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Transcript of Transfer Pricing
Transfer prices are the prices at which an enterprise transfers physical goods and intangible property or provides services to associated enterprises.
All international firms already use transfer pricing.
All multinational firms that transfer products, services, or intangible internationally are currently setting prices for these transfers.
Transfer pricing is just the process of setting prices for transfers between related firms.
Most firms are not setting correct transfer prices.
The MNE´s want to select transfer prices that minimize taxes. Table of Contents 1.What is transfer pricing?
1.1. Related or associated companies
1.2 Types of Transfer Pricing
1.3 Why do governments/businesses care about transfer pricing?
2. Guidance for applying Arm´s length principle
2.1 Comparability analysis
2.2 Factors determining comparability
3. Spanish Transfer Pricing Regulation
4.Transfer pricing Methods
4.1 Comparable Uncontrolled Price Method
4.2 Resale Price Method
4.3 Cost Plus Method
4.4Transactional Net Margin Method
4.5 Profit Split Method For purposes of the Guidelines, an “associated enterprise” is an enterprise that satisfies the conditions set forth in Article 9, sub-paragraphs 1a) and 1b) of the OECD Model Tax Convention. Under these conditions, two enterprises are associated if:
One of the enterprises participates directly or indirectly in the management, control, or capital of the other;or Transfer prices are significant for both taxpayers and tax administrations because they determine in large part the income and expenses, and therefore taxable profits, of associated enterprises in different tax jurisdictions.
o US firms dodge billions in taxes by moving profits overseas
o ‘Transfer pricing’ allows companies to avoid tax on profits – legally
o As America struggles with record deficits, tax dodgers apparently are taking billions of dollars out of the country
30% to 60% of all international trade occurs between related parties
US loses as much as $60B of income tax revenue each year Types of transactions
Tangible property (inventory, equipment, etc.)
Services (back office, contract R&D, etc.)
Intangibles (licenses, royalties, IP migration, etc.)
Cost sharing It should not be assumed that the conditions established in the commercial and financial relations between associated enterprises will invariably deviate from what the open market would demand. Statement of the arm’s length principle
(Article 9 of the OECD Model Tax Convention):
[Where] conditions are made or imposed between the two [associated] 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. 2. Guidance for applying Arm´s length principle Comparability analysis
Application of the arm’s length principle is generally based on a comparison of the conditions in a controlled transaction with the conditions in transactions between independent enterprises.
In order for such comparisons to be useful, the economically relevant characteristics of the situations being compared must be sufficiently comparable. By definition, a comparison implies examining two terms:
the controlled transaction under review and
the uncontrolled transactions that are regarded as potentially comparable. Factors determining comparability :
Characteristics of property or services
Business strategies 4.Transfer Pricing Methods 4.1 Comparable Uncontrolled Price Method 4.2 Resale Price Method 4.3 Cost Plus Method 4.4 Transactional Net Margin Method 4.5 Profit Split Method Traditional transaction methods:
4.1 Comparable Uncontrolled Price Method (CUP)
4.2 Resale Price Method
4.3 Cost Plus Method
Transactional profit methods:
4.4 Transactional Net Margin Method
4.5 Transactional Profit Split Method “Traditional transaction methods” and “Transactional profit methods” that can be used to establish whether the conditions imposed in the commercial or financial relations between associated enterprises are consistent with the arm's length principle. A traditional transaction method and a transactional profit method can be applied in an equally reliable manner, the traditional transaction method is preferable to the transactional profit method. Hierarchy of Methods Use of more than one method The OECD Guidelines do not require either the tax examiner or taxpayer to perform analysis under more than one method. While in some cases the selection of a method may not be straightforward and more than one method may be initially considered, generally it will be possible to select one method that is apt to provide the best estimation of an arm’s length price The CUP method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances.
If there is any difference between the two prices, this may indicate that the conditions of the commercial and financial relations of the associated enterprises are not arm's length, and that the price in the uncontrolled transaction may need to be substituted for the price in the controlled transaction. Comparability
An uncontrolled transaction is comparable to a controlled transaction for purposes of the CUP method if one of two conditions is met:
a) 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,
b) reasonably accurate adjustments can be made to eliminate the material effects of such differences. 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.
For example, a minor difference in the property transferred in the controlled and uncontrolled transactions could materially affect the price even though the nature of the business activities undertaken may be sufficiently similar to generate the same overall profit margin Examples of the application of the CUP method The CUP method is a particularly reliable method where an independent enterprise sells the same product as is sold between two associated enterprises.
For example, an independent enterprise sells unbranded Colombian coffee beans of a similar type, quality, and quantity as those sold between two associated enterprises, assuming that the controlled and uncontrolled transactions occur at about the same time, at the same stage in the production/distribution chain, and under similar conditions. If the only available uncontrolled transaction involved unbranded Brazilian coffee beans, it would be appropriate to inquire whether the difference in the coffee beans has a material effect on the price.
For example, it could be asked whether the source of coffee beans commands a premium or requires a discount generally in the open market.
Such information may be obtainable from commodity markets or may be deduced from dealer prices. If this difference does have a material effect on price, some adjustments would be appropriate. If a reasonably accurate adjustment cannot be made, the reliability of the CUP method would be reduced, and it might be necessary to select another less direct method
instead. Example: Different Incoterms
One illustrative case where adjustments may be required is where the circumstances surrounding controlled and uncontrolled sales are identical, except for the fact that the controlled sales price is a delivered price and the uncontrolled sales are made f.o.b. factory. The differences in terms of transportation and insurance generally have a definite and reasonably ascertainable effect on price. Therefore, to determine the uncontrolled sales price, adjustment should be made to the price for the difference in delivery terms. As another example, assume a taxpayer sells 1,000 tons of a product for $80 per ton to an associated enterprise in its MNE group, and at the same time sells 500 tons of the same product for $100 per ton to an independent enterprise. This case requires an evaluation of whether the different volumes should result in an adjustment of the transfer price. The relevant market should be researched by analysing transactions in similar products to determine typical volume discounts. Concept:
The resale price method 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 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. The resale price margin of the reseller in the controlled transaction may be determined by reference to the resale price margin that the same reseller earns on items purchased and sold in comparable uncontrolled transactions (“internal comparable”).
Also, the resale price margin earned by an independent enterprise in comparable uncontrolled transactions may serve as a guide (“external comparable”). The resale price method also depends on comparability of functions performed (taking into account assets used and risks assumed). It may become less reliable when there are differences between the controlled and uncontrolled transactions and the parties to the transactions, and those differences have a material effect on the attribute being used to measure arm's length conditions, in this case the resale price margin used.
Where there are material differences that affect the gross margins earned in the controlled and uncontrolled transactions (e.g. in the nature of the functions performed by the parties to the transactions), adjustments should be made to account for such differences.
Example: Small Island Banana owns a banana distributor in the United States. The banana distributor sells bananas to unrelated retailers for $20/box.
Unrelated banana distributors earn average commissions of 10%. Therefore, the banana distributor should have revenue of $2 per box, and Small Island Banana will have revenue of $18 per box.
The transfer price is $18/box. Example:
Assume that there are two distributors selling the same product in the same market under the same brand name. Distributor A offers a warranty; Distributor B offers none. Distributor A is not including the warranty as part of a pricing strategy and so sells its product at a higher price resulting in a higher gross profit margin (if the costs of servicing the warranty are not taken into account) than that of Distributor B, which sells at a lower price. The two margins are not comparable until a reasonably accurate adjustment is made to account for that difference. The cost plus method begins with the costs incurred by the supplier of property (or services) in a controlled transaction for property transferred or services provided to an associated purchaser. An appropriate cost plus mark up is then added to this cost, to make an appropriate profit in light of the functions performed and the market conditions. What is arrived at after adding the cost plus mark up to the above costs may be regarded as an arm's length price of the original controlled transaction.
This method probably 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. 1.What is transfer pricing? Changing a transfer price shifts taxable income from one country to another.
If a transfer price is increased, the selling firm’s revenue and profits increase, and the receiving firm’s profits decrease.
If both firms are in Spain (or in any one country), the taxable income remains in Spain, and the transfer price is not important to the country’s tax authority.
However, if firms are in different countries, changing the transfer price changes both Spain and foreign taxable income. Both Spain and foreign governments are very interested in the profit they can tax. If “the same persons participate directly or indirectly in the management, control, or capital” of both enterprises (i.e. if both enterprises are under common control). 1.3 Why do governments/businesses care about transfer pricing? Some examples:
•Google 2.4% rate shows how $60 Billion Lost to Tax Loopholes (Bloomberg)
•Medtronic fights $2.7 billion in adjustments related to transfer pricing, other issues (BNA Transfer Pricing Report)
•Chrysler agrees to pay Canada $1.5 billion (BNA Transfer Pricing Report)
•IBM reports $2 billion 482 adjustment (BNA Transfer Pricing Report)
•AstraZeneca pays IRS $1.1 billion to settle transfer pricing issues (BNA Transfer Pricing Report) 3. Spanish Transfer Pricing Regulation Art.16.1 1º (CITLaw): The transactions between associated persons or entities should be assessed at their arm’s length price, being this understood as the price which would have been agreed between unrelated parties in free market conditions.
To the effects of the Spanish Law, any mention made to “entity” shall be understood as entities liable to the Spanish corporation tax. 1. Reference to the OECD Transfer Pricing Guidelines Art. 16.3(CITLaw). It is deemed to be associated:
a) An entity and the owners of its equity (at least the 5% or 1% when the shares are carried out on official secondary securities regulated markets), or the spouse, ascendants or descendents.
b) An entity and the member of its board of directors or their administrators (includes the fact administrators) or the spouse, ascendants or descendents.
c) Two entities of the same group.
d) An entity and the partners (or the spouse, ascendants or descendents) of an entity of the same group.
e) An entity and the members of the board of directors of an entity of the same group or their administrators.
f) Two entities where the second entity owns, indirectly, at least, 25% of the capital of the first one.
g) Two entities when the same person (or the spouse, ascendants or descendents) or entity own, directly or indirectly, 25% of the equity.
h) An entity resident in Spain and their permanent establishment situated in other country.
i) An entity resident in other country and their PE situated in Spain.
j) Two entities of the same group liable to tax under the cooperative group’s regime.
Art.16.4 CITLaw states that to determine the AL price the following methods should be used:
a) The comparable uncontrolled price (CUP) method;
b) The cost plus method;
c) The resale price method.
Where the methods mentioned before can not be applied in a proper manner because of the complexity of the transactions or the information available is considered not to be sufficient, the two profit methods could be apply:
a) the profit split method, or
b) the transactional net margin method.
Art. 16.2 CIT Law states that associated persons or entities should keep some documentation; the specific documents are specified in Corporate Income Tax Rules (as drafted in Royal Decree 1973/2008, of 3 November and in Royal Decree 897/2010, of 9 July).
The Regulations stipulate a number of factors to be borne in mind by the taxpayer, almost following verbatim the recommendations made for such purpose in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the “OECD Guidelines”). These factors are as follows:
The characteristics of the property or services transferred under the related-party transactions;
Functions performed and risks assumed, as well as assets used by the parties;
Contractual terms of the transactions (responsibilities, risks and benefits of each party);
The characteristics of the markets or other economic circumstances that may affect the transactions;
Any other factor that may be relevant (such as business strategies).
Art. 16.9 CIT Law states the basic principles of a specific transfer pricing audit procedure to be developed on further regulations.
Art. 16.10 CIT Law states a new penalty regime based on two pillars:
a) It will constitute serious tax penalty the failure to provide transfer pricing documentation or provide it in a severe incomplete manner and if the arm’s length price states in the CIT assessment differs from that derived from the documentation;
b) No penalty will be levied in the case the taxpayer has complied with the documentation requirements and has properly applied the criteria in the tax assessment even if there is an adjustment. Advance Pricing Arrangements (APA)
An advance pricing arrangement (“APA”) is an arrangement that determines, in advance of controlled transactions, an appropriate set of criteria for the determination of the transfer pricing for those transactions over a fixed period of time.
An APA is formally initiated by a taxpayer and requires negotiations between the taxpayer, one or more associated enterprises, and one or more tax administrations.
APAs are intended to supplement the traditional administrative, judicial, and treaty mechanisms for resolving transfer pricing issues. They may be most useful when traditional mechanisms fail or are difficult to apply. Preamble of the Law 36/2006 of 29 November. It mentions that the law should be interpreted according to the OECD Guidelines. 2. Reference to the Arm’s Length Principle: 3. Definition of related parties 4. Transfer pricing documentation requirements 5. Comparability analysis: 6. Specific transfer pricing audit procedures and / or specific transfer pricing penalties 7. Transfer pricing methods Company A Associated Company Uncontrolled Company Colombian coffee in bulk Colombian coffee in bulk Company A Colombian coffee Brazilian coffee Associated Company Uncontrolled Company Factors determining comparability :
Characteristics of property or services
Business strategies Factors determining comparability :
Characteristics of property or services
Business strategies COMPARABLE Incomparable
Need some adjust to be comparable Comparability Resale Price to an independent third party _ reseller margin = Normal value for the original transaction on open market Example: Franceferra (located in France) Ferra (located in Spain) Franceferra buys products from its associated Ferra and sells to third parts in France Franceferra Accounts: Sales 1000
Cost of Sales (800)
- product purchased 600
- other costs 200
Gross Margin 200 The tax authority in France understand that the company should obtain a gross margin of 25% to market value. Franceferra accounting adjusted by the French authority: Sales 1000
Cost of Sales (750)
- product purchased 550
- other costs 200
Gross Margin 250 Production Cost + Added margin according to information available about third companies = Market value of the original transaction Example C +:
U.S. Auto opens an assembly plant in Mexico. The assembly plant supplies no capital, no automotive knowledge, and takes no risk. Similar assembly businesses earn a margin of 30% on costs (cost plus 30%). The costs are $10. Therefore, the transfer price is $13. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations Chapter I The Arm's Length Principle Chapter II Transfer Pricing Methods Chapter III Comparability Analysis Chapter IV Administrative Approaches to Avoiding and Resolving Transfer Pricing Disputes Chapter V Documentation Chapter VI Special Considerations for Intangible Property Chapter VII Special Considerations for Intra-Group Services Chapter VIII Cost Contribution Arrangements Chapter IX Transfer Pricing Aspects of Business Restructurings An "arm's length" price - a price two independent firms operating at
arm's length would agree on - is needed to determine taxable profits
earned in each country. While the economic analysis is complex, the idea can be summarized by the following two questions: Would the selling firm agree on the price if it were selling to an unrelated firm (a firm at arm’s length)?
Would the purchasing firm agree on the price if it were buying from an unrelated firm (a firm at arm’s length)? If the answer is no to either of the above questions, the price is not
an arm’s length price. TNM Method
The transactional net margin method (‘TNMM’) is a profit-based method that can be used to apply the arm’s length principle. The TNMM can be applied on either the related party manufacturer or the related party distributor as the tested party for transfer pricing purposes.
The TNMM examines the net profit margin relative to an appropriate base (e.g., costs, sales, assets) that a taxpayer realizes from a controlled transaction (or transactions that are appropriate to be aggregated). º TNM Method
The TNMM compares the net profit margin (relative to an appropriate base) that the tested party earns in the controlled transactions to the same net profit margins earned by the tested party in comparable uncontrolled transactions or alternatively, by independent comparable companies.
The TNMM is a more indirect method than the cost plus / resale price method that compares gross margins.
It is also a much more indirect method than the CUP method that compares prices, because it uses net profit margins to determine (arm’s length) prices. It is consistent with arm´s length price It is not consistent with arm´s length price The profit split method is typically applied when both sides of the controlled transaction own significant intangible properties. The profit is to be divided such as is expected in a joint venture relationship.
The profit split method seeks to eliminate the effect on profits of special conditions made or imposed in a controlled transaction (or in controlled transactions that are appropriate to aggregate) by determining the division of profits that independent enterprises would have expected to realise from engaging in the transaction or
transactions. The combined profits to be divided between the associated enterprises from the controlled transactions should be determined first and foremost. Subsequently, these profits are divided between the associated enterprises based on the relative value of eachenterprise’s contribution, which should reflect the functions performed, risks incurred and assets used by each enterprise in the controlled transactions.
The profit split method is applicable to transfer pricing issues involving tangible property, intangible property and services.
The Profit split method is not as dependent of comparable data as the other methods, hence it can be applicable when comparable data isnt accessible. The method analyses both parties of the transaction which entails a reasonable split between the associated enterprises, though the application of the method also depends on the collaboration of all the associated enterprises. Approaches to allocate or Split the Profits residual analysis Under the contribution analysis, the combined profits from the controlled transactions are allocated between the associated enterprises on the basis of the relative value of functions performed by the associated enterprises engaged in the controlled transactions.
The profit is split based on the functions and risks that the enterprises assume in relation to the transaction Under the residual analysis, the combined profits from the controlled transactions are allocated between the associated enterprises based on a two-step approach: • step 1: allocation of sufficient profit to each enterprise to provide a basic compensation for routine contributions. This basic compensation does not include a return for possible valuable intangible assets owned by the associated enterprises.The basic compensation is determined based on the returns earned by comparable independent enterprises in comparable transactions. In practice, the traditional transaction methods can be used to determine a normal profit in step 1 of the residual analysis; and • step 2: allocation of residual profit (i.e. profit remaining after step 1) between the associated enterprises based on the facts and circumstances. If the residual profit is attributable to intangible property, then the allocation of this profit should be based on the relative value of each enterprise’s contributions of intangible property. contribution analysis In the first stage the enterprises are remunerated for its non-unique contribution in relation to the transaction. In the second stage any residual profit remaining are allocated to the enterprises based on an analysis of the facts and circumstances. Article 42 of the Commercial Law:
There is a group where a company has or may have, directly or indirectly, control of another or others. In particular Control is presumed to exist when a society, to be qualified as dominant, is in relation to another company, which qualify as a dependent, in any of the following situations:
a)The company holds the majority of voting rights.
b) The company have the power to appoint or remove a majority of the members of the board of administration.
c) The company holds the majority of voting rights, because of agreements with third parts.
d) The company has appointed with their votes the majority of the members of the board of administration who held their office at the time they must drawn up consolidated accounts and for the two immediately preceding periods. 35% U.S. Corporate Tax Rate
2,4% Google Tax on Non-U.S. profit 12,5 % Ireland Income Tax Google Inc. had cut its taxes by $3.1 billion in 2008,2009 and 2010 using this technique. "Such income shifting costs the U.S. government as much as $60 billion in annual revenue"
Kimberly A. Clausing,Reed College in Portland, Oregon. Certain items of income are exempt from Dutch corporate tax. The most important items of income that are exempt are:
capital gains and dividends derived from qualifying subsidiaries ("participation exemption");
•More countries with transfer pricing rules
Kenya, Qatar, and Kazakhstan recently in the news
•Worldwide, a significant increase in…
o Transfer pricing audits, disputes, and controversies
o Penalty assessments
o Advance pricing agreements