation of foreign corporations' branches and agents. As regards the content
of the circular, we may find six types of regulations therein. Though only one
of these categories relate to subject matter of the present article, first we
have to give a general view of other parts of the circular as well.
The categories referred to above can be summarized as follows:
A) This part of the circular (paragraphs 1 and 2) does not
contain any specific provisions. It only points out that according to the
current regulations, the agents and branches of foreign companies can be
registered in this country solely for certain purposes that are enumerated in
the same part of the circular. It also
refers to the fact that beside those registered as agents and branches, there
are some Iranian persons (natural or legal) that consider themselves as the
agents of foreign enterprises and are engaged in such activities in addition to
their own economic operations.
B) The second category relates to documents and data that
can be obtained by tax officials regarding the situation of the said branches
and agents. The documents and information so obtainable are as follows:
1. As we mentioned above, the branches and agents of foreign companies can
be registered as such only for engaging in certain activities. The report
submitted by them to relevant authorities for justification of their status (or
continuation thereof) on basis of the said requirement, can be obtained by tax
officials from respective organizations (paragraph 3 of the circular).
2. Tax officials are entitled to ask the foreign branches and agents to
submit their financial statements after such documents are audited by qualified
auditors (paragraph 4 of the circular).
3.The branches and agents in question have to obtain agreement or
permission of a government organization. Such permission would also be
obtainable by tax officials from relevant organizations (paragraph 5 of the
circular).
4. Under the regulations concerning registration of branches and agents of
foreign companies, the financial statements of original (mother) companies must
also be submitted to the government organizations that have issued the
aforesaid permissions. Such statements should have been audited by independent
auditors of the country where the mother company is resided. Tax officials are
directed to obtain copy of these statements from relevant government
organizations (paragraph 6 of the circular).
5. Paragraph 9 of the circular states that an agreement is usually
concluded between mother companies and their agents. Tax officials are ordered
to ask for submission of copies of such agreements as well.
C) Next type of provisions of the circular concerns the
Note 2 of the Article 107 of the Direct Taxes Act (the country's main tax law),
which provides:
"Branches and agents of foreign companies and banks in Iran that are
engaged in information gathering or marketing activities for their parent
entities, without having the right to make transaction, and receive
remuneration from them against their expenditures, shall not be subject to
taxation in respect of such remuneration"
Now the paragraph 7 of the circular specifies the cases where the said
legal limitation is infringed and branches and agents in question are engaged
in operations beyond that limitation. Paragraph 7 refers to the following
cases:
a) Some foreign branches and agents engage in marketing and information
gathering activities for other enterprises as well (those other than their own
principals). Such extra activities shall be subject to taxation according to
the law (subparagraph 7-1 of the circular).
b) Some others provide after-sale services beside the activities envisaged
under the said Note 3 of the Article 107.
Incomes from those additional works shall also be subject to taxation
(subparagraph 7-2 of the circular).
c) There are cases where the said branches and agents enter into
transactions by providing invoices and concluding contracts on behalf of
principal (mother) enterprises. In such cases they shall not be subject to the
said Note 3 of the Article 107 any more and will be taxed on their income
(subparagraph 7-3 of the circular).
d) In case the principal company is involved in direct selling of goods or
services, the non-profit status of its branch or agent shall be considered as
terminated, unless they can show that there exists another agent with the task
of direct selling (paragraph 8 of the circular).
D) Paragraphs 13 and 14 of the circular deal with the
auditing of accounts:
1. The Paragraphs 13 refers to the regulations that require the branches
and agents of foreign companies to choose their auditors from among the members
of the Iranian association of chartered accountants. In that case the audit
report will be accepted as basis of examination as far as possible.
2. Paragraph 14 states that domestic audit reports will be rejected. It
means the reports drawn by the same auditors who were responsible for keeping
the entity's books and preparation of its accounts.
E) Sometimes the foreign branches and agents engage in
direct selling of goods and provision of services. In that case, the amount of
sales and earnings from services will be taken as the basis for computation of
taxes in accordance with the law (subparagraph 15-1 of the circular). The same
treatment will be accorded to Iranian persons (natural or legal) who are
exclusive agents of foreign companies and engage in the same activity of direct
selling (paragraph 16 of the circular).
F) The last category of
rules envisaged under the circular letter of the tax administration
deals with the subject matter of the present article, namely the topic of
transfer pricing as far as it concerns the operations of foreign companies'
branches and agents in
Connected enterprises and arm's length principle
The problem of transfer pricing would usually arise in case of prices
charged for goods, services, intangible properties, etc. that are transacted
between connected persons. As examples of connected persons we may refer to
members of the same partnership, a corporation and its subsidiary, family
relatives and the like. The term would obviously cover a company and its
branches and agents as well.
For a more comprehensive and concrete definition of connected (or
associated) persons we may look at the paragraph 1, article 9 of the OECD model
tax treaty, which reads:
"Article 9 Associated Enterprises
1. Where:
(a) An enterprise of a
(b) The same persons participate directly or indirectly in the management,
control or capital of an enterprise of a
and in either case conditions are made or imposed between the two
enterprises in their commercial or financial relations which differ from those
which would be made between independent enterprises, then any profits which
would, but for those conditions, have not so accrued, may be included in the
profits of that enterprise and taxed accordingly.
Our study is confined to branches and agents of foreign companies in
Arm's length principle
In the business transactions between associated enterprises (for instance
among two entities, one of whom controls the other or both of them are
controlled by a third person), the prices and terms of transaction may differ
from what prevails in dealings between unrelated parties. An arm's length price
is the price independent parties would have agreed under the same or similar
circumstances.
As we said above, the arms' length principle is emphasized under the
circular letter of the tax administration. Paragraph 10 of the circular reads:
"According to the model international treaty of the OECD and also the
laws on treaties for avoidance of double taxation between Iran and other
countries, where an enterprise of a contracting state participates directly or
indirectly in the management, control or capital of an enterprise of the other
contracting state, or the same persons participate directly or indirectly in
the management, control or capital of an enterprise of a contracting state and
an enterprise of the other contracting state, and in either case conditions are
made or imposed between the two enterprises in their commercial or financial
relations which differ from those which would be made between independent
enterprises (arm's length principle/third party comparison basis), then any profits
which would, but for those conditions, have not so accrued, may be included in
the profits of that enterprise and taxed accordingly"
As it can be seen, the circular has repeated the wording of the article 9
of the OECD model and thus accepted the arm's length principle as a criterion
for handling the problems that may arise in connection with the activities of
foreign companies' branches and agents.
Application of the arm's length principle
This is an area more easily stated than implemented. Many issues might be
encountered, for solving of which detailed technicalities are developed so far.
But the point has been somehow simplified by the circular. It has determined
the conditions supposedly prevailing in case of arm's length transactions, of
course as far as the issue concerns the operations of foreign companies'
branches and agents. Let us see the article 11 of the circular:
"Therefore, legal principles and criteria of transactions in normal
circumstances must be observed for computation of income and determination of
profits. So, it is hereby ruled that tax officials have to conduct inquiries
into the type of relationship between branches and agents of foreign companies
in Iran and relevant principal companies, and to study the evidence and documents
they have obtained, and thus become sure about the correctness or incorrectness
of agency contracts and declared incomes. International custom in respect of
agency and brokerage requires that acceptability of contracts concluded on
basis of cost plus, fixed amount of income or compensation of expenditures
would depend on conformity of contracts with reasonable grounds and similar
conditions (conditions similar to contracts concluded with unconnected persons,
in which the relevant income is determined under the title of commission or fee
and as a percentage of final invoice of the seller. The criterion in this
respect will be the invoice of foreign seller issued on basis of any kind of
letter of credit that is opened in cash, in the form of documentary bill,
without transfer of foreign exchange, or other bank forms). If, therefore, the
declared income would not conform with the usual rate of commission exchanged
between independent persons, the income of agency shall be determined by
reference to final amount of opened documentary credit and its equivalent in
Iranian Rial, equivalent of the amount of registered order in Iranian Rial, and
other relevant factors".
Thus, according to the circular of the tax administration:
First, the income of agents of foreign companies usually is a kind of
commission,
Second, the commission is, as a rule, determined as a percentage of final
invoice of the principal seller, and
Third, that final invoice is based on the documentary credit opened for
relevant transaction.
But an important point has not been determined by the circular and that is
the customary rate of commission in each case. The circular considered it
suffice to say "If the declared income would not conform to the usual
rate of commission exchanged between independent persons", then we
have to take the amount of relevant documentary credit as the basis for
computation of the taxable income. So, the issue made depended on determination
of customary rate of commission without providing a clue to the ways of such
determination.
Paragraph 12 of the circular may clarify the issue in a better way, It
reads:
"According to the paragraph 16 pf the article 20 of the by law on
keeping the books of account, registration of unreal expenditures, incomes and
financial items would, if ascertained, constitute a cause for rejection of the
books of accounts. Wherefore, tax officials shall examine the submitted
contracts, similar cases of commission contracts and take into consideration
the normal conditions of transactions, so that to find the cases of unreal
presentation that are incompatible with international custom and conditions of
the market, and refer such cases to the 3-member board of the paragraph 3,
article 97 of the Direct Taxes Act for their examination"
Here again the solution depends on finding the similar cases. The figures
declared by the taxpayer must be compared with those of similar transactions.
In this way one may doubt whether we have not returned to the point of
beginning? In other words, we are faced with the task of deciding on the
meaning of similarity. When and where we can consider the cases of this kind as
similar? It seems that for deciding whether two contracts or transactions are
similar, one has to take into account different features such as the type and
other specifications of relevant goods and services, complexity of the job,
difference in conditions of the market and other conditions that are usually
relied upon at the time of entering into respective contracts. One may ask
whether the factors of those types are to be taken into consideration in
deciding upon the existence of
similarity between compared contracts, or it would suffice to find a commission
contract of unrelated persons, which looks like the relevant agency contract
vaguely and in general terms?
Other relevant provisions
The circular of the tax
administration contains few other regulations that are somehow related to
transfer pricing concepts. The following presentation of these points would
bring our study to an end.
1. As it was mentioned earlier, if it becomes evident that financial
statements and accounts of foreign branches and agents are not compatible with
requirements of arm's length principle, such state of affairs is considered by
the circular to mean the submission of unreal figures and accounts, which would
necessitate the referral of the case to a forum for trial and examination. This
means that a remedy is available to foreign agents and branches, should they
consider themselves in the right.
2. The subparagraph 15-2 of the circular also has a connection with the
arm's length principle. It relates to a situation where the direct selling of
goods or services is carried out by the principal company and the agent would
only record the discounts or commissions in books of accounts. In that case,
the relevant figures should not be less than the amounts that the arm's length
principle would require. Otherwise, tax offices will assess the taxable income
on basis of similar cases and contracts.
3. Arm's length principle and audit report – The paragraph 15 of the
circular states:
"The
certified public accountants who are responsible for auditing of branches and
agents of foreign companies in Iran, have to clearly express their opinion on
normality of conditions of business operations of their clients and correctness
of the declared incomes, whether the income consists of commission, fees or
received discounts, and have to fill in the attached forms”.
So,
observance of arm’s length principle must be observed and certified by relevant
auditors. Under the form attached to the circular, the auditor should determine
whether the income of the taxpayer is declared on basis of principles governing
the arm’s length transactions or not. In latter case, the income must be
computed and mentioned on the form by due regard to those principles.
Thus, the transfer pricing concepts are officially introduced into the
Iranian regulations, a phenomenon that would have to go some way before being
efficiently integrated in the tax system.
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Interest
and fees paid to foreign banks deductible
The theme of deductible expenses is dealt with in a
special chapter of the Direct Taxes Act (Iranian main tax law). The Article 146
in the same chapter enumerates a series of different types of acceptable
expenditures, then the Note 1 of that article provides: "Other
expenditures that are recognizes as relevant to earning of entities' income,
shall be accepted as deductible, after being proposed by the State Tax
Organization and approved by the Ministry of Economic Affairs and
Finance". Based on that article, a new circular letter has been issued
from the tax administration, according to which any interest or fees paid to
foreign banks against the receipt of bank facilities will be accepted as
deductible expenses. But for these payments to be so accepted, certain
conditions are to be met. Theses conditions can be summarized as below:
1. The received facilities (loans, etc.) should have been
spent either for increasing the current capital of the respective entity, or
for buying of fixed and tangible assets for the entity.
2. Accounting standards must have been duly observed.
3. The relevant bank (that has granted the facilities) is
to be an officially authorized bank and have permission to embark on such kind
of operations. The documents that show the bank's authorization should be
verified by the relevant authorities in the Iranian embassies abroad, and in
the Ministry of Foreign Affairs in
4. As far as the using of the received facility is
concerned, an official accountant must certify that the loan, etc. is added to
current capital of the receiving entity or is spent for adding to its fixed and
intangible properties. By the official accountant, either an accounting firm
that is the member of the Iranian Association of Certified Public Accountants,
or the Audit Organization is meant.
5. A ceiling has also been determined for the relevant
interest rates and that is the rate of LIBOR (London Inter Bank Offered Rate)
plus 0.75%.
Regarding these new regulations some points are worthy of
mentioning.
a) Beside the said circular, we have another legal
reference to acceptance of bank interest and fees as deductible expenses. That
is the paragraph 18 of the Article 148, DTA, which rules that the following
items are deductible:
"The interest and fees paid or allocated to banks,
cooperative funds and non-bank credit institutions"
So, there we had already a legal permission for this
purpose at hand. As it can be seen, a text of such phrases can be construed as
to covering the interests and fees paid to both the domestic and foreign banks.
But now the new circular letter has granted a similar permission in respect of
interests and fees paid to foreign banks. The case being so, a new
interpretation of the subject is to be accorded to the whole situation. The
paragraph 16, Article 148, DTA would, under that interpretation, relate to
domestic, and the circular to foreign banks.
b) The new circular mentions the word "bank"
only and does not refer to similar financial agencies, such as non-bank credit
institutions and the like, while those latter agencies have been mentioned
under the aforesaid paragraph 16 of the Article 148, DTA. The question is
whether the omission of other institutions in the circular would mean that
payments to latter category will not be considered as deductible? According to
the writer of this article, the answer may not be positive, especially by
taking into account the reasoning behind the permission granted under the
circular, and also by comparing the same with the text of the paragraph 16,
Article 148, DTA.
c) As it was mentioned earlier, a condition for
deductibility of the paid interests and fees is to use the received facilities
for increasing the capital of, or buying fixed assets for, the relevant entity.
Now the price of fixed assets so bought will be subject to depreciation
deduction over their economic life. The price so depreciable is the cost price
and may include not only the purchase price paid to the seller, but the
interest paid for its acquirement as well. This would mean that the one and the
same expenditure be accounted for two times, once as a deductible expense and
second time as depreciation.
7. The essence of the issue goes back to the fact that
expenses of this kind may be considered as capital expenditures which are
generally not deductible from current taxable income. Instead, in case of fixed
assets depreciation is taken and any expenses incurred for their acquirement
will be so compensated for. Thus, if the same expenditure is allowed to be
deducted directly from the entity's income, it may lead to a king of double
deduction. We have to wait and see how a problem of this nature will be tackled
and by the respective authorities.
The
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