This article will provide you with a high-level methodology for the different methods and types of transfer pricing.
You will not become a tax expert, but next time you will be asked the question “what is your transfer pricing method”, you probably won’t respond “Cost +”…
Multinational companies, MNE, used to allocate profits (earnings before interest and taxes - EBIT) among its various subsidiaries, generally in “tax friendly” countries to benefit from double non-taxation.
However, since the financial crisis in 2008, the G20 countries put tax, specially tax avoidance, on the top of their agenda. In 2012 a plan against Base Erosion and Profit Shifting was elaborated. BEPS was just born.
The Article 9 of the OECD Model Tax Convention on Transfer Pricing regulations require transfer prices within a controlled group to meet the arm’s length principle. In other words, transactions between related parties must take place under market conditions.
The arm's length principle provides broad parity of tax treatment for members of MNE groups and independent enterprises as it avoids the creation of tax advantages or disadvantages that would otherwise distort the relative competitive positions of either type of entity.
There are five different transfer pricing methods in two categories:
and for highly specialized goods, services and intangibles,
Regardless of the method, master and local files as well as international comparable transactions are required.
The traditional transaction methods, commonly and wrongly called “Cost +”, are used for a wide range of operations such as purchase ans sale of commodities (goods), lending money and services. Generally the transactions are straight forward and the margins involved are rather small.
Transactional profit methods require a profound analysis of routine and non-routine transactions and the elements of the value chain of the companies involved. It details risks occurred by participant companies and the margins at play are potentially higher.
If the latter is more complex, it has a significant benefit for the companies which implement it; tax transparency across several jurisdictions.
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You can continue reading the chapters below to gain a comprehensive and high-level understanding of transfer pricing.
1. Overview of transactions
It describes the origin and type of transactions as well as the companies involved and their relationship.
Every transaction or service is analysed separately.
2. OECD Transfer Pricing Guidelines & the Arm’s Length Principle
The OECD Guidelines provide details about;
Economic and Comparability analysis (Chapters I and III);
The selection of the most appropriate transfer pricing method and the application of the transactional methods (Chapter II)
The Comparability Analysis
The Paragraph 3.4 of the OECD Model Tax Convention on Transfer Pricing regulations describes a nine-step method of a typical process when performing a comparability analysis:
Determination of years to be covered.
Broad-based analysis of the taxpayer’s circumstances.
Understanding the controlled transaction(s) under examination, based in particular on a functional analysis, in order to choose the tested party (where needed), the most appropriate transfer pricing method to the circumstances of the case, the financial indicator that will be tested (in the case of a transactional profit method), and to identify the significant comparability factors that should be taken into account.
Review of existing internal comparables, if any.
Determination of available sources of information on external comparables where such external comparables are needed taking into account their relative reliability.
Selection of the most appropriate transfer pricing method and, depending on the method, determination of the relevant financial indicator (e.g. determination of the relevant net profit indicator in case of a transactional net margin method).
Identification of potential comparables: determining the key characteristics to be met by any uncontrolled transaction in order to be regarded as potentially comparable, based on the relevant factors identified in Step 3 and in accordance with the comparability factors set forth at Section D.1 of Chapter I.
Determination of and making comparability adjustments where appropriate.
Interpretation and use of data collected, determination of the arm’s length remuneration.
3. Functional and risk analysis
Provides the commercial and financial context about the related parties involved in the intercompany transaction.
It provides information about the industry sector and the factors affecting the performance of any business operating in that sector.
It includes business strategies, markets, products, supply chain, key functions, material assets (Intellectual property), risks (financial, market, R&D, credit) assumed and also very important, but often neglected, geographical location.
4. Transfer pricing analysis
Paragraph 2.2 of the OECD Guidelines states that the selection of a transfer pricing method always aims at finding the most appropriate method for a particular case. For this purpose, the selection process should consider:
of the respective strengths and weaknesses of the OECD recognised methods;
the appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis;
the availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method and/or other methods;
and the degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them.
No one method is suitable in every possible situation, nor is it necessary to prove that a particular method is not suitable under the circumstances.
There are two types of methods:
Traditional transaction methods
Comparable Uncontrolled Price method (CUP method)
The resale price minus method (RPM method)
The cost plus method (CPM)
Transactional profit methods
Transactional net margin method (TNM method)
Transactional profit split method (PSM method)
5. When to apply traditional transaction methods?
Subject to the guidance in paragraph 2.2 of the OECD Guidelines for selecting the most appropriate transfer pricing method in the circumstances of a particular case, generally it is assumed that:
The transfer of commodities
Used for physical products for which a quoted price is used as a reference by the industry in uncontrolled transactions.
Marketing and Distribution, brokerage and agent operations.
It is assumed that the reseller has special expertise in the marketing of such goods, in effect bears special risks, or contributes substantially to the creation or maintenance of intangible property associated with the product and carries substantial commercial activity.
It is important to note that where the accounting rules differ from the controlled transaction to the uncontrolled transaction, appropriate adjustments should be made (example: costs of R&D).
Mass-market manufactured products
To summarize the CPM is a simplified version of the CUP method. The expression “Cost +” is widely used however it is not as simple as this method presents difficulties in proper application, particularly in the determination of costs. In competitive markets which scale down sales prices, companies have to be cautious on the costs incurred versus market prices.
In addition, accounting rules may impact the method as well.
6. When to apply Transactional profit methods?
While in some cases the selection of a method may not be straightforward and more than one method may be initially considered, generally it will be possible to select one method that is apt to provide the best estimation of an arm’s length price.
However, for difficult cases, where no one approach is conclusive, a flexible approach would allow the evidence of various methods to be used in conjunction. In such cases, an attempt should be made to reach a conclusion consistent with the arm’s length principle that is satisfactory from a practical viewpoint to all the parties involved, considering the facts and circumstances of the case, the mix of evidence available, and the relative reliability of the various methods under consideration.
It can be weighted to sales;
used to determine the price of purchases from an associated enterprise for resale to independent customers.
It can be weighted to costs;
used in cases where costs are a relevant indicator of the value of the functions performed, assets used and risks assumed by the tested party.
It can be weighted to assets;
used in certain manufacturing or other asset- intensive activities and in capital-intensive financial activities.
This method was revised by Action 10 of the action plan against Base Erosion and Profit Shifting (BEPS) in June 2018.
PSM may be considered the most appropriate transfer pricing method in a specific set of circumstances only:
The existence of a unique and valuable contribution
not comparable to those made by uncontrolled parties,
key source of actual and future economic benefits,
significant risks relating to unique and valuable intangibles assumed by involved parties.
A high level of integration of business transactions
a high degree of integration in business is required,
proven and visible inter-dependency of complementary activities if not comparable to uncontrolled arrangements,
parties jointly use assets, assume risks and perform functions.
The shared assumptions of economically significant risks or separate assumption of economically closely related risks by the parties to the transaction.
Besides the constraints already mentioned in the previous paragraph it is also important to indicate when it may not be appropriate to use the PSM:
Where one of the parties to the transaction performs only simple functions and does not make unique and valuable contributions; and/or
The accurately delineated transaction can be appropriately benchmarked (even when the accurately delineated transaction is quite complex), comparable transactions and functions can be identified;
Despite it’s complexity, the PSM is being largely adopted because it enhances tax transparency specially for companies subject to Country-by-country reporting (CbCR) as the tax authorities have a complete view of the routine and non-routine thanks to the analysis of the value chain.
As the profits are jointly shared, it is likely to satisfy the tax administrations of the parties involved.
OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations
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