Transfer Pricing Directive – Implications for Latvia

In September 2023, the European Commission published a proposal for a Council directive on transfer pricing (hereinafter – TP Directive). The TP Directive aims to establish a common transfer pricing regulation in European Union (hereinafter – EU) countries, thereby harmonizing this area of taxation at the EU level.

Currently, across the EU the arm’s length principle  is applied based on the provisions of bilateral tax conventions and local transfer pricing regulations. Many EU countries apply the Organisation for Economic Cooperation and Development Transfer Pricing Guidelines (hereinafter – OECD Guidelines), which are only advisory in nature in most EU countries, rather than legally binding.

As each EU country has its own regulatory framework, multinational enterprises (hereinafter – MNEs) must take into account the different rules of each country in which they operate. These varying regulations not only create higher costs, but also higher risks of double taxation and incentives for the MNEs.

The main objective of the TP Directive is to standardize transfer pricing regulations across the EU and thus introduce greater clarity in the field of taxation, since the clarity and predictability of tax systems are considered a high priority by taxpayers.

The TP Directive will effectively introduce harmonized transfer pricing regulation across the EU. This will also give uniform status to the OECD Guidelines in all EU countries. In fact, the OECD Guidelines (i.e. the latest version of the guidelines at the time the TP Directive comes into force) will become a legally binding instrument for all countries.

In addition, transfer pricing practices will also be harmonized. There is a plan to establish an expert group to discuss and agree on a uniform interpretation of the arm's length principle. It is also planned to issue rules for specific transactions in the form of Council implementing acts.

Let's dive deeper into the content of the TP Directive, highlighting the most important clauses and analysing their impact in the context of current Latvian transfer pricing practice.

General rule on application of arm’s length principle

The TP Directive lays out the general rule of applying the arm’s length principle in related party transactions as follows:  "Member States shall ensure that, where an enterprise engages in one or more commercial or financial cross-border transactions with an associated enterprise, such enterprise determines the amount of its taxable profits in a manner that is consistent with the arm’s length principle. "

• This definition includes a cross-border element. Thus, the TP Directive will not cover purely domestic related party transactions. Of course, this does not limit each country's right to apply transfer pricing regulations for domestic transactions, which is the case in Latvia.

Definition of the associated enterprises:

The TP Directive will provide a unified definition of associated enterprises.

• This means that Latvia will have to review its current related party definitions as per local tax law. For example, in Latvia, the shareholding threshold for enterprises to be considered related is set at 20%, while the TP Directive foresees 25%. Similarly, in Latvia, the threshold for individuals to be considered related to the company is 50%, while the TP Directive foresees a 25% threshold - therefore, a greater burden will lie with the companies that deal with related individuals.

Application of the arm's length principle to permanent establishments:

The TP Directive provides that a permanent establishment (hereinafter – PE) shall be considered an associated enterprise of the enterprise of which it is a part. Accordingly, the arm's length principle will also apply to internal transactions of a company with its foreign PEs.

• Latvia has introduced rather unique regulations on the allocation of head office expenses to PEs, which does not always lead to arm’s length outcomes. Namely, Latvia limits the allocation of the main company's expenses to Latvian PEs (while there are no such restrictions for LLCs). It is expected that Latvia will have to review its regulations to ensure compliance with the arm's length principle with regard to the allocation of head office expenses to PEs.

Transfer pricing methods:

The TP Directive will define five transfer pricing methods in accordance with the OECD Guidelines,  which are aligned with current transfer pricing practices in EU Member States.

• Latvia has a specific practice for applying the resale price method - case law supports the incorrect application of this method when evaluating the net profit indicator, not the gross profit indicator, as provided by the OECD Guidelines. Such a practice will not be compatible with the TP directive upon introduction. Accordingly, the local interpretation of this method, which is detrimental for taxpayers, could be resolved.

Cost contribution arrangements:

The Directive defines the concept of cost contribution arrangements.

• Currently, such a concept is not defined in Latvian tax law. The introduction of such a new term is a positive development and will allow taxpayers to benefit from the advantages provided by cost contribution arrangements.

Transfer pricing adjustments:

Article 6 of the TP Directive will provide a procedure whereby EU Member States will be obliged to grant corresponding adjustments. If one of the group companies increases its taxable income in the first country, the relevant related company in the second country may apply to the tax administration of the second country to accordingly reduce its taxable income by a transfer pricing adjustment in the second country within 180 days. In the event that the tax administration of the second country does not consider the taxpayer's submission to be justified, the taxpayer will be permitted to initiate a mutual agreement procedure.

• This is a significant step forward with regard to elimination of double taxation due to transfer pricing adjustments. Currently, in Latvia, there is no way to make corresponding adjustments other than through the mutual agreement procedure, which can take much longer than 180 days. The TP Directive thus provides a fast track path to enable the corresponding adjustments.

In addition, the TP Directive will provide conditions under which taxpayers will be able to make "compensating adjustments" – an adjustment in which the taxpayer reports a transfer price for tax purposes that is, in the taxpayer’s opinion, an arm’s length price for a controlled transaction, even though this price differs from the amount actually charged between the associated enterprises.

• Since the TP Directive does not provide that a compensatory adjustment can only increase taxable income, there is hope that in accordance with the TP Directive, the compensatory adjustments reducing the taxable base for corporate taxation could also be introduced, which will be beneficial for Latvian taxpayers.

Using quartiles to determine market price range:

The TP Directive notes, that in cases where the application of transfer pricing methods identifies a range of values, the interquartile range (1st to 3rd quartile) is considered as the arm’s length range. If the taxpayer's financial result falls within the range, the taxable income does not need to be adjusted unless it is proven that specific facts and circumstances justify a specific different positioning within the range. However, if the taxpayer's results do not fall within the arm’s length range, an adjustment would be made to the median value of all the results unless it is proven that any other point in the range determines an arm’s length price, taking into account the circumstances of the specific case.

• Latvian tax regulations currently do not foresee similar rules. In practice, in Latvia, the State Revenue Service usually makes transfer pricing adjustments using the median value of the arm’s length range, but it often does not coincide with the taxpayer's view in specific cases. The current version of the TP Directive does not provide more clarity in terms of how a different positioning could be proved.

Content of transfer pricing documentation:

The TP Directive will require that the following elements that have been defined and described in this Directive must be included in transfer pricing documentation:

• Identifying the commercial or financial relations;
• Methods for determining transfer prices;
• The most appropriate method selection;
• Comparability analysis;
• Determination of the arm's length range.

• These elements are already included in the requirements of Latvian legislation for the content of transfer pricing documentation. Although the list of mandatory documentation components is slightly narrower than the current Latvian requirements for documentation, it is not expected that there will be any deviations from the generally accepted OECD approach, i.e. three-level documentation– Master File, Local File, and a country-by-country report - which have also been introduced in Latvia in the same format.
  

The European Commission will be entitled to supplement the requirements for the content of transfer pricing documentation, prepare common documentation templates, establish language requirements, determine the scope of taxpayers subject to transfer pricing documentation requirements, and set deadlines.

• This clause of the Directive tells us that there will be more detailed involvement of the EU Commission in regulating transfer pricing documentation in the future. This development may also bring some improvements for Latvian taxpayers, such as the increased use of English language in the transfer pricing field, as well as potential changes in the range of taxpayers subject to documentation requirements. It should be noted that currently, for example, a Local File prepared in English is considered a significant violation according to the guidelines recently published by the SRS, which could result in significant fines for taxpayers.

Status of the OECD Guidelines:

The TP Directive provides an obligation for EU Member States to include in their national legislation that the transfer pricing rules provided for in the TP Directive are applied in accordance with the OECD Guidelines. Thus, the OECD Guidelines are given a legally binding status. The TP Directive will be amended accordingly when new versions of the guidelines are issued.

• As the OECD Guidelines are considered the main source of transfer pricing application principles, the granting of legally binding status to these guidelines is a positive development. In practice, this might lead to the improvement of local transfer pricing practices by taxpayers and the tax authority (including judicial practices).

Further explanation on the application of the TP Directive:

The TP Directive provides the development of Council implementing acts that would clarify the application of the TP Directive in specific transactions:

a) transfer of intangible assets or rights in intangible assets between associated enterprises, including hard-to-value intangible assets;

b) provision of services between associated enterprises, including the provision of marketing and distribution services;

c) cost contribution arrangements between associated enterprises;

d) transactions between associated enterprises in the context of business restructuring;

e) financial transactions;

f)  dealings between the head office and its PEs.

The explanatory memorandum to the TP Directive states that the implementing acts will not only describe the applicable methodology for specific transactions, but may also establish safe harbours (!) that would significantly streamline compliance with transfer pricing requirements.

• It is a positive development that additional interpretations will be prepared for various transactions, which both tax administrations and taxpayers would rely on. Safe harbours would be a particularly valuable relief for Latvian taxpayers, given that the volumes of related party transactions for Latvian taxpayers are often relatively small.

If the TP Directive is adopted, it is anticipated that it will have to be transposed into national legislation by 31 December 2025, and the TP Directive will apply from 1 January 2026.

The TP Directive can significantly change the “rules of the game“ and bring improvements to Latvian transfer pricing practices by adopting progressive practices and approaches of other countries. It is expected that such a development will ease the burden on taxpayers regarding transfer pricing, as transfer pricing practices all across the EU member states will be aligned with the internationally accepted standards. As the transfer pricing area will be regulated by a TP Directive (an EU legislative act), it will be possible to turn to the Court of Justice of the European Union in case of disputes related to the application of the TP Directive and ensure that local tax law clauses are in line with the generally accepted transfer pricing principles in the EU.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

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