Statutory rules The transfer pricing area in Latvia is governed by the following legislation:

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1 46. Latvia Introduction The adoption of the Latvian Corporate Income Tax (CIT) Act in 1995 established a requirement that transactions with related parties comply with the arm s-length principle. Since then, the development of transfer pricing law has been relatively slow. However, recently the Latvian State Revenue Service (SRS) has started to tackle the transfer pricing issue actively and a set of supporting regulations has been developed. Statutory rules The transfer pricing area in Latvia is governed by the following legislation: The Taxes and Duties Act (Section 23 and amendments of Section 152, which will become effective as of 1 January 2013). The CIT Act (Section 12). The Commercial Code (Section 182). The Cabinet of Ministers 4 July 2006 Rule 556, Application of the CIT Act (CIT rule). Transactions Latvian law requires that foreign-related party transactions meet the arm s-length standard. Furthermore, the CIT Act requires transfer pricing adjustments for a noncompliant transaction between two Latvian companies that belong to the same group (i.e. direct or indirect ownership of at least 90% is required). In addition, any transaction with a company located in a low-tax jurisdiction is regarded as a related party transaction and has to meet the arm s-length requirement. Taxable income specifically for CIT purposes must be adjusted if the price applied to any of the following related party transactions differs from its arm s-length value: Fixed assets, goods or services sold at below-market prices. Fixed assets, goods or services bought at above-market prices. The Taxes and Duties Act states in determining the market price or value of a transaction that any discounts and mark-ups applied to transactions between unrelated parties should be taken into account, as well as any pricing changes driven by the following factors: Demand fluctuations due to seasonality or other factors. Differences in the quality or characteristics of goods or services. Expiry of the sell-by date. Marketing policy on placing new products in the market or placing products in a new market. 562

2 Sales of samples and demo versions to attract customers. The Taxes and Duties Act provides for a wider application of the arm s-length principle than only between related parties. A tax audit may examine and adjust the price of the following transactions: Transactions between related parties. Barters and set-offs. Price deviations exceeding 20% of prices that a taxpayer had applied to similar goods or services over a short period. Exports and imports. Other regulations Calculating an arm s-length price The CIT rule prescribes five transfer pricing calculation methods that are consistent with the Organisation for Economic Co-operation and Development (OECD) Guidelines: Traditional transaction-based transfer pricing methods: The comparable uncontrolled price method. The resale price method. The cost-plus method. Transactional net profit methods: The transactional net margin method. The profit split method. L The CIT rule gives a preference to the three traditional transaction-based methods, whereas the transactional profit methods are to be used only when all of the traditional transaction-based methods are inadequate or inapplicable. Transfer pricing documentation requirements Latvian law currently does not require Latvian companies to have appropriate transfer pricing documentation, in place that provides a reasonable calculation of prices applied to related party transactions. On a tax audit, however, the SRS may demand transfer pricing documentation or other documents showing that the company s transfer prices are arm s length. In that case, the taxpayer is expected to provide appropriate transfer pricing documentation within days after receiving a request from the SRS. However, transfer pricing documentation rules are adopted and will be effective as of 1 January These rules set the requirements for the taxpayers and transactions who are obliged to have transfer pricing documentation and to information which should be comprised by full transfer pricing documentation. According to pending requirements, full transfer pricing documentation will be mandatory for companies with a turnover in excess of 1 million lat (LVL) having related party transactions amounting to LVL or more. The draft amendments state that within one month after receiving a request from the SRS a company must submit full transfer pricing documentation in Latvian containing certain information on the industry the taxpayer operates in; the overview on its operations, group and related-party transactions; functional analysis and description of what transfer pricing 563

3 Latvia methods are applied and what comparable data is used for substantiating that transfer prices are arm s length. Reporting related party transactions Latvian taxpayers are required to report transactions with related parties on a special form as an attachment to their annual CIT return. The addendum gives the identification or details of the related company, describes the nature of the transaction, states the amount of business conducted and specifies the method applied for the particular transaction. Legal cases Until recently Latvia had no established transfer pricing practice as the Latvian tax authorities are still experiencing a learning curve in this field. In the last few years there have been some court cases dealing with disputes between taxpayers and the SRS relating to transfer pricing issues. Due to the increasing number of transfer pricing investigations over past year, the number of cases brought before the court is expected to increase. Burden of proof The Tax and Duties Act places the burden of proof in tax matters, including transfer pricing, firmly on the taxpayer. A tax decision issued by the SRS has to state only the basis for adjusting tax payment and calculating penalties. The taxpayer then has to provide proof to challenge the decision. Tax audit procedures In Latvia, transfer pricing is audited as part of a regular tax audit, which generally may cover up to three previous tax years. Under the pending amendments in statutory requirements transfer pricing audits will cover up to five years. The SRS must give a taxpayer at least ten days written notice of a decision to conduct a tax audit. The notice must state the commencement date and duration of a tax audit, as well as taxes and duties and tax periods subject to the tax audit. a tax audit may not take longer than 90 days, unless the SRS director general sanctions an extension. The duration of a tax audit may be extended by 30 days if additional information is required and by 60 days if such additional information has to be requested from foreign tax authorities or foreign companies. Any period between the date an information request is made and the date it is received will be excluded from the extension. These temporal limitations do not apply to simultaneous tax audits in which the SRS liaises with the tax authorities of a foreign country in which the related party of a Latvian entity is registered as a taxpayer. Although simultaneous cross-border tax audits are not regular, the SRS during tax audits does use its right under effective double tax treaties to request information from corresponding countries tax authorities. Upon completion of a tax audit, the SRS must provide the taxpayer with an audit report that sets out the results of the audit. If any tax offence is identified, the SRS will prepare a decision about increasing the tax liability to include additional taxes and penalties. 564

4 Revised assessments and the appeals procedure If a tax audit has resulted in an additional liability, the taxpayer must pay it, together with any penalty, within 30 days of receiving a tax decision, or the taxpayer may challenge the decision by appealing to a) the Transaction Evaluation Commission within 10 days after receipt of tax decision or b) the superior official (i.e. the SRS director general) within 30 days after receipt of tax decision. If the taxpayer does not agree with a decision of the Transaction Evaluation Commission or the SRS director general, the decision may be taken to court. Additional tax and penalties Current tax penalties prescribe the following penalty levels: If the tax charge for the period under review has been understated by one of the following: Up to 15% of the tax charge, there is a possible penalty of 20% of the total tax liability that should have been reported. More than 15% of the tax charge, there is a possible penalty of 30% of the total tax liability that should have been reported. If the taxpayer admits the understatement of tax, is willing to collaborate with tax authorities and to pay the understated amount, the imposed penalty will be reduced by 50%. If a taxpayer who has already committed a repeat offence commits one or more similar offences within three years, there is a penalty of 100% of the tax that should have been reported for each of these subsequent offences. L To make taxpayers less willing to undertake last-minute corrections to their tax returns right before a tax audit, the law imposes a penalty of 5% of any understated tax liability on a taxpayer that submits an adjustment and pays the outstanding tax and interest only after receiving a notice of the start of a tax audit. The penalty must be paid to the tax authorities before the date the tax audit starts. The SRS director general may decide to reduce the penalty if the taxpayer admits an offence and pays the unreported tax and penalty of 50% of the total tax liability that should have been reported within 30 days of receiving the SRS decision on the tax audit results. Resources available to the tax authorities The SRS has established a separate central team specialising in transfer pricing issues. If regional tax auditors face a difficult transfer pricing issue or if their decision is appealed, then they may seek assistance from the central transfer pricing team. Use and availability of comparable information The SRS has acquired the Van Dijk Bureau database Analyse Major Databases from European Sources (AMADEUS) to be able to perform independent benchmarking. The Taxes and Duties Act also provides that if the price of a transaction is not at arm s length, then the tax authorities may determine during a tax audit the market price of the transaction, relying on the following methods and information sources: Internal comparables of the taxpayer. Prices and values that independent companies have applied in similar transactions

5 Latvia Calculating the costs of the transaction and adding a mark-up calculated in line with the industry average financial results derived from either the Latvian Central Statistical Office database or the tax authorities own databases, but if such information is not available, the relevant average profitability indicators from the information base established by the SRS. Using the average price of similar goods as provided by the Central Statistical Office. Engaging an independent valuation expert. Risk transactions or industries In the absence of developed transfer pricing auditing practices, there is no particular industry or transaction having any larger transfer pricing risk than others, qualifying for exemption, or governed by stricter rules than others. However, transactions involving a related provider of services, especially management services, or intellectual property are more likely to be scrutinised. These transactions typically are challenged on the grounds that the underlying contracts or other supporting documents are inadequately formalised or the tax auditors require proof of services being received and of benefit to the taxpayer. It is frequently forgotten that in transactions with any entity located in a low-tax jurisdiction, transfer pricing rules should be applied. Recent cases show that tax authorities tend to challenge the transfer pricing adjustments of taxpayers even if the transfer pricing documentation is in place. Limitation of double taxation and competent authority proceedings Almost all double tax agreements contain a clause relating to competent authority proceedings, (i.e. mutual agreement procedures). However, there is no information about the SRS involvement with competent authority proceedings because no such information is published. As of 1 January 2011, Section 12 of the CIT Act explicitly allows the transfer pricing corresponding adjustment. If the person or company related to the Latvian company has made a transfer pricing adjustment, the Latvian company may reduce its taxable income by the same amount. However, the corresponding adjustment is restricted to transactions with a company resident in Latvia, another EU member country or an EEA country that has an effective double tax agreement with Latvia. Advance pricing agreements (APAs) There are no provisions enabling taxpayers to enter into APAs with the SRS. However, the tax law amendments were adopted and provisions on APAs will be effective as of 1 January The Administrative Proceedings Act entitles a person to seek an advance ruling regarding the exercise of his rights in specific legal circumstances, including the application of transfer pricing law. 566

6 in practice, however, this procedure is more likely to be used to substantiate the application of a particular transfer pricing method or provision of law rather than to negotiate advance approval for a specific transfer pricing situation. An advance ruling is not binding on the requesting party, but it is binding on the issuing government agency, which may not change its position to one that is less favourable for a taxpayer, even if the legal opinion contained in the ruling is subsequently shown to have been incorrect. Anticipated developments in law and practice The amendments in the Taxes and Duties Act introduce APA and govern transfer pricing documentation requirements. Both developments are adopted and will become effective in Liaison with customs authorities The State Revenue Service is the main body for tax administration and customs authority. Thus, there are no obstacles to cooperation and information exchange between tax authorities and customs authorities. OECD issues Latvia is not yet an OECD member but has committed to join the OECD in the foreseeable future. Given that the arm s-length principle and Latvian transfer pricing rules are borrowed from the OECD Guidelines, the SRS has expressed its willingness to adopt the principles set out in the guidelines. As a result, the CIT rule that came into force on 1 July 2006 contains a paragraph stating that the OECD Guidelines may be used in selecting and applying methods for determining the arm s-length price or value. L Joint investigations The SRS practices information exchange with foreign tax authorities in line with Latvia s double tax agreements. However, there is no publicly available information about the results of joint investigations that took place as a result of information exchange. Thin capitalisation Latvian thin capitalisation rules are contained in the CIT Act to prevent companies from being highly leveraged and distributing profits through interest payments to shareholders and third parties. A taxpayer must comply with the following restrictions on interest deductions: Taxable income should be adjusted for interest payments exceeding the amount of interest calculated by applying to the interest bearing liability 1.2 times the average short-term interest rate of credit institutions as determined by the Central Statistical Office for the last month of the tax year. Taxable income should be adjusted for the amount of interest in proportion to the excess of the average interest bearing liability over an amount equal to four times shareholders equity at the beginning of the tax year, less any revaluation reserve. If the shareholder s equity is negative, for calculation purposes it is assumed to be zero

7 Latvia If taxable income must be adjusted under both criteria, the larger of the two adjusted amounts would apply. These rules are neither applied to credit institutions and insurance companies, nor to payments of interest on loans acquired from EEA credit institutions, the State Treasury, the World Bank group, the Nordic Investment Bank, the European Reconstruction and Development Bank, the European Investment Bank, the Council of Europe Development Bank, and residents of countries with which Latvia has double tax agreements. The second restriction is also not applied to interest paid to a financial institution provided that it is a resident of EEA or of a country with which Latvia has a double tax agreement and provides crediting or finance lease services that are supervised by the respective states credit and financial institutions controlling body. Management services When auditing intragroup services, tax auditors will analyse two key questions, namely (1) whether an intragroup service has in fact been provided and, if so, (2) what charge for that service is consistent with the arm s-length principle. To prove the existence of a management services transaction, a contract and/or an invoice might be insufficient. The taxpayer also should prepare a memorandum of delivery and acceptance explaining the nature and amount of service and confirming that the services have been acquired and approved by both parties. Also, it is useful to retain other documents, such as meeting notes or reports prepared during or as a result of consultation. 568