Specific hallmarks concerning transfer pricing in DAC6 regulation: practical experience (Part 1)

The DAC6 legislation introducing the obligation to notify tax arrangements has received limited publicity in Hungary. This is partly due to the fact that the European Commission postponed the actual reporting obligation until the beginning of 2021 in view of the pandemic COVID-19 emergency. It is also due to the fact that businesses typically perceive the regulation as an obligation for tax advisors and lawyers, although this is not necessarily the case.

In this series of articles, we will focus on the narrow segment of the regulation that applies to certain cross-border transactions between associated enterprises (hallmarks Category E) and demonstrate how companies themselves may become subject to reporting obligation in relation to these types of transactions. We will share the unique - and exceptionally valuable for Hungarian businesses - experience gathered in our international network, Nexia, and present the practical issues involved.

Due to the hands-on nature of our article series, the legal background is described only to the extent necessary.

First of all, in Hungary, the DAC6 rules are contained in Chapter V/F ("Reporting and automatic exchange of information on cross-border arrangements subject to reporting obligations") of Hungarian Act XXXVII of 2013 on Certain Rules of International Administrative Cooperation in Relation to Taxes and Other Public Charges (hereinafter: the "Act"). The scope of the regulation does not cover VAT, excise duties, customs duties, or social security contributions, so that the benefits obtained in these tax categories are outside the scope of the reporting obligation. Furthermore, due to the definition of a related company in the Act, under Hungarian rules the DAC6 rules do not apply to transactions between a company and its foreign permanent establishment or branch office, nor to transactions between establishments.

The hallmarks of the reportable arrangements are set out in Annex 4 of the Act. There are five categories of hallmarks (A. "Generic hallmarks linked to the main benefit test", B. "Specific hallmarks linked to the main benefit test", C. "Specific hallmarks related to cross-border transactions", D. "Specific hallmarks concerning automatic exchange of information and beneficial ownership", E. "Specific hallmarks concerning transfer pricing"), but all hallmarks can also be divided into two broad categories:

• the hallmarks that need to be tested only if the arrangement fulfils the so-called 'Main Benefit Test' (all hallmarks of Categories A and B and the specific hallmarks of category C1), and
• the hallmarks which are not subject to the Main Benefit Test (other characteristics in Category C and all characteristics in Categories D and E). 

(The Main Benefit Test is satisfied if it can be established that the main benefit or one of the main benefits which, having regard to all relevant facts and circumstances, a person may reasonably expect to derive from an arrangement is the obtaining of a tax advantage).

Based on the above, we could therefore conclude that Category E transfer pricing hallmarks are considered to be particularly aggressive tax planning arrangements, because they create disclosure obligations without any prior examination; an average Hungarian company is unlikely to encounter such arrangements. In the following, we will attempt to refute this assumption by analysing all three hallmarks in Category E and by illustrating the regulatory uncertainties that arise in relation to them.  

But before moving on to the analysis of the specific hallmarks, it is important to note that, unlike in several other EU Member States, the severity of sanctions for non-compliance in Hungary is within the "normal" tolerance of Hungarian legal entity taxpayers, i.e. a default penalty of up to HUF 500,000 (appr. EUR 1,370; the positive/negative status of the taxpayer is not taken into account when imposing the penalty, but the penalty may be waived if the taxpayer can prove it acted as it could normally be expected in the given situation). The default penalty may be aggravated up to HUF 5 million (appr. EUR 13,670) only in the case the failure has been committed intentionally or recklessly. In several EU Member States, the penalties for non-compliance or incomplete compliance with the DAC6 reporting obligation are significantly higher than even this maximum Hungarian penalty. Among the record holders are, for example, Poland and the Netherlands with fines of almost PLN 35 million (about EUR 7.4 million) and EUR 870,000 respectively.

Hallmark E1: An arrangement which involves the use of unilateral safe harbour rules

Neither the Act, nor its underlying Directive (Council Directive (EU) 2018/822 of 25 May 2018 amending Directive 2011/16/EU as regards mandatory automatic exchange of information in the field of taxation in relation to reportable cross-border arrangements) defines the concept of unilateral exemption rules, therefore, the definitions laid down in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the "OECD Guidelines"[1]) apply.

Under the OECD Guidelines, a safe harbour generally refers to relieving defined categories of taxpayers or transactions from certain obligations otherwise imposed by a country’s general transfer pricing rules (pricing, administrative etc.)[2]. Specifically, however, the OECD Guidelines explicitly exclude from the scope of the safe harbours covered by the Guidelines any simplifications of a purely administrative nature that do not directly involve determination of arm’s length prices (including simplified, or exemption from, documentation requirements in the absence of a pricing determination), simplifications that are part of an advanced pricing agreements and the “thin capitalisation” rules[3]. Thus, the unilateral safe harbours dealt with in the OECD Guidelines cannot include purely administrative simplifications that do not directly affect pricing. In Hungary, such administrative simplifications which do not directly involve determination of arm’s length prices include the exemption for small and medium-sized enterprises (subject to certain conditions), the exemption for group corporate taxpayers, the exemption for transactions with a net annual turnover of less than HUF 50 million etc.

This being premised, only the unilateral safe harbours directly involving determination of arm’s length prices should be examined for the purposes of Hallmark E1.

In different countries, the following unilateral safe harbours can be found:

• Manufacturing: application of cost-plus method with a defined mark-up (Mexico); specific profitability margin or ratio between applied intra-group price and market price (Brazil);
• Service rendering: application of Services Cost Method (USA), a mark-up for contract R&D and software development (India);
• Financial transactions: application of certain interest rates for intra-group loans accepted by tax authorities without further evidence or benchmarking (Switzerland, Poland, Luxembourg, France, USA, India).

Therefore, intra-group transactions, that may be subject to the above unilateral safe harbours, may well occur in the ordinary course of business and cannot be regarded as extraordinary. For example, an average company may enter into an intra-group transaction subject to Hallmark E1 when receiving a loan from its Swiss parent company.

The DAC6 legislation does not impose any additional conditions for the notification under Category E, therefore, the arrangement should be reported even if taxpayers involved did not (could not) intend to benefit from the tax advantage resulting from the unilateral safe harbour. Further, given that there is no value limit in Hallmark E1, any transaction, even of negligible value, may be subject to the reporting obligation.

It is worth noting that safe harbours recognised in bilateral or multilateral agreements cannot be considered "unilateral" (such as safe harbours recognised by the OECD or the EU Joint Transfer Pricing Forum[4]), and therefore intra-group transactions falling under their scope do not give rise to reporting obligations under the DAC6 regulation. From this point of view, the exemption rule for low value-added intra-group services, which is also known in Hungarian legislation, cannot be considered unilateral, because it is in line with the rules issued by the EU Joint Transfer Pricing Forum both in terms of the services and the mark-up applied (the range of 3-7% provided for by the Hungarian rules falls within the range of 3-10% under the EU rules).

Finally, we note that if an arrangement would still be subject to a unilateral safe harbour, but the parties to the transaction do not apply it, i.e. they determine the arm's length price according to the general rules, the reporting obligation should not apply.