Technical and Legal Analysis, regarding the interpretation of the Technical Sheet for the Standardization of Transfer Pricing Analysis, approved by the Internal Revenue Service (SRI) on April 5, 2024

Quito, August 15, 2024

Transfer pricing regulations have been in force in Ecuador since 2005 and are governed by the Internal Tax Regime Law (LRTI), the Regulations for the Implementation of the Internal Tax Regime Law, and Resolutions issued by the SRI.

On the other hand, since May 29, 2015, the IRS has approved a Technical Sheet regarding the application of Transfer Pricing methods and how adjustments should be made.

In general, neither Ecuadorian nor any other country’s tax regulations can force a company to sell at a certain price. However, they can state that, regardless of the price agreed upon by the parties, for Income Tax purposes in Ecuador, taxes must be paid based on the transfer pricing method. In simple terms, if a company in Ecuador exported to its affiliate at a price of $100 and, upon applying the transfer pricing methodology, it is established that the price that complies with Transfer Pricing regulations (at which the transaction should have been recorded) is $110, the company will have to pay taxes in Ecuador on $110 or, in other words, make a transfer pricing adjustment of $10. The so-called transfer pricing adjustment is explained, which must be declared in box 811 of the Corporate Income Tax Return.

On the other hand, the Transactional Operating Profit Method is one of the most widely used methods in all countries for analyzing transactions subject to Transfer Pricing. This method compares the profitability of the analyzed company with that of other comparable companies.

Currently in Ecuador, the aforementioned Technical Data Sheet is being interpreted as follows: if the company’s ratio is below the interquartile range of comparable companies, an adjustment is made to all of the company’s revenues , without the possibility of segmenting operations, in order to adjust only the operation carried out with affiliates. The following example is clear:

Let’s imagine a company in Ecuador with total revenues of US$100 million and exports only US$100,000 to its affiliated company abroad. If its overall operating margin is -2%, and the comparable company’s margin ranges from 2% to 8%, with a median of 5%, the Technical Data Sheet is being interpreted to mean that the company must add 7% (-2% to 5%, which is the median = 7%), or, in other words, add 7% to its Income Tax return, which equals US$7 million. However, it’s worth asking: if the transaction with the affiliated company was only US$100,000, is it reasonable to make a US$7 million adjustment considering its total revenue, which is mostly composed of transactions with independent parties, conducted at market value?

Article 122 of the Tax Code establishes that an Improper Payment is considered to be one made for a tax not legally established or for which there is a legally mandated exemption; one made without the respective tax obligation having arisen in accordance with the circumstances that constitute the generating event; as well as one that has been paid or demanded illegally or outside of the legal framework .

For its part, Article 123 of the Tax Code establishes that an Excess Payment will be considered as one that results in excess of the value that should have been paid when applying the rate provided for in the law on the respective tax base .

If the spirit of the Transfer Pricing regulations is that taxpayers, in their transactions with related parties, declare and pay taxes under the same parameters as the taxation carried out in operations carried out with independent parties, an erroneous interpretation of the provisions of the Technical Sheet could lead to the situation that the adjustment to be made in operations with related parties is also intended to be transferred to operations carried out at market value, with independent parties, which would cause the causes for the configuration of Improper Payment or Excess Payment to be incurred.

We believe that the interpretation of the aforementioned Technical Sheet raises technical and legal issues under Ecuadorian law, so it is necessary to analyze each case to determine whether this interpretation is correct. If your company is going to make a Transfer Pricing adjustment, it is important to take the above into account and analyze whether the adjustment is actually necessary.

Sincerely,

Enrique Díaz Tong,
General Manager, TP Consulting Ecuador,
Founding Partner, TP Consulting