Ministry of Finance Amends Transfer

On 22 May 2018, the Ministry of Finance issued an important decision amending the Executive Regulations of the Income Tax Law with an effect on transfer pricing regulation in Egypt. The move is in line with Egypt’s general plan of applying economic reforms under the IMF program which started in 2016. Indeed, one of the policy objectives of the IMF-funded program is to increase Egypt’s tax revenues as a percentage of GDP, which can be fulfilled through adopting a set of measures aimed mainly at addressing tax avoidance.

Background

When affiliated companies are transacting with one another, their mutual commercial and financial relations may be subject to special terms that are not directly affected by external market forces. In this regard, both the Organization for Economic Cooperation and Development (“OECD”), and the World Bank recommend that commercial and financial transactions between related companies be valued as if they had been carried out between unrelated parties, each acting in their own best interest. This is referred to as the “arm’s length” principle. On the other hand, the term “transfer pricing” refers to the rules and methods set by a government for pricing transactions between companies that are under common ownership or control. The adjustment of related party transfer prices may differ from what would have been charged by unrelated enterprises dealing at arm’s length in order to reduce the final tax burden. The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration[1] therefore determines certain methods for the calculation of transfer pricing to reduce or eliminate tax avoidance. According to the OECD, deviation from the arm’s length principle may result in distorting the host states’ revenues and the tax liabilities of the companies involved. In 2005, the Egyptian government embarked on a plan to modernize the income taxation system. Income Tax Law No. 91 of 2005 (“ITL”)[2] was passed introducing the arm’s length principle for the first time. Following that, in 2010 the Egyptian Transfer Pricing Guidelines were issued containing practical rules for the application of the arm’s length principle.

Egypt’s Transfer Pricing Legal Framework

The Income Tax Law and its Executive Regulations provide the main transfer-pricing legal framework, including definitions of arm’s length price, and related party transactions. Said definitions are mirrored in the VAT Law, which adopts the same definition of arm’s length price, and the Tax Authority’s power to intervene to adjust taxable income amount where the arm’s length price was not adopted. Finally, Egypt’s Transfer Pricing Guidelines issued by the Tax Authority in 2010 contain transfer-pricing methods which for the most part mirrored the OECD guidelines as they were at the time.

• Income Tax Law

The ITL defines “arm’s length price” as “the price upon which two or more unrelated persons transact, determined according to market forces and transaction conditions”. The ITL also provides that the tax authority is entitled to make its own taxable profit determination according to arm’s length price in the event that related parties conduct commercial or financial transactions at prices other than those which would be charged between un-related parties, in order to reduce the tax base or shift the tax burden. The ITL’s scope of application of the arm’s length principal includes related party transactions on both the cross-border and domestic levels, as the rule applies to transactions between a resident and a non-resident, as well as transactions between two resident entities. Importantly, the ITL also defines what is to be considered a “related party” for the purpose of the application of its rules. It states that a related party is: Any person related to a taxpayer in a way that affects the determination of the tax base, including:

1. Husband, wife, descendants, and ascendants.
2. A corporation and the person who directly or indirectly holds at least 50% of shares, or voting rights therein.
3. Partnerships, active partners, and silent partners.
4. Any two or more companies in which another person holds at least 50% of shares, or voting rights in each.

• VAT Law

Similar to the ITL, the VAT Law provides that in the sale of goods or supply of services – whether local or imported – between related parties, the value must not be less than the price upon which unrelated parties would have charged according to market conditions. The VAT Law also adopts the same definition of related parties as under the ITL.

• Executive Regulations (“ER”) of the ITL

Articles 38-40 of the ITL ER address the arm’s length principle. In this respect, Article (38) gives the tax authority the power to ascertain whether two related parties have adopted an arm’s length price in their commercial and financial transactions, including “the exchange of goods and services, raw material, capital equipment, cost contribution arrangements, royalties, returns and any other commercial and financial transactions that are carried out between the two entities”. Meanwhile – prior to the most recent amendment to the ITL ER - Article (39) listed the methods to be applied in order to specify transfer price in accordance to the arm’s length principle. The three listed methods were (i) the comparable uncontrolled price method, (ii) the cost-plus method, and (iii) the resale price method. The three methods fall within the “traditional methods” introduced by the OECD guidelines at the time. Moreover, Article (39) contained explanations of each of the three pricing methods, while Article (40) of the ER provided a hierarchy that must be followed in applying the traditional methods to determine transfer pricing in compliance with the arm’s length principle. It stated that the comparable uncontrolled price method takes precedence over the other traditional methods. In the event that the application of the comparable uncontrolled price method is not possible, then the taxpayer could revert to either the cost-plus method or the resale price method to determine transfer price. This hierarchy was in line with the OECD’s former approach that was changed in 2010. From 2010 onwards, the OECD has adopted the “most appropriate method” rule as the best manner to transfer prices in compliance with the arm’s length principle. In case the three traditional methods fail or prove less reliable in identifying the arm’s length transfer pricing, Article 40 (2) of the ITL ER allowed the utilization of any other methods provided under the OECD guidelines.

• The Egyptian Transfer Pricing Guidelines (“TPG”)

When it came out in November 2010, Egypt was the first country in the Arab world to issue Transfer Pricing Guidelines containing practical rules for the application of transfer pricing methods. Nevertheless, the guidelines were issued in a first part that addressed main transfer pricing concepts and issues, with a view of issuing a second part in the future to cover intangible assets, intra-group services, cost contribution and advance pricing arrangements. To date, this second part of Egypt’s TPG has not been issued.

• The Recent Amendment to the ITL ER

Minister of Finance Decision No. 221 of 2018[3] introduces amendments to Articles 38, 39, 40 and 104 of the ITL ER. The amendment introduced a slight word shuffle to Article (38). The effect of the Article however remains the same: the tax authority has the power to investigate any commercial and financial transactions between related parties, and “in particular” the above listed transaction examples. More importantly however, the amendment modifies Article (39) containing the three transfer pricing methods to be adopted in applying the arms-length principle. Firstly, elaboration of what the three-pricing methods entail has been removed. In addition, the Article now provides that application of arm’s length price can be in any of the following manners:

1. Comparable uncontrolled price;
2. Cost plus method;
3. Resale price method;
4. Profit split method; or,
5. Transactional net margin method.

Note that in addition to removing the hierarchy of these pricing methods, the Article adds two new methods for applying arm’s length price; namely the profit split method, and the transactional net margin. Amendment to Article (40) reiterates that the taxpayer can choose any of the above listed methods depending on the nature of the transaction, without having to follow a certain hierarchy. This approach is more in line with the “most appropriate method” rule adopted in the OECD guidelines. Furthermore, where prior to amendment Article (40) stated that in the event that the three traditional pricing methods could not be applied, then the taxpayer could apply any other OECD method, the Article now states that any other suitable method may be applied “on the condition that the taxpayer must maintain records and documentation that prove the suitability of the applied method.” As has been the case before, the Article allows for advance pricing agreements (APAs) to take place between the taxpayer and the tax authority in order to avoid future transfer pricing disputes. Article (40) after amendment also states that the Minister of Finance is to issue an implementation guide to be the main reference that the tax authority has to abide by when determining whether the arm’s length price has been adopted. The Article further restricts the authority’s ability to use reference outside said guide unless the taxpayer makes a request that is approved by the Head of the Tax Authority. Finally, whereas Article (104) of the ITL ER stated that the taxpayer could elect to submit the tax declaration through the government’s electronic portal, the amendment now obligates enterprises to submit their tax filings electronically, while allowing individual taxpayers to choose between electronic or physical submission.

Conclusion

Many Developing economies focus on competing to attract foreign direct investment and multinational enterprises while often disregarding the impact of unfair tax practices on eroding the country’s tax bases. This is why it is crucial that Egypt is paying attention to transfer pricing as part of its policy objective under the IMF economic reform program to increase tax revenue and adopt measures that address tax avoidance and evasion. Indeed, the Egyptian Tax Authority has recently established a Transfer Pricing Unit based on IMF recommendations. While progress in terms of updating transfer pricing regulations so that they are in line with international best practice has been generally sluggish (note the adoption of the arm’s length principle in the ITL in 2005, then issuing the Egyptian Transfer Pricing Guidelines in part five years later); the government seems to be more determined on modernizing transfer pricing practices. It therefore remains to be seen whether this guide to be issued by the Ministry of Finance containing the rules of implementation by the tax authority of arms-length-price determinations will complete the initiative taken to issue part one of the Egyptian Transfer Pricing Guidelines.   [1] OECD, “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations”, July 2017, Available through this link. [2] Law No. 91/2005 on Income Tax, Official Gazette, Issue No. 23 (cont.), 09 June 2005. [3] Minister of Finance Decision No. 221/2018 amending certain provisions of the Executive Regulations of the Income Tax Law issued by virtue of Minister of Finance Decision No. 991/2005, Egyptian Gazette, Issue No. 117 (cont.), 22 May 2018.