The Essentials of Transfer Pricing in
Latin America and the U.S. (Part I)

BY ROBERT B. STACK, MARIA LUCIA DEL CASTILLO;
AND NATAN J. LEYVA (WILMER, CUTLER & PICKERING)

The purpose of this two part article is to summarize the transfer pricing regimes of Latin America and the United States and highlight some of the relevant differences between them. The only Latin American countries included are those that have enacted comprehensive transfer pricing legislationÑArgentina, Brazil, Chile, Mexico, Peru and Venezuela. With the exception of Brazil and Venezuela, which have adopted a formulary approach, the United States and all of the other Latin American countries have adopted the arm's length approach, which is also followed by the OECD.2

Part I of this article summarizes and compares the transfer pricing regimes of the arm's length approach countries. Part II, which will be published in the December issue, will summarize and compare the two formulary approach countriesÑBrazil and Venezuela. Part II will also discuss some of the salient differences between arm's length approach regimes and formulary approach regimes generally.

United States regulations on transfer pricing are much more extensive than those of other countries, and generally provide detailed descriptions and examples on how to apply the general statutory and regulatory transfer pricing principles and methods. In contrast, the Latin American countries work within the civil law tradition and, accordingly, their statutory and regulatory transfer pricing framework will set forth certain general rules, but will generally not include detailed descriptions or examples that might assist in the application of these general rules.

Parties and Transactions Subject to Regulation

In general the transfer pricing regulations are applicable to all imports or exports of goods or services between related parties. There are differences between countries, however, particularly with regard to the definition of a related party and, in the case of some countries, the application of the regime to certain unrelated parties in tax haven jurisdictions.

United States. The transfer pricing regulations are generally applicable to individuals and entities considered to be related parties. Related parties are defined broadly as entities that are Òowned or controlled directly or indirectly by the same interests.Ó

Mexico. The transfer pricing regulations apply to transactions between related parties and to transactions with entities located in certain tax havens. Two parties are related when one participates directly or indirectly in the management, control, or ownership of the other. The Mexican definition is broader than that of the U.S. regulations and in principle could extend the transfer pricing regime to parties in which one has a small equity stake in the other, even absent any effective control.

Chile. The transfer pricing regulations are generally applied to transactions between individuals and entities that are related parties. The Chilean definition of a related party is similar to the Mexican definition. However, in order to be considered a controlled or related entity through ownership requirements, the controlling entity must have, directly or indirectly, at least 10 percent of the equity of the controlled entity, or the ability to elect one board member or the manager of the company.

Peru. The transfer pricing regulations apply to transactions between related parties and to transactions with entities located in certain tax havens. Two or more parties are related when (i) a party (or group of parties) participates directly or indirectly in the management of the other, (ii) a party (or group of parties) owns directly or indirectly more than 30 percent of the equity of the other, (iii) 50 percent of the goods or services of a party are sold to another party or to two related parties during a 12 month period, (iv) one is a consortium maintaining separate books and the other is a member of the consortium.

Argentina. The regulations apply to transactions between related parties and to transactions with unrelated parties that are located in certain tax havens. The scope and definition of the term Òrelated partyÓ in Argentina is much broader than in any of the other countries analyzed. In general, two parties will be considered related parties when the parties are subject directly or indirectly to the control of the same individual or legal entities, or when these entities have the capacity to orient or determine the activities of the company based on ownership participation, the level of indebtedness, functional or other influence, contractual or not (e.g., exclusive agents and single customer relationships). In addition, the tax authorities are empowered to adjust the price of exports and imports of goods agreed to by any unrelated parties if such price is lower than the wholesale price of the destination country for export transactions or higher than the wholesale price in Argentina for import transactions, unless the affected taxpayer can show that the price was in fact an arm's length price.

Income tax treaties. Some income tax treaties contain separate definitions of a Òrelated party.Ó Therefore, it is important to always confirm whether there is a treaty definition that would apply in connection with transactions entered into between residents of such treaty countries. The U.S. has treaties in force only with Mexico and Venezuela, and is currently in negotiations with Chile.

Methods

In each of the countries following the arm's-length approach, the arm's length nature of a transaction between related parties (i.e., a controlled transaction) is tested by comparing the pricing, terms, and other characteristics of the transaction in question with the pricing, terms, and other characteristics of comparable transactions entered into between unrelated parties (i.e., uncontrolled transactions). However, the specific methods used to make such comparisons vary, as follows.

United States. Comparable Uncontrolled Price (CUP) Method (comparison to price in comparable uncontrolled transactions), Resale Price Method (comparison to price at which goods are resold by the related buyer to unrelated persons less an appropriate gross profit margin determined from uncontrolled transactions), Cost Plus Method (comparison to actual cost to related seller plus an appropriate gross profit margin determined from uncontrolled transactions), Comparable Profits Method (profit levels from uncontrolled transactions are applied to the controlled transaction), Profit Split Method (profitability of a related company group is allocated among members of the group in accord with their economic contributions to the enterprise), Comparable Uncontrolled Transaction (CUT) Method (for intangible property) (comparison to price in comparable uncontrolled transactions), and other unspecified methods that may be appropriate under the circumstances.

Argentina and Mexico. CUP Method, Resale Price Method, Additional Cost Method (Cost-Plus Method), Profit Split Method, Transactional Profit Margin Method (comparable to the Comparable Profits Method), and the Residual Profit Split Method (only in Mexico) (comparable to the Profit Split Method).

Peru. Cost Plus Method, Resale Price Method, and Profit Margin Method (similar to the Profit Split Method).

Chile. Chile has adopted a significantly different approach from each of those found in the other countries. Currently, there are no general codified substantive transfer pricing regulations. However, the tax authorities are allowed to challenge pricing between related parties if such prices do not comply with the arm's length standard, using as a reference a Òreasonable returnÓ in light of the characteristics of the operation. In searching for a reasonable return parameter, the authorities could rely on almost any of the methods allowed for in other countries. In addition, in cases where a Chilean branch or agency (a permanent establishment) of a foreign entity has not maintained adequate accounting records to show Chilean source income, the Chilean regime contains provisions that recompute the taxable income of the permanent establishment by determining the percentage of the parent's net income to its gross receipts or its total assets, and then applying such percentage to Chilean gross receipts or total assets, as the case may be.

Best Method Rule

United States. Under a best method rule, the controlled parties cannot simply choose the method that gives them the most beneficial result. Instead, the best method rule requires that the arm's length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm's length result.

Mexico and Chile. Neither regime contains a best method rule as such. However, in Mexico, taxpayers requesting Advanced Pricing Agreements (discussed below) must include specific information regarding the method or methods proposed, including the objective analysis of all the elements that have lead them to conclude that the proposed method is the best method for a given transaction or company.

Argentina. The Argentine regime contains a best method rule, requiring the taxpayer to apply the method that best reflects the economic reality of the transaction.

Peru. Although the Peruvian regime does not expressly contain a best method rule as such, the regulations provide for guidelines as to which method and comparables should be used to ascertain the arm's length price for each specific type of transaction, including inventory goods, fixed assets, services, and securities.

Comparables

The concept of comparability is at play where a controlled transaction is compared to uncontrolled transactions. Uncontrolled transactions are only useful in arriving at an arm's length price for a controlled transaction if such uncontrolled transactions are comparable to the controlled transaction at issue. The factors to be considered in order to evaluate the degree of comparability between controlled and uncontrolled transactions are essentially the same in all of the countries analyzed. These factors are the characteristics of the goods or services, the functions performed by the parties, the risks undertaken in providing such goods or services, the applicable contractual terms and economic conditions, and any other special circumstances that might affect the comparability of prices. The U.S. regime is unique, however, in that it specifies in much more detail than other regimes the way in which to interpret and apply each of the comparability factors.

Argentina, Mexico and Peru. One of the key problems that taxpayers are facing in these three countries is the lack of adequate comparables. Some of the current sources of comparables used by the taxpayers are the following: (i) internal comparables, (ii) data from the Stock Exchange (iii) and public company data. If these sources lack adequate comparables, taxpayers will generally use data from foreign countries, such as from the United States and Europe, and make appropriate price adjustments to take into account market differences.

Chile. The Chilean approach differs from the others in one important respect. It is the tax authorities, and not the taxpayer, that are responsible for the analysis of the different elements of the transaction in order to evaluate the degree of comparability between the controlled transaction and uncontrolled transactions. In addition, the Chilean regime does not include a definition of Ôcomparable' transactions or entities, nor does it include rules regarding the way to handle differences in prices or the application of adjustments. Accordingly, finding comparables in Chile is a problem for the tax authorities (the ÒSIIÓ), not taxpayers. The SII is empowered to use pricing obtained from foreign markets for the same or for similar products or services. In practice, the SII is using mostly Canadian, Argentine, and Mexican data bases.

Secret Comparables. Use of confidential third-party comparables during the course of transfer pricing audits is allowed only under Mexican and Argentine law.

Reallocation and Recharacterization

Each regime empowers its respective tax authority to make allocations (i.e., to adjust the price and reallocate income between the related parties) whenever the transactions entered into between controlled taxpayers do not follow the arm's length standard. However, unlike the U.S. regime, which contains detailed provisions regarding when the tax authorities can make collateral adjustments (which includes allocations from one related party to another, recharacterization of income, or setoffs against other transactions), the other regimes do not include descriptions of how and when to carry out such collateral adjustments, but do give the authorities the power to allocate country source income and make transfer pricing adjustments. In addition, some of the non-U.S. regimes allow for the recharacterization of income, as follows:

Mexico. The regulations provide a list of events that can lead to recharacterization of interest derived from credits granted or secured by related parties as deemed dividends.

Argentina. The regulations specify that those transactions entered into by related Argentine taxpayers that do not comply with the arm's length standard or do not keep comprehensive or clear accounting records, will be partially recharacterized as contributions and/or repatriation of profits. In any of these cases, any excess payment over the correctly determined arm's length price will not be allowed to be treated as a deductible expense.

Arm's Length Range

The concept of an arm's length range is meant to take into account the likelihood that the application at different times of even a single method will yield varying results. Accordingly, a taxpayer will not be subject to adjustment if its results fall within a range around the median or average of all the comparable results. Such range is referred to as the arm's length range.

United States. The U.S. has included in its regulations the concept of the arm's length range and has also specified statistical methodologies in order to increase the reliability of the analysis made. In the United States, this arm's length range is the range between the 25th to the 75th percentile (the interquartile range) of the results derived from the uncontrolled comparables.

Mexico. The Mexican regime also employs an arm's length range. Where the price being tested falls outside of a range established using appropriate statistical methods, the price will be adjusted to the median of such range.

Chile and Peru. These countries do not employ the concept of arm's length range.

Argentina. If the authorities consider that in order to evaluate the comparability of a controlled transaction, the use of more than one method is necessary, no adjustment will be made provided that the transaction falls within an acceptable arm's length range. For these purposes, it is considered that an acceptable arm's length range is one that does not deviate more than 5 percent from third party comparables.

Advance Pricing Agreements

An Advance Pricing Agreement (APA) is an agreement that binds the taxpayer to a defined transfer pricing methodology and provides that if the conditions of the agreement are satisfied, the taxing authority will not subsequently challenge transactions between the taxpayer and a related party.

A unilateral APA involves only the taxpayer and its home jurisdiction's taxing authority, while a bilateral APA also includes the foreign affiliate and the foreign taxing authority. Bilateral APAs are particularly useful in that they avoid a situation where separate taxing authorities may take different positions on the same set of transactions and expose the affected taxpayers to double taxation.

In cases where APAs are not available, some practitioners are of the opinion that a similar result could be reached via binding private letter rulings. However, caution should be exercised when contemplating the use of private letter rulings, since the confidentiality of data provided to the taxing authorities may not always be protected. In fact, under Argentine and Mexican law, such data could be used by the authorities as comparables for testing other taxpayers' transactions.

U.S. and Mexico. Both the United States and Mexico provide for unilateral and bilateral APAs.

Peru. Although the Peruvian regime does allow for the issuance of APAs, no regulations have yet been issued on this subject.

Argentina and Chile. These regimes do not expressly provide for APAs.

Information and Documentation
Requirements

The U.S., Mexican and Argentine regimes require the taxpayer to keep documentation, in order to substantiate its application of the transfer pricing rules to specific pricing. In all of these countries, the documentation required must be prepared prior to the filing of the return.

Mexico. Mexican taxpayers must have the documentation ready at the time they file their tax return. In addition, the taxpayer will need to conduct a transfer pricing study and provide an opinion by its public accountants that the taxpayer has complied with the formal requirements of the transfer pricing rules.

Argentina. The documentation and information requirements in Argentina are similar but more extensive than in Mexico. The Argentine regime provides that those taxpayers that are subject to the transfer pricing rules must file semi-annual statements on designated forms containing comprehensive information on intercompany transactions. In addition, the taxpayer must file a transfer pricing report with its annual tax return.

Chile. There are no special documentation and information requirements in Chile.

Peru. The Peruvian rules require that related and unrelated taxpayers maintain the information and documentation related to the methods used to determine the price of their transactions, indicating the criteria and objective elements that were taken into account.

Penalties

United States. The regulations contemplate specific penalties attributable to any underpayment attributable to a substantial valuation misstatement pertaining to either a transaction between persons described in the transfer pricing regulations (the transactional penalty) or a net transfer price adjustment (the net adjustment penalty). The penalty is 20 percent of the underpayment for a substantial valuation misstatement and is increased to 40 percent in the case of a gross valuation misstatement. The transfer pricing penalty is not imposed, however, on any portion of the penalty base attributable to transactions for which the taxpayer demonstrates reasonable cause and good faith in setting its transfer prices.

None of the other countries specify fines for transfer pricing adjustments, as such. However, the general penalties for a resulting underpayment of tax may be applicable, as follows:

Mexico. Mexican penalties range from 50 percent to 100 percent of the unpaid tax. Mexico provides for an automatic reduction of 50 percent of the original fines imposed if the taxpayer complies with the requirements set forth in the law.

Argentina. Argentine penalties range from 50 percent to 100 percent of the unpaid tax, plus interest. The non-filing of the complementary Òdeclaraci—n juradaÓ established for all taxpayers that are subject to transfer pricing regulations will also be subject to specific fines. The law provides for a reduction of penalties if the taxpayer complies with the information and documentation requirements. In the case of late filing of the tax return, for example, the law provides for an automatic reduction of one third of the original fine if the taxpayer voluntarily (without prior notice from the tax authorities) complies with the requirements.

Chile. Chilean penalties range from 5 percent to 20 percent of the unpaid tax.

Peru. Peruvian penalties range from 10 percent to 100 percent of the unpaid tax, plus interest. o

1 This article was prepared with the assistance of the following Latin American law firms: Marval, O'Farrel & Mairal (Argentina), Veirano e Advogados Associados (Brazil), Carey & C’a Ltda. (Chile), Ortiz, Sainz & Erreguerena (Mexico), Barrios Fuentes Urquiaga Abogados (Peru), and d'Empaire Reyna Bermœdez & Asociados (Venezuela). Additional valuable assistance was provided by Daniel K. Goldberg, an International Lawyer at Wilmer, Cutler & Pickering.

2 Of the countries analyzed, only Mexico and the United States are members of the OECD.