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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 Iran. Our discussion on that topic is presented under the following separate heading.

 

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

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1. Where:

(a) 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

(b) 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, 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.

Iran has entered into many double taxation treaties with other countries and all these treaties are approved by the legislature. Thus, the above definition is to be considered a legal one as far as the Iranian legal system is concerned.

Our study is confined to branches and agents of foreign companies in Iran whose relation with their principals is undoubtedly a clear example of relationship between connected or associated persons. So, it is legal and reasonable to see whether the operations and relations of these entities are duly conducted and reflected or not. A well known and internationally recognized criterion in this respect is the arms' length principle. The circular letter of the tax organization has also clearly referred to this rule. Therefore, we will continue our discussion by looking at the same circular.

 

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 Tehran. In cases where the Organization of Investment and Economic and Technical Assistance of Iran has authorized the issue, the verification of that organization is to be obtained and that will suffice.

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 End

 

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