Tax Incentives for Foreign Investors in Ecuador: Transfer Pricing Prior Valuation Process

One of the main concerns worldwide regarding private investing and funding is the tax treatment that each country will apply on the moneys transferred abroad and their returns, especially when an operation is conducted throughout multiple related parties, among several jurisdictions. When it comes to the functions, assets and risks that each related party supports and through which each of them aggregates value to a multi-side operation, the arm’s length principle becomes a milestone for the allocation of costs and benefits. The tax administrations will look into it to verify that any contributor subject to its jurisdiction will not erode its tax base or shift its benefits through transfer pricing.

When a tax authority considers that a taxpayer is avoiding its tax obligations through Base Erosion Profit Shifting (BEPS), it might assess the transaction to establish the correct taxable amount and charge it to the taxpayer along with fines, interest and other surcharges as provided by law. This may lead to a never-ending cycle of administrative and judicial processes; with the discomfort it drags along. In Ecuador, certain transactions and operations may be assessed by the tax administration prior, to avoid that burden. This process is called a Prior Valuation Consultation and works similarly to an Advance Pricing Agreement (APA).

The Prior Valuation Process consists of a consultation filed by a taxpayer in order to obtain a revision and approval of the transfer pricing methodology and the results of such application, that it intends to use in a specific transaction with related parties. The purpose of this procedure is to avoid future audits, adjustments and litigations due to discrepancies in the method, benchmarks and other transfer pricing issues in cross-border transactions. It is not properly an agreement (as provided for in other legislation), as it is issued within the tax authority’s legal capacity to solve taxpayers’ consultations, with a binding effect for the tax administration, which may, nonetheless, be revoked as per the legal procedure. As such, provided that there are no significant changes of the economic conditions described in the petition for consultation, the approved method and benchmark (and the results of applying the same) may not be challenged later on by the tax authority through audit procedures or in any other manner.

If the consultation is denied or the method is modified by the tax authority through a resolution, the taxpayer may choose to apply the method it deems appropriate which may then be assessed by the tax administration through its normal control procedures. After a deep examination of the petition, the transfer pricing method and benchmarks will be approved as per the transactions and other conditions described in the petition by the taxpayer. The resolution approving the transaction taxation rules will be effective from the date on which it is approved and will be valid for the following three fiscal periods, as well as for transactions carried out in the previous period (ie, the one in which the process was commenced).

The tax administration has a limit of two years for the issuance of the resolution, failing which it must be understood that the petition was denied. This leaves the taxpayer in the same position as if it/they had not filed the Prior Valuation petition whatsoever.

The tax administration has the option, though not the obligation, to agree to the valuation, method and/or adjustments with other tax administrations that may be competent regarding the specific transaction through a friendly, formal procedure. This means that any adjustments made in Ecuador as per the Prior Valuation Procedure may affect the tax base in other jurisdictions without the possibility of the tax administrations reaching a consensus on their respective positions and tax collection. Evidently, this could lead to double taxation in certain cases.

Once the resolution of Prior Valuation is formally issued, the taxpayer must, in addition to its/their standard duties and obligations, file a report on the following:

-Transactions carried out during the tax period to which the methodology has been applied;
-Prices, amounts of payments or profit margins of these operations, calculated, if applicable, as a consequence of the application of the selected transfer pricing method;
-Description of the behaviour of the circumstances referred to by the critical assumptions established in the methodology and the justification of the fulfilment of each of the critical assumptions;
-Description of the application of the methodology to the results of the exercise, attaching the working papers, where the calculations corresponding to the indicator (or price) of the taxpayer, the indicators (or prices) of the comparable transactions, comparability adjustments, interquartile range, among others, depending on the methodology used, should be evidenced;
-And description and justification of any particular fact or circumstance of the fiscal year analysed, which has affected the valuation of the prices or financial margins of the analysed party, provided that the critical assumptions were not affected.

The tax administration is allowed to verify that the transactions covered by the Prior Valuation Procedure are being taxed according to the resolution. However, as mentioned earlier, it may not challenge the approved transfer pricing method and benchmarks as such, providing legal and economic certainty to the transactions covered through this procedure.

For broader detail on Ecuadorian tax incentives for foreign investment, visit the firm’s video at Chambers Expert Focus.