Recharacterisation in the Context of Transfer Pricing

Under the Corporate Income Tax Act, related parties are required to conduct transactions on arm’s-length terms. If these conditions are not met, the tax authorities may recharacterise the transaction. As a result of recharacterisation, the authority may change the nature of the transaction and the settlements between related parties, or disregard the transaction entirely.

Definition

The legal basis is Article 11c of the Corporate Income Tax Act. Pursuant to Article 11c(2), if, due to existing relationships, conditions are established or imposed that differ from those which would have been agreed between unrelated parties, and as a result the taxpayer reports a lower income (or a higher loss) than would be expected had those relationships not existed, the tax authority shall determine the taxpayer’s income (or loss) without regard to the conditions arising from those relationships.

Next, under Article 11c(3), when determining the taxpayer’s income (or loss) in the above situation, the tax authority takes into account the actual course and circumstances of the conclusion and performance of the controlled transaction, as well as the conduct of the parties to that transaction.

If the tax authority concludes that, in comparable circumstances, unrelated parties acting with economic rationality would not have entered into the controlled transaction in question, or would have entered into a different transaction or undertaken a different action (hereinafter the “appropriate transaction”), then—taking into account:

• the conditions agreed between the related parties, and
• the fact that the conditions set between related parties prevent the determination of a transfer price at a level that unrelated parties acting with economic rationality would have accepted, considering the realistically available options at the time of entering into the transaction,

the authority determines the taxpayer’s income (or loss) without regard to the controlled transaction, and—where justified—determines the income (or loss) from the appropriate transaction instead of the controlled transaction.

It is also necessary to consider Article 122 of the Tax Ordinance, which provides that, in the course of proceedings, tax authorities take all necessary steps to thoroughly clarify the facts and to resolve the case in the tax proceedings.

Limitations on Recharacterisation

The Corporate Income Tax Act stipulates that recharacterisation cannot be based solely on difficulties in verifying transfer prices by the authority (Article 11c(5)(1)) or on the absence of comparable transactions between unrelated parties in comparable circumstances (Article 11c(5)(2)). This means the tax authority must hold reliable evidence that the conditions of the controlled transaction actually differ from those that would have been set by unrelated parties, and that such differences result in non-arm’s-length settlements between the parties.

How to Avoid Recharacterisation?

To avoid the recharacterisation mechanism, it is crucial to carry out transactions on arm’s-length terms. To mitigate risk and safeguard the taxpayer’s position, it is essential to prepare comprehensive transfer pricing documentation and benchmarking analyses assessing the conditions of the controlled transactions undertaken. These documents enable verification of whether the transaction was concluded on market terms.

Our experts provide support and prepare transfer pricing documentation designed to minimise tax risk—please feel free to contact us.