Transfer Pricing Rules Introduced in Paraguay

Law No. 6,380/2019 (Tax Law) modernized the Paraguayan fiscal system significantly. The Tax Law introduced, among other measures, a full set of transfer pricing rules to determine the market value of controlled transactions conducted between associated entities. This set of rules came into force on January 1, 2021, with a few exceptions, mentioned below.

The arm’s-length principle has been applied in many countries worldwide since its adoption by the U.S. Internal Revenue Service in 1935. This norm was crafted to properly allocate income and expenses arising from controlled transactions between associated enterprises. In accordance with this principle, associated entities must apply the same prices and conditions that would have been applied by independent entities in similar transactions and circumstances. As of today, this principle is incorporated in Article 9 of the Model Tax Convention of the Organization for Economic Co-operation and Development (OECD) and serves as the foundation for the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the Guidelines).

Transfer pricing rules are primarily aimed at determining whether the arm’s-length principle has been properly applied to a controlled transaction, in which both parties are associated, and market forces might not have been the main driver behind the prices and conditions agreed upon. The scrutiny of controlled transactions through transfer pricing methods is necessary to detect artificial allocations of profits to a company located in a territory where the value of the transaction was not created. Through this set of rules, controlled transactions can be adjusted by the tax administration in order to establish the proper market value, and, most importantly, to determine the taxable income and concomitant fiscal liabilities generated in its jurisdiction.

The Guidelines represent a clear example of modern soft law, as most countries adhere to this set of rules by incorporating the appropriate provisions into their fiscal systems. In this regard, Paraguay, as a member of the Development Centre of the OECD, has incorporated these norms through the enactment of the Tax Law, which is regulated through Decree No. 4,644/2020 (the Decree). Consequently, transfer pricing rules came into full force on January 1, 2021, except for the export of certain commodities, which will be subject to these rules from July 1, 2021 onward.

Who is Affected by These Norms?

Under the Tax Law, transfer pricing rules are applied to taxpayers of the Paraguayan corporate income tax (“IRE” per its Spanish acronym) who conduct transactions with:

• associated entities with fiscal residence outside Paraguay;
• associated entities with fiscal residence in Paraguay, when the transaction generates income exempted or not taxable in the context of the IRE for one of the entities of the transaction; or
• entities located in territories of low or no taxation, or entities which benefit from special regimes established in the Paraguayan fiscal system, specifically, tax-free zone users and companies under the maquila regime; however, an exemption is obtainable if it can be proved that there is no association between the transacting parties in these former cases, under conditions that are yet to be regulated by the Paraguayan tax authority.

Relatedness or association between the transaction parties is the preliminary condition to apply this set of rules.

When are Two or More Entities Considered Associated?

According to the Tax Law, two or more entities are associated or related when a person or a group of persons from one entity participates directly or indirectly in the administration, control, or capital of the other entity. Participation in the capital of the controlled entity is manifested if one entity holds, directly or indirectly, more than 50% of the equity capital with voting rights of the other company.

In addition, there is participation in the administration or control when one company has the ability to influence the commercial decisions of the other company through the appointment of managers, directors, or administrations, or through a dominant contractual or functional influence, which can also affect the credit rights of the controlled entity. In this regard, a company’s capacity to define or orient the activities of the controlled entity, which is a taxpayer under the IRE, is sufficient to establish relatedness.

Furthermore, permanent establishments located in Paraguay are considered related entities in regard to their head companies. The Tax Law also assumes association in cases in which a company with fiscal residence in Paraguay conducts transactions with companies located in countries of low or no taxation, tax-free zones, or companies under the maquila regime; nevertheless, evidence to the contrary of this relatedness is admitted by the Tax Law.

Once the relatedness or association between two or more entities is determined within these norms, the arm’s-length principle should be observed in all controlled transactions.

How is the Arm’s-length Principle Applied?

In order to properly evaluate the operations for which transfer pricing methods will be applied, the Tax Law proposes an analysis to delineate the relevant circumstances of the controlled transaction, based on the comparability factors recommended in Section D, Chapter I of the OECD Guidelines. Thereby, the analysis has to be conducted through a study of:

• the characteristics of property or services;
• functional analysis;
• contractual terms of the transaction;
• economic circumstances; and
• business strategies.

In addition, the Tax Law states that adjustments between potential comparable operations can be conducted in order to increase the similarity between the operations that will be compared.

It must be also noted that if internal and external comparable operations are available for the analysis, the IRE taxpayer is obliged to consider the internal comparable first. If not, the Decree stipulates that it is mandatory to justify the reason for considering external comparable operations instead. The comparability analysis can be conducted over the IRE taxpayer, as well as the related entity—located in Paraguay or abroad—considering the information available as well as the analysis described above.

Once the comparable operations are selected based on the criteria described above, the proper transfer pricing method has to be applied.

What Methods are Introduced?

The Tax Law introduces the traditional transactional methods (comparable uncontrolled price, resale price, and cost-plus) as well as the transactional profit methods (transactional net margin and profit split) recommended by the OECD in Parts II and III of Chapter II of the Guidelines.

In addition, two special methods are designated in view of the particular economic circumstances of Paraguay.

Export of Commodities

Firstly, the so-called sixth Latin American method is introduced as a special method applicable to controlled transactions, where certain commodities are being exported from Paraguay. It should be noted that these rules have not been introduced as special anti-avoidance norms in the context of the comparable uncontrolled price method, but nevertheless, the recommendations contained in paragraphs 2.18 to 2.22 of the Guidelines regarding commodities were taken into account to design this local method.

Therefore, the Decree dictates that this method is applied solely to the export of soybeans and their derivatives (oil, pellets, expellers and flour) as well as maize, rice and wheat. Paraguay’s economy is primarily agricultural, as it is one of the major producers of soybean worldwide; therefore, controlled transactions conducted in regard to these commodities represent a sensitive issue for fiscal purposes.

In order to apply this method, the quoted price obtained in an international commodity exchange market must be used to establish the market value of the goods exported. The international public markets from which prices will be obtained have to be defined by the tax authority through a future general resolution. Adjustments of the quoted price can be performed to increase comparability, but only regarding freight and insurance costs, under the condition that the IRE taxpayer that is making the export has not disbursed the payment of these services.

For the comparability analysis, the Free On Board value of the exported goods at any Paraguayan port has to be considered in every case.

Additionally, to determine the date from which to obtain the quoted price in the international commodity market, the Tax Law adopts some of the recommendations contained in paragraph 2.22 of the Guidelines. Thereby, as a general rule, the shipment date must be used to obtain the quoted price. However, under certain conditions, associated enterprises can determine a pricing date for export contracts, as long as the relevant agreements are properly registered in a public registry (that will be created). If the conditions to register the contracts are not met, the quoted price of the shipment date will apply.

As a result of this method, the adjustment of values will apply when the price contained in the export invoice issued by the IRE taxpayer is less than:

• the quoted price of the shipment date, as determined by the international commodity exchange market (adjusted, if necessary); or
• the price settled in the contract date, properly registered.

The taxable base of the IRE will be the difference between the values contained in the export invoice and the quoted price of the relevant date or the price settled in the registered contracts.

As mentioned above, this method will be applicable from July 1, 2021 onward, as some aspects of these transactions have yet to be regulated by the tax authority.

Residual Profit Split

In addition to the standard profit split method proposed in Section C, Part III, Chapter II of the Guidelines, the Tax Law incorporates an additional profit split method, which is explicitly described as an alternative approach in paragraph 2.127 of the Guidelines. The residual profit split method is intended to be applied when unique and valuable contributions are made by related enterprises in highly integrated operations, taking into account the distribution of the profits that would have been conducted between independent enterprises in similar transactions.

The main difference between this residual method and the standard profit split method is that the residual method proposes that, as a first step to allocating the combined profit obtained by all the related enterprises in the operation being analyzed, a “minimum profit” must be assessed for each party of the transaction. To conduct this first phase, any transfer pricing method suitable for determining the profit that each party of the transaction had to obtain in accordance with arm’s length can be applied, without considering any intangible assets employed in the operation.

Afterwards, in the second phase, the “residual profit” will be determined by subtracting the “minimum profit” from the combined profit obtained in the operation. This “residual profit” will then be allocated between the related entities, considering the intangible assets utilized in the operation.

As a result of the application of this special method, only the “residual profit” will be affected by the special intangible assets contributed by the parties of the transaction.

The objective of this special method is to both ensure the allocation of a reasonable “minimum profit” to the associated entities and mitigate the impact of intangible assets in controlled operations and the potential difficulty in determining their market value for arm’s-length purposes.

How Will These Methods be Applied?

As a general rule, the Tax Law requires that the comparable uncontrolled price be applied as the first option in every analysis. However, the other methods can be used when the comparable uncontrolled price method is not suitable to determine an operation’s market value, based on the special characteristics of the operation or the information available. In every case, the comparability factors have to be analyzed.

Notwithstanding, when commodities affected by the special method are exported, only this method can be applied to determine the market value of the transaction, observing the price quoted in the international commodities exchange markets or the price of the registered contracts.

Furthermore, interquartile ranges must be obtained if two or more comparable transactions are analyzed, in order to determine the market value after the application of the method. If the transaction analyzed falls within any of the interquartile ranges, the transaction will be considered as being at market value.

Conversely, if the transaction is outside the interquartile ranges and this affects the IRE taxable base, an adjustment has to be conducted, and for this purpose, only the median quartile is considered to be at market value.

In case an adjustment of values takes place through the application of transfer pricing norms, the amount resulting from this adjustment will be considered as net income for tax reassessment purposes. The subsequent payment of the IRE based on these reassessments will be conducted on a yearly basis.

Formal Obligations

The Tax Law stipulates that it is mandatory to submit a yearly technical report on transfer pricing regarding controlled transactions for IRE taxpayers who conduct transactions with related entities with fiscal residence abroad and with related entities located in the country. This report must include an analysis of the controlled transactions as well as the documents related to the operations analyzed and a general description of the structure of the multinational group.

However, if the gross income obtained by the IRE taxpayer in the previous fiscal year is less than 10 billion Paraguayan guaranies ($1.4 million), it is not mandatory to submit this report. This exception is not applied to IRE taxpayers who conduct operations with entities who have fiscal residence in a territory of low or no taxation or with users of the free-tax zone or companies under the maquila regime.

Regarding the sources of information available to the tax authority, it is important to note that besides the local information submitted by the taxpayers, Paraguay has signed the OECD Convention on Mutual Administrative Assistance in Tax Matters, which has been incorporated into the local system through Law No. 6,656/2020. Therefore, in order to determine whether a controlled operation is being conducted at market value, the Paraguayan tax authority can exchange fiscal information with the tax authorities of other countries who participate in this multilateral treaty.

In the event that norms related to the arm’s-length principle are breached, the general sanctioning regime contained in Law No. 125/1991 will apply, as no special provisions are contained in the Tax Law or its Decree regarding sanctions.

Planning Points

If multinational companies that operate in Paraguay fall within the scope of these provisions, to address any issue that might arise, the IRE taxpayer must take the following actions:

• determine whether it is conducting controlled transactions with related entities;
• if controlled transactions are taking place, it is essential to determine if the market value is being applied, in accordance with the transfer pricing methods described above;
• stay updated on the implementation of the special method applicable to the export of commodities. It is yet to be defined which international commodity exchange markets will be considered to determine the quoted price, nor has the special public registry for contracts been created.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Horacio Sánchez Pangrazio is a Senior Associate in the Tax Department of Ferrere, Paraguay.

The author may be contacted at: hsanchez@ferrere.com