Transfer Pricing Basics: How to set the correct transfer price?

For a number of years now, tax authorities have been paying increasing attention to transfer pricing. But, how to set the correct transfer price? Transfer pricing involves determining arm’s length transfer prices for transactions between related entities. In other words: any non-business elements must be eliminated for tax purposes. By adjusting the transfer prices to the prices that would be established between unrelated parties, it is ensured that the entire business profit is taxed. In determining transfer prices, the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Guidelines) play an important role. But, how to set the correct transfer price?

The OECD describes the steps that can comprise the determination of the transfer price as follows:

The examination of the comparability of transactions is called the comparability analysis. The comparability analysis is relevant to all transfer pricing methodologies used to assess whether intra-group transactions comply with the arm’s-length principle. It forms the basis for any substantiation of the transfer prices used.

In the analysis, however, it is important to first (step 1-3) examine the commercial and financial relations between the related parties and to identify the relevant conditions and circumstances to determine the actual transaction that must ultimately be compared with unrelated transactions. This process is referred to in OECD terminology as the ‘accurate delineation of the actual transaction’. Before comparing, it is important to have a clear picture of what the transaction as such actually entails. Therefore, it could be necessary to determine a so called ‘tested party’. The choice of the ‘tested party’ is an essential part of the process. This is the entity whose financial indicator (such as gross or net profit), when applying certain transfer pricing methods, is compared with that of an unrelated entity with similar functions. As a general rule, the choice of the tested party will depend on how easily the most reliable comparables can be found. This will usually be the case with the entity with the least complex functions.

The arm’s-length principle

The OECD guidelines focus on the arm’s-length principle. The starting point of this principle is that transactions between related enterprises lead to a comparable result for tax purposes as comparable transactions between unrelated enterprises. The essence of the arm’s-length principle is to compare the conditions under which the transaction between related parties takes place and the conditions that would have been agreed if the parties involved had been independent third parties. The taxpayer must therefore look for comparable independent transactions taking place in comparable circumstances. The OECD guidelines indicate that this comparison should be made on the basis of five comparability factors, of which the functional analysis is the most important. You can read also our other blog on the arm’s-length principle.

Comparability factors

The OECD guidelines recognise the following comparability factors:

1. The contractual conditions under which the related transaction takes place.
2. The functions performed by the parties involved, taking into account the assets they use and the risks they accept in relation to the related transaction. This examination is referred to as the ‘functional analysis’.
3. The nature of the goods or services provided.
4. The economic conditions in which the parties involved find themselves.
5. The business strategy pursued by the parties concerned in relation to the related transaction.

The contractual terms

In a business relationship, the contract as agreed between unrelated parties will in many cases be leading in terms of what parties can expect from each other. After all, both parties have an interest in clearly recording the contents of the transaction. Also, it is usually explicitly agreed who bears the risks associated with the transaction.

Related parties, however, do not always clearly lay down their mutual relationship in a written agreement. In many cases, an agreement that only sets out the main points of the transaction is sufficient, or there is not even a written agreement. If there is an intercompany agreement, the conditions are not always complied with in affiliated relationships and no consequences are attached to this non-compliance. Although the content of the agreement should be looked at even in related situations, it is important to look at how the parties involved act in practice. If the parties’ behaviour deviates from what has been agreed in writing, this should be taken into account when setting transfer prices.

The functional analysis

Performing a functional analysis is at the heart of a transfer pricing study. This is because the functional analysis examines which functions the parties perform, which assets they use and which risks they bear.

Functions include for example management, research and development, purchasing, production, sales, marketing, transport and financing. It also examines the assets that the group entities involved use to perform their functions. This includes both intangible assets (e.g. patents, trade name and brand rights) and tangible assets (factory building, office, machinery). Furthermore, the parties involved will face risks such as market risk, inventory risk, capacity risk, liability risk and receivables risk.

After completing the functional analysis, the group entities involved in the transaction can be qualified. This qualification is then important in determining the level of the business remuneration. For example, an entity that is a full-fledged distributor and bears all related risks will qualify for higher remuneration than an entity that performs sales activities for another group entity and bears only limited risk itself.

Nature of the goods or services supplied

With tangible goods, the quality of the goods, the physical properties, availability and volume are important when comparing an related transaction with an unrelated transaction. With intangible goods, the nature of the good (patent, trademark, know-how) is important, the way in which the good is legally protected and the duration of this protection. The expected future income from the exploitation of the good also plays an important role. With regard to services, the nature, scope and complexity of the service provided is important.

Economic conditions

The analysis of the economic conditions in which the parties operate includes, for example, the geographic region in which the parties operate, the size of their sales market, the degree of competition on the market, whether substitute goods are present and the level of supply and demand on the market.

Business strategy

The strategy of a company depends, among other things, on whether there is innovation and product development, the degree of diversification and whether the company must take account of changes in legislation and regulations. It is also important whether the company aims to increase its market share or tries to enter a new market. This may explain higher costs (start-up costs) and thus a lower profit than comparable companies that have been active in the same market for a longer time.

Transfer pricing methods

The OECD guidelines list five methods that can be used to determine an arm’s length transfer price. These are three traditional methods (Comparable Uncontrolled Price method, Resale Price method and Cost-plus method) and two transactional methods (Transactional Net Margin method and Transactional Profit Split). In practice, the Transactional Net Margin Method is usually used in combination with a profit level indicator.

The benchmark study: the backbone to set the correct transfer price

After the functional analysis of the parties involved in the transactions and having selected a suitable transfer pricing method, the search for reliable comparables is the next step in finding the arm’s-length price. After finding the comparables it’s possible to establish an arm’s length margin. This is done by carrying out a benchmark study, involving a financial analysis of the results of independent companies that perform similar activities to the affiliate for which an arm’s length margin must be established. The main purpose of the benchmark study is to determine the general conditions surrounding the transactions conducted by third parties on a given market. With this information an arm’s length margin can be determined. Because transfer pricing is not an exact science, a range is used. If the margin achieved by the related enterprise in the intra-group transaction falls within this range, the transfer price applied is at arm’s length. If not, the transfer price must be adjusted until a margin is achieved that falls within the range.

Besides that, a well-executed benchmark study can also be used as an argument in a dispute with the tax authorities when they do not agree with the prices used. It can justify the income allocation within a group or for a specific intercompany transaction. In other words, a reliable benchmark study equals minimising transfer pricing risks. Furthermore, it can give a good insight about the competition and industry performance.

Different types of comparables

In the comparability analysis, a distinction is made between internal and external comparables. Internal comparables are comparable transactions which the investigated entity enters into with unrelated parties. External comparables are comparable transactions which are entered into between two unrelated parties. In the case of the first type of comparables, the information is present in the administration of the investigated entity, whereas for the second type of comparables data in the public domain should be sought. External comparables are usually found in commercial databases, which collect a lot of corporate financial data.

For the identification of the external comparables two main types of identification are recognised in the OECD Guidelines. The first one is the additive approach. The additive approach consists of drawing up a list of potentially comparable companies, such as the taxpayer’s competitors. The second method is the deductive approach. The deductive approach starts with a wide set of companies operating in the same sector, established using domestic or international databases. The main criteria when creating the list of potentially comparable companies from the database in the benchmarking studies of companies are:

• Independence: potentially comparable companies must not have any related parties
• Available financial statements in last 3 – 5 years
• Activity: searching only active companies which still perform regular business activities
• Geographic market: starting from the country of the taxpayer and then expanding the geographic reach if necessary
• Excluding companies with negative financial results in three consecutive years
• Year of incorporation: The criterion year of incorporation screening prevents the arm’s length range from being affected by companies that are in a start-up phase and therefore have non-comparable economic conditions during the considered period
• Industry Screening
• Revenues and number of employees

Limited presence of comparables

Despite the search process carried out, the conclusion must sometimes be drawn that not enough reliable comparables can be found. It then depends on the facts and circumstances what should be done. Sometimes it may be decided to broaden the search by also looking at, for example, slightly different geographical markets or to search for activities in a comparable industry sector. In doing so, the effects on the reliability of the data must always be considered and a very critical attitude is necessary.

Comparability adjustments

If the comparables are not comparable in the first place, this does not have to be a problem in itself if there are comparability adjustments that ensure that the observed differences are eliminated as much as possible. Different comparability adjustments can be made. Adjustments can be made because of the different reporting rules.  In addition, adjustments regularly occur as a result of differences in functions, assets and risks.

The OECD explicitly warns that comparability adjustments should not be applied automatically if it remains uncertain whether the adjustments would lead to a comparable ‘comparable’. This would only lead to a form of false certainty that is not considered desirable.

The use of an arm’s-length range

Rarely will it be possible, on the basis of the comparability analysis, to set a single price that is reliable enough to be considered the arm’s-length price. If the reliability of the various comparables differs, the less reliable comparables should be eliminated. The remaining comparables should have a comparable reliability. The OECD Guidelines note that, in principle, any value within the range satisfies the arm’s-length principle. If, on the other hand, it is possible to identify a point within the range that best matches the facts and circumstances of the group transaction in question, the adjustment should be made up to that point. If there are imperfections in the construction of the range, the OECD considers that there is a case for using a statistical method to establish the point. For example, the median, the mean, or the weighted average.

Keep hold of evidence of the process and the decision-making reasons

Taxpayers are obliged to include in their records information that shows how their transfer prices were determined and whether there are transfer prices that correspond to prices that would also have been agreed upon by independent third parties. Every taxpayer involved in an intra-group transaction should fulfil this basic obligation. If the taxpayer does not comply with this obligation, this may lead to a reversal of the burden of proof. A penalty may also be imposed because the records do not meet the requirements of the tax law.

For group entities belonging to a multinational group with a consolidated turnover of more than €50 million, additional documentation requirements have also applied since 2016. These group entities must include a group file and a local file in their records. These files must comply with certain form requirements. A group entity belonging to a multinational group with a consolidated turnover of more than €750 million also has a notification obligation based on which it must inform the inspector whether it is the ultimate parent of the group. If this is the case, the group entity will also have to submit a country-by-country-report.

It is important to record the entire process. Not only the results, but also the realisation of decisions are relevant here. With this you can clearly indicate why certain decisions have been taken and you can make the judge or the tax authorities understand this better. Also, a court case or an audit by the tax authorities often takes place years after the benchmarking study is performed. It is possible that people involved in the initial benchmark study no longer work for the company. Therefore, keeping records and files on the work performed is key to defend your comparable data in case of a disagreement on the results with a tax authority.

Use an appropriate database

As aforementioned the external comparables in the benchmarking study are often found by using a specialised database. Depending on the type of transaction you will require a specific type of database. Therefore, whether you perform the benchmark or outsourced it to a third party, it is important to ensure that the database you are using is the right one for the type of transaction you are testing.

Conclusion

To set the correct transfer price can be a difficult process. Especially finding the right comparables for the benchmark study. Since the benchmark study is the backbone of your transfer pricing documentation, it is necessary that it is well-executed.

TPGenie can help you with all above facets of creating top notch transfer pricing documentation including our Transfer Pricing benchmarking database and its automated Functional Analysis determination algorithms. This will reduce time spent and increases efficiency. Contact us so we can tell you more about it!

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Sources:

• Verrekenprijzen; de verdeling van de winst van een multinational
• Transferpricing.ro
• Atipic
• Wtsserbia