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Latvia: Risk analysis in transfer pricing documentation


The latest version of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, which came into force in autumn 2015, substantially widens the range of requirements for analysing risk as part of the functional analysis in a company’s transfer pricing documentation. This article takes a look at details.

Risk analysis

Section D1.2.1 of the OECD guidelines states that the process for analysing risk in a controlled transaction should comprise the following six steps:

  1. Identify economically significant risks with specificity;
  2. Determine how specific, economically significant risks are contractually assumed by the associated enterprises under the terms of the transaction;
  3. Determine through a functional analysis how the associated enterprises that are parties to the transaction operate in relation to assumption and management of the specific, economically significant risks, and in particular which enterprise or enterprises perform control functions and risk mitigation functions, which enterprise or enterprises encounter upside or downside consequences of risk outcomes, and which enterprise or enterprises have the financial capacity to assume the risk;
  4. Determine whether the contractual assumption of risk is consistent with the conduct of the associated enterprises and other facts of the case by analysing (i) whether the associated enterprises follow the contractual terms under the relevant principles; and (ii) whether the party assuming risk, as analysed under (i), exercises control over the risk and has the financial capacity to assume the risk;
  5. Where the party assuming risk under steps 1–4(i) does not control the risk or does not have the financial capacity to assume the risk, apply the guidance on allocating risk;
  6. The actual transaction, as accurately delineated by considering the evidence of all the economically relevant characteristics of the transaction as set out in the guidance, should then be priced, taking into account the financial and other consequences of risk assumption, as appropriately allocated, and appropriately compensating risk management functions.

Practice

We have noticed that certain SRS officers who specialise in transfer pricing reviews are already adopting this OECD approach during tax audits and issuing information requests focused on managing various risks.

This means that Latvian taxpayers should control all expenses they incur in their dealings with related companies to ensure that those expenses are deductible for corporate income tax purposes.

For example, corporate groups often have a dedicated purchase company or a purchase department within a group company that selects suppliers, negotiates terms that are favourable to the group, and takes care of ordering, buying and transporting goods for a Latvian taxpayer. Corporate groups typically organise centralised purchases to reduce the group’s total expenses and negotiate favourable terms of purchase, including a bulk discount on goods ordered for the whole group.

However, if the Latvian taxpayer is not involved in the process of selecting suppliers, has no right to reject or change a supplier, and is unable to independently analyse or control purchase prices, there is a high risk that the SRS will find that the expenses the Latvian taxpayer incurs in making purchases beyond his control are not deductible for Latvian tax purposes and should be borne by the group entities that exercise control over those expenses. To mitigate this risk, the Latvian taxpayer’s functional analysis should accurately describe all activities that are associated with control over the Latvian company’s business operations in general and costs in particular.

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