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LEARNING OBJECTIVESUN-ATAF Workshop on Transfer PricingAdministrative Aspects and Recent DevelopmentsEzulwini, Swaziland4-8 December 2017What istransfer pricing?INTRODUCTION TOTRANSFER PRICINGConducting a TransferPricing AnalysisMonday, 4 December 20179.30am – 11.00amUnderstanding the basicelementsof transfer pricingThe arm’s lengthprincipleLegal Environment2OVERVIEWWhat is transfer pricing and why is it important?The arm’s’ length principleElements of a transfer pricing analysis:- Functional analysis- Comparables and comparability analysis- Transfer pricing methodsThe business frameworkThe legal environmentWhat is Transfer Pricing andWhy is it Important?341

A SIMPLE EXAMPLEQUESTIONSCompany A manufactures automobiles in Japan that are ultimately tobe sold to customers in Germany.The automobiles are sold by Company A to its distribution subsidiary inGermany, Company B. Company B resells the automobiles toindependent dealers.The automobiles cost 10,000 per unit to develop and build.The customers pay 20,000 for the automobiles at retail.The independent dealers earn gross profit of 15% of the end sale priceor 3,000 per automobile. That is, they buy automobiles fromCompany B at a price of 17,000 per unit.That leaves 7,000 (20,000 – 3,000 – 10,000) to cover freight, selling /marketing costs, and overhead costs, to fund development of new carmodels and technology, and to provide profit for Company A andCompany B.How much should should Company A charge CompanyB for the automobiles?a. 9,000b. 10,500c. 13,000d. 15,000e. 17,000f. Cannot tell based on the information presented5QUESTIONS6QUESTIONSWhat additional facts do you need to know in order to identify anarm’s length price?a. Profit margins of other manufacturers?b. Company B’s distribution costs?c. Per unit freight costs from Japan to Germany?d. Retail prices charged by competing companies for their cars?e. Prices charged selling similar cars to unrelated dealers in Japan?f. Company A’s total investment in manufacturing plant andequipment?g. Whether Company A uses the same brand in Japan andGermany?h. Anything else?7What are the tax consequences of any possible answerto the question of what is the right price?- For Japan- For Germany- For the automobile company82

WHAT IS TRANSFER PRICINGKEY TERMS IN THE DEFINITIONUN Practical Manual Para 1.1.6.“Transfer pricing is the general term for the pricing ofcross-border, intra-firm transactions between relatedparties. Transfer pricing , refers to the setting ofprices for transactions between associated enterprisesinvolving the transfer of property or services.”Cross-borderTransactionsBetween “related” parties or “associated enterprises”9EXAMPLES OF TRANSACTIONS REQUIRING TRANSFERPRICING ANALYSISSales of tangible goods including finished inventory, parts andcomponents, and commodity products.Provision of services including corporate administration, salesand marketing, research, other technical services, etc.Transfers of intangibles including rights to use patents,trademarks, brands, technical know-how, etc.Financial transactions including loans, financial guarantees,performance guarantees, related party insurancearrangements, derivatives.Etc., etc., etc.Intra – group transactions constitute at least 30 percent ofglobal trade.1110WORDS NOT FOUND IN THE DEFINITIONProfit shiftingManipulationTransfer mispricingTax avoidanceKey concept: Transfer pricing is a normal part ofinternational commerce. While companies can, andsometimes do, manipulate related party prices fortax advantage, tax authorities need to be concernedabout whether the right prices are charged evenwhere intentional, tax motivated price manipulationis not present.123

OBJECTIVES OF A TRANSFER PRICING ANALYSISDetermine the proper prices for transactions betweenassociated enterprises.Make sure that the resulting allocation of incomebetween taxing jurisdictions reflects the underlyingeconomic activity.Reach cross border agreements on proper pricingamong the taxpayer and the affected countries.Avoid double taxation.The Arm’s Length Principle13ARM’S LENGTH PRINCIPLE14RATIONALE FOR APPLYING THEARM’S LENGTH PRINCIPLEStated most simply, the arm’s length principle requiresthe prices and other conditions of transactions betweenassociated enterprises (related parties) to be the sameas the prices and other conditions that would beestablished in comparable transactions betweenindependent enterprises (unrelated parties).The rationale for the arm’s length principle is thatbecause markets govern transactions between unrelatedparties, determination of prices for related partytransactions on the basis of the prices charged ormargins earned in comparable unrelated partytransactions will assure a market based allocation ofincome between the related parties.15164

CENTRAL ROLE OF THEARM’S LENGTH PRINCIPLEUN AND OECD MODELARTICLE 9 (1)The arm’s length principle is the generally accepted guiding principleused in establishing acceptable transfer prices.1. Where:(a) an enterprise of a Contracting State participates directly or indirectly in themanagement, control or capital of an enterprise of the other Contracting State,or(b) the same persons participate directly or indirectly in the management, control orcapital of an enterprise of a Contracting State and an enterprise of the otherContracting State,and in either case conditions are made or imposed between the two enterprisesin their commercial or financial relations which differ from those which would bemade between independent enterprises, then any profits which would, but forthose conditions, have accrued to one of the enterprises, but, by reason ofthose conditions, have not so accrued, may be included in the profits of thatenterprise and taxed accordingly.The transfer pricing rules in nearly all countries are based on thearm’s length principle.Nearly all bilateral tax treaties commit countries to follow the arm’slength principle. Article 9 of both the UN and OECD Model Treatiesincorporates the arm’s length principle.Consistent application of the arm’s length principle across countriesmakes it possible to resolve transfer pricing disputes and to avoiddouble taxation – The need to resolve disputes makes it important tohave a single set of rules.1718SOURCES OF GUIDANCE ON THE ALPThe UN Practical Manual on Transfer Pricing for DevelopingCountries, first published in 2012 and expanded and updated in2017. The UN manual provides practical advice on applying thearm’s length principle in many situations relevant to developingcountries.The OECD Transfer Pricing Guidelines (updated in 2017) providedetailed guidance on applying the arm’s length principle. Theyare accepted and followed by most countries and they areroutinely used in resolving cross border transfer pricing disputes.The UN Manual and the OECD Guidelines are generallyconsistent.There are also numerous decided court cases from countriesaround the world that apply the ALP.19Conducting a TransferPricing Analysis205

APPLYING THE ARM’S LENGTH PRINCIPLEFUNCTIONAL ANALYSISTransfer pricing under the arm’s length principle is basedon comparing controlled transactions to uncontrolledtransactions.There are three key steps in a transfer pricing analysis:- Get the relevant facts – functional analysis;- Identify useful comparable transactions orrelationships – comparability analysis;- Select and apply the most appropriate transfer pricingmethod.A functional analysis is the process used to assemble theeconomically relevant facts for a transfer pricing analysis.Key elements of the functional analysis may include:Understanding the overall process by which the MNE createsvalue and the key factors contributing to value creation in itsglobal business.Identifying the relevant cross border transactions betweenassociated enterprises.Identifying the specific terms of those transactions by referenceto written contracts and the actual conduct of the parties.Identifying specifically the functions performed, assets used, andrisks assumed by each of the parties in relation to the identifiedtransactions – Accurately Delineating the Transaction.21SOURCES OF INFORMATIONON TAXPAYERS’ TRANSACTIONS22COMPARABLESApplication of the arm’s length principle is usually based on acomparison of the conditions of a controlled transaction withthe conditions of transactions between independententerprisesWritten contracts, invoices, payments, etc.Conduct of partiesWhat did they actually doWas it consistent with the contractsAre there activities undertaken or risks assumed notcovered by the contractsAre functions assigned to a party under the contractwhich that party lacks the capability to performThe comparison is only useful if the economically relevantcircumstances of the controlled and uncontrolled transactionsbeing compared are sufficiently similar, i.e. if they are in factcomparableTo be comparable means that none of the differencesbetween the situations being compared could materiallyaffect the price for the transaction, or if materialdifferences do exist, reasonably accurate adjustmentscan be made to eliminate the effect of such differenceson prices.23246

COMPARABILITY FACTORSCOMPARABILITY ADJUSTMENTSIn some situations comparability adjustments should beconsidered in order to improve the reliability of thetransfer pricing analysisComparability adjustments should be considered only ifthe adjustment will increase the reliability of the resultsDepending on the transfer pricing method being used,common comparability adjustments include adjustmentsfor financing costs, payment terms, and specificdifferences in other contract terms (e.g. delivery, freight,etc.)Adjustments for country and market differences,currency exchange movements, different levels of risk,purchase volumes, and similar items can be far moredifficult to calculate on a reliable basisThe relevant factors to consider in evaluating comparabilityinclude: characteristics of the goods or services in question comparability of the functions performed by each of theparties terms of the transactions being compared nature and of the risks assumed by each of the parties economic circumstances of the parties business strategies followed by the parties25TRANSFER PRICING METHODS26SELECTING THE TESTED PARTYTransfer pricing methods are used to determine appropriatetransfer prices and profits from controlled transactionsThe selection of the most appropriate transfer pricingmethod depends on the factual / functional analysis and onthe availability of information on comparablesThe most appropriate transfer pricing method is thatmethod that will most reliably lead to the identification of anarm’s length price, given the relevant facts and theavailability of relevant data.There are 5 specified transfer pricing methods27The general practice is to select the less complexparty as the tested party.It is usually quite difficult to treat an entity that ownsimportant intangibles as the tested party in applying aone-sided transfer pricing method.It is important in applying one-sided methods to makesure that the functional analysis also considers thefunctions performed, assets used, and risks assumedon the other side of the transaction.287

REVIEW – A NINE STEP PROCESS FORCONDUCTING A TRANSFER PRICING ANALYSIS1.2.3.4.5.6.7.8.9.PRINCIPLES TO REMEMBERTransfer pricing is not a science – there may not be a single correctarm’s length price for a specific transactions.Determine years coveredBroad analysis of taxpayer’s circumstancesUnderstand the controlled transactionsReview existing internal comparables, if anyIdentify sources of possible external comparablesSelect the most appropriate transfer pricing methodIdentify potential comparablesMake comparability adjustments if necessaryInterpret relevant data and determine arm’s lengthpricesInstead, there will often be a range of reasonable arm’s lengthoutcomes. Where a taxpayer’s reported pricing is within thatreasonable range, transfer pricing adjustment generally should notbe made.But – outcomes should not consistently be at either the top end ofthe bottom end of the reasonable range.Tax administrations may wish to focus their attention on largertransactions with material amounts of tax at stake, particularlywhere there is evidence of a good faith effort to comply with thearm’s length principle.2930OVERVIEWDomestic transfer pricing legislationPrinciples and obligations under tax treatiesThe Legal EnvironmentBurden of proofSafe harbour rulesAdvance pricing agreementsDispute resolution31328

DOMESTIC LEGISLATIONDOMESTIC LEGISLATIONUN Practical Manual Paras. 3.2.2. – 3.2.6.Many countries have enacted domestic transfer pricingrulesIn most countries transfer pricing rules are based on thearm’s length principleDomestic transfer pricing law variesThe transfer pricing law may be included inlegislation, orThe legislation may express the main principles withdefinitions and examples included in subordinatelegislation such as regulationsUN Practical Manual Para. 3.2.6.Domestic legislation may includeThe definition of associated enterprisesTransfer pricing methodologiesDocumentation requirementsPenaltiesProcedures for Advance Pricing AgreementsRules related to the burden of proof33TAX TREATIESTax treaties often include provisions regarding transferpricingArticle 9(1) permits adjustments to taxpayer incomewhen the conditions of transactions between associatedenterprises differ from those that would be foundbetween independent enterprisesTax treaties also often contain provisions requiring reliefof double taxation when transfer pricing adjustments aremade and provisions establishing international disputeresolution mechanismsThe UN Practical Manual on Transfer Pricing and theOECD Transfer Pricing Guidelines contain guidance onapplying these treaty provisions3534BURDEN OF PROOFUN Practical Manual Paras. 3.6.1. – 3.6.3.A country’s domestic law will place the burden of proof intax cases on either the MNE or the tax authorityThe MNE may