Recharacterization i non-recognition

The coming revolution in transfer pricing regulations equips the tax authorities with new tools to question settlements between related parties and widens the possibility of enforcing the requirement to execute the arm’s length principle, giving the tax authorities tools to verify transactions by establishing that in specified circumstances a given transaction would be replaced by another (recharacterization), or even establishing that in given terms a transaction would not be executed at all (non-recognition).

It is worth indicating that tax authorities have tried to recharacterize transactions (or not recognize them) for some time already, based on the questionable legal basis of art. 199a of the Tax Ordinance. After introducing art.11c par. 4 to the CIT act, the tax authorities will gain a surefire basis for action that may influence boldness and building „alternative scenarios” in relations to transactions executed by the taxpayer in reality.

In accordance with the justification to the act: The regulation concerning instruments of recharacterization and non-recognition has „(…) significant meaning in sealing the tax system due to the fact that related parties may execute transactions that non-related parties would not have executed on the specified terms or not execute such a transaction at all. The complexity of relations within capital groups, especially international groups along with lack of regulations directly defining recharacterization or non-recognition made it difficult to question terms of settlement by the tax authorities, as there may have been transactions where the price was set based on market terms, but the transaction would not have been executed between non-related parties.”

How will the new instruments work?

In line with the new regulations, in defining the amount of income or loss, the tax authorities can conclude that in comparable circumstances non-related parties following economic rationality would not have entered into a given transaction or would have entered into a different transaction, or would have concluded a different activity.

At the same time, regulations of art.11c par.5 of the CIT act limit the possibility of recharacterization or non-recognition, pointing at two conditions that cannot be an exclusive base for applying the abovementioned instruments: difficulty in verifying the transfer price or lack of comparable transactions occurring between non-related parties in comparable circumstances.


The meaning of the tax authorities’ new tools

The changes introduced at the beginning of 2019 are a reflection of rules set out in the OECD guidelines as a result of work on the BEPS project. Section D.2 of the OECD guidelines (July 2017) states that besides the possibility of verifying the transfer price there is also the possibility of reclassifying the transaction or passing it over.

The lynchpin of the conflict during recharacterization or non-recognition of the transaction is understanding the economic rationality in given factual circumstances. Considering the diversity of relations between related parties, at the same time implementing discretionality in defining economic rationality by tax authorities, it is worth verifying executed and planned transactions with related parties based on their economic justification.

It is also important to mention that the justification of crossing-out art. 15ca of the CIT act (market creditworthiness) points out that this regulation will be irrelevant due to the fact that tax authorities will be able to perform recharacterization and non-recognition of controlled transactions (including financial transactions).

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