Russian Court Overrides Authorities' Use Of Net-Back Approach In ...

This article originally
appeared in the 13 June
2011 issue of Tax Notes
International Magazine, on
page 866.
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Russian Court Overrides
Authorities’ Use Of
Net-Back Approach In
Transfer Pricing Case
By Henrik Hansen, Natalija Reuta and Ruslan Radzhabov
The Federal Arbitration Court of the Moscow Region recently shot down
Russian tax authorities’ attempt to adjust a taxpayer’s transfer pricing
by applying the net-back approach (effectively an adjusted comparable
uncontrolled price method).
The Federal Arbitration Court of the Moscow Region recently shot down
Russian tax authorities’ attempt to adjust a taxpayer’s transfer pricing
by applying the net-back approach (effectively an adjusted comparable
uncontrolled price method).
The ruling 1 is notable because the court found that the net-back pricing
method is not included in article 40 of the Russian Tax Code (the transfer
pricing article) and is not in line with its provisions. The decision may
therefore affect taxpayers with similar fact patterns, particularly those
relating to certain types of commodities.
Background
The taxpayer, Gazprom Extraction Astrakhan LLC (GEA), made export
sales of sulfur to Fedcominvest Monaco S.A.M, a trading company
registered in Monaco. Fedcominvest resold the sulfur to customers in
North Africa.
GEA and Fedcominvest were co-founders of another company, Inter-S
LLC, from which GEA rented sulfur granulation equipment. The tax
authorities argued that the joint participation of GEA and Fedcominvest
in Inter-S provided a basis for recognizing GEA and Fedcominvest as

elated parties. They concluded
that GEA’s prices for the sulfur
it sold to Fedcominvest in 2006
were significantly lower than the
market price, resulting in GEA’s
underreporting of its taxable
income for profits tax purposes.
The Tax Authorities’ Arguments
The tax authorities conducted
a comparative analysis of sulfur
prices in the North African market
because the sulfur acquired by
Fedcominvest from GEA was
resold primarily to customers
in North Africa. They obtained
the pricing information from a
report prepared by the Centre
for Marketing Research and
Expertise CJSC (CMRE) based on
the customs and trade statistics of
relevant North African countries
as well as data from two industry
magazines, Industrial Minerals and
Fertilizer Week. The tax authorities
adjusted the sulfur prices identified
in the North African market for
transportation costs, insurance
expenses (0.2 percent), export
tariffs (6.5 percent), differences
in financial terms (1 percent), and
the minimum trading margin of
Fedcominvest (5 percent).
To support their approach, the tax
authorities argued that the prices
in GEA’s transactions with third
parties could not be used as a
benchmark because of significant
differences in transaction volumes
with Fedcominvest relative to those
with third parties. Consequently,
the tax authorities said, they
had to seek comparable external
prices. There are no comparable
transactions in the Russian sulfur
market, however, because GEA has
a monopoly in Russia. 2
The adjusted sulfur prices
calculated by the tax authorities
were significantly higher than
the actual prices GEA charged to
Fedcominvest. (It is not clear from
the decision whether the deviation
exceeded 20 percent.) Based on
this finding, the tax authorities
assessed additional tax and
penalties on GEA.
The Court’s Decision
The court found that the tax
authorities did not prove beyond
doubt that GEA and Fedcominvest’s
joint interest in Inter-S influenced
the conditions of their transactions
together. However, the court
emphasized that the sulfur sales
transactions between GEA and
Fedcominvest were still subject
to transfer pricing control on the
grounds that they were foreign
trade transactions. 3
The court also challenged CMRE’s
competence and expertise in
determining market prices for the
purpose of Tax Code article 40 and
particularly for the application of
the net-back approach. Holding
that the net-back method is not
in line with article 40, the court
disregarded the arguments of the
tax authorities on the following
grounds:
• The CMRE report and the two
industry magazines do not
qualify as “official sources of
information” for purposes of
article 40.
2 ITS in the News Our people in the press
• The North African market was
not considered an appropriate
reference market and the tax
authorities should have tried to
identify sulfur price benchmarks
in Russia or neighboring markets
such as Kazakhstan.
• The tax authorities did not review
competitors’ pricing policies.
(Because GEA has a monopoly in
the Russian market, it is unclear
what competitors the court was
referring to.)
• The tax authorities overstepped
article 40 by effectively using
a combination of two transfer
pricing methods in their analysis:
the CUP method (by identifying
the sulfur prices in the North
African market) and the resale
minus method (by determining
the market price of sulfur by
deducting GEA’s expenses and
remuneration from the sulfur
prices in the North African
market).
• The resale minus method was
not applied as prescribed by
article 40 because the basis was
not Fedcominvest’s actual resale
price. Moreover, when applying
the resale minus method, the tax
authorities had not proved beyond
doubt the absence of comparable
transactions with identical or
similar sulfur or the absence of
information to determine the
market price.
• The CMRE’s report did not
provide any details about how the
adjustments (insurance expense,
Fedcominvest’s remuneration, and
so on) were determined.

• In the court’s view, adjustments
are allowed only for differences in
contractual terms and conditions,
and not for differences in
markets. Interestingly, the court
seems to have chosen to ignore
its right “to take into account any
circumstances that have a bearing
upon the determination of results
of a transaction, without being
limited to those listed under Items
4-11” of article 40 of the Tax
Code.
The Net-Back Approach and the
Proposed Transfer Pricing Rules
Interestingly, a proposed transfer
pricing law published on the
Finance Ministry’s website on May
4 and proposed for enactment
on January 1, 2012, states that
prices can be adjusted to take into
account differences in economic
(commercial) conditions when
applying the CUP method, but only
when using exchange quotation
data. The adjustments would take
into account:
• reasonable expenses to deliver
goods (and works and services)
to a particular market, supported
by documentation or information
sources;
• expenses for the payment of
export customs duties;
• conditions of payment; and
• commission (agency) fees payable
to a broker (trader or agent) for
the performance of intermediary
trading functions.
Moreover, the proposed transfer
pricing law would require that
adjustments be made to reflect the
commercial and financial terms
of controlled and uncontrolled
transactions as well as market
characteristics, if possible. In
principle, it should therefore be
possible to make the adjustments
attempted by the tax authorities
in GEA when applying the CUP
method, independent of the source
of the data they used.
Finally, the proposed transfer
pricing rules state that a
combination of two or more
transfer pricing methods is possible,
thereby removing the current
hindrances to applying the net-back
approach.
Endnotes
For additional information with respect to this ITS in the News, please contact the following:
Moscow, Russia
• Henrik Hansen +7 495 648 9608 henrik.hansen@ru.ey.com
• Natalija Reuta +7 495 662 9322 natalija.reuta@ru.ey.com
• Ruslan Radzhabov +7 495 755 9700 ruslan.radzhabov@ru.ey.com
3 ITS in the News Our people in the press
1. Case No. KA-A40/13304-10 of
December 1, 2010.
2. GEA is also the third-largest
sulfur producer in the world.
3. Note that under the proposed
transfer pricing law, even
in the absence of a formal
interdependency between
GEA and Fedcominvest, the
transactions between them
would still be subject to
transfer pricing control because
Fedcominvest is registered
in Monaco, a blacklisted
jurisdiction.

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