Transfer pricing

Transfer pricing: Determining and documenting arm's length prices for intercompany

transactions

Introduction

Transfer pricing refers to the prices at which an integrated multinational enterprise transfers

physical goods and intangible property or provides services to associated enterprises of the

same multinational enterprise. Because multinational enterprises operate as unified

business operations, transfer prices can be manipulated to shift profits between national tax

jurisdictions in order to reduce the overall tax burden of the multinational group. To prevent

profit shifting through manipulation of intra-group transfer prices, it is important that transfer

prices of associated enterprises be set according to the arm's length principle.

This paper will discuss transfer pricing in the context of international tax rules and how

transfer prices for intercompany transactions should be determined and documented

according to the arm's length principle. First, we will explain the concept of transfer pricing

and why it is important from a tax perspective. Then we will examine the arm's length

principle and how arm's length prices are determined in practice using acceptable transfer

pricing methods. Finally, we will discuss documentation requirements and the information

that needs to be maintained to support a company's transfer pricing policy.

Transfer Pricing Basics

Transfer pricing refers to the price charged for goods, services or intangible property that are

transferred between associated enterprises within a multinational enterprise group.

Associated enterprises are separate legal entities, such as subsidiaries, branches, divisions

and associated companies that are owned by or have control through significant common

ownership or otherwise of any business carried on by them.

Since associated enterprises have common ownership or control, their commercial and

financial relations can differ from relations between independent enterprises. Transfer prices

set between associated enterprises do not necessarily correspond to prices that would have

been agreed upon between independent companies operating at arm's length. This means

multinational enterprises have flexibility to manipulate transfer prices in order to reduce their

overall taxable income reported in higher-tax jurisdictions and shift profits to lower-tax

jurisdictions.

For example, a US parent company may overcharge its manufacturing subsidiary in a low-

tax country for components or undercharge the subsidiary for services provided in order to

shift taxable income out of the US. Likewise, the same subsidiary may undercharge its sales

affiliates in Europe and Canada for finished goods in order to shift income into the low-tax

manufacturing country. These types of transfer pricing strategies essentially involve the

allocation of a multinational enterprise's profits across tax jurisdictions where the affiliated

companies are located.

To prevent multinational enterprises from exploiting transfer pricing for tax avoidance

purposes, most countries have enacted transfer pricing rules based on the arm's length

principle. The arm's length principle endorsed by the OECD and applicable under most tax

treaties mandates that transfer prices between associated enterprises should be the same

as if the transactions were between uncontrolled parties operating at arm's length. Put

simply, transfer prices between associated enterprises must meet the standard of an

independent enterprise dealing at arm's length with another independent enterprise. The

arm's length principle aims to allocate multinational group profits based on where economic

activities take place and value is created rather than tax planning considerations.

Determining Arm's Length Prices

With the arm's length principle as the international standard, the next question is how to

actually determine or test transfer prices to ensure they meet the requirement of being arm's

length. Acceptable transfer pricing methods that can be used to approximate arm's length

pricing include:

1. Comparable Uncontrolled Price (CUP) Method

The CUP method is considered the most direct transfer pricing method since it involves an

actual arm's length price that is paid for property or services identical or very similar to those

involved in the controlled transaction, taking into account differences in contractual terms

and economic circumstances that could materially affect price. Simply put, if an uncontrolled

transaction involving the same or very similar assets exists, it provides the best evidence of

an arm's length price for tax and transfer pricing purposes.

However, finding a true comparable external transaction is very rare in practice given how

uniquely integrated MNE groups are. Factors including volume discounts, contractual terms,

market conditions and product characteristics often differ between internal and external

transactions limiting the feasibility of this method. Nonetheless, it provides a useful

benchmark when an identical or highly comparable uncontrolled transaction exists.

2. Resale Price Method

The resale price method is typically used for distribution and sales activities where an

associated enterprise buys goods from another associated enterprise and then resells them

at arm's length to uncontrolled parties. Backing out from the uncontrolled resale price to

determine the appropriate transfer price paid to the supplier accounts for the reseller's

functions, assets and risks.

The method involves calculation of a gross margin percentage earned by resellers on

comparable uncontrolled transactions. This gross margin percentage is subtracted from the

applicable resale price of the property to derive an arm's length price that the reseller should

pay to the initial seller. Adjustments can be made to account for material differences in

functions or circumstances.

3. Cost Plus Method

Similar to the resale price method, the cost plus method is applicable to transactions where

one associated enterprise provides services or components to another associated

enterprise. The method involves computation of an arm's length price by adding an

appropriate gross profit mark-up to the relevant costs incurred by the provider resulting in a

cost-plus pricing transaction.

The gross profit mark-up is determined by analyzing mark-ups earned by independent

companies performing comparable uncontrolled services or producing comparable goods

that are incorporated into other products. Factors like cost structures, economies of scale,

experience and risk allocation are considered when making any adjustments to determined

mark-ups.

4. Transactional Net Margin Method (TNMM)

TNMM is applicable to less complex transactions and typically used for services or

manufacturing activities. Rather than focusing on one side of a controlled transaction like

resale price and cost plus, TNMM establishes transfer prices by comparing net profit

indicators like operating margins achieved by uncontrolled taxpayers on comparable

uncontrolled transactions to net profit indicators realized by companies of the tested party to

the controlled transactions under review.

TNMM looks at net profit as a percentage of an appropriate base like costs, sales or assets

to compare controlled and uncontrolled transactions after accounting for differences affecting

price or margin. To apply TNMM, evaluation is required to determine reliability of data,

selection of appropriate net profit indicator, financial ratios of comparable uncontrolled

transactions, and functional analysis for comparability adjustments if warranted.

5. Profit Split Method

The profit split method is more commonly applied to transactions involving unique and

valuable intangibles or situations where both parties make important contributions and it is

difficult to separately evaluate the contributions. The method splits profits between

associated enterprises from related transactions based on an analysis of the functions

performed, assets used and risks assumed.

Various profit split approaches include the contribution analysis approach, residual analysis

approach, and the comparable profit split approach. Contribution and residual analysis

require judgment regarding division of residual profits. Comparable profit splits use profit

splits from independent party arrangements involving similar transactions. Profit split

methods require extensive financial and functional analysis.

Selection and Application of Appropriate Method

While every transaction is unique, the most accurate transfer pricing method will produce an

arm’s length price closet to the price that would have been established in a comparable

uncontrolled transaction based on comparable factors and reliable adjustment. To determine

the best method, a comparability analysis is required that evaluates critically:

- Reliability and quality of available data for the tested party and potential external

comparable companies.

- Degree of actual comparability between controlled and uncontrolled transactions based on

characteristics of property/services transferred, functions performed, contractual terms, risks

assumed, economics of industry, geographic markets, market level conditions,

property/asset investment levels, expected future events.

- Appropriateness and reliability of adjustments applied to account for remaining differences

between controlled and uncontrolled comparables.

The selection of the most reliable method should also consider availability of reliable

financial/transaction data and which method can most reliably be applied based on the facts

and circumstances. Documentation should demonstrate why one method provides the best

measure based on available information. Methods may be combined to determine aggregate

arm's length result.

It is important to apply the method consistently year over year unless fact patterns change

significantly. Databases of financial benchmarks and ratios should be reviewed annually to

keep analysis current with evolving market conditions. Appropriate transfer pricing

documentation demonstrating selection and application of the chosen method is critical to

substantiate compliance with the arm's length principle.

Documentation Requirements

Compliance with the arm's length principle means multinational enterprises are required

under most national tax laws to maintain certain transfer pricing documentation to support

transactions between associated enterprises. Documentation serves as contemporaneous

evidence that a) transactions between associated enterprises meet the arm’s length

standard and b) transfer pricing outcomes are consistent with the functions performed,

assets used and risks assumed by related parties.

Tax authorities generally require documentation to be in place at the time tax returns are

filed. Contents of transfer pricing documentation may include:

- Overview of MNE group structure and description of business operations of parties to

material transactions.

- Details of material controlled transactions including transaction amounts, dates and parties,

activities undertaken, contractual terms.

- Analysis of comparability factors and functional analysis of parties to transactions.

- Identification and selection of most reliable tested party and transfer pricing method for

determining arm’s length prices.

- Economic analysis supporting selection and application of chosen method including:

- Description and financial data for selected independent enterprises.

- Rationale for any adjustments and availability of reliable financial data.

- Financial statements and group taxation schedules showing accounting records and

profit/loss positions allocated by jurisdiction.

- Benchmarks and ranges of financial metrics establishing reliability and accuracy of transfer

pricing methodology and outcomes.

- Record of annual benchmarking analysis and updates to methodology and application.

- Statements of compliance with arm's length requirements and reliability of analysis given

best available information.

- Record related-party transactions that meet exemption rules that do not require transfer

pricing documentation.

- Description of transfer pricing policies applied with rationale for any changes over time.

- Identifying information and business relationships to access individuals involved in

establishing/approving transfer prices.

Key documentation components include the contemporaneous nature, accuracy of data

relied on, and completeness allowing tax authorities to understand factors affecting pricing.

MNEs are required to retain documentation for the statutory limitation period in relevant tax

jurisdictions, usually between 5-10 years.

Contemporaneous documentation is integral to satisfying authorities transfer prices meet the

arm's length standard and can be relied upon to support declared tax positions. Well-

maintained, periodically reviewed transfer pricing documentation builds a stronger defense in

the event of a tax authority inquiry or challenge. Compliance improves over time as

documentation quality evolves based on examining prior experience.

Case Studies

Below are two case studies demonstrating application of transfer pricing methods and

documentation requirements to establish arm's length prices:

Case Study 1:

A Mexican subsidiary of a US pharmaceutical company manufactures a patented

prescription drug for sale globally. The subsidiary purchases finished drug molecules from

the US parent and completes the final packaging, labelling and distribution processes locally.

To determine appropriate arm's length prices between the parent and subsidiary:

- Management performs a comparability study of independent companies performing similar

transformation activities on comparable products and analyzes differences.

- Based on analysis, management selects the cost plus method supported by financial

benchmarks of comparables.

- Costs are identified and a gross profit mark-up for independent companies is applied to

determine transfer price.

- Pricing outcomes are reviewed against available CUP data from parent's licensing of drug

to third parties.

- Cost plus analysis documentation is prepared proving selection and application of the

method, comparables analysis, benchmarks relied on, and consistency with arm's length

results.

Case Study 2:

A UK subsidiary of a US software company provides IT services to support and maintain

customized enterprise resource planning (ERP) solutions to affiliated European entities.

To establish arm's length compensation:

- Management evaluates functions, risks, assets and comparability to independent contracts.

- TNMM is selected due to lack of public cost or price data for comparable transactions.

- Financial performance indicators of independent support service providers shape tested

party selection.

- Operating margins of independent comparables establish the arm's length remuneration

range.

- Documentation records selection of TNMM, comparables analysis, benchmarking and

ongoing monitoring processes aligning outcomes with market data over time.

Both case studies demonstrate thorough transfer pricing analysis and documentation in

compliance with arms' length standards and supporting intercompany charges fall within

reliable benchmark expectations. This mitigates tax authority compliance risk through rigor

and transparency.

Conclusion

In today's globally integrated business landscape, associated enterprises must substantiate

transfer prices meet the internationally recognized arm's length principle through application

of accepted methods that align outcomes with independent market transactions. Proper

selection and consistent application of the most reliable method requires quality

comparables analyses and credible benchmarks monitored periodically.

Thorough transfer pricing documentation serves to record the process and rationale

underlying treatment of intercompany dealings. Lack of documentation or weak application

risks potential transfer pricing adjustments and penalties. Engaging experts with business

experience ensures arm's length standards are understandably implemented in accordance

with complex international tax rules.

Overall, the arm's length principle aims for profits to follow economic activities and value

drivers, not tax circumstances alone. Compliance demands adherence through transfer

pricing analyses grounded in commercial and economic substance reasonably matched to

material transactions between affiliated parties. Establishing accurate transfer pricing

policies and sufficient documentation strengthens multinationals' positions and fosters

cooperation with tax authorities.