Overview of transfer pricing methodology for multinational corporates providing other services across intercompany legal entities

1. Overview on transfer
pricing methodology
MULTINATIONAL CORPORATE ENTITIES, AND LOCAL LEGAL
ENTITIES PROVIDING “OTHER SERVICES”
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2. • Background to OECD guidelines
• Overview of applicable methods:
• Comparable Uncontrolled Price (CUP) Method
• Resale Price Method (RPM)
• Cost Plus Method
• Transactional Profit Methods - Profit Split Method
• Transaction Net Margin Method (TNMM)
• Master file concept
• Legal Entity documentation: Functional & Risk Analysis
• Analysis of Risks:
• Appropriate method:The Cost Plus Method
• Transfer Pricing Agreement proposal
• Preamble to Any Agreement
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Contents

3. Background
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• Chapter I, paragraph 1 of Article 9 of the OECD ModelTax Convention provides that where
"conditions are made or imposed between the two enterprises in their commercial or financial
relations which differ from those which would be made between independent enterprises, then
any profits which would, but for those conditions, have accrued to one of the enterprises, but, by
reason of those conditions, have not so accrued, may be included in the profits of that enterprise
and taxed accordingly."
• The most direct way to establish whether the conditions made or imposed between associated
enterprises are at arm's length is to compare the prices charged in the transactions undertaken
between related parties with prices charged in comparable transactions undertaken between
independent enterprises.
• Due to lack of information on such transactions, it is necessary to compare other indicators
created on the basis of available financial data to establish whether the conditions between
related parties are at arm’s length.
• In analysing intercompany transactions for tax purposes, taxpayers must select the transfer pricing
method that provides the most reliable results. According to Chapter II and Chapter III of the OECD
Guidelines the transfer pricing methods preferred for analysing the arm’s length transfer price
include the transactional methods, such as the comparable uncontrolled price, resale price and
cost plus methods. Profit-based methods, such as the transactional net margin method and profit
split methods may also be used if they provide a better result than those methods classified as
transactional.

4. Comparable Uncontrolled Price (CUP) Method
• The CUP method, a transaction-based method, is a reliable and preferred method under the OECD
Guidelines. In addition, the OECD advocates the use of the CUP method if comparable internal or
external agreements can be identified.
• The CUP method compares the price for services or the transfer of goods provided in a controlled
transaction to the price for services provided in a comparable uncontrolled transaction in
comparable circumstances. Under the OECD Guidelines, the results from applying the CUP
generally will be the most direct and reliable measure of an arm’s length price for the controlled
transaction if an uncontrolled transaction has no material differences with the controlled
transaction that would affect price or if there are only minor differences that have a definite and
reasonably ascertainable effect on price and for which adjustments can be made.
• However, if there are material differences between the transactions for which reliable adjustments
cannot be made, the CUP method will not generally provide a reliable arm’s length result. Specific
comparability factors that may be particularly relevant to the CUP method are product
characteristics and quality, contractual terms, market conditions, geographic market, transaction
date, intangibles associated with the transaction and foreign currency risk.
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5. Resale Price Method (RPM)
• The RPM determines arm’s length pricing for related-party transactions by reference to
the gross profit margin realized in comparable uncontrolled sales. Generally the
distribution entity should be reimbursed for its efforts on the basis of an appropriate
gross profit margin.The determination of this margin depends on the functions
performed, risks assumed and assets employed by the distributor.
• The RPM measures the value of the distribution function in those cases where the
related-party purchaser does not add substantial value before resale to an unrelated
party.This method typically cannot be utilized if the reseller adds substantial value to the
property purchased by undertaking additional assembly or manufacturing steps or by
applying its valuable intangible property.
• The preferred way to establish an appropriate gross profit margin is to identify
comparable gross profit margins in transactions with unrelated parties, either between
the group company and a third party (internal comparables) or exclusively between third
parties (external comparables).The appropriate gross profit is computed by multiplying
the applicable resale by the above-mentioned gross profit margin.
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6. Cost Plus Method
• The cost plus method evaluates the arm’s length price of a transaction by calculating
the direct and the indirect costs incurred in the transaction, excluding overheads,
and adding a cost mark-up to ensure an appropriate profit in the light of the
functions performed.The result may be regarded as the arm’s length price in a
controlled transaction.
• The cost plus method is typically used in transactions involving provision of services
or semi-finished products. As with the resale price method, comparability under the
cost plus method is particularly dependent on the similarity of the functions
performed, risks borne and contractual terms.
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7. Transactional Profit Methods:
- Profit Split Method
• The profit split method seeks to eliminate the effect on profits of special conditions
made or imposed in a controlled transaction by determining the division of profits that
independent enterprises would have expected to realize from engaging in the
transaction or transactions.The profit split method first identifies the profit to be split
for the associated enterprises from the controlled transactions in which the associated
enterprises are engaged. It then splits those profits between the associated enterprises
on an economically valid basis that approximates the division of profits that would have
been anticipated and reflected in an agreement made at arm's length.
• The combined profit may be the total profit from the transactions or a residual profit
intended to represent the profit that cannot readily be assigned to one of the parties,
such as the profit arising from high-value, sometimes unique, intangibles.
• The contribution of each enterprise is based upon a functional analysis, and valued to
the extent possible by any available reliable external market data.The profit split
method is typically used in cases involving highly valuable intangible property,
particularly where both parties to the transaction own valuable intangible property or
unique assets used in the transaction that distinguish the transaction from those of
potential competitors.
• In such cases the profit split method may be relevant although there may be practical
problems in its application.
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8. Transactional Profit Methods:
- Transaction Net Margin Method
(TNMM)
• TheTNMM examines the net profit margin relative to an appropriate base (e.g.
costs, sales, assets) that a taxpayer realizes from a transaction with a related entity
and compares it with the level of the margin set by the same entity in transactions
with independent entities, or the margin set in comparable transactions by
independent entities.
• The transactional net margin is arrived at by deducting from the gross income
earned on the transaction the costs incurred in earning this gross income (including
overhead costs, which should be deducted according to the proportion of gross
income from a given transaction to total gross income).
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9. Methodology & Process :
Master File concept proposal
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10. Legal Entity documentation:
Functional & Risk Analysis
• As part of the Functional and Risk analysis, the legal entity documentation should
include:
• History of legal entity
• Legal and organisation structure
• Business operations included in the legal entity
• Functions / activities in the legal units (function and risk analysis)
• Intra-group transactions
• Overview of the financial performance
• In completing the functional and risk analysis it will determine the definition of the
entity and functions performed between that of Entrepreneur and Service provider
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11. Analysis of Risks:
• Types of risks to be identified and analysed to enable appropriate split of functions,
roles and responsibilities between entrepreneur and service providers, focused but
not limited to the following main risk areas:
• Inventory Risk
• Market Risk
• Customer Credit Risk
• Foreign Exchange Risk
• ProductWarranty Risk
• Product Liability Risk
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12. Appropriate method:The Cost Plus Method
• As concluded in the Functional Analysis, in their function of merely providing “Other Services” on a
contract basis to a Entrepreneur, the Group companies are operating as service providers.
• The Entrepreneur funds, manages and coordinates the activities and is the economic owner to all
intangible assets developed.
• As service providers, the companies provide basic, cost-effective services.The service providers are
virtually risk-free providers since the Entrepreneurs purchase the service output and assume the risk of
unsuccessful projects.
• When the CUP method cannot be reliably applied, the OECD Guidelines state that the most suitable
method for setting an arm’s length transfer price for services is the cost plus method, where the
identified costs charged are marked up with a profit margin.
• The underlying rationale is that cost coverage plus an arm’s length mark-up provide an appropriate
remuneration for the activities undertaken, the assets employed and the risks borne by the taxpayer.
• Generally, the mark-up to be applied to the costs should be representative of the mark-up on costs that
an independent party would expect to earn in undertaking similar services and risks when providing
comparable services.
• The cost plus method is considered as an appropriate method for “Other Services” in the absence
of comparable uncontrolled prices.
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13. Transfer Pricing Agreement proposal
• Documentation to outline agreement between related parties on services performed
and remuneration.
• Defines Entrepreneur and Service Provider roles between the two parties, defines
each risk and assigns responsibility
• Currency of transactions, to be local currency of service provider to remove foreign
exchange risk
• States appropriate mark-up to be charged on associated costs, to ensure arms-
length profit is achieved
• Ensures compliance with local tax rules, and provides evidence of approach on inter-
company transactions
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14. This agreement shall be read and interpreted in the light of the Transfer Pricing
Policy and related documents (TPP) as modified from time to time. (if such policy
exists)
The TPP is founded on the notion of the arm’s length principle. A cornerstone of the
TPP is the differentiation between legal entities within the Corporate Group that hold
the position as Entrepreneurs and Service Providers.
-An Entrepreneur assumes all significant economic risks and has the control,
assets and financial capacity to carry these risks.
-A Service Provider carries out certain functions and does not bear any significant
economic risks.
This agreement is concluded to ensure that the parties in their internal relations
adhere to the TPP and the arm’s length principle.
Preamble to Any Agreement:
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