Introduction
The purpose of this paper aims to …
Transfer pricing represents the policies and procedures associated with the way in which a company's prices goods, services, and intangibles transferred to its foreign affiliates. Transfer pricing is significant for both taxpayers and tax administrations because it affects the allocation of profits from intra-group transactions, which impacts the income and expenses reported, and therefore taxable profits of related companies that operate in different taxing jurisdictions. One of the most challenging issues that arise from an international tax perspective is the establishment of arm's-length transfer prices.
Transfer pricing is an area that has been getting increasing attention from tax authorities around the world, as well as from multinational enterprises ("MNEs"). Transfer pricing does not only affect large MNEs, but potentially every company engaging in cross-border transactions with related parties. A transfer pricing issue can arise when related parties are involved in any of the following situations:
• Sales and/or purchases of tangible property;
• Sales and/or use of intangible property;
• Provision and/or receipt of services or know-how;
• Joint development of intangibles with a related party, or
• Loans.
The following sections define some of the terms that are central to the practice of transfer pricing.
Transfer pricing & OECD
The "arm's length principle" attempts to measure the value of a transaction "as if" the parties do not have the relationship between them that, in fact, exists (i.e., as if the related parties were independent, unrelated parties). The arm's length standard also ignores the fact that there are certain efficiencies and economies of scale from operating related businesses that would not exist if the parties were not related. Nevertheless, the arm's length standard has been accepted by the Organization for Cooperation and Economic Development ("OECD") and is the standard used globally to resolve transfer pricing disputes.
The two approaches generally used to assess whether cross-border, related party transactions produce arm's length results are 1) transaction-based methodologies and 2) profit-based methodologies. Transaction-based methods require the identification of prices or margins from individual transactions or groups of transactions involving related entities, and comparing these results to the price or margin information obtained involving independent third parties. The profit-based methods seek to benchmark the overall profitability earned by controlled entities and unrelated parties performing similar functions and incurring similar risks.
The literature surrounding the arm's length principle yields two main conclusions. First, there is little reason to expect that observations of actual arm's length prices even exist for most goods traded by multinational corporations. Second, in cases where such direct arm's length price observations are unavailable, profit based applications of the arm's length principle yield, at best, a range of prices within which any price could be characterized as an arm's length price. This latter problem is referred to as the "continuum price problem", and is considered the source of many lengthy and expensive disputes between governmental authorities and taxpayers.
Types of transaction: tangible goods, services, financing, and intangible property
Uncontrolled transactions are those business transactions that take place between two unrelated entities and involve the sale or purchase of tangible or intangible property or the provision of services. These transactions are also referred to as "unrelated" or "third-party" transactions. Transactions that take place between related entities that sell or purchase tangible or intangible property or provide services are considered "controlled" transactions, and are the focus of our transfer pricing studies. These transactions are also referred to as "related party" transactions.
Description of methods
This section outlines the transfer pricing methodologies used to determine whether a client's transfer prices are arm's length. There are two types: (i) transaction-based methods and (ii) profit-based methods. The transaction-based methods include the Comparable Uncontrolled Price ("CUP") method, the Comparable Uncontrolled Transaction ("CUT") method, the resale price method ("RPM"), and the cost plus method. The profit-based methods include the profit split and the Comparable Profits Method ("CPM")/Transactional Net Margin Method ("TNMM"). The U.S. regulations specify the following methods to analyze tangible property transactions: CUP, Resale Price, Cost Plus, Profit Split (Comparable and Residual), and Comparable Profits Method. To analyze intangible property transactions, the U.S. regulations specify: CUT, Profit Split (Comparable and Residual), and CPM. The OECD Guidelines specify the following methods: CUP, Resale Price, Cost Plus, Profit Split (Comparable and Residual), and TNMM.
Transaction-based methodologies:
CUP - The Comparable Uncontrolled Price ("CUP") method compares the amounts charged in controlled transactions with the amounts charged in comparable third party transactions. Comparable transactions may be between two unrelated parties or between one of the related parties and an unrelated party. The CUP method is generally the most reliable measure of an arm's length result if the transaction is identical, or if only minor readily quantifiable differences exist. The CUP method requires a high degree of comparability of products and functions. Comparability can be enhanced by making adjustments to the comparable price. Adjustments likely to be required include adjustments for differences in:
• product quality;
• sales volume;
• contractual terms (such as payment terms, shipping liability, etc.);
• geographic market;
• embedded intangibles; and
• foreign currency risks.
CUP Example
For illustrative purposes, consider an example where a parent company ("Canco"), located in Canada manufactures "product X." Canco sells product X to both related ("USco") and unrelated distributors in the United States and the circumstances surrounding the controlled and uncontrolled transactions are substantially the same. Under the CUP method, if Canco sells product X to the unrelated distributors for $10/unit, then Canco should sell product X to USco at the same price, i.e., $10/unit, to satisfy the arm's length principle. However, assume that Canco arranges for and pays to ship product X to USco whereas the unrelated entities pick up product X directly from Canco's manufacturing facility. Since Canco performs more activities and incurs more risk for USco than it does for the unrelated parties, it should be compensated accordingly. Assuming the additional compensation Canco should receive for performing the additional activities and bearing the additional risks equals $1/unit, then Canco should charge USco $11/unit.
In practice, there may be more than one comparable transaction, which would result in a range of potentially arm's length results rather than an individual result.
CUT - The Comparable Uncontrolled Transaction ("CUT") method compares the amount charged for a controlled transfer of intangible property to the amount charged in a comparable uncontrolled transaction. An intangible is defined as an asset that comprises of any of the following items and has a substantial value independent of the services of any individual:
• Patents, inventions, formulae, processes, designs, patterns, or know-how;
• Copyrights and literary, musical, or artistic compositions;
• Trademarks, trade names, or brand names;
• Franchises, licenses, or contracts;
• Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; and
• Other similar items.
For purposes of applying the comparable uncontrolled transaction method, comparable intangible property must be used in connection with similar products or processes, within the same general industry or market, and have similar profit potential. Profit potential ideally is measured by the net present value of the benefits from the intangible based on prospective profits to be realized or costs to be saved. However, under the U.S. regulations more subjective factors may be considered to determine profit potential, such as:
• the terms of transfer, including the exploitation rights granted in the intangible, the exclusive or nonexclusive character of any rights granted, and any restrictions in use including limits on the geographic area in which the rights may be exploited;
• stage of development of the intangible;
• right to receive periodic updates, revisions, or modifications of the intangible;
• duration of license, contract or other agreement and any termination or renegotiation rights;
• uniqueness of the property and the period for which it remains unique;
• economic or product liability risks assumed by the transferee;
• exclusivity;
• existence and extent of collateral transactions or ongoing business relationships between the
transferee and the transferor; and
• the functions performed by the transferor and transferee.
CUT Example
In this example assume that Foreign Parent ("FP"), located in the U.K., licenses the use of its trademark/trade name to USco, a related party located in the U.S. In addition, FP also licenses the use of the same trademark/trade name to an Unrelated Co. located in the U.S. at the rate of 4.0 percent of sales (in other words, for each dollar of sales, Unrelated Co. must pay FP $.04). The circumstances affecting USco and Unrelated Co. are similar, as are their license terms. Thus, the royalty rate between FP and Unrelated Co. is comparable to the royalty paid by USco to FP.
RPM - The resale price method ("RPM") compares the gross margin earned in the controlled transaction to the gross margins earned in comparable uncontrolled transactions. Under this method, the arm's length price is measured by subtracting the appropriate gross profit from the applicable resale price of the property involved in the controlled transaction. The RPM is most often used for distributors that resell products without physically altering or adding substantial value.
The RPM requires detailed comparisons of functions performed, risks borne, and contractual terms of controlled and uncontrolled transactions. As a result, a higher degree of comparability is more likely to exist between controlled and uncontrolled transactions involving the same reseller (i.e., internal RPM). In the absence of comparable uncontrolled transactions involving the same reseller, an appropriate comparison may be derived from comparable uncontrolled transactions involving other resellers (i.e., external RPM).
The RPM is unlikely to lead to accurate results if there are significant differences in the:
• level of market for which the products are being sold;
• functions performed;
• type of products; or
• embedded intangibles.
A reasonable number of adjustments may be made to compensate for the lack of comparability between controlled and uncontrolled transactions including:
• inventory turnover;
• contractual terms;
• transportation costs; and
• other measurable differences.
Resale Price Method Example
Returning to our previous example of Canco and USco, assume that USco buys product Y from Canco but also purchases variations of product Y from unrelated manufacturers. Although each of the individual products is similar to one another, they are not exactly the same and no reasonable adjustments could be made to the unit prices to establish a CUP.
To apply the RPM we compare the gross margins earned by USco on products purchased from Canco to the gross margins earned by USco on products purchased from the unrelated manufacturers. Other factors to consider in such an analysis would be the similarity of the terms and conditions, the volumes purchased, and the market conditions faced by Canco and the unrelated manufacturers. USco's gross margins on purchases from unrelated manufacturers form an arm's length range of gross margins. For example, consider five comparable manufacturers and USco's resulting gross margins are as follows:
Unrelated Manufacturer 1 32%
Unrelated Manufacturer 2 29%
Unrelated Manufacturer 3 33%
Unrelated Manufacturer 4 36%
Unrelated Manufacturer 5 35%
The interquartile range of gross margins would be 32% to 35%, with a median of 33%. Thus, to satisfy the arm' length principle, USco should earn a gross margin of between 32% and 35%. A result outside this range would indicate the need for an adjustment to the current transfer pricing.
CPM - The cost plus method compares gross margins of controlled and uncontrolled transactions. Under this method, the arm's length price is determined by adding the appropriate gross profit to the controlled taxpayer's cost of producing the property involved in the controlled transaction. The cost plus method is most often used to assess the mark-up earned by manufacturers selling to related parties.
The cost plus method requires detailed comparisons of products produced, functions performed, risks borne, manufacturing complexity, cost structures and intangibles between controlled and uncontrolled transactions. Comparability is most likely found among controlled and uncontrolled sales of property by the same seller (i.e., internal cost plus method). In the absence of such transactions, an appropriate comparison may be derived from comparable uncontrolled transactions involving other producers (i.e., external cost plus method).
The cost plus method is less likely to be reliable if material differences exist between the controlled and uncontrolled transactions with respect to:
• intangibles;
• cost structure;
• business experience;
• management efficiency;
• functions performed; and
• products.
A reasonable number of adjustments may be made to compensate for the lack of comparability between controlled and uncontrolled transactions including:
• inventory turnover;
• contractual terms;
• transportation costs; and
• other measurable differences.
The degree of consistency in accounting practices between the controlled transaction and the uncontrolled comparable that materially affect the gross profit mark-up will impact the reliability of the result. For example, if differences in inventory and other cost accounting practices would materially affect the gross profit mark-up, the ability to make reliable adjustments for such differences would materially impact the reliability of the result. Further, the controlled transaction and the comparable uncontrolled transaction should be consistent in the reporting of costs between cost of goods sold and operating expenses.
Cost Plus Method Example
Consider the following fact pattern, in which USco manufactures product both for Canco and for unrelated parties. In both cases, USco acts as a "contract manufacturer" which means, in general, that USco does not undertake sales and marketing activities; it does not develop its own products, and typically uses patents and designs owned by the purchaser. Further, USco does not assume significant inventory and forecasting risks.
Application of the cost plus method requires a comparison of the gross profits generated relative to the manufacturing costs (gross costs) incurred based on sales to Canco and unrelated companies. For example, consider the gross mark-ups realized by USco when selling products manufactured for five different unrelated parties:
Unrelated Co1 42%
Unrelated Co2 45%
Unrelated Co3 41%
Unrelated Co4 44%
Unrelated Co5 39%
The interquartile range of gross mark-ups would be 41% to 44%, with a median of 42%. This indicates that USco needs to earn a gross mark-up between 41% and 44% for transactions with Canco to satisfy the arm's length principle. Any result outside this range would indicate the need for an adjustment to the current transfer pricing.
Profit-based methodologies:
Given the high degree of comparability required to apply the transactional methods, these methods are not used as frequently as the profit based methods unless reliable internal data are available.
Profit Split method - The profit split methods allocate the combined operating profits or losses from controlled transactions in proportion to the relative contributions made by each party in creating the combined profits or losses. Relative contributions must be determined in a manner that reflects the functions performed, risks assumed, and resources employed by each party to the controlled transaction.
a) Comparable Profit Split Method
Based on the comparable profit split method, transfer prices are based on the division of combined operating profit between uncontrolled taxpayers whose transactions and activities are similar to those of the controlled taxpayers in the relevant business activity. Under this method, the uncontrolled parties' percentage shares of the combined operating profit or loss is used to allocate the combined operating profit or loss of the relevant business activity between the related parties.
This method is rarely use because it is extremely difficult to find two companies in an uncontrolled circumstance with similar functions, risks, and transactions.
b) Residual Profit Split Method
The residual profit split method involves two steps. First, operating income is allocated to each party in the controlled transactions to provide a market return for their routine contributions to the relevant business activity. Second, any residual profit is divided among the controlled parties based on the relative value of their contributions of any valuable intangible property to the relevant business activity. This method is particularly suited to transactions involving the transfer of highly profitable intangibles.
Residual Profit Split Method Example
Consider the following example. After completing the functional analysis, you determine that both the manufacturer and the distributor contribute to the development of intangible property. In this example, assume that the manufacturer's product is recognized by the industry as a better quality product than any competitors and therefore can obtain a higher price. In addition, the distributor has access to a comprehensive distribution network and is able to generate sales high enough to allow the manufacturer to operate at very high levels of utilization that it would otherwise not have access to on its own. For purposes of this example, we assume that the total operating profit available for these transactions is $100.
(1) Step 1 - Allocate Routine Returns
The first step is to allocate routine returns for the manufacturing and distribution activities undertaken by each company respectively. Routine returns are the profitability levels that the manufacturing and distribution companies would earn absent the intangibles used in the manufacture and distribution of the product. For simplicity, we assume that the routine profit associated with the distribution activities is $18 and that the routine profit associated with the manufacturing activities is $22.1 This would leave $60 ($100-$18-$22) of profit remaining to be split between the distributor and manufacturer based on their relative contributions of any valuable intangible property.
(2) Step 2 - Allocate Non-Routine Returns
There are various ways to allocate the non-routine returns, but generally, the method used should quantitatively reflect the relative non-routine contributions by each party involved in the transaction. For this example, we will use the relative "value-added" costs incurred by each party. For the distributor, we will include the costs of the senior sales, marketing, and customer service personnel, as well as costs incurred to launch various campaigns that have proven successful for the company. These costs total $500. For the manufacturer, we will include the costs of the quality control department, as well as the senior management of the production area. These costs total $800.2
Therefore, the total cost associated with generating the "residual" returns is $1300. The relative split of residual profits is calculated as follows:
Manufacturer's Contribution 800/1300 = 61.5%
Distributor's Contribution 500/1300 = 38.5%
Total Residual $60
Manufacturer's Share of Residual 61.5% * $60 = $36.9
Distributor's Share of Residual 38.5% * $60 = $23.1
CPM - The Comparable Profits Method ("CPM") evaluates whether the amount charged in a controlled transaction is at arm's length by comparing the profitability of the tested party to that of companies that are similar to the tested party. In most cases, the tested party should not use intangible property or unique assets that distinguish it from unrelated comparable companies.
The degree of comparability between the tested party and the comparable company affects the reliability of the CPM analysis. Reliability may be adversely affected by varying cost structures, differences in business experience, or differences in management efficiency. However, less functional comparability is required for reliable results than under the transactional methods (e.g., the CUP method, the RPM, or the cost plus method). In addition, less product similarity is required for reliable results under the CPM than under the transactional methods.
Adjustments that may be required include those for differences in:
• accounting classifications;
• credit terms;
• inventory;
• currency risk; and
• business circumstances.
CPM Example
In this example assume that USco manufactures and distributes consumer products on behalf of its Foreign Parent ("FP") for sale in the United States. FP does not allow unrelated parties to manufacture its product. USco's does not own any valuable intangibles associated with the manufacturing process or product, and FP owns all valuable intangibles and conducts additional research to increase manufacturing efficiencies. USco's responsibility is to manufacture the product and distribute it to customers located in the United States. We assume that USco is the tested party in this transaction.
Given this fact pattern, we use the operating margin to analyze the company's intercompany pricing. Assume that we identified five comparable companies. They are listed below with their operating margins.
Unrelated Co1 4.7%
Unrelated Co2 6.1%
Unrelated Co3 7.2%
Unrelated Co4 5.8%
Unrelated Co5 2.5%
The full range of operating margins is 2.5% to 7.2%, and the interquartile range is 4.7% to 6.1% with a median of 5.8%. This indicates that USco needs to earn an operating margin between 4.7% and 6.1% for transactions with FP to satisfy the arm's length principle. Any result outside this range would indicate the need for an adjustment to the current transfer pricing.
TNMM - The Transactional Net Margin Method ("TNMM") is a profit-based method in the OECD Guidelines and is similar to the CPM. The TNMM evaluates whether the amount charged in a controlled transaction is arm's length by comparing the net operating return that the tested party realizes from a controlled transaction (or transactions that are appropriate to aggregate under the principles specified in the OECD Guidelines) relative to an appropriate base (e.g., sales, costs, or assets).
Thus, the TNMM operates in a manner similar to the RPM or cost plus method and, as a result, should be applied in a manner consistent with the manner in which the RPM and cost plus method are applied. This means that the net operating return realized by a tested party in respect of a controlled transaction should ideally be established by comparing it to the net operating return it earned in respect of comparable uncontrolled transactions. Where this is not possible, the net operating return that would have been realized in comparable transactions by an independent party may serve as a guide.
The degree of comparability affects the reliability of the TNMM analysis. Reliability may be adversely affected by varying cost structures, differences in business experience, or differences in management efficiency. As in the case of the RPM and cost plus method, less product similarity is required for reliable results under the TNMM than under the CUP method.
Adjustments that may be required include those for differences in:
• accounting classifications;
• credit terms;
• inventory;
• currency risk; and
• business circumstances.
TNMM Example
In this example, we assume that USco is a distributor with limited functions and risks. Although the company takes title to products, ownership of the product is only temporary during transportation, as the products are shipped directly from the manufacturing facility to the end users. USco's responsibility is to identify new customers, maintain existing customer relationships, and provide technical services both for pre and post sale. We assume that USco is the tested party in this transaction.
Given this fact pattern, we use the Berry Ratio3 to analyze the company's intercompany pricing. Assume that we identified the following five comparable companies:
Unrelated Co1 1.12
Unrelated Co2 1.21
Unrelated Co3 1.18
Unrelated Co4 1.09
Unrelated Co5 1.27
Therefore the arm's length range of Berry Ratios is 1.12 to 1.21, with a median of 1.18. This indicates that USco needs to earn a Berry Ratio between 1.12 and 1.21 for transactions with Canco to satisfy the arm's length principle. Any result outside this range would indicate the need for an adjustment to the current transfer pricing.
Transfer pricing planning
A transfer pricing planning project is similar to a documentation project in that a transfer pricing report is prepared. The key difference is that a planning or restructuring project is forward looking in nature. In planning projects, historical results will be considered; however, past results are considered in conjunction with budgets or projections that reflect future expectations about the industry and the business.
An example of a planning/restructuring project is a company may wish to convert a local manufacturing plant into a contract manufacturer with limited functions and risks, and thus expecting a limited return. Similarly, a company may wish to begin charging royalties to foreign subsidiaries as a result of new global branding initiatives. Either restructuring scenario could have a significant impact on a company's transfer pricing.
With planning or restructuring projects, Transfer Pricing often works in conjunction with other service lines such as Indirect Tax (for customs and duties implications due to changes), Corporate Tax (for Canadian corporate tax, withholding tax or other treaty implications), International Tax (for U.S. corporate tax, income sourcing implications, foreign tax credit issues, withholding tax or other treaty implications, etc.), Valuations (for dispositions of assets), Consulting (for systems changes), or others as may be appropriate based on the nature of the project.
Advance Pricing Agreement
An advance pricing agreement ("APA") is an arrangement or agreement with relevant tax authorities, in advance, regarding transfer pricing. An APA often covers five future taxation years and the methodology may be rolled back to any open years in the past that have not yet been audited, provided the IRS examination team agrees. It is possible to seek unilateral APAs (where only one tax authority is involved), bilateral APAs (where two tax authorities are involved), or multilateral APAs (where multiple tax authorities are involved).
A taxpayer may decide to seek an APA for a variety of reasons. For example, there may have been contentious transfer pricing audits in the past. In this case, the APA may become part of the taxpayer's overall strategy for dealing with the years audited (through the Competent Authority process as discussed below).
Other potential reasons for seeking an APA may include: taxpayers that wish to obtain certainty regarding their transfer pricing, taxpayers that are restructuring and wish to obtain agreement to the changes in advance, or taxpayers that are contemplating significant or potentially controversial new transactions. Whatever the motivation is for the taxpayer to seek an APA, the APA process is generally the same.
These key steps (assuming a bilateral APA is sought) in the APA process are:
1) Pre-filing meetings with the relevant tax authorities;
2) Transfer Pricing analysis to support the submission to each tax authority;
3) APA request and submission to each tax authority;
4) Series of meetings between Transfer Pricing team and tax authority to support the
analysis in the submission;
5) Acceptance letters from the tax authorities;
6) Preliminary review and establishment of case plans by the tax authorities;
7) Review, analysis and evaluation by the tax authorities;
8) Site visits by the tax authorities;
9) Negotiations between the tax authorities;
10) Agreements between the tax authorities and between the tax authorities and the
taxpayers in each country;
11) Post settlement meetings; and
12) APA compliance in each country.
Seeking an APA requires the preparation of transfer pricing documentation. Given that the objective of the APA is for tax authorities to agree to a particular transfer pricing method, the report and analysis for an APA may be more detailed or present different analyses from a typical transfer pricing documentation package in order to address any concerns that the tax authorities may have expressed to the taxpayer during the pre-filing meetings.
Once the submissions are made to the relevant tax authorities, the tax authorities perform information gathering and analyses to develop their respective negotiating positions. This process involves the taxpayers in each country, as the taxpayers respond to queries and discuss issues with the tax authorities.
Once agreement is reached, the taxpayers must demonstrate compliance with the APA each year by submitting a report/memo documenting compliance to the IRS.
Summary and Conclusions
