Transfer prices are the prices or considerations for transactions between related or affiliated parties.
These prices must be in accordance with the principle of full competition, a fundamental principle governing transfer prices, which consists of these prices agreed between related parties being at market value, i.e., as if they had been agreed between independent parties.
In order to determine whether prices are in accordance with this principle, a certain transfer pricing methodology is available for analysis.
In Ecuador the transfer pricing regime is regulated by the Organic Law of the Internal Tax Regime (LORTI) and its regulations, as well as by various resolutions issued by the Internal Revenue Service.
Specifically, the transfer pricing methodology is regulated by Article 85 of the LORTI Regulations.
The purpose of this article is to disclose the main aspects regarding transfer pricing methodology in Ecuador, as well as the effects on Income Tax of not determining these prices in accordance with the principle of full competition.
Transfer Pricing Methods in Ecuador
According to Article 85 of the LORTI Regulations, in Ecuador taxpayers subject to transfer pricing may apply one of the six methods established in the LORTI regulations, which are consistent with the guidelines established by the Organization for Economic Cooperation and Development (OECD).
These methods are as follows:
Uncontrolled Comparable Price Method
In order to determine the price of a good or service carried out between associated companies under the application of this method, this price must be compared with that of comparable transactions carried out with independent third parties.
Likewise, the following should be taken into consideration in the case of import and export transactions to related parties:
- Import and Export: In the case of these operations in which an international price can be established that is public and notorious in transparent markets, stock exchanges or other similar ones, said prices must be taken, unless there is proof to the contrary.
- Import and Export through an Intermediary: In case these operations are related to an agricultural primary product, non-renewable natural resources and in general, goods with a known price in transparent markets, in which there is an international intermediary that is not the effective recipient of the goods, the price of the good in the transparent market of the day of loading of the goods must be taken.
Resale Price Method
For this methodology, in order to determine the price of transactions between related parties, the resale price of the good, service or other, to independent parties, should be multiplied by the result of decreasing, by the unit, the percentage of gross profit that would have been obtained between independent parties in comparable operations.
Added Cost Method
This method determines the consideration for a good or service between related parties by multiplying the cost of the good or service to independent parties by the result that results in adding, to the unit, a percentage of the gross profit that was obtained between independent parties in comparable transactions.
This method is normally used when the party under analysis is a production company.
Profit Distribution Method
Under the application of this method the determination of the price will be given by means of the distribution of the Global Operating Profit obtained in the transactions between related parties, which will be in the same proportion in which it would have been distributed between independent parties, in comparable operations.
For this purpose, it should be taken into consideration that the overall operating profit between related parties should be determined by the sum of the operating profit obtained by each one of them and such profit generated should be distributed among each one of the related parties, taking into consideration issues such as assets, costs and expenses.
Residual Profit Distribution Method
As in the previous method, the price is determined by the Global Operating Profit, however the following should be observed:
The Global Operating Profit of the transactions with related parties will have to be determined by means of the sum of the operating profit obtained by each one of them and with this profit obtained both the Basic Profit and the Residual Profit will be determined and distributed.
Transactional Margin Method of Operating Income
Through this method, the price is set by determining, in transactions with related parties, the operating profit that would have been obtained independently in comparable transactions. Taking into account profitability factors that take into consideration variables such as assets, sales or costs.
Preference of Transfer Pricing Methods in Ecuador
In order to establish the most appropriate valuation method, the taxpayer should, in principle, use the comparable uncontrolled price method and should continue with the resale price method and the added cost method, for which it should take into consideration the one that is most compatible with the business and the structure.
When one of these methods cannot be adequately applied, the last three may be used.