Office Information No.: 71 (EN)

The OECD’s
Transfer Pricing Methods

International Tax Law

 

February 2020

 

 

 

Dear Sir or Madam,

The following brochure provides a short summary of the different transfer pricing methods of the OECD.

We are aware of the fact that it can only be a first step to describe the complex subject of a very crucial part of international tax law. However, we hope that this information can be useful for your further decisions.

Lorenz & Partners Co., Ltd. is an international firm of business lawyers and consultants headquartered in Bangkok since 1995 and specializing in legal, tax and business consultation of foreign companies with respect to their investments in Southeast Asia.

Please allow us to inform you that despite all our efforts, we cannot accept liability for this brochure and its contents and we reserve all rights derived from it. However, copies of this brochure with reference to its author are welcome.

Lorenz & Partners

 

Table of Content
 
I. Introduction ……………………………………………………………………………………………………….4
 
II. Formulary Apportionment vs. the Arm’s Length Principle ……………………………………….5
 
III. The Functionality and Comparability Analysis ……………………………………………………..7
 
1. The Functionality Analysis …………………………………………………………………………………7
 
2. The Comparability Analysis ………………………………………………………………………………7
 
IV. Transfer Pricing Methods ………………………………………………………………………………..9
 
1. Traditional Transaction Methods ……………………………………………………………………….9
a) The Comparable Uncontrolled Price Method (CUP) ……………………………………………9
b) The Resale Price method (RP) ……………………………………………………………………….10
c) The Cost Plus Method ……………………………………………………………………………………13
 
2. Transactional Profit Methods …………………………………………………………………………..14
d) Transactional Net Margin Method (TNMM) ……………………………………………………….14
e) The Profit Split Method …………………………………………………………………………………..17
 
V. Conclusion …………………………………………………………………………………………………..19
 
 

 

I.                  Introduction

Transfer pricing refers to the rules and methods for fixing prices for internal transactions within and between internationally operating companies under common ownership or control. Multinational enterprises are active in several countries through various (sometimes legally independent) companies. These entities may exchange/sell various services or goods to each other for which “transfer prices” must be determined.

A company in a low tax jurisdiction (A) could overcharge an affiliated company in a high tax jurisdiction (B) for specific services or goods that are exchanged through intercompany agreements, thereby shifting company B’s profit from a high tax to a low tax jurisdiction.

 

This artificial shifting of profits gained a lot of international attention, especially after the financial crisis of 2008. Many countries asked for intervention against such harmful tax practices. This is the reason why the Organisation for Economic Co-operation and Development (“OECD”) together with the G20[1] launched the Base Erosion and Profit Shifting (“BEPS”) project. BEPS refers to tax planning strategies used by multinational enterprises that exploit gaps and mismatches in local tax rules to avoid or reduce paying tax. BEPS practices cost countries around USD 100-240 billion in lost tax revenue annually. Developing countries’ higher reliance on corporate income tax means they suffer from BEPS disproportionately. Working together within the OECD/ G20 Inclusive Framework on BEPS, over 135 countries and jurisdictions are collaborating on the implementation of 15 measures to tackle tax avoidance, improve the coherence of international tax rules and ensure a more transparent tax environment.

 

Since the launch of the BEPS Action Plan of the OECD, transfer pricing and the respective methods are also highly discussed internationally. Action Points 8-10 refer to this issue. They aim to strengthen the arm’s length principle, address transfer pricing issues related to intangible assets (such as patents, trademarks, R&D expenses etc.) and clarify transfer pricing guidelines regarding the allocation of risks and capital within multinational enterprises.

 

This brochure gives an overview of the different transfer pricing methods, which the OECD suggests to comply with the arm’s length principle.

II.              Formulary Apportionment vs. the Arm’s Length Principle

 

One method (that is not accepted by the international community) for sharing the profit of a multinational enterprise is called “Formulary Apportionment”. The income earned by each group member is consolidated and then shared between the different members of the group on the basis of an allocation key. By applying this method, the income that was originally earned by a group member has no importance as each country would be allocated a certain portion of the consolidated profits and losses. The apportionment is based on a formula that includes, for example, the number of persons employed by a group member in one country, the assets located in this country or the overall sales that were achieved there.

After the apportionment of income, each country taxes the allocated part of the consolidated income with its local tax rate. Ultimately, the pricing of transactions between  group companies play no role anymore, as each country only taxes the allocated portion of the consolidated income, not the specific income initially earned by each group member.

Formulary apportionment includes the following steps:

  • Agree on a specific formula
  • Consolidate the group’s income
  • Compute the relative portion of each element of the formula that is located in each country
  • Determine the share of the consolidated income attributable to the respective country

 

Assuming that all countries where the group companies are taxable chose the number of employees and the overall turnover as the elements of the formula and that these two elements are attributed the same weight in the formula, the formula would be as follows:[2]

Share for the respective country

=

consolidated profit
x
((share of T/consolidated T)/2 + (share of E/total number of E)/2)

The main advantage of formulary apportionment is the foreseeability and the easy use of this method. The risks of disagreements between tax payers and authorities can be mitigated. Nevertheless, only the elements of the formula are taken into account while other aspects are wholly disregarded from the apportionment. A typical example are intangible assets that often contribute to a significant part of an enterprise’s profit. However, they are difficult to quantify when choosing an allocation key and sharing the profit. In general, some countries could be losing part of the tax base if important elements of profit making are just lacking on their territory. For example, if countries invest a lot in education, this can lead to the creation of valuable intellectual property; on the other hand, if a country only has a small market, this would mitigate the sales factor if it were included in the formula.

Therefore, the application of this method has so far been rejected by most countries as well as the UN and the OECD.

Instead of using formulary apportionment, the members of the OECD and also many non-OECD countries prefer the arm’s length principle. By applying this principle, the profits (and losses) of a multinationally-operating enterprise that arose from cross-border intercompany transactions are shared between the members of the group on the basis of the pricing of comparable transactions between independent companies, i.e. the market price.

Formulary apportionment requires that the overall worldwide income from a transaction has to be adjusted before being shared between group members. The arm’s length principle might require an adjustment of the intercompany pricing if the actual prices charged for the intercompany transactions do not match the pricing of third-party comparable transactions between independent companies. The  local revenue department might retroactively adjust the prices which will lead in many cases to a higher or actual double taxation of the profit.

The arm’s length principle implies a case-by-case analysis that must be adapted to each situation. The arm’s length principle also better captures the value created by the members of an international enterprise. At the same time, it gives rise to potential controversies and discussions with local revenue departments and might be less foreseeable.

The arm’s length principle is the international standard for determining the income/profit of the local enterprises/ PEs/ companies of multinationally operating companies. Many domestic laws refer to the compliance with the arm’s length principle, allowing the local administrations to reassess the taxable income of associated enterprises when certain transactions differ from comparable transactions between independent entities. Such domestic provisions are often inspired by the wording of Art. 9 (1) of the OECD Model Tax Convention as well as Art. 9 (1) of the UN Model Tax Convention. The arm’s length principle is also included in most double taxation agreements (“DTA”).

 

III.           The Functionality and Comparability Analysis

1.      The Functionality Analysis

The arm’s length principle requires a comparison of prices charged between independent and controlled transactions (meaning transactions between affiliated companies). To set the respective transfer prices, it is first necessary to determine the role played by each party to the transaction. The more important the group member is in a given transaction, the more exposed this company should be to profits or losses that arises from the transaction. This rationale of the arm’s length principle corresponds with independent party transactions in any business activities.

The OECD Guidelines present three elements that have to be taken into account in order to classify the role of an associated enterprise in an intercompany transaction:

  • The functions performed
  • The risks assumed
  • The assets (capital, cash, loan facilities, patents, trademarks etc.) used

 

According to the OECD, each party should be exposed to the economic outcome (or value added) of the transaction in proportion to the functions it performs, the risks it assumes and the assets it uses for the purpose of the transaction. It is therefore necessary to conduct a functional analysis to understand the contribution of each party to the creation of value in relation to the contributions made by the other party.

 

2.     The Comparability Analysis

Once each party’s role in the transaction has been identified, the next step of setting a correct transfer price includes the search for information about comparable transactions. This is called the comparability analysis. The price paid to (or by) the affiliated company has to be tested against the one paid by an independent comparable transactions. Depending on the method used (see below), the profits (prices) of an affiliated company will be tested against those earned by an independent comparable transactions.

There are two types of independent transactions that can be relied on to set the transfer price:

  • Transactions between a group company and an independent company (internal comparables)
  • Transactions between two independent companies that are not related to the multinational enterprise (external comparables)

 

If there is only one comparable independent transaction (either internal or external), the value of the independent transaction would be applied directly or slightly corrected by making comparability adjustments in case of smaller differences of the transaction (e.g. the price of an independent transaction can be decreased in the controlled transaction if the volume of the tested controlled transaction is significantly higher and therefore the buyer got a rebate which is considered normal in a business environment).

If there are more uncontrolled transactions that can be compared to the tested intercompany transaction, the information is usually aggregated to set an arm’s length range, consisting of:

  • The first quartile (lower quartile) that represents the 25% lowest values of the comparables
  • The second quartile (or median) that separates the higher half from the lower half of the results
  • The third quartile (upper quartile) that represents the 25% highest values of the comparables

 

The OECD Guidelines state that a transfer price or profit margin that is within the arm’s length range is consistent with the arm’s length principle.

To achieve a high degree of comparability, the OECD further defines four comparability factors in addition to performing the functional analysis:

  • The characteristics of the property or the services at hand (e.g. quality of products)
  • The contractual terms of the transaction at hand (e.g. higher volumes)
  • The economic circumstances that are relevant for the transaction at hand (e.g. economic downturn in a given industry/lower demand)
  • The business strategies of the independent and associated enterprises (e.g. prices that are kept at a lower level during a start-up phase of a newly launched product)

 

If the comparability analysis reveals certain differences between the uncontrolled and controlled transactions, the OECD Guidelines recommend that the uncontrolled transactions are only valid (meaning sufficiently comparable to the controlled transaction) if reasonably accurate adjustments can be made to eliminate the effect of any such differences. If no such adjustments can be made, the uncontrolled transaction should not be used as comparable.

IV.            Transfer Pricing Methods

The OECD classifies the different transfer pricing methods in two categories: traditional transaction methods and transactional profit methods. All intercompany transactions include at least two parties but the application of a one-sided method requires choosing the tested party to which the method is applied.

 

          1.  Traditional Transaction Methods

a)    The Comparable Uncontrolled Price Method (CUP)

The CUP method is a two-sided transfer pricing method and compares the price charged for goods or services transferred in a controlled transaction to the price charged for goods or services transferred in an uncontrolled transaction in comparable circumstances. If there is any difference between the two prices, this may indicate that the conditions of the commercial or financial relations of the associated enterprises are not at arm’s length, and that the price in the controlled transaction may need to be adjusted to the price in the uncontrolled transaction.

There are two types of CUPs, internal and external CUPs. Internal CUPs refer to the price of a good or a service charged between a group company and an independent party, e.g. if a manufacturer sells goods to associated companies as well as to third party not associated parties. The  price that is used with the third parties can be relied on to be the correct price with associated companies as well, as long as the circumstances of the transaction are comparable or, in case of any differences, reasonable adjustments can be made.

External CUPs refer to the price of a comparable good or service between two unrelated parties, however, it is important that the products or services are sufficiently comparable, which is the case if one of the two conditions is met:

  • None of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions could materially affect the price in the open market; or
  • Reasonably accurate adjustments can be made to eliminate the material effects of such differences.

 

Where it is possible to locate comparable uncontrolled transactions, the CUP method is the most direct and reliable way to apply the arm’s length principle. In such cases, the CUP method is preferable over all other methods.

However, it may be difficult to find a transaction between independent enterprises that is similar enough to a controlled transaction such that no differences have a material effect on price. Therefore, this method is used when there is a lot of available data, e.g. in the case of certain raw materials that are publicly traded. The CUP method is also often used for financial transactions such as group loans. Most banks work with the same formulas to determine credit ratings of borrowers. This serves as a basis for the interest rate of a loan and therefore offers a lot of comparable data. Particularly intangible assets (trademarks process know-how etc.) are difficult to compare as great differences may exist due to the intrinsic quality, the logo or the trade name of the product.

 

If no CUP can be found or no adjustments can be made, another transfer pricing method has to be used.

b)    The Resale Price Method (RP)

The RP method is a one-sided transfer pricing method, which is mostly used when tangible property is sold to a related party or distributor. The rationale of the RP method is to set the transfer price of certain products based on the gross margin that should be earned by the distributor at arm’s length. Thus, the distributor is the tested party. The purchase price of the goods (cost of goods sold, COGS) has to be determined to let the distributor earn a gross margin at arm’s length.

It begins with the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise. This price (the resale price) is then reduced by an appropriate gross margin on this price (the resale price margin) representing the amount out of which the reseller would seek to cover its selling and other operating expenses (i.e. the cost left after the COGS) and, in the light of the functions performed (taking into account assets used and risks assumed), make an appropriate profit. What is left after subtracting the gross margin can be regarded, after adjustment for other costs associated with the purchase of the product (e.g. customs duties), as an arm’s length price for the original transfer of property between the associated enterprises.

Assuming that a group produces and sells mobile phones as finished products to its distributing subsidiaries that will then resell the phones to retailers. The group sets the transfer prices according to the RP method, and the COGS is set on the basis of the targeted gross margin of the distributor. This margin has to be found out by a benchmarking study to gather as much data of independent companies in a comparable situation as possible. If this study demonstrates that independent distributors usually earn a gross margin of 20% on their sales, the transfer price of the phones should be set in such a way that the related distributor also earns a 20% gross margin on phones bought from associated companies and resold to retailers.

 

Step 1:

Turnover               100

–   COGS                   ?

=  Gross margin         20                20% of sales

 

Step 2:

Turnover               100

–   COGS                   80                100 – 20 = 80

=  Gross margin         20                20% of sales

 

By paying 80 to acquire a certain quantity of phones, the distributer will be able to achieve the targeted gross margin of 20% if the distributer sells them for 100 to retailers. Some adjustments (e.g. custom duties) may be needed to set the definitive transfer price.

In making comparisons for purposes of the RP method, fewer adjustments are normally needed to account for product differences than under the CUP method, because minor product differences are less likely to have as material an effect on profit margins as they do on price. However, the RP method requires that the functions, risks and assets of the controlled and uncontrolled companies are truly comparable. Differences in the quality of the products, accounting standards used, the exclusivity of the right to distribute the products, or economic circumstances such as foreign exchange rates or the competitivity of an industry may preclude the use of the RP method.

Assuming that, in the example above, the market is highly competitive which requires a massive investment in marketing and advertising from the distributor. The operating expenses amount to 23. “Operating margin” here means Earnings before Interest and Taxes, or simply “EBIT”.

Turnover                        100

–   COGS                            80

=  Gross margin                  20

–   Operating expenses          23

=  Operating margin            -3

 

In the example below, there is only little competition on the market, so that the marketing and advertising expenses amount to 10, while the distributor is still buying the goods for 80 and selling them for 100.

Turnover                        100

–   COGS                            80

=  Gross margin                  20

–   Operating expenses          10

=  Operating margin            10

 

This example shows that applying the RP method through targeting a gross margin of 20 in both cases is not a suitable solution. Even if the distributors exercise the same role in the value chains of these two products, the differences in the marketing function imply different operating expenses, resulting in different operating margins. The higher marketing expenses may also contribute to the creation of intangible property.

The RP method is thus very sensitive to functional differences.

 

c)     The Cost Plus Method

The Cost Plus Method is a one-sided transfer pricing method. The goods or services are sold at a price that corresponds to the actual costs incurred in the production of the good or the supply of the service, to which a profit mark-up is added. The rationale of the cost plus method is therefore to set a transfer price that covers certain costs and lets the supplier earn an arm’s length mark-up (profit) according to the functions performed and the market conditions.

The cost plus mark-up of the supplier in the controlled transaction should be established by reference to the cost plus mark-up that the same supplier earns in comparable uncontrolled transactions (internal comparable). In addition, the cost plus mark-up that is earned in comparable transactions between independent enterprises may also serve as a guide (external comparable).

It is important to note that the Cost Plus Method does not apply (contrary to what its name implies) to all costs incurred by the service provider. The method is based on transactions as opposed to profits. It is only the costs incurred for a certain transaction that the transfer price will need to cover. It is therefore necessary that the company providing the services distinguishes between the costs that are linked with the transaction (typically direct costs such as the costs of production) and the costs that are related to that transaction, for example operating expenses. The profit mark-up corresponds to the gross margin left after incurring the costs of production of the goods or services.

Assuming that company X produces bags on behalf of its affiliate, company Y (resident in another country), which designs the bags and provides quantitative and qualitative instructions to company X in relation to the production of the bags. Once the bags have been manufactured, they are sold by company X to Y. The transfer prices are calculated on the Cost Plus Method.

A benchmarking study demonstrates that the profit mark-up for comparable transactions is 20%. Assuming that the COGS amount to 100, company X will need to invoice 120 (100 + (100 x 0.2) = 120) to company Y. The remaining gross margin amounts to 20 (120 – 100 = 20) which also covers the operating expenses. If the operating expenses amount to, for example 15, the net margin will be positive and amount to 5 (20 – 15 = 5).

The Cost Plus Method can be helpful to assess the arm’s length remuneration of low-risk, routine-like activities as it can ensure that the seller will be reimbursed for its costs and has a guaranteed  profit. An example of such activities is contract manufacturing, where there is a manufacturing enterprise which contracts exclusively with one client and assumes limited risks. An example is the provision of simple administrative services. The Cost Plus Method is most useful where semi-finished goods are sold between associated parties, where associated parties have concluded joint facility agreements or long-term buy-and-supply arrangements, or where the controlled transaction is the provision of services.

The downside of the Cost Plus Method is that it requires controlled and uncontrolled transactions to be highly comparable. To establish such level of comparability, detailed information on the transactions has to be available. Differences in the functions performed may affect the profitability, especially if intangibles are used or developed. A manufacturer receiving technical instructions of the production of goods is not likely to achieve the same results as a manufacturer producing comparable goods on the basis of its own know-how, because the latter is likely to be exposed to higher costs due to the ownership of valuable manufacturing intangibles. Also, differences in accounting standards may disrupt the application of the Cost Plus Method as COGS and operating expenses may be classified differently. Further, you must be aware that the cost plus intercompany agreement cannot easily be changed, even when actual losses are occurring in the supply  chain. This means that even if a product is finally sold with a loss, the mark up still has to be paid and will also be taxed. Cost plus is only one method, but it cannot be applied if it leads to obviously wrong results.

2.     Transactional Profit Methods

The OECD Guidelines refer to two transactional profit methods: the transactional net margin method and the transactional profit split method. The OECD was first reluctant to use these methods as they focus on profits, not on transactions. Independent parties would not do business and set prices on the basis of an analysis of profits, especially net profits. Transactional profit methods also often result in aggregating the profits of different transactions which may lead to the loss of traceability on the profitability of each individual transaction. Therefore, the transactional profit methods are considered as methods of last resort, meaning they should only be used when traditional transaction methods cannot be applied reliably.

     a)       Transactional Net Margin Method (TNMM)

The TNMM is a one-sided transfer pricing method. As opposed to the RP method and the Cost Plus Method, it does not focus on the gross margin but on the net margin/profit of the tested party, i.e. it includes the operating expenses in the margin that is measured. This net profit is then compared to the net profit realized by comparable uncontrolled transactions of independent enterprises. A comparable uncontrolled transaction can occur between an associated enterprise and an independent enterprise (internal comparable) and between two independent enterprises (external comparable).

The rationale of the TNMM is to set the transfer price of a certain good or service based on the net margin, that should be earned by the tested party at arm’s length, in relation to a particular item of the financial statements of the tested party.

In most cases, the operating margin of the tested party is assessed in relation to its sales, costs, or assets, meaning it is a ratio between two different items in the financial statements of the tested party. Such ratios are often referred to as “financial indicator” or “profit level indicator”. Depending on the type of business activity that the tested party carries out, companies choose a certain financial indicator, e.g. the return on sales (operating margin divided by sales), the full cost mark-up (operating margin divided by relevant full costs) or the return on capital employed (operating margin divided by capital employed). Sometimes, the so-called Berry ratio (gross profits divided by operating expenses) may be applied, if other methods (RP or cost plus) cannot be relied on in case of intermediary activities.

The following example uses the return on sales as financial indicator. Assuming a company has the following financial statement:

Turnover                        100

–   COGS                            80

=  Gross margin                  20

–   Operating expenses          10

=  Operating margin            10

 

The RP method would assess the gross margin, which is 20% in the above example. The TNMM in combination with the return on sales reveals a net margin of 10% (10/100=10%).

The use of the TNMM has mainly four advantages:

  • The same cost that is recorded as COGS in one country may be recorded as an operating expense in another country. Focusing on the net margin (which is on a lower level on the financial statement) instead of the gross margin by using the TNMM can help mitigating differences in accounting standards.
  • Focusing on the net margin also means that functional differences can be more tolerated and consequently, the need for product comparability can be reduced. Differences in the functions performed are often reflected in variations in operating expenses (as shown above under IV. 1. b), e.g. regarding marketing and advertising expenses). The RP method is not suitable in such situations as it requires very detailed knowledge of the functional profiles of the distributor and companies in the benchmark study in order to compare companies that are actually comparable to the tested party.
  • Information on the net margin of comparable companies is easier to obtain in e.g. publicly available financial information. Gross margins are usually not reported therein.
  • The fact that multiple forms of net profit indicators can be used makes this method widely applicable. It is therefore not a surprise, that this is the most frequently usedtransfer pricing method.

 

A major reason why the OECD is very cautious with promoting this method is the risk that different transactions are aggregated and remunerated together according to a single transfer pricing methodology. If a company is distributing machinery but also sells spare parts, performs services and leases machinery, it may not be possible to remunerate all these activities on the basis of a single application of the TNMM. This would make it impossible to assess the profitability of each transaction with sufficient accuracy. Therefore, there is a risk of improperly transferring profits to or from the entities with which the transactions are entered into. It would also be very difficult to find independent companies that perform a comparable combination of activities.

In this situation the OECD recommends to segment the income statement and remunerate each transaction at arm’s length. For example, the distribution activity (which focuses on marketing and sales) could be remunerated on the basis of the return on sales (TNMM), but it also has to be differentiated between the sale of machinery and the sale of spare parts, as these two activities may have different levels of profitability. The service activity could be priced on the basis of a full cost mark-up. The leasing activity may be priced on the basis of the return on total capital employed (TNMM) if the equipment is owned by the tested party. However, this segmentation requires a lot of detailed documentation and analysis which can be complex and also very costly. Nevertheless, tax authorities are more and more cautious when checking transfer pricing methods, so it is advisable to pay great attention to transfer pricing issues.

b)    The Profit Split Method

The Profit Split Method is a two-sided transfer pricing method because it splits profits or losses between at least two parties. Associated enterprises mostly engage in transactions that are very complex and interrelated which is why they tend to fragment their value chain and extend it across borders. This is also called “global value chains”.

When there are no independent comparable transactions or when no party to a transaction has functions that characterise it as the tested party, the profit split method may be the only way to share the income from intercompany transactions between the associated companies.

Assuming companies X, Y and Z (residents of different countries) develop and sell high-end cosmetic products. Each company has expertise in a certain area, and the combination of the three types of expertise enables the group to manufacture and successfully sell cosmetic products. The CUP method is not suitable as the specific contributions of each entity to the common project are unlikely to be found anywhere else, so it would be hard to find comparables. All three companies act in an entrepreneurial manner and do not act on behalf of other companies. Consequently, there is no company that qualifies as a tested party, which excludes the use of the RP method, the Cost Plus Method and the TNMM. The profit split method aims at sharing the income in these special situations.

The Profit Split Method applies to the operating profits (or losses) that result from a given business activity (not the income from capital gains or financial income). Once these profits have been identified, they would be shared between the participants and taxed in their respective country of tax residence on the basis of an allocation key. There is no specific allocation key recommended by the OECD as long as one approximates as closely as possible the split of profits that would have been realized had the parties been independent enterprises. Examples of the allocation key are the split of profits on the basis of the value added, the costs incurred by each party, the number of employees, the wages paid to employees or the ownership of intangibles. The allocation keys can also be combined. Most importantly, a comprehensive functional analysis has to be conducted in order to choose a profit split methodology that could be adopted by independent parties.

Another method is the residual profit split method. The profits to be split often exclude those connected to routine functions as these profits could be more easily remunerated by using the other transfer pricing methods. The residual profit split method requires the identification of the routine profit for an entity as a first step. Any remaining profit is then split based on each party’s contribution to the earning of the non-routine profit, for example the ownership of intangibles.

Assuming a multinational enterprise has three associated companies: R (Research and Development, R&D), M (Manufacturing) and D (Distributor). The companies are tax residents in three different countries. R and M own valuable product and manufacturing intangibles and D performs routine distribution functions. The end price for consumers is 100, the global net margin is 20%, meaning the total operational costs amount to 80.

From a transfer pricing perspective, the distributor D performs routine business activities that can be compared with third parties. D is considered as a tested party and is remunerated based on the TNMM. It is assumed that D should earn a 4% return on sales based on a benchmark study, i.e. 4 (100 x 4% = 4). Out of the total net margin of 20, this leaves 16 as residual profits to be shared between R and M. As both companies own valuable intangibles, R and M make unique contributions to the value chain and cannot be remunerated on the basis of any other method than the profit split method.

It is assumed that independent comparable enterprises would split profits in similar joint-ventures so that the R&D company gets 50% of these profits and the manufacturer 50% of these profits. This ratio could be obtained by evaluating to what extent the different intangibles contribute to the decision to purchase products by end-consumers. Accordingly, both companies should be attributed 50% of the residual profits (16 x 50% = 8).

The Profit Split Method strongly reminds of formulary apportionment because both methods imply that income is shared between associated companies on the basis of an allocation key. However, there are two fundamental differences between the two methods.

The first difference relates to the objective: The profit split method aims at applying the arm’s length principle, formulary apportionment does not. The allocation key of formulary apportionment does not have to comply with any principle. Secondly, formulary apportionment is based on a pre-determined formula, while the profit split method implies the determination of the allocation key as a result of a case-by-case analysis. Because of its flexibility, the Profit Split Method is gaining more and more popularity, especially among developing countries, as specific local features can be taken into account.

V.                Conclusion

Although the OECD Guidelines are widely accepted internationally, transfer pricing issues still give rise to differences of interpretations between multinational enterprises and tax authorities or between the authorities of different jurisdictions. Not all countries agree on the whole content of the OECD Guidelines and interpretations vary a lot. Different views still exist between developed and developing countries with the latter creating own concepts of certain transfer pricing methods. The OECD Guidelines only provide a general overview and not concrete solutions to specific problems in this field. Consequently, it is always necessary to have knowledge about the domestic transfer pricing rules in order to be properly compliant with the arm’s length principle in a certain country.

We strongly recommend to have  proper and actual transfer pricing documentation available and be prepared for questions from the local revenue department, because otherwise the local tax  authorities can and will adjust the local profit  which will lead in many cases to an actual double tax on the same profit.

 

[1]      Argentina, Australia, Brazil, Canada, China, the European Union, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom, and the United States.

[2]       T stands for turnover and E for employeesI

 

 

We hope that the information provided in this brochure was helpful for you.
If you have any further questions, please do not hesitate to contact us.

 LORENZ & PARTNERS Co., Ltd.
27th Floor Bangkok City Tower
179 South Sathorn Road, Bangkok 10120, Thailand
Tel.: +66 (0) 2-287 1882
E-Mail: [email protected]

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