This document summarizes a thesis presentation on transfer pricing approaches. It discusses the arm's length principle versus formulary apportionment, outlines the current OECD, US, and Brazil transfer pricing systems, and concludes that while no single approach is optimal, developing economies may initially adopt formulary apportionment to establish transfer pricing expertise before transitioning to an arm's length system.

1. Advisor: Siciliano Gianfranco
Second Advisor: Prencipe Annalisa
Discussant: Mondin Lorenzo
Thesis:
Transfer Pricing dilemma:
Arm's-length principle VS Formulary apportionment.
Is there an optimal solution?
The OECD, US and Brazil approaches
Università Commerciale L.Bocconi
Corso di Laurea in Economia e Legislaiyone d’Impresa CLELI
Mondin Lorenzo
Contacts: mondin.lorenzo@studbocconi.it
lorenzo.mondin@lu.ey.com .

2. Agenda
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Transfer Pricing dilemma: Arm's-length principle VS Formulary apportionment. Is there an optimal solution?
The OECD, US and Brazil approaches 2
 Transfer Pricing at a glance
 A common recognized pillar: the Arm’s-length principle
 The Formulary apportionment
 The dilemma: which approach is the best for Transfer Pricing?
Current Situation Arm’s Length based Hybrid system
 U.S. - OECD - Brazil Transfer Pricing Approaches
 Conclusions

3. Transfer Pricing at a Glance
Definition – Why is important – Which topics affect
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Transfer Pricing dilemma: Arm's-length principle VS Formulary apportionment. Is there an optimal solution?
The OECD, US and Brazil approaches 3
Transfer Pricing relates to the process of the determination, implementation and
assessment of the prices applied in transactions undertaken between related parties.
Transfer Pricing is recognised as the top tax priority for both MNEs and Tax Administrations
Main Topics other than Corporate Income Tax
VAT and Custom Valuation a conflict of interests and a need of cooperation
Business restructuring and Transfer Pricing influence on Tax Effective Supply Chain
Management
Transfer Pricing as a tool to fight the Base Erosion and Profit Shifting

4. Transfer Pricing at a Glance
Transfer Pricing Assessment Steps
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Transfer Pricing dilemma: Arm's-length principle VS Formulary apportionment. Is there an optimal solution?
The OECD, US and Brazil approaches 4
Investigation and
data collection
Economic analysis
Financial and
descriptive
information
Recommendations
and conclusions
 Identify important
intercompany pricing
issues
 Questionnaires
 Interviews
 Documentation
collection
 Functional analysis
 Selection of transfer pricing
method and comparables,
 Analysis of company and
industry data
 Application of comparables
to relevant entities
 Arm’s length transfer price
computation
 Preliminary
recommendations
 Financial ratios tests
 Business plan analysis
 ETR analysis
 Overall Conclusions in
relation to the Transfer
Pricing policies implemented
by the MNE

5. Transfer Pricing at a Glance
How MNEs can take advantage from transfer prices
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Transfer Pricing dilemma: Arm's-length principle VS Formulary apportionment. Is there an optimal solution?
The OECD, US and Brazil approaches 5
Group X in which
there are only two companies: the
Parent company located in Country A
with a Corporate Income Tax (CIT) of
40% and the Subsidiary (Sub) located
in Country B with a CIT of 10%
The fact that the Group has two different
CIT rates (40% and 10%) opens an
opportunity for the implementation of a
Tax Effective Supply Chain Management
(TESCM).
The TESCM model basically aim to allocate in
the most tax efficient way the activities of the
Group in order to achieve the lowest ETR
maintain the operatively levels needed by the
Group.

6. Transfer Pricing at a Glance
How MNEs can take advantage from transfer prices
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Transfer Pricing dilemma: Arm's-length principle VS Formulary apportionment. Is there an optimal solution?
The OECD, US and Brazil approaches 6
As Is Situation
To Be Situation

7. A common recognized pillar: the
Arm’s-length principle
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“A transaction settled at Arm’s Length conditions is a transaction entered into by two
parties freely and independently of each other, without special relationship, such as
being a relative, having another deal on the side or one party having complete control of
the other”.
Separate entity approach and the comparability analysis
Focus on the nature of the transactions between the related parties and on whether the
conditions of the transactions incurred differ from the conditions that would be
obtained in comparable uncontrolled transactions.
To ensure this is performed the comparability analysis: which should prove that in a
related parties transaction it has been achieved the arm's-length condition through the
use of comparables.
Practical difficulties: due to specific characteristics of the item traded, contractual
framework and arrangements, function performed by the parties, risk assumed and asset
used.

8. Limits and critics to the Arm’s-length
principle
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Transfer Pricing dilemma: Arm's-length principle VS Formulary apportionment. Is there an optimal solution?
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Main critics made from academic exponents, mainly from the U.S in relation to the
effectiveness of the Arm's length mainly on two points:
 First is on the economical level: the Arm's Length contradicts the economic reality
of intra-firm transactions by effectively treating the relatedness of the parties as
incidental, rather than integral to the transaction
 Second on the administrative level: an hypothetical arms-length transfer price does
not correspond to economic reality, it suffers from a lack of administration feasibility
symptomatic of a dysfunctional regulatory framework with burdensome compliance
requirements, multiple layers of subjective judgment about allocation, and a lack of
correspondence to any reasonable measure of how the global corporate tax base
ought to be allocated.

9. The Formulary apportionment
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The OECD, US and Brazil approaches 9
Formulary apportionment is a methodology for the allocation of the MNE's profit
to a particular tax jurisdiction in which the MNE has a taxable presence.
The Formulary apportionment attributes the MNE total worldwide profit to each
jurisdiction, based on a predetermined formula which is tailored in a way to allocate
all the profits in the different tax jurisdictions based on several factors such as the
proportion of sales, the assets used, the headcounts etc.
Globalization make hard to determine where the income is created e.g. Cloud Computing
Industry, hard to have a clear tax structure in MNEs most common practices includes the
so called “Irish double sandwich”, “double dip”, “fiscal transparency”, “treaty shopping” etc.
The implementation of a Formulary apportionment would remove the current artificial
incentives to shift reported incomes
These measures are far more difficult to manipulate for tax purposes than
the location of income establishing a common set of rules eliminating the high component
of current uncertainty.

10. Formulary apportionment, limits and
practical issues for implementation
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Transfer Pricing dilemma: Arm's-length principle VS Formulary apportionment. Is there an optimal solution?
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The main point of the debate around the Formulary apportionment is the formula for
the apportionment of the profits among the tax jurisdictions, the common base is the
Massachusetts Formula established during the 1950's built around three main variables: group
sales, payroll, and property with the same weight
A common accepted formula is the main driver of the practical implementation of a Formulary
apportionment, the need of a common accepted formula will lead to a great afford of cooperation
and harmonization within the tax and accounting systems of the countries in which such formulary
apportionment is implemented.
Two main categories of issues:
A practical one: General Accepted Accounting Principles (GAAP) to be applied most commons
used are IAS-IFRS and US GAAP which have different approaches
A more abstract one: the limits of sovereignty of each country, in the actual Geo-political
framework the only tool that countries have for affirm their sovereignty on their territory is the fiscal
policy and a formulary apportionment somehow will limit the flexibility of this tool
Consequence is a limited diffusion of the Formulary apportionment increasing the tax burden for
tax payers both on the economic side and on the administrative side

11. The dilemma: Arm’s length principle
or Formulary apportionment?
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Transfer Pricing dilemma: Arm's-length principle VS Formulary apportionment. Is there an optimal solution?
The OECD, US and Brazil approaches 11
Both systems have sound defense lines they are not perfect in practice
The effectiveness of the Arm's length have two main inadequacy problems.
Economic contraddiction and lack of administrability
While a Formulary apportionment will led to double taxation issue for the income of MNEs unless
a proper agreement among ALL the tax jurisdictions worldwide on the formula and on the
apportionment to be implemented are established.
Practical issues of cooperation, harmonization and tax sovereignty of tax jurisdictions.
Tax manipulations can be reached leveraging the formula including currency manipulations
Compliance costs for tax payers

12. Current Situation: Arm’s-length based
Hybrid system
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Transfer Pricing dilemma: Arm's-length principle VS Formulary apportionment. Is there an optimal solution?
The OECD, US and Brazil approaches 12
While the OECD openly refuse to apply a Formulary apportionment and keep promoting the
Arms’ length as the right approach it is possible to say that the current system for most countries
(excluding Brazil and pure formulary jurisdictions) is configured as a hybrid between the two
possible approaches.
• Safe Harbors: give to tax payers the possibility to apply defined arm's-length margin
remuneration to certain typologies of transactions. (e.g. EU Joint Transfer Pricing Forum)
• Advanced Pricing Agreements Pricing Agreements: APAs are contracts between a taxpayer and
at least one tax authority specifying the pricing method that the taxpayer will apply to a defined
related-company transaction avoiding the assessment process and the future tax audit.
• Mutual agreement procedure (MAP): the taxpayer is assured that income associated with
Covered Transactions is not subject to double taxation.
• Cost Contribution Arrangements (or Agreements) (“CCAs”) are arrangements between
companies to share the costs and risks of developing, producing or obtaining assets,
services or rights, for which the interests of each participant are determined.

13. OECD – US – Brazil
Transfer Pricing Approaches
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Transfer Pricing dilemma: Arm's-length principle VS Formulary apportionment. Is there an optimal solution?
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OECD US Brazil
Tp Guidelines Local Legislation Local Legislation
Arm’s lenght principle Arm’s lenght principle Formulary Apportionemnt
Most suitable method
approach
Best Method approach Formulary Apportionemnt
TP Methods:
Comparable uncontrolled
price (CUP),
Resale price
Cost plus
Profit split
Alternative Methods
Services:
comparable uncontrolled services price,
gross services margin,
cost of services plus,
comparable profits,
profit split
Exports:
Average Price of Export Sales
Wholesale Price in the Destination Country
Less Profits
Retail Price in the Destination Country Less
Profits
Production Cost Plus Profits
Intangible Property: comparable
uncontrolled transaction
Comparable profits method,
Profit splits Imports:
Comparable Uncontrolled Price
Purchase Price less Profit method
Production Cost Plus Profit Method
, Tangible Property:
Comparable uncontrolled price (CUP),
Resale price
Cost plus
Profit split

14. Conclusions
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Transfer Pricing dilemma: Arm's-length principle VS Formulary apportionment. Is there an optimal solution?
The OECD, US and Brazil approaches 14
Transfer Pricing is a top priority for both tax administrations and tax payers
Transfer Pricing is not only a corporate income tax issue (VAT, Restructuring, Strategies etc.)
No optimal practical approach both the Arm’s Length and the Formulary apportionment have to cope with lack
in applicability or effectiveness.
The real system applied is an Arm's length Hybrid system
There are opportunities available under a tax efficient structuring point of view,:
Developed and developing economies (or countries with no TP culture) are in two different positions:
Developed economies have already the tools for fighting illegal tax practices
Developing economies do not enough expertise and tools to cope with aggressive tax planning and should
find a way to prevent foreign exploitation while protecting their tax base in order to have enough tax
income to sustain the development of the economy.
Under certain extent and with certain common shared principles Formulary apportionment can be a good starting
point for Transfer Pricing systems that then will evolve into an Arm's length based system once the Transfer Pricing
expertise are developed in the tax administration
Not likely to happen:
OECD context Formulary apportionment from both practical and theoretical perspective
The number of countries already included in the current system is too high to manage a change of such dimension.
The CBCR debate will, however, open a new source of debate around the acceptance o a formulary apportionment
among OECD countries