TRANSFER PRICING GUIDELINES
FOR MULTINATIONAL ENTERPRISES
AND TAX ADMINISTRATIONS
ORGANISATION FOR ECONOMIC CO-OPERATION
AND DEVELOPMENT
Pursuant to Article 1 of the Convention signed in Paris on 14th December
1960,
and which came into force on 30th September 1961, the Organisation for
Economic
Co-operation and Development (OECD) shall promote policies designed:
Ð to achieve the highest sustainable economic growth and employment and
a rising
standard of living in Member countries, while maintaining financial
stability, and
thus to contribute to the development of the world economy;
Ð to contribute to sound economic expansion in Member as well as
non-member
countries in the process of economic development; and
Ð to contribute to the expansion of world trade on a multilateral,
non-discriminatory
basis in accordance with international obligations.
The original Member countries of the OECD are Austria, Belgium, Canada,
Denmark, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg,
the
Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the
United Kingdom and the United States. The following countries became
Members
subsequently through accession at the dates indicated hereafter: Japan
(28th April 1964),
Finland (28th January 1969), Australia (7th June 1971), New Zealand
(29th May 1973),
Mexico (18th May 1994), the Czech Republic (21st December 1995), Hungary
(7th May 1996), Poland (22nd November 1996) and Korea (12th December
1996). The
Commission of the European Communities takes part in the work of the
OECD
(Article 13 of the OECD Convention).
Publi«e en franücais sous le titre :
PRINCIPES APPLICABLES EN MATI`ERE DE PRIX DE TRANSFERT
A LÕINTENTION DES ENTREPRISES MULTINATIONALES ET DES
ADMINISTRATIONS FISCALES
Reprinted 1998
î OECD 1995
Permission to reproduce a portion of this work for non-commercial
purposes or classroom use
should be obtained through the Centre franücais dÕexploitation du droit
de copie (CFC),
20, rue des Grands-Augustins, 75006 Paris, France, Tel. (33-1) 44 07 47
70,
Fax (33-1) 46 34 67 19, for every country except the United States. In
the United States permission
should be obtained through the Copyright Clearance Center, Customer
Service, (508)750-8400,
222 Rosewood Drive, Danvers, MA 01923 USA, or CCC Online:
http://www.copyright.com/. All other applications for permission to
reproduce or translate all or
part of this book should be made to OECD Publications, 2, rue
Andr«e-Pascal,
75775 Paris Cedex 16, France.
July 1995 iii
©OECD
FOREWORD
These Guidelines are a revision of the OECD Report Transfer Pricing
and Multinational Enterprises (1979). They
were approved by the Committee
on Fiscal Affairs on 27 June 1995 and by the OECD Council for
publication on
13 July 1995. These Guidelines will be supplemented with additional
chapters
addressing other aspects of transfer pricing and will be periodically
reviewed
and revised on an ongoing basis.
August 1997 v
©OCDE
TABLE OF CONTENTS
Preface
....................................................................................................................P-1
Glossary
.................................................................................................................
G-1
Chapter I
The Arm's Length Principle
A. Introduction .....................................................................................................I-1
B. Statement of the arm's length principle
..........................................................I-3
i) Article 9 of the OECD Model Tax Convention
.....................................I-3
ii) Maintaining the arm's length principle
as the international
consensus.................................................................I-6
C. Guidance for applying the arm's length principle
..........................................I-7
i) Comparability analysis............................................................................I-7
a) Reason for examining comparability
...............................................I-7
b) Factors determining
comparability.................................................. I-9
1. Characteristics of property or services
........................................I-9
2. Functional
analysis.......................................................................I-9
3. Contractual terms ......................................................................
I-12
4. Economic
circumstances........................................................... I-12
5. Business strategies
.................................................................... I-13
ii) Recognition of the actual transactions
undertaken ............................. I-15
iii) Evaluation of separate and combined
transactions ............................. I-17
iv) Use of an arm's length
range................................................................ I-19
v) Use of multiple year data
.................................................................... I-20
vi) Losses
...................................................................................................
I-21
vii) The effect of government policies ......................................................
I-22
viii) Intentional
set-offs................................................................................
I-24
ix) Use of customs
valuations....................................................................
I-26
x) Use of transfer pricing
methods........................................................... I-27
OECD TRANSFER PRICING GUIDELINES
vi August 1997
©OCDE
Chapter II
Traditional Transaction Methods
A. Introduction ...................................................................................................
II-1
B. Relationship to Article 9
..............................................................................
II-1
C. Types of traditional transaction methods .....................................................
II-2
i) Comparable uncontrolled price method
.............................................. II-2
ii) Resale price method
.............................................................................
II-5
iii) Cost plus method.................................................................................
II-11
D. Relationship to other methods
.................................................................... II-17
Chapter III
Other Methods
A. Introduction ..................................................................................................
III-1
B. Transactional profit methods
....................................................................... III-1
i) Profit split
method................................................................................
III-2
a) In
general........................................................................................
III-2
b) Strengths and
weaknesses.............................................................. III-3
c) Guidance for
application................................................................
III-4
ii) Transactional net margin method
........................................................ III-9
a) In
general........................................................................................
III-9
b) Strengths and
weaknesses............................................................ III-10
c) Guidance for application
............................................................. III-12
1. The comparability standard to be applied
to the transactional net margin method.................................
III-12
2. Other
guidance.......................................................................
III-14
iii) Conclusions on transactional profit
methods .................................... III-16
TABLE OF CONTENTS
August 1997 vii
©OCDE
C. A non-arm's-length approach:global formulary
apportionment............... III-19
i) Background and description of
method............................................. III-19
ii) Comparison with the arm's length
principle...................................... III-20
iii) Rejection of non-arm's-length
methods............................................. III-24
Chapter IV
Administrative Approaches to Avoiding
and Resolving Transfer Pricing Disputes
A. Introduction
..................................................................................................IV-1
B. Transfer pricing compliance practices
........................................................IV-2
i) Examination practices
..........................................................................IV-3
ii) Burden of proof
....................................................................................IV-4
iii) Penalties................................................................................................IV-7
C. Corresponding adjustments and the mutual agreement procedure:
Articles 9 and 25 of the OECD Model Tax
Convention...........................IV-10
i) The mutual agreement procedure
......................................................IV-10
ii) Corresponding adjustments:Paragraph 2 of
Article 9 .......................IV-11
iii) Concerns with the
procedures............................................................IV-13
iv) Recommendations to address concerns
.............................................IV-15
a) Time limits
...................................................................................IV-15
b) Duration of mutual agreement
proceedings................................IV-17
c) Taxpayer participation
.................................................................IV-19
d) Publication of applicable procedures
..........................................IV-20
e) Problems concerning collection of tax
deficiencies
and accrual of interest ..................................................................IV-21
v) Secondary
adjustments.......................................................................IV-22
OECD TRANSFER PRICING GUIDELINES
viii August 1997
©OCDE
D. Simultaneous tax examinations. ...............................................................IV-26
i) Definition and
background.................................................................IV-26
ii) Legal basis for simultaneous tax
examinations.................................IV-27
iii) Simultaneous tax examinations and transfer
pricing ........................IV-28
iv) Recommendation on the use of simultaneous
tax examinations .....IV-31
E. Safe
harbours..............................................................................................IV-31
i) Introduction
........................................................................................IV-31
ii) Definition and concept of safe
harbours............................................IV-32
iii) Factors supporting use of safe harbours
............................................IV-33
a) Compliance
relief.........................................................................IV-33
b) Certainty.......................................................................................IV-33
c) Administrative simplicity
............................................................IV-34
iv) Problems presented by use of safe
harbours......................................IV-34
a) Risk of double taxation and mutual
agreement procedure
difficulties
....................................................................................IV-36
b) Possibility of opening avenues for tax
planning .........................IV-38
c) Equity and uniformity issues
.......................................................IV-39
v) Recommendations on use of safe harbours
.......................................IV-40
F. Advance pricing arrangements
..................................................................IV-41
i) Definition and concept of advance pricing
arrangements.................IV-41
ii) Possible approaches for legal and
administrative rules
governing advance pricing
arrangements..........................................IV-45
iii) Advantages of advance pricing
arrangements...................................IV-46
iv) Disadvantages relating to advance pricing
arrangements.................IV-48
v) Recommendations
..............................................................................IV-52
a) In
general......................................................................................IV-52
b) Coverage of an
arrangement........................................................IV-52
c) Unilateral
versus bilateral (multilateral) arrangements ..............IV-52
d) Equitable access to APAs for all taxpayers.................................IV-53
e) Developing working agreements between
competent
authorities and improved procedures
..........................................IV-53
G. Arbitration
................................................................................................IV-53
TABLE OF CONTENTS
August 1997 ix
©OCDE
Chapter V
Documentation
A. Introduction
...................................................................................................
V-1
B. Guidance on documentation rules and procedures
...................................... V-2
C. Useful information for effective transfer pricing audits
.............................. V-6
D. General recommendations on
documentation.............................................. V-9
Chapter VI
Special Considerations for Intangible Property
A. Introduction
..................................................................................................VI-1
B. Commercial intangibles
...............................................................................VI-1
i) In general
..............................................................................................VI-1
ii) Examples: patents and
trademarks.....................................................VI-4
C. Applying the arm's length principle
............................................................VI-6
i) In general
..............................................................................................VI-6
ii) Identifying arrangements made for the
transfer
of intangible property...........................................................................VI-7
iii) Calculation of an arm's length
consideration ......................................VI-8
iv) Arm's length pricing when valuation is
highly uncertain
at the time of the
transaction..............................................................VI-11
D. Marketing activities undertaken by enterprises not owning
trademarks or tradenames
..........................................................................VI-13
OECD TRANSFER PRICING GUIDELINES
x August 1997
©OCDE
Chapter VII
Special Considerations for Intra-Group Services
A. Introduction
.................................................................................................VII-1
B. Main issues..................................................................................................VII-2
i) Determining whether intra-group services
have been rendered ........VII-2
ii) Determining an arm's length charge
...................................................VII-7
a) In
general.......................................................................................VII-7
b) Identifying actual arrangements for
charging for
intra-group
services.......................................................................VII-7
c) Calculating the arm's length consideration
............................... VII-10
C. Some examples of intra-group
services................................................... VII-13
Chapter VIII
Cost Contribution Arrangements
A. Introduction ..........................................................................................VIII-1
B. Concept of a
CCA.................................................................................VIII-2
i) In
general.......................................................................................VIII-2
ii) Relationship to other chapters
.......................................................VIII-3
iii) Types of
CCAs..............................................................................VIII-3
C. Applying the arm's length principle
.....................................................VIII-4
i) In
general.......................................................................................VIII-4
ii) Determining participants
...............................................................VIII-5
iii) The amount of each participantÕs
contribution .............................VIII-6
iv) Determining whether the allocation is
appropriate .......................VIII-7
v) The tax treatment of contributions and
balancing payments ........VIII-9
TABLE OF CONTENTS
October 1999 xi
© OECD
D. Tax consequences if a CCA is not armÕs length
.................................VIII-10
i) Adjustment of contributions
........................................................VIII-10
ii) Disregarding part or all of the terms of a
CCA...........................VIII-11
E. CCA entry, withdrawal, or termination
..............................................VIII-12
F. Recommendations for structuring and documenting CCAs
...............VIII-15
APPENDIX:
Recommendation of the OECD
Council...........................................A-1
ANNEXES
Guidelines for Monitoring Procedures on the OECD Transfer Pricing
Guidelines and the Involvement of the business Community
.......................AN-1
Examples to Illustrate the Transfer Pricing
Guidelines.................................AN-9
Application of the Residual Profit Split Method
.................................AN-11
Intangible Property and Uncertain Valuation
.....................................AN-15
Guidelines for Conducting Advance Pricing Arrangements
Under The Mutual Agreement Procedure ("MAP
APAs")..........................AN-19
July 1995 P-1
©OECD
PREFACE
1. The role of multinational enterprises (MNEs) in world trade has
increased dramatically over the last 20 years. This in part reflects the
increased
integration of national economies and technological progress,
particularly in
the area of communications. The growth of MNEs presents increasingly
complex taxation issues for both tax administrations and the MNEs
themselves
since separate country rules for the taxation of MNEs cannot be viewed
in
isolation but must be addressed in a broad international context.
2. These issues arise primarily from the practical difficulty, for both
MNEs and tax administrations, of determining the income and expenses of
a
company or a permanent establishment that is part of an MNE group that
should be taken into account within a jurisdiction, particularly where
the MNE
group's operations are highly integrated.
3. In the case of MNEs, the need to comply with laws and administrative
requirements that may differ from country to country creates additional
problems. The differing requirements may lead to a greater burden on an
MNE, and result in higher costs of compliance, than for a similar
enterprise
operating solely within a single tax jurisdiction.
4. In the case of tax administrations, specific problems arise at both
policy and practical levels. At the policy level, countries need to
reconcile
their legitimate right to tax the profits of a taxpayer based upon
income and
expenses that can reasonably be considered to arise within their
territory with
the need to avoid the taxation of the same item of income by more than
one tax
jurisdiction. Such double or multiple taxation can create an impediment
to
cross-border transactions in goods and services and the movement of
capital.
At a practical level, a country's determination of such income and
expense
allocation may be impeded by difficulties in obtaining pertinent data
located
outside its own jurisdiction.
5. At a primary level, the taxing rights that each country asserts
depend
on whether the country uses a system of taxation that is
residence-based,
source-based, or both. In a residence-based tax system, a country will
include
in its tax base all or part of the income, including income from sources
outside
that country, of any person (including juridical persons such as
corporations)
OECD TRANSFER PRICING GUIDELINES
P-2 July 1995
©OECD
who is considered resident in that jurisdiction. In a source-based tax
system, a
country will include in its tax base income arising within its tax
jurisdiction,
irrespective of the residence of the taxpayer. As applied to MNEs, these
two
bases, often used in conjunction, generally treat each enterprise within
the
MNE group as a separate entity. OECD Member countries have chosen this
separate entity approach as the most reasonable means for achieving
equitable
results and minimising the risk of unrelieved double taxation. Thus,
each
individual group member is subject to tax on the income arising to it
(on a
residence or source basis).
6. In order to apply the separate entity approach to intra-group
transactions, individual group members must be taxed on the basis that
they act at
arm's length in their dealings with each other. However, the
relationship among
members of an MNE group may permit the group members to establish
special
conditions in their intra-group relations that differ from those that
would have
been established had the group members been acting as independent
enterprises
operating in open markets. To ensure the correct application of the
separate
entity approach, OECD Member countries have adopted the arm's length
principle, under which the effect of special conditions on the levels of
profits
should be eliminated.
7. These international taxation principles have been chosen by OECD
Member countries as serving the dual objectives of securing the
appropriate tax
base in each jurisdiction and avoiding double taxation, thereby minimizing
conflict between tax administrations and promoting international trade
and
investment. In a global economy, coordination among countries is better
placed
to achieve these goals than tax competition. The OECD, with its mission
to
contribute to the expansion of world trade on a multilateral,
non-discriminatory
basis and to achieve the highest sustainable economic growth in Member
countries, has continuously worked to build a consensus on international
taxation
principles, thereby avoiding unilateral responses to multilateral
problems.
8. The foregoing principles concerning the taxation of MNEs are
incorporated in the OECD Model Tax Convention on Income and on
Capital
(OECD Model Tax Convention), which forms the basis of the extensive
network
of bilateral income tax treaties between OECD Member countries and
between
OECD Member and non-Member countries. These principles also are
incorporated in the Model United Nations Double Taxation Convention
between
Developed and Developing Nations.
PREFACE
July 1995 P-3
©OECD
9. The main mechanisms for resolving issues that arise in the
application
of international tax principles to MNEs are contained in these bilateral
treaties.
The Articles that chiefly affect the taxation of MNEs are: Article 4,
which
defines residence; Articles 5 and 7, which determine the taxation of
permanent
establishments; Article 9, which relates to the taxation of the profits
of associated
enterprises and applies the arm's length principle; Articles 10, 11, and
12, which
determine the taxation of dividends, interest, and royalties,
respectively; and
Articles 24, 25, and 26, which contain special provisions relating to
nondiscrimination,
the resolution of disputes, and exchange of information.
10. The Committee on Fiscal Affairs, which is the main tax policy body
of
the OECD, has issued a number of reports relating to the application of
these
Articles to MNEs and to others. The Committee has encouraged the
acceptance
of common interpretations of these Articles, thereby reducing the risk
of
inappropriate taxation and providing satisfactory means of resolving
problems
arising from the interaction of the laws and practices of different
countries.
11. In applying the foregoing principles to the taxation of MNEs, one of
the
most difficult issues that has arisen is the establishment for tax
purposes of
appropriate transfer prices. Transfer prices are the prices at which an
enterprise
transfers physical goods and intangible property or provides services to
associated
enterprises. For purposes of this Report, 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 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).
The issues
discussed in this Report also arise in the treatment of permanent
establishments
and will be dealt with subsequently. Some relevant discussion may also
be found
in the OECD Report Model Tax Convention: Attribution of Income to
Permanent
Establishments (1994) and in the OECD
Report International Tax Avoidance and
Evasion (1987).
12. 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. Transfer pricing issues originally arose in dealings
between
associated enterprises operating within the same tax jurisdiction. The
domestic
OECD TRANSFER PRICING GUIDELINES
P-4 July 1995
©OECD
issues are not considered in this Report, which focuses on the
international
aspects of transfer pricing. These international aspects are more
difficult to deal
with because they involve more than one tax jurisdiction and therefore
any
adjustment to the transfer price in one jurisdiction implies that a
corresponding
change in another jurisdiction is appropriate. However, if the other
jurisdiction
does not agree to make a corresponding adjustment the MNE group will be
taxed
twice on this part of its profits. In order to minimise the risk of such
double
taxation, an international consensus is required on how to establish for
tax
purposes transfer prices on cross-border transactions.
13. These Guidelines are intended to be a revision and compilation of
previous reports by the OECD Committee on Fiscal Affairs addressing
transfer
pricing and other related tax issues with respect to multinational
enterprises. The
principal report is Transfer Pricing and Multinational Enterprises (1979) (the
"1979 Report") which elaborated on the arm's length principle
as set out in Article
9. Other reports address transfer pricing issues in the context of
specific topics.
These reports are Transfer Pricing and Multinational Enterprises --
Three
Taxation Issues (1984) (the "1984
Report"), and Thin Capitalization (the
"1987
Report").
14. These Guidelines also draw upon the discussion undertaken by the
OECD on the proposed transfer pricing regulations in the United States
[see the
OECD Report Tax Aspects of Transfer Pricing within Multinational Enterprises:
The United States Proposed Regulations (1993)]. However, the context in which
that Report was written was very different from that in which these
Guidelines
have been undertaken, its scope was far more limited, and it
specifically
addressed the United States proposed regulations.
15. OECD Member countries continue to endorse the arm's length principle
as embodied in the OECD Model Tax Convention (and in the bilateral
conventions that legally bind treaty partners in this respect) and in
the 1979
Report. These Guidelines focus on the application of the arm's length
principle to
evaluate the transfer pricing of associated enterprises. The Guidelines
are
intended to help tax administrations (of both OECD Member countries and
non-
Member countries) and MNEs by indicating ways to find mutually
satisfactory
solutions to transfer pricing cases, thereby minimizing conflict among
tax
administrations and between tax administrations and MNEs and avoiding
costly
litigation. The Guidelines analyse the methods for evaluating whether
the
conditions of commercial and financial relations within an MNE satisfy
the arm's
PREFACE
July 1995 P-5
©OECD
length principle and discuss the practical application of those methods.
They also
include a discussion of global formulary apportionment.
16. OECD Member countries are encouraged to follow these Guidelines in
their domestic transfer pricing practices, and taxpayers are encouraged
to follow
these Guidelines in evaluating for tax purposes whether their transfer
pricing
complies with the arm's length principle. Tax administrations are
encouraged to
take into account the taxpayer's commercial judgement about the
application of
the arm's length principle in their examination practices and to
undertake their
analyses of transfer pricing from that perspective.
17. These Guidelines are also intended primarily to govern the
resolution of
transfer pricing cases in mutual agreement proceedings between OECD
Member
countries and, where appropriate, arbitration proceedings. They further
provide
guidance when a corresponding adjustment request has been made. The
Commentary on paragraph 2 of Article 9 of the OECD Model Tax Convention
makes clear that the State from which a corresponding adjustment is
requested
should comply with the request only if that State "considers that
the figure of
adjusted profits correctly reflects what the profits would have been if
the
transactions had been at arm's length". This means that in
competent authority
proceedings the State that has proposed the primary adjustment bears the
burden
of demonstrating to the other State that the adjustment "is
justified both in
principle and as regards the amount." Both competent authorities
are expected to
take a cooperative approach in resolving mutual agreement cases.
18. In seeking to achieve the balance between the interests of taxpayers
and
tax administrators in a way that is fair to all parties, it is necessary
to consider all
aspects of the system that are relevant in a transfer pricing case. One
such aspect
is the allocation of the burden of proof. In most jurisdictions, the tax
administration bears the burden of proof, which may require the tax
administration
to make a prima facie showing that the taxpayer's pricing is
inconsistent with
the arm's length principle. It should be noted, however, that even in
such a case a
tax administration might still reasonably oblige the taxpayer to produce
its
records to enable the tax administration to undertake its examination of
the
controlled transactions. In other jurisdictions the taxpayer may bear
the burden of
proof in some respects. Some OECD Member countries are of the view that
Article 9 of the OECD Model Tax Convention establishes burden of proof
rules
in transfer pricing cases which override any contrary domestic
provisions. Other
countries, however, consider that Article 9 does not establish burden of
proof
OECD TRANSFER PRICING GUIDELINES
P-6 July 1995
©OECD
rules (cf. paragraph 4 of the Commentary on Article 9 of the OECD Model
Tax
Convention). Regardless of which party bears the burden of proof, an
assessment
of the fairness of the allocation of the burden of proof would have to
be made in
view of the other features of the jurisdiction's tax system that have a
bearing on
the overall administration of transfer pricing rules, including the
resolution of
disputes. These features include penalties, examination practices,
administrative
appeals processes, rules regarding payment of interest with respect to
tax
assessments and refunds, whether proposed tax deficiencies must be paid
before
protesting an adjustment, the statute of limitations, and the extent to
which rules
are made known in advance. It would be inappropriate to rely on any of
these
features, including the burden of proof, to make unfounded assertions
about
transfer pricing. Some of these issues are discussed further in Chapter
IV.
19. This Report focuses on the main issues of principle that arise in
the
transfer pricing area. The Committee on Fiscal Affairs intends to
continue its
work in this area and so has decided to issue these Guidelines in a
looseleaf
format. Future work will address such issues as the application of the
arm's
length principle to transactions involving intangible property,
services, cost
contribution arrangements, permanent establishments, and thin
capitalization.
The Committee intends to have regular reviews of the experiences of OECD
Member and selected non-Member countries in the use of the methods used
to
apply the arm's length principle, with particular emphasis on
difficulties
encountered in the application of transactional profit methods (as
defined in
Chapter III) and the ways in which these problems have been resolved
between
countries. The Committee will also expect a regular reporting back on
the
frequency with which transactional profit methods are used. On the basis
of these
reviews and reporting the Committee may find that it needs to issue
supplementary guidelines on the use of these methods.
February 1998 G-1
©OECD
GLOSSARY
Advance pricing arrangement ("APA")
An arrangement that determines, in advance of controlled transactions,
an
appropriate set of criteria (e.g. method, comparables and appropriate
adjustments
thereto, critical assumptions as to future events) for the determination
of the
transfer pricing for those transactions over a fixed period of time. An
advance
pricing arrangement may be unilateral involving one tax administration
and a
taxpayer or multilateral involving the agreement of two or more tax
administrations .
Arm's length principle
The international standard that OECD Member countries have agreed
should be used for determining transfer prices for tax purposes. It is
set forth in
Article 9 of the OECD Model Tax Convention as follows: 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".
Arm's length range
A range of figures that are acceptable for establishing whether the
conditions of a controlled transaction are arm's length and that are
derived either
from applying the same transfer pricing method to multiple comparable
data or
from applying different transfer pricing methods.
OECD TRANSFER PRICING GUIDELINES
G-2 February 1998
©OECD
Associated enterprises
Two enterprises are associated enterprises with respect to each other if
one
of the enterprises meets the conditions of Article 9, sub-paragraphs 1a)
or 1b) of
the OECD Model Tax Convention with respect to the other enterprise.
Balancing payment
A payment, normally from one or more participants to another, to
adjust participantsÕ proportionate shares of contributions, that
increases the
value of the contributions of the payer and decreases the value of the
contributions of the payee by the amount of the payment.
Buy-in payment
A payment made by a new entrant to an already active CCA for
obtaining an interest in any results of prior CCA activity.
Buy-out payment
Compensation that a participant who withdraws from an already
active CCA may receive from the remaining participants for an effective
transfer of its interests in the results of past CCA activities.
Commercial intangible
An intangible that is used in commercial activities such as the
production of a good or the provision of a service, as well as an
intangible right
that is itself a business asset transferred to customers or used in the
operation of
business.
Comparability analysis
A comparison of a controlled transaction with an uncontrolled
transaction
or transactions. Controlled and uncontrolled transactions are comparable
if none
of the differences between the transactions could materially affect the
factor
being examined in the methodology (e.g. price or margin), or if
reasonably
accurate adjustments can be made to eliminate the material effects of
any such
differences.
GLOSSARY
February 1998 G-3
©OECD
Comparable uncontrolled price (CUP) method
A transfer pricing method that compares the price 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.
Compensating adjustment
An adjustment in which the taxpayer reports a transfer price for tax
purposes that is, in the taxpayer's opinion, an arm's length price for a
controlled
transaction, even though this price differs from the amount actually
charged
between the associated enterprises. This adjustment would be made before
the
tax return is filed.
Contribution analysis
An analysis used in the profit split method under which the combined
profits from controlled transactions are divided between the associated
enterprises based upon the relative value of the functions performed
(taking into
account assets used and risks assumed) by each of the associated
enterprises
participating in those transactions, supplemented as much as possible by
external
market data that indicate how independent enterprises would have divided
profits
in similar circumstances.
Controlled transactions
Transactions between two enterprises that are associated enterprises
with
respect to each other.
Corresponding adjustment
An adjustment to the tax liability of the associated enterprise in a
second
tax jurisdiction made by the tax administration of that jurisdiction,
corresponding
to a primary adjustment made by the tax administration in a first tax
jurisdiction,
so that the allocation of profits by the two jurisdictions is
consistent.
OECD TRANSFER PRICING GUIDELINES
G-4 February 1998
©OECD
Cost contribution arrangement (ÒCCAÓ)
A CCA is a framework agreed among enterprises to share the costs
and risks of developing, producing, or obtaining assets, services, or
rights, and
to determine the nature and extent of the interests of each participant
in the
results of the activity of developing, producing, or obtaining those
assets,
services, or rights.
Cost plus mark up
A mark up that is measured by reference to margins computed after the
direct and indirect costs incurred by a supplier of property or services
in a
transaction.
Cost plus method
A transfer pricing method using the costs incurred by the supplier of
property (or services) in a controlled transaction. An appropriate cost
plus mark
up is added to this cost, to make an appropriate profit in light of the
functions
performed (taking into account assets used and risks assumed) 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.
Direct-charge method
A method of charging directly for specific intra-group services on a
clearly identified basis.
Direct costs
Costs that are incurred specifically for producing a product or
rendering
service, such as the cost of raw materials.
GLOSSARY
February 1998 G-5
©OECD
Functional analysis
An analysis of the functions performed (taking into account assets used
and risks assumed) by associated enterprises in controlled transactions
and by
independent enterprises in comparable uncontrolled transactions.
Global formulary apportionment method
A method to allocate the global profits of an MNE group on a
consolidated basis among the associated enterprises in different
countries on the
basis of a predetermined formula.
Gross profits
The gross profits from a business transaction are the amount computed by
deducting from the gross receipts of the transaction the allocable
purchases or
production costs of sales, with due adjustment for increases or
decreases in
inventory or stock-in-trade, but without taking account of other
expenses.
Independent enterprises
Two enterprises are independent enterprises with respect to each other
if
they are not associated enterprises with respect to each other.
Indirect-charge method
A method of charging for intra-group services based upon cost
allocation and apportionment methods.
Indirect costs
Costs of producing a product or service which, although closely related
to
the production process, may be common to several products or services
(for
example, the costs of a repair department that services equipment used
to produce
different products).
OECD TRANSFER PRICING GUIDELINES
G-6 February 1998
©OECD
Intra-group service
An activity (e.g. administrative, technical, financial, commercial,
etc.)
for which an independent enterprise would have been willing to pay or
perform
for itself.
Intentional set-off
A benefit provided by one associated enterprise to another associated
enterprise within the group that is deliberately balanced to some degree
by
different benefits received from that enterprise in return.
Marketing intangible
An intangible that is concerned with marketing activities, which aids
in the commercial exploitation of a product or service and/or has an
important
promotional value for the product concerned.
Multinational enterprise group (MNE group)
A group of associated companies with business establishments in two or
more countries.
Multinational enterprise (MNE)
A company that is part of an MNE group.
Mutual agreement procedure
A means through which tax administrations consult to resolve disputes
regarding the application of double tax conventions. This procedure,
described
and authorized by Article 25 of the OECD Model Tax Convention, can be
used to
eliminate double taxation that could arise from a transfer pricing
adjustment.
GLOSSARY
February 1998 G-7
©OECD
ÒOn callÓ services
Services provided by a parent company or a group service centre,
which are available at any time for members of an MNE group.
Primary adjustment
An adjustment that a tax administration in a first jurisdiction makes to
a
company's taxable profits as a result of applying the arm's length
principle to
transactions involving an associated enterprise in a second tax
jurisdiction.
Profit split method
A transactional profit method that identifies the combined profit to be
split
for the associated enterprises from a controlled transaction (or
controlled
transactions that it is appropriate to aggregate under the principles of
Chapter I)
and then splits those profits between the associated enterprises based
upon 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.
Resale price margin
A margin representing the amount out of which a 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.
Resale price method
A transfer pricing method based on the price at which a product that has
been purchased from an associated enterprise is resold to an independent
enterprise. The resale price is reduced by the resale price margin. What
is left
after subtracting the resale price margin can be regarded, after
adjustment for
other costs associated with the purchase of the product (e.g. custom
duties), as an
arm's length price of the original transfer of property between the
associated
enterprises.
OECD TRANSFER PRICING GUIDELINES
G-8 February 1998
©OECD
Residual analysis
An analysis used in the profit split method which divides the combined
profit from the controlled transactions under examination in two stages.
In the
first stage, each participant is allocated sufficient profit to provide
it with a basic
return appropriate for the type of transactions in which it is engaged.
Ordinarily
this basic return would be determined by reference to the market returns
achieved
for similar types of transactions by independent enterprises. Thus, the
basic
return would generally not account for the return that would be
generated by any
unique and valuable assets possessed by the participants. In the second
stage, any
residual profit (or loss) remaining after the first stage division would
be allocated
among the parties based on an analysis of the facts and circumstances
that might
indicate how this residual would have been divided between independent
enterprises.
Secondary adjustment
An adjustment that arises from imposing tax on a secondary transaction.
Secondary transaction
A constructive transaction that some countries will assert under their
domestic legislation after having proposed a primary adjustment in order
to make
the actual allocation of profits consistent with the primary adjustment.
Secondary
transactions may take the form of constructive dividends, constructive
equity
contributions, or constructive loans.
Shareholder activity
An activity which is performed by a member of an MNE group
(usually the parent company or a regional holding company) solely
because of
its ownership interest in one or more other group members, i.e. in its
capacity
as shareholder..
GLOSSARY
February 1998 G-9
©OECD
Simultaneous tax examinations
A simultaneous tax examination, as defined in Part A of the OECD Model
Agreement for the Undertaking of Simultaneous Tax Examinations, means an
"arrangement between two or more parties to examine simultaneously
and
independently, each on its own territory, the tax affairs of (a)
taxpayer(s) in which
they have a common or related interest with a view to exchanging any
relevant
information which they so obtain".
Trade intangible
A commercial intangible other than a marketing intangible.
Traditional transaction methods
The comparable uncontrolled price method, the resale price method, and
the cost plus method.
Transactional net margin method
A transactional profit method that 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 it is appropriate to
aggregate under the
principles of Chapter I).
Transactional profit method
A transfer pricing method that examines the profits that arise from
particular controlled transactions of one or more of the associated
enterprises
participating in those transactions.
Uncontrolled transactions
Transactions between enterprises that are independent enterprises with
respect to each other.
July 1995 I-1
©OECD
Chapter I
The Arm's Length Principle
A. Introduction
1.1 This Chapter provides a background discussion of the arm's length
principle, which is the international transfer pricing standard that
OECD Member
countries have agreed should be used for tax purposes by MNE groups and
tax
administrations. The Chapter discusses the arm's length principle,
reaffirms its
status as the international standard, and sets forth guidelines for its
application.
1.2 When independent enterprises deal with each other, the conditions of
their commercial and financial relations (e.g. the price of goods
transferred or
services provided and the conditions of the transfer or provision)
ordinarily are
determined by market forces. When associated enterprises deal with each
other,
their commercial and financial relations may not be directly affected by
external
market forces in the same way, although associated enterprises often
seek to
replicate the dynamics of market forces in their dealings with each
other, as
discussed in paragraph 1.5, below. Tax administrations should not
automatically
assume that associated enterprises have sought to manipulate their
profits. There
may be a genuine difficulty in accurately determining a market price in
the
absence of market forces or when adopting a particular commercial
strategy. It is
important to bear in mind that the need to make adjustments to
approximate arm's
length dealings arises irrespective of any contractual obligation
undertaken by the
parties to pay a particular price or of any intention of the parties to
minimize tax.
Thus, a tax adjustment under the arm's length principle would not affect
the
underlying contractual obligations for non-tax purposes between the
associated
enterprises, and may be appropriate even where there is no intent to
minimize or
avoid tax. The consideration of transfer pricing should not be confused
with the
consideration of problems of tax fraud or tax avoidance, even though
transfer
pricing policies may be used for such purposes.
1.3 When transfer pricing does not reflect market forces and the arm's
length principle, the tax liabilities of the associated enterprises and
the tax
revenues of the host countries could be distorted. Therefore, OECD
Member
countries have agreed that for tax purposes the profits of associated
enterprises
may be adjusted as necessary to correct any such distortions and thereby
ensure
OECD TRANSFER PRICING GUIDELINES
I-2 July 1995
©OECD
that the arm's length principle is satisfied. OECD Member countries
consider that
an appropriate adjustment is achieved by establishing the conditions of
the
commercial and financial relations that they would expect to find
between
independent enterprises in similar transactions under similar
circumstances.
1.4 Factors other than tax considerations may distort the conditions of
commercial and financial relations established between associated
enterprises.
For example, such enterprises may be subject to conflicting governmental
pressures (in the domestic as well as foreign country) relating to
customs
valuations, anti-dumping duties, and exchange or price controls. In
addition,
transfer price distortions may be caused by the cash flow requirements
of
enterprises within an MNE group. An MNE group that is publicly held may
feel
pressure from shareholders to show high profitability at the parent
company level,
particularly if shareholder reporting is not undertaken on a
consolidated basis.
All of these factors may affect transfer prices and the amount of
profits accruing
to associated enterprises within an MNE group.
1.5 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. Associated enterprises
in
MNEs commonly have a considerable amount of autonomy and often bargain
with each other as though they were independent enterprises. Enterprises
respond
to economic situations arising from market conditions, in their
relations with both
third parties and associated enterprises. For example, local managers
may be
interested in establishing good profit records and therefore would not
want to
establish prices that would reduce the profits of their own companies.
Tax
administrations should bear in mind that MNEs from a managerial point of
view
have an incentive to use arm's length prices to be able to judge the
real
performance of their different profit centres. Tax administrations
should keep
these considerations in mind to facilitate efficient allocation of their
resources in
selecting and conducting transfer pricing examinations. Sometimes, it
may occur
that the relationship between the associated enterprises may influence
the
outcome of the bargaining. Therefore, evidence of hard bargaining alone
is not
sufficient to establish that the dealings are at arm's length.
ARMÕS LENGTH PRINCIPLE
July 1995 I-3
©OECD
B. Statement of the arm's length principle
i) Article 9 of the OECD Model Tax Convention
1.6 The authoritative statement of the arm's length principle is found
in
paragraph 1 of Article 9 of the OECD Model Tax Convention, which forms
the
basis of bilateral tax treaties involving OECD Member countries and an
increasing number of non-Member countries. Article 9 provides:
"[When] conditions are made or imposed between ... 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."
By seeking to adjust profits by reference to the conditions which would
have
obtained between independent enterprises in comparable transactions and
comparable circumstances, the arm's length principle follows the
approach of
treating the members of an MNE group as operating as separate entities
rather
than as inseparable parts of a single unified business. Because the
separate entity
approach treats the members of an MNE group as if they were independent
entities, attention is focused on the nature of the dealings between
those
members.
1.7 There are several reasons why OECD Member countries and other
countries have adopted the arm's length principle. A major reason is that
the
arm's length principle provides broad parity of tax treatment for MNEs
and
independent enterprises. Because the arm's length principle puts
associated and
independent enterprises on a more equal footing for tax purposes, it
avoids the
creation of tax advantages or disadvantages that would otherwise distort
the
relative competitive positions of either type of entity. In so removing
these tax
considerations from economic decisions, the arm's length principle
promotes the
growth of international trade and investment.
1.8 The arm's length principle has also been found to work effectively
in the
vast majority of cases. For example, there are many cases involving the
purchase
and sale of commodities and the lending of money where an arm's length
price
OECD TRANSFER PRICING GUIDELINES
I-4 July 1995
©OECD
may readily be found in a comparable transaction undertaken by
comparable
independent enterprises under comparable circumstances. Nevertheless,
there are
some significant cases in which the arm's length principle is difficult
and
complicated to apply, for example, in MNE groups dealing in the
integrated
production of highly specialized goods, in unique intangibles, and/or in
the
provision of specialised services.
1.9 The arm's length principle is viewed by some as inherently flawed
because the separate entity approach may not always account for the
economies
of scale and interrelation of diverse activities created by integrated
businesses.
There are, however, no widely accepted objective criteria for allocating
the
economies of scale or benefits of integration between associated
enterprises. The
issue of possible alternatives to the arm's length principle is
discussed in Section
C of Chapter III.
1.10 A practical difficulty in applying the arm's length principle is
that
associated enterprises may engage in transactions that independent
enterprises
would not undertake. Such transactions may not necessarily be motivated
by tax
avoidance but may occur because in transacting business with each other,
members of an MNE group face different commercial circumstances than
would
independent enterprises. For example, an independent enterprise may not
be
willing to sell an intangible (e.g. the right to exploit the fruits of
all future
research) for a fixed price if the profit potential of the intangible
cannot be
adequately estimated and there are other means of exploiting the
intangible. In
such a case, an independent enterprise may not want to risk an outright
sale
because the price might not reflect the potential for the intangible to
become
extremely profitable. Similarly, the owner of an intangible may be
hesitant to
enter into licensing arrangements with independent enterprises for fear
of the
value of the intangible being degraded. In contrast, the intangible
owner may be
prepared to offer terms to associated enterprises that are less
restrictive because
the use of the intangible can be more closely monitored. There is no
risk to the
overall group's profit from a transaction of this kind between members
of an
MNE group. An independent enterprise in such circumstances might exploit
the
intangible itself or license it to another independent enterprise for a
limited period
of time (or possibly under an arrangement to adjust the royalty).
However, there
is always a risk that the intangible is not as valuable as it seems to
be. Therefore,
an independent enterprise has to make the choice between selling the
intangible
and so diminishing the risk and safeguarding the profit, and
ARMÕS LENGTH PRINCIPLE
July 1995 I-5
©OECD
exploiting the intangible and taking the risk that the profit will vary
from the
profit which could be gained by selling the intangible. Where
independent
enterprises seldom undertake transactions of the type entered into by
associated
enterprises, the arm's length principle is difficult to apply because
there is little or
no direct evidence of what conditions would have been established by
independent enterprises.
1.11 In certain cases, the arm's length principle may result in an
administrative burden for both the taxpayer and the tax administrations
of
evaluating significant numbers and types of cross-border transactions.
Although
an associated enterprise normally establishes the conditions for a
transaction at
the time it is undertaken, at some point the enterprise may be required
to
demonstrate that these are consistent with the arm's length principle.
(See
Chapter V on Documentation). The tax administration may also have to
engage
in this verification process perhaps some years after the transactions
have taken
place. The tax administration would then attempt to gather information
about
similar transactions, the market conditions at the time the transactions
took place,
etc., for numerous and varied transactions. Such an undertaking usually
becomes
more difficult with the passage of time.
1.12 Both tax administrations and taxpayers often have difficulty in
obtaining adequate information to apply the arm's length principle.
Because the
arm's length principle usually requires taxpayers and tax
administrations to
evaluate uncontrolled transactions and the business activities of
independent
enterprises, and to compare these with the transactions and activities
of associated
enterprises, it can demand a substantial amount of data. The information
that is
accessible may be incomplete and difficult to interpret; other
information, if it
exists, may be difficult to obtain for reasons of its geographical
location or that of
the parties from whom it may have to be acquired. In addition, it may
not be
possible to obtain information from independent enterprises because of
confidentiality concerns. In other cases information about an
independent
enterprise which could be relevant may simply not exist. It should also
be
recalled at this point that transfer pricing is not an exact science but
does require
the exercise of judgment on the part of both the tax administration and
taxpayer.
OECD TRANSFER PRICING GUIDELINES
I-6 July 1995
©OECD
ii) Maintaining the arm's length principle as the international
consensus
1.13 While recognizing the foregoing considerations, the view of OECD
Member countries continues to be that the arm's length principle should
govern
the evaluation of transfer prices among associated enterprises. The
arm's
length principle is sound in theory since it provides the closest
approximation
of the workings of the open market in cases where goods and services are
transferred between associated enterprises. While it may not always be
straightforward to apply in practice, it does generally produce
appropriate
levels of income between members of MNE groups, acceptable to tax
administrations. This reflects the economic realities of the controlled
taxpayer's particular facts and circumstances and adopts as a benchmark
the
normal operation of the market.
1.14 A move away from the arm's length principle would abandon the
sound theoretical basis described above and threaten the international
consensus, thereby substantially increasing the risk of double taxation.
Experience under the arm's length principle has become sufficiently
broad and
sophisticated to establish a substantial body of common understanding
among
the business community and tax administrations. This shared
understanding is
of great practical value in achieving the objectives of securing the
appropriate
tax base in each jurisdiction and avoiding double taxation. This
experience
should be drawn on to elaborate the arm's length principle further, to
refine its
operation, and to improve its administration by providing clearer
guidance to
taxpayers and more timely examinations. In sum, OECD Member countries
continue to support strongly the arm's length principle. In fact, no
legitimate or
realistic alternative to the arm's length principle has emerged. The
global
formulary apportionment approach, sometimes mentioned as a possible
alternative, would not be acceptable in theory, implementation, or
practice.
(See Chapter III, Part C, for a discussion of the global formulary
apportionment
method.)
ARMÕS LENGTH PRINCIPLE
July 1995 I-7
©OECD
C. Guidance for applying the arm's length principle
i) Comparability analysis
a) Reason for examining comparability
1.15 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. To be comparable means that
none
of the differences (if any) between the situations being compared could
materially
affect the condition being examined in the methodology (e.g. price or
margin), or
that reasonably accurate adjustments can be made to eliminate the effect
of any
such differences. In determining the degree of comparability, including
what
adjustments are necessary to establish it, an understanding of how
unrelated
companies evaluate potential transactions is required. Independent
enterprises,
when evaluating the terms of a potential transaction, will compare the
transaction
to the other options realistically available to them, and they will only
enter into
the transaction if they see no alternative that is clearly more
attractive. For
example, one enterprise is unlikely to accept a price offered for its
product by an
independent enterprise if it knows that other potential customers are
willing to
pay more under similar conditions. This point is relevant to the
question of
comparability, since independent enterprises would generally take into
account
any economically relevant differences between the options realistically
available
to them (such as differences in the level of risk or other comparability
factors
discussed below) when valuing those options. Therefore, when making the
comparisons entailed by application of the arm's length principle, tax
administrations should also take these differences into account when
establishing
whether there is comparability between the situations being compared and
what
adjustments may be necessary to achieve comparability.
1.16 All methods that apply the arm's length principle can be tied to
the
concept that independent enterprises consider the options available to
them and in
comparing one option to another they consider any differences between
the
options that would significantly affect their value. For instance,
before
purchasing a product at a given price, independent enterprises normally
would be
expected to consider whether they could buy the same product at a lower
OECD TRANSFER PRICING GUIDELINES
I-8 July 1995
©OECD
price from another party. Therefore, as discussed in Chapter II, the
comparable
uncontrolled price method compares a controlled transaction to similar
uncontrolled transactions to provide a direct estimate of the price the
parties
would have agreed to had they resorted directly to a market alternative
to the
controlled transaction. However, the method becomes a less reliable
substitute
for arm's length dealings if not all the characteristics of these
uncontrolled
transactions that significantly affect the price charged between
independent
enterprises are comparable. Similarly, the resale price and cost plus
methods
compare the gross profit margin earned in the controlled transaction to
gross
profit margins earned in similar uncontrolled transactions. The
comparison
provides an estimate of the gross profit margin one of the parties could
have
earned had it performed the same functions for independent enterprises
and
therefore provides an estimate of the payment that party would have
demanded,
and the other party would have been willing to pay, at arm's length for
performing
those functions. Other methods as discussed in Chapter III are based on
comparisons of profit rates or margins between independent and
associated
enterprises as a means to estimate the profits that one or both of the
associated
enterprises could have earned had they dealt solely with independent
enterprises,
and therefore the payment those enterprises would have demanded at arm's
length
to compensate them for using their resources in the controlled transaction.
In all
cases adjustments must be made to account for differences between the
controlled
and uncontrolled situations that would significantly affect the price
charged or
return required by independent enterprises. Therefore, in no event can
unadjusted
industry average returns themselves establish arm's length conditions.
1.17 As noted above, in making these comparisons, material differences
between the compared transactions or enterprises should be taken into
account.
In order to establish the degree of actual comparability and then to
make
appropriate adjustments to establish arm's length conditions (or a range
thereof),
it is necessary to compare attributes of the transactions or enterprises
that would
affect conditions in arm's length dealings. Attributes that may be
important
include the characteristics of the property or services transferred, the
functions
performed by the parties (taking into account assets used and risks
assumed), the
contractual terms, the economic circumstances of the parties, and the
business
strategies pursued by the parties. These factors are discussed in more
detail
below.
ARMÕS LENGTH PRINCIPLE
July 1995 I-9
©OECD
1.18 The extent to which each of these factors matters in establishing
comparability will depend upon the nature of the controlled transaction
and the
pricing method adopted. For a discussion of the relevance of these
factors for the
application of particular pricing methods, see the consideration of
those methods
in Chapters II and III.
b) Factors determining comparability
1. Characteristics of property or services
1.19 Differences in the specific characteristics of property or services
often
account, at least in part, for differences in their value in the open
market.
Therefore, comparisons of these features may be useful in determining
the
comparability of controlled and uncontrolled transactions. In general,
similarity
in the characteristics of the property or services transferred will
matter most when
comparing prices of controlled and uncontrolled transactions and less
when
comparing profit margins. Characteristics that it may be important to
consider
include the following: in the case of transfers of tangible property,
the physical
features of the property, its quality and reliability, and the
availability and volume
of supply; in the case of the provision of services, the nature and
extent of the
services; and in the case of intangible property, the form of
transaction (e.g.
licensing or sale), the type of property (e.g. patent, trademark, or
know-how), the
duration and degree of protection, and the anticipated benefits from the
use of the
property.
2. Functional analysis
1.20 In dealings between two independent enterprises, compensation
usually
will reflect the functions that each enterprise performs (taking into account
assets
used and risks assumed). Therefore, in determining whether controlled
and
uncontrolled transactions or entities are comparable, comparison of the
functions
taken on by the parties is necessary. This comparison is based on a
functional
analysis, which seeks to identify and to compare the economically
significant
activities and responsibilities undertaken or to be undertaken by the
independent
and associated enterprises. For this purpose, particular attention
should be paid to
the structure and organisation of the group. It will also be relevant to
determine
in what juridical capacity the taxpayer performs its functions.
OECD TRANSFER PRICING GUIDELINES
I-10 July 1995
©OECD
1.21 The functions that taxpayers and tax administrations might need to
identify and compare include, e.g., design, manufacturing, assembling,
research
and development, servicing, purchasing, distribution, marketing,
advertising,
transportation, financing, and management. The principal functions
performed
by the party under examination should be identified. Adjustments should
be
made for any material differences from the functions undertaken by any
independent enterprises with which that party is being compared. While
one party
may provide a large number of functions relative to that of the other
party to the
transaction, it is the economic significance of those functions in terms
of their
frequency, nature, and value to the respective parties to the
transactions that is
important.
1.22 It may also be relevant and useful in identifying and comparing the
functions performed to consider the assets that are employed or to be
employed.
This analysis should consider the type of assets used, such as plant and
equipment, the use of valuable intangibles, etc., and the nature of the
assets used,
such as the age, market value, location, property right protections
available, etc.
1.23 It may also be relevant and useful in comparing the functions
performed to consider the risks assumed by the respective parties. In
the open
market, the assumption of increased risk will also be compensated by an
increase
in the expected return. Therefore, controlled and uncontrolled
transactions and
entities are not comparable if there are significant differences in the
risks
assumed for which appropriate adjustments cannot be made. Functional
analysis
is incomplete unless the material risks assumed by each party have been
considered since the assumption or allocation of risks would influence
the
conditions of transactions between the associated enterprises. Theoretically,
in
the open market, the assumption of increased risk must also be
compensated by
an increase in the expected return, although the actual return may or
may not
increase depending on the degree to which the risks are actually
realised.
1.24 The types of risks to consider include market risks, such as input
cost
and output price fluctuations; risks of loss associated with the
investment in and
use of property, plant, and equipment; risks of the success or failure
of investment
in research and development; financial risks such as those caused by
currency
exchange rate and interest rate variability; credit risks; and so forth.
ARMÕS LENGTH PRINCIPLE
July 1995 I-11
©OECD
1.25 The functions carried out (taking into account the assets used and
the
risks assumed) will determine to some extent the allocation of risks
between the
parties, and therefore the conditions each party would expect in arm's
length
dealings. For example, when a distributor takes on responsibility for
marketing
and advertising by risking its own resources in these activities, it
would be
entitled to a commensurately higher anticipated return from the activity
and the
conditions of the transaction would be different from when the
distributor acts
merely as an agent, being reimbursed for its costs and receiving the
income
appropriate to that activity. Similarly, a contract manufacturer or a
contract
research provider that takes on no meaningful risk would be entitled to
only a
limited return.
1.26 In line with the discussion below in relation to contractual terms,
it may
be considered whether a purported allocation of risk is consistent with
the
economic substance of the transaction. In this regard, the parties'
conduct should
generally be taken as the best evidence concerning the true allocation
of risk. If,
for example, a manufacturer sells property to a related distributor in
another
country and the distributor is claimed to assume all exchange rate
risks, but the
transfer price appears in fact to be adjusted so as to insulate the
distributor from
the effects of exchange rate movements, then the tax administrations may
wish to
challenge the purported allocation of exchange rate risk.
1.27 An additional factor to consider in examining the economic
substance
of a purported risk allocation is the consequence of such an allocation
in arm's
length transactions. In arm's length dealings it generally makes sense
for parties
to be allocated a greater share of those risks over which they have
relatively more
control. For example, suppose that Company A contracts to produce and
ship
goods to Company B, and the level of production and shipment of goods
are to be
at the discretion of Company B. In such a case, Company A would be
unlikely to
agree to take on substantial inventory risk, since it exercises no
control over the
inventory level while Company B does. Of course, there are many risks,
such as
general business cycle risks, over which typically neither party has
significant
control and which at arm's length could therefore be allocated to one or
the other
party to a transaction. Analysis is required to determine to what extent
each party
bears such risks in practice. When addressing the issue of the extent to
which a
party to a transaction bears any currency exchange and/or interest rate
risk, it will
ordinarily be necessary to consider the extent, if any, to which the
taxpayer and/or
the MNE group have a business strategy which deals with the minimisation
or
OECD TRANSFER PRICING GUIDELINES
I-12 July 1995
©OECD
management of such risks. Hedging arrangements, forward contracts, put
and
call options, etc, both "on-market" and
"off-market", are now in common use.
Failure on the part of a taxpayer bearing currency exchange and interest
rate risk
to address such exposure may arise as a result of a business strategy of
the MNE
group seeking to hedge its overall exposure to such risks or seeking to
hedge only
some portion of the group's exposure. This latter practice, if not
accounted for
appropriately, could lead to significant profits or losses being made
which are
capable of being sourced in the most advantageous place to the MNE
group.
3. Contractual terms
1.28 In arm's length dealings, the contractual terms of a transaction
generally
define explicitly or implicitly how the responsibilities, risks and benefits
are to be
divided between the parties. As such, an analysis of contractual terms
should be a
part of the functional analysis discussed above. The terms of a
transaction may
also be found in correspondence/communications between the parties other
than a
written contract. Where no written terms exist, the contractual
relationships of
the parties must be deduced from their conduct and the economic
principles that
generally govern relationships between independent enterprises.
1.29 In dealings between independent enterprises, the divergence of
interests
between the parties ensures that they will ordinarily seek to hold each
other to the
terms of the contract, and that contractual terms will be ignored or
modified after
the fact generally only if it is in the interests of both parties. The
same
divergence of interests may not exist in the case of associated
enterprises, and it is
therefore important to examine whether the conduct of the parties
conforms to the
terms of the contract or whether the parties' conduct indicates that the
contractual
terms have not been followed or are a sham. In such cases, further
analysis is
required to determine the true terms of the transaction.
4. Economic circumstances
1.30 Arm's length prices may vary across different markets even for
transactions involving the same property or services; therefore, to
achieve
comparability requires that the markets in which the independent and
associated
enterprises operate are comparable, and that differences do not have a
material
effect on price or that appropriate adjustments can be made. As a first
step, it is
essential to identify the relevant market or markets taking account of
available
substitute goods or services. Economic circumstances that may be
relevant to
ARMÕS LENGTH PRINCIPLE
July 1995 I-13
©OECD
determining market comparability include the geographic location; the
size of the
markets; the extent of competition in the markets and the relative
competitive
positions of the buyers and sellers; the availability (risk thereof) of
substitute
goods and services; the levels of supply and demand in the market as a
whole and
in particular regions, if relevant; consumer purchasing power; the
nature and
extent of government regulation of the market; costs of production,
including the
costs of land, labour, and capital; transport costs; the level of the
market (e.g.
retail or wholesale); the date and time of transactions; and so forth.
5. Business strategies
1.31 Business strategies must also be examined in determining
comparability for transfer pricing purposes. Business strategies would
take into
account many aspects of an enterprise, such as innovation and new
product
development, degree of diversification, risk aversion, assessment of
political
changes, input of existing and planned labour laws, and other factors
bearing
upon the daily conduct of business. Such business strategies may need to
be
taken into account when determining the comparability of controlled and
uncontrolled transactions and enterprises. It will also be relevant to
consider
whether business strategies have been devised by the MNE group or by a
member
of the group acting separately and the nature and extent of the
involvement of
other members of the MNE group necessary for the purpose of implementing
the
business strategy.
1.32 Business strategies also could include market penetration schemes.
A
taxpayer seeking to penetrate a market or to increase its market share
might
temporarily charge a price for its product that is lower than the price
charged for
otherwise comparable products in the same market. Furthermore, a
taxpayer
seeking to enter a new market or expand (or defend) its market share
might
temporarily incur higher costs (e.g. due to start-up costs or increased
marketing
efforts) and hence achieve lower profit levels than other taxpayers
operating in
the same market.
1.33 Timing issues can pose particular problems for tax administrations
when evaluating the legitimacy of a taxpayer's claim that it is
following a
business strategy that distinguishes it from potential comparables. Some
business
strategies, such as those involving market penetration or expansion of
market
share, involve reductions in the taxpayer's current profits in
anticipation of
OECD TRANSFER PRICING GUIDELINES
I-14 July 1995
©OECD
increased future profits. If in the future those increased profits fail
to materialize
because the purported business strategy was not actually followed by the
taxpayer, legal constraints may prevent re-examination of earlier tax
years by the
tax administrations. At least in part for this reason, tax
administrations may wish
to subject a taxpayer's claim that it is following such a business
strategy to
particular scrutiny.
1.34 When evaluating a taxpayer's claim that it was following a business
strategy that temporarily decreased profits in return for higher
long-run profits,
several factors should be considered. Tax administrations should examine
the
conduct of the parties to determine if it is consistent with the
professed business
strategy. For example, if a manufacturer charges its related distributor
a belowmarket
price as part of a market penetration strategy, the cost savings to the
distributor may be reflected in the price charged to the distributor's
customers or
in greater market penetration expenses incurred by the distributor. A
market
penetration strategy of an MNE group could be put in place by the
manufacturer
or by the distributor acting separately from the manufacturer (and the
resulting
cost borne by either of them). Furthermore, unusually intensive marketing
and
advertising efforts would often accompany a market penetration or market
share
expansion strategy. Another factor to consider is whether the nature of
the
relationship between the parties to the controlled transaction would be
consistent
with the taxpayer bearing the costs of the business strategy. For
example, in
arm's length dealings a company acting solely as a sales agent with
little or no
responsibility for long-term market development would generally not bear
the
costs of a market penetration strategy. Where a company has undertaken
market
development activities at its own risk and enhances the value of a
product through
a trademark or tradename or increases goodwill associated with the
product, this
situation should be reflected in the analysis of functions for the
purposes of
establishing comparability.
1.35 An additional consideration is whether there is a plausible
expectation
that following the business strategy will produce a return sufficient to
justify its
costs within a period of time that would be acceptable in an arm's
length
arrangement. It is recognised that a business strategy such as market
penetration
may fail, and the failure does not of itself allow the strategy to be
ignored for
transfer pricing purposes. However, if such an expected outcome was
implausible at the time of the transaction, or if the claimed business
strategy is
unsuccessful but nonetheless is continued beyond what an independent
enterprise
ARMÕS LENGTH PRINCIPLE
July 1995 I-15
©OECD
would accept, the taxpayer's claim may be doubtful. In determining what
period
of time an independent enterprise would accept, tax administrations may
wish to
consider evidence of the commercial strategies evident in the country in
which
the business strategy is being pursued. In the end, however, the most
important
consideration is whether the strategy in question could plausibly be
expected to
prove profitable within the foreseeable future (while recognising that
the strategy
might fail), and that a party operating at arm's length would have been
prepared to
sacrifice profitability for a similar period under such economic
circumstances and
competitive conditions.
ii) Recognition of the actual transactions undertaken
1.36 A tax administration's examination of a controlled transaction
ordinarily should be based on the transaction actually undertaken by the
associated enterprises as it has been structured by them, using the
methods
applied by the taxpayer insofar as these are consistent with the methods
described
in Chapters II and III. In other than exceptional cases, the tax
administration
should not disregard the actual transactions or substitute other
transactions for
them. Restructuring of legitimate business transactions would be a
wholly
arbitrary exercise the inequity of which could be compounded by double
taxation
created where the other tax administration does not share the same views
as to
how the transaction should be structured.
1.37 However, there are two particular circumstances in which it may,
exceptionally, be both appropriate and legitimate for a tax
administration to
consider disregarding the structure adopted by a taxpayer in entering
into a
controlled transaction. The first circumstance arises where the economic
substance of a transaction differs from its form. In such a case the tax
administration may disregard the parties' characterisation of the
transaction and
re-characterise it in accordance with its substance. An example of this
circumstance would be an investment in an associated enterprise in the
form of
interest-bearing debt when, at arm's length, having regard to the
economic
circumstances of the borrowing company, the investment would not be
expected
to be structured in this way. In this case it might be appropriate for a
tax
administration to characterise the investment in accordance with its
economic
substance with the result that the loan may be treated as a subscription
of capital.
The second circumstance arises where, while the form and substance of
the
transaction are the same, the arrangements made in relation to the
transaction,
OECD TRANSFER PRICING GUIDELINES
I-16 July 1995
©OECD
viewed in their totality, differ from those which would have been
adopted by
independent enterprises behaving in a commercially rational manner and
the
actual structure practically impedes the tax administration from
determining an
appropriate transfer price. An example of this circumstance would be a
sale
under a long-term contract, for a lump sum payment, of unlimited
entitlement to
the intellectual property rights arising as a result of future research
for the term of
the contract (as previously indicated in paragraph 1.10). While in this
case it may
be proper to respect the transaction as a transfer of commercial
property, it would
nevertheless be appropriate for a tax administration to conform the
terms of that
transfer in their entirety (and not simply by reference to pricing) to
those that
might reasonably have been expected had the transfer of property been
the
subject of a transaction involving independent enterprises. Thus, in the
case
described above it might be appropriate for the tax administration, for
example, to
adjust the conditions of the agreement in a commercially rational manner
as a
continuing research agreement.
1.38 In both sets of circumstances described above, the character of the
transaction may derive from the relationship between the parties rather
than be
determined by normal commercial conditions and may have been structured
by
the taxpayer to avoid or minimise tax. In such cases, the totality of
its terms
would be the result of a condition that would not have been made if the
parties
had been engaged in arm's length dealings. Article 9 would thus allow an
adjustment of conditions to reflect those which the parties would have
attained
had the transaction been structured in accordance with the economic and
commercial reality of parties dealing at arm's length.
1.39 Associated enterprises are able to make a much greater variety of
contracts and arrangements than can unrelated enterprises because the
normal
conflict of interest which would exist between independent parties is
often absent.
Associated enterprises may and frequently do conclude arrangements of a
specific nature that are not or are very rarely encountered between
unrelated
parties. This may be done for various economic, legal, or fiscal reasons
dependent on the circumstances in a particular case. Moreover, contracts
within
an MNE could be quite easily altered, suspended, extended, or terminated
according to the overall strategies of the MNE as a whole and such
alterations
may even be made retroactively. In such instances tax administrations
would
have to determine what is the underlying reality behind a contractual
arrangement
in applying the arm's length principle.
ARMÕS LENGTH PRINCIPLE
July 1995 I-17
©OECD
1.40 In addition, tax administrations may find it useful to refer to
alternatively structured transactions between independent enterprises to
determine whether the controlled transaction as structured satisfies the
arm's
length principle. Whether evidence from a particular alternative can be
considered will depend on the facts and circumstances of the particular
case,
including the number and accuracy of the adjustments necessary to
account for
differences between the controlled transaction and the alternative and
the quality
of any other evidence that may be available.
1.41 The difference between restructuring the controlled transaction
under
review which, as stated above, generally is inappropriate, and using
alternatively
structured transactions as comparable uncontrolled transactions is
demonstrated
in the following example. Suppose a manufacturer sells goods to a
controlled
distributor located in another country and the distributor accepts all
currency risk
associated with these transactions. Suppose further that similar
transactions
between independent manufacturers and distributors are structured
differently in
that the manufacturer, and not the distributor, bears all currency risk.
In such a
case, the tax administration should not disregard the controlled
taxpayer's
purported assignment of risk unless there is good reason to doubt the
economic
substance of the controlled distributor's assumption of currency risk.
The fact
that independent enterprises do not structure their transactions in a particular
fashion might be a reason to examine the economic logic of the structure
more
closely, but it would not be determinative. However, the uncontrolled
transactions involving a differently structured allocation of currency
risk could be
useful in pricing the controlled transaction, perhaps employing the
comparable
uncontrolled price method if sufficiently accurate adjustments to their
prices
could be made to reflect the difference in the structure of the
transactions.
iii) Evaluation of separate and combined transactions
1.42 Ideally, in order to arrive at the most precise approximation of
fair
market value, the arm's length principle should be applied on a
transaction-bytransaction
basis. However, there are often situations where separate transactions
are so closely linked or continuous that they cannot be evaluated
adequately on a
separate basis. Examples may include 1. some long-term contracts for the supply
of commodities or services, 2. rights
to use intangible property, and 3. pricing a
range of closely-linked products (e.g. in a product line) when it is
impractical to
OECD TRANSFER PRICING GUIDELINES
I-18 July 1995
©OECD
determine pricing for each individual product or transaction. Another
example
would be the licensing of manufacturing know-how and the supply of vital
components to an associated manufacturer; it may be more reasonable to
assess
the arm's length terms for the two items together rather than
individually. Such
transactions should be evaluated together using the most appropriate
arm's length
method or methods. A further example would be the routing of a
transaction
through another associated enterprise; it may be more appropriate to
consider the
transaction of which the routing is a part in its entirety, rather than
consider the
individual transactions on a separate basis.
1.43 While some separately contracted transactions between associated
enterprises may need to be evaluated together in order to determine
whether the
conditions are arm's length, other transactions contracted between such
enterprises as a package may need to be evaluated separately. An MNE may
package as a single transaction and establish a single price for a
number of
benefits such as licenses for patents, know-how, and trademarks, the
provision of
technical and administrative services, and the lease of production
facilities. This
type of arrangement is often referred to as a package deal. Such
comprehensive
packages would be unlikely to include sales of goods, however, although
the
price charged for sales of goods may cover some accompanying services.
In
some cases, it may not be feasible to evaluate the package as a whole so
that the
elements of the package must be segregated. In such cases, after
determining
separate transfer pricing for the separate elements, the tax
administration should
nonetheless consider whether in total the transfer pricing for the
entire package is
arm's length.
1.44 Even in uncontrolled transactions, package deals may combine
elements that are subject to different tax treatment under domestic law
or an
income tax convention. For example, royalty payments may be subject to
withholding tax but lease payments may be subject to net taxation. In
such
circumstances, it may still be appropriate to determine the transfer
pricing on a
package basis, and the tax administration could then determine whether
for other
tax reasons it is necessary to allocate the price to the elements of the
package. In
making this determination, tax administrations should examine the
package deal
between associated enterprises in the same way that they would analyze
similar
deals between independent enterprises. Taxpayers should be prepared to
show
that the package deal reflects appropriate transfer pricing.
ARMÕS LENGTH PRINCIPLE
July 1995 I-19
©OECD
iv) Use of an arm's length range
1.45 In some cases it will be possible to apply the arm's length
principle to
arrive at a single figure (e.g. price or margin) that is the most
reliable to establish
whether the conditions of a transaction are arm's length. However,
because
transfer pricing is not an exact science, there will also be many
occasions when
the application of the most appropriate method or methods produces a
range of
figures all of which are relatively equally reliable. In these cases,
differences in
the figures that comprise the range may be caused by the fact that in
general the
application of the arm's length principle only produces an approximation
of
conditions that would have been established between independent
enterprises. It
is also possible that the different points in a range represent the fact
that
independent enterprises engaged in comparable transactions under
comparable
circumstances may not establish exactly the same price for the
transaction.
However, in some cases, not all comparable transactions examined will
have a
relatively equal degree of comparability. Therefore, the actual
determination of
the arm's length price necessarily requires exercising good judgment. As
discussed in Chapter III, use of a range may be particularly appropriate
where, as
a last resort, the transactional net margin method is applied.
1.46 A range of figures may also result when more than one method is
applied to evaluate a controlled transaction. For example, two methods
that attain
similar degrees of comparability may be used to evaluate the arm's
length
character of a controlled transaction. Each method may produce an
outcome or a
range of outcomes that differs from the other because of differences in
the nature
of the methods and the data, relevant to the application of a particular
method,
used. Nevertheless, each separate range potentially could be used to
define an
acceptable range of arm's length figures. Data from these ranges could
be useful
for purposes of more accurately defining the arm's length range, for
example
when the ranges overlap, or for reconsidering the accuracy of the
methods used
when the ranges do not overlap. No general rule may be stated with
respect to the
use of ranges derived from the application of multiple methods because
the
conclusions to be drawn from their use will depend on the relative
reliability of
the methods employed to determine the ranges and the quality of the
information
used in applying the different methods.
1.47 Where the application of one or more methods produces a range of
figures, a substantial deviation among points in that range may indicate
that the
OECD TRANSFER PRICING GUIDELINES
I-20 July 1995
©OECD
data used in establishing some of the points may not be as reliable as
the data
used to establish the other points in the range or that the deviation
may result
from features of the comparable data that require adjustments. In such
cases,
further analysis of those points may be necessary to evaluate their
suitability for
inclusion in any arm's length range.
1.48 If the relevant conditions of the controlled transactions (e.g.
price or
margin) are within the arm's length range, no adjustment should be made.
If the
relevant conditions of the controlled transaction (e.g. price or margin)
fall outside
the arm's length range asserted by the tax administration, the taxpayer
should
have the opportunity to present arguments that the conditions of the
transaction
satisfy the arm's length principle, and that the arm's length range
includes their
results. If the taxpayer is unable to establish this fact, the tax
administration must
determine how to adjust the conditions of the controlled transaction
taking into
account the arm's length range. It could be argued that any point in the
range
nevertheless satisfies the arm's length principle. In general, and to
the extent that
it is possible to distinguish among the various points within the range,
such
adjustments should be made to the point within the range that best
reflects the
facts and circumstances of the particular controlled transaction.
v) Use of multiple year data
1.49 In order to obtain a complete understanding of the facts and
circumstances surrounding the controlled transaction, it generally might
be useful
to examine data from both the year under examination and prior years.
The
analysis of such information might disclose facts that may have
influenced (or
should have influenced) the determination of the transfer price. For
example, the
use of data from past years will show whether a taxpayer's reported loss
on a
transaction is part of a history of losses on similar transactions, the
result of
particular economic conditions in a prior year that increased costs in
the
subsequent year, or a reflection of the fact that a product is at the
end of its life
cycle. Such an analysis may be particularly useful where as a last
resort a
transactional profit method is applied.
1.50 Multiple year data will also be useful in providing information
about
the relevant business and product life cycles of the comparables.
Differences in
business or product life cycles may have a material effect on transfer
pricing
conditions that needs to be assessed in determining comparability. The
data from
ARMÕS LENGTH PRINCIPLE
July 1995 I-21
©OECD
earlier years may show whether the independent enterprise engaged in a
comparable transaction was affected by comparable economic conditions in
a
comparable manner, or whether different conditions in an earlier year
materially
affected its price or profit so that it should not be used as a
comparable.
1.51 Data from years following the year of the transaction may also be
relevant to the analysis of transfer prices, but care must be taken by
tax
administrations to avoid the use of hindsight. For example, data from
later years
may be useful in comparing product life cycles of controlled and
uncontrolled
transactions for the purpose of determining whether the uncontrolled
transaction
is an appropriate comparable to use in applying a particular method.
Subsequent
conduct by the parties will also be relevant in ascertaining the actual
terms and
conditions that operate between the parties.
vi) Losses
1.52 When an associated enterprise consistently realizes losses while
the
MNE group as a whole is profitable, the facts could trigger some special
scrutiny
of transfer pricing issues. Of course, associated enterprises, like
independent
enterprises, can sustain genuine losses, whether due to heavy start-up
costs,
unfavourable economic conditions, inefficiencies, or other legitimate
business
reasons. However, an independent enterprise would not be prepared to
tolerate
losses that continue indefinitely. An independent enterprise that
experiences
recurring losses will eventually cease to undertake business on such
terms. In
contrast, an associated enterprise that realizes losses may remain in
business if the
business is beneficial to the MNE group as a whole.
1.53 The fact that there is an enterprise making losses that is doing
business
with profitable members of its MNE group may suggest to the taxpayers or
tax
administrations that the transfer pricing should be examined. The loss
enterprise
may not be receiving adequate compensation from the MNE group of which
it is
a part in relation to the benefits derived from its activities. For
example, an MNE
group may need to produce a full range of products and/or services in
order to
remain competitive and realize an overall profit, but some of the
individual
product lines may regularly lose revenue. One member of the MNE group
might
realize consistent losses because it produces all the loss-making products
while
other members produce the profit-making products. An independent
enterprise
would perform such a service only if it were compensated by an adequate
service
OECD TRANSFER PRICING GUIDELINES
I-22 July 1995
©OECD
charge. Therefore, one way to approach this type of transfer pricing
problem
would be to deem the loss enterprise to receive the same type of service
charge
that an independent enterprise would receive under the arm's length
principle.
1.54 A factor to consider in analysing losses is that business
strategies may
differ from MNE group to MNE group due to a variety of historic,
economic, and
cultural reasons. Recurring losses for a reasonable period may be
justified in
some cases by a business strategy to set specially low prices to achieve
market
penetration. For example, a producer may lower the prices of its goods,
even to
the extent of temporarily incurring losses, in order to enter new
markets, to
increase its share of an existing market, to introduce new products or
services, or
to discourage potential competitors. However, specially low prices
should be
expected for a limited period only, with the specific object of
improving profits in
the longer term. If the pricing strategy continues beyond a reasonable
period, a
transfer pricing adjustment may be appropriate, particularly where
comparable
data over several years show that the losses have been incurred for a
period
longer than that affecting comparable independent enterprises. Further,
tax
administrations should not accept specially low prices (e.g. pricing at
marginal
cost in a situation of underemployed production capacities) as arm's
length prices
unless independent enterprises could be expected to have determined
prices in a
comparable manner .
vii) The effect of government policies
1.55 There are some circumstances in which a taxpayer will claim that an
arm's length price must be adjusted to account for government
interventions such
as price controls (even price cuts), interest rate controls, controls
over payments
for services or management fees, controls over the payment of royalties,
subsidies
to particular sectors, exchange control, anti-dumping duties, or
exchange rate
policy. As a general rule, these government interventions should be
treated as
conditions of the market in the particular country, and in the ordinary
course they
should be taken into account in evaluating the taxpayer's transfer price
in that
market. The question then presented is whether in light of these
conditions the
transactions undertaken by the controlled parties are consistent with
transactions
between independent enterprises.
1.56 One issue that arises is determining the stage at which a price
control
affects the price of a product or service. Often the direct impact will
be on the
ARMÕS LENGTH PRINCIPLE
July 1995 I-23
©OECD
final price to the consumer, but there may nonetheless be an impact on
prices paid
at prior stages in the supply of goods to the market. MNEs in practice
may make
no adjustment in their transfer prices to take account of such controls,
leaving the
final seller to suffer any limitation on profit that may occur, or they
may charge
prices that share the burden in some way between the final seller and
the
intermediate supplier. It should be considered whether or not an
independent
supplier would share in the costs of the price controls and whether an
independent
enterprise would seek alternative product lines and business
opportunities. In this
regard, it is unlikely that an independent enterprise would be prepared
to produce,
distribute, or otherwise provide products or services on terms that
allowed it no
profit. Nevertheless, it is quite obvious that a country with price
controls must
take into account that those price controls will affect the profits that
can be
realised by enterprises selling goods subject to those controls.
1.57 A special problem arises when a country prevents or
"blocks" the
payment of an amount which is owed by one associated enterprise to
another or
which in an arm's length arrangement would be charged by one associated
enterprise to another. For example, exchange controls may effectively
prevent an
associated enterprise from transferring interest payments abroad on a
loan made
by another associated enterprise located in a different country. This
circumstance
may be treated differently by the two countries involved: the country of
the
borrower may or may not regard the untransferred interest as having been
paid,
and the country of the lender may or may not treat the lender as having
received
the interest. As a general rule, where the government intervention
applies equally
to transactions between associated enterprises and transactions between
independent enterprises (both in law and in fact), the approach to this
problem
where it occurs between associated enterprises should be the same for
tax
purposes as that adopted for transactions between independent
enterprises.
Where the government intervention applies only to transactions between
associated enterprises, there is no simple solution to the problem.
Perhaps one
way to deal with the issue is to apply the arm's length principle
viewing the
intervention as a condition affecting the terms of the transaction.
Treaties may
specifically address the approaches available to the treaty partners
where such
circumstances exist.
1.58 A difficulty with this analysis is that often independent
enterprises
simply would not enter into a transaction in which payments were
blocked. An
independent enterprise might find itself in such an arrangement from
time to
OECD TRANSFER PRICING GUIDELINES
I-24 July 1995
©OECD
time, most likely because the government interventions were imposed
subsequent
to the time that the arrangement began. But it seems unlikely that an
independent
enterprise would willingly subject itself to a substantial risk of
nonpayment for
products or services rendered by entering into an arrangement when
severe
government interventions already existed unless the profit projections
or
anticipated return from the independent enterprise's proposed business
strategy
are sufficient to yield it an acceptable rate of return notwithstanding
the existence
of the government intervention that may affect payment.
1.59 Because independent enterprises might not engage in a transaction
subject to government interventions, it is unclear how the arm's length
principle
should apply. One possibility is to treat the payment as having been
made
between the associated enterprises, on the assumption that an
independent
enterprise in a similar circumstance would have insisted on payment by
some
other means. This approach would treat the party to whom the blocked
payment
is owed as performing a service for the MNE group. An alternative
approach that
may be available in some countries would be to defer both the income and
the
relevant expenses of the taxpayer. In other words, the party to whom
this blocked
payment was due would not be allowed to deduct expenses, such as
additional
financing costs, until the blocked payment was made. The concern of tax
administrations in these situations is mainly their respective tax
bases. If an
associated enterprise claims a deduction in its tax computations for a
blocked
payment, then there should be corresponding income to the other party.
In any
case, a taxpayer should not be permitted to treat blocked payments due
from an
associated enterprise differently from blocked payments due from an
independent
enterprise.
viii) Intentional set-offs
1.60 An intentional set-off is one that associated enterprises
incorporate
knowingly into the terms of the controlled transactions. It occurs when
one
associated enterprise has provided a benefit to another associated
enterprise
within the group that is balanced to some degree by different benefits
received
from that enterprise in return. These enterprises may claim that the
benefit each
has received should be set off against the benefit each has provided as
full or part
payment for those benefits so that only the net gain or loss (if any) on
the
transactions needs to be considered for purpose of assessing tax
liabilities. For
example, an enterprise may license another enterprise to use a patent in
return for
ARMÕS LENGTH PRINCIPLE
July 1995 I-25
©OECD
the provision of know-how in another connection and claim that the
transactions
result in no profit or loss to either party. Such arrangements may
sometimes be
encountered between independent enterprises and should be assessed in
accordance with the arm's length principle in order to quantify the
value of the
respective benefits claimed as set-offs.
1.61 Intentional set-offs may vary in size and complexity. Such set-offs
may
range from a simple balance of two transactions (such as a favourable
selling
price for manufactured goods in return for a favourable purchase price
for the raw
material used in producing the goods) to an arrangement for a general
settlement
balancing all benefits accruing to both parties over a period.
Independent
enterprises would be very unlikely to consider the latter type of
arrangement
unless the benefits could be accurately quantified and the contract
created in
advance. Otherwise, independent enterprises normally would prefer to
allow
their receipts and disbursements to flow independently of each other,
taking any
profit or loss resulting from normal trading.
1.62 Recognition of intentional set-offs does not change the fundamental
requirement that for tax purposes the transfer prices for controlled
transactions
must be consistent with the arm's length principle. It would be helpful
for
taxpayers to disclose the existence of set-offs intentionally built into
two or more
transactions between associated enterprises and demonstrate (or
acknowledge that
they have relevant documentation and have undertaken sufficient analysis
to be
able to show) that, after taking account of the set-offs, the conditions
governing
the transactions are consistent with the arm's length principle at the
time of filing
the tax return.
1.63 It may be necessary to evaluate the transactions separately to
determine
whether they each satisfy the arm's length principle. If the
transactions are to be
analysed together, care should be taken in selecting comparable
transactions and
regard had to the discussion in Section iii) of Part C. The terms of set-offs
relating to international transactions between associated enterprises
may not be
fully consistent with those relating to purely domestic transactions
between
independent enterprises because of the differences in tax treatment of
the set-off
under different national tax systems or differences in the treatment of
the
payment under a bilateral tax treaty. For example, withholding tax would
complicate a set-off of royalties against sales receipts.
OECD TRANSFER PRICING GUIDELINES
I-26 July 1995
©OECD
1.64 A taxpayer may seek on examination a reduction in a transfer
pricing
adjustment based on an unintentional over-reporting of taxable income.
Tax
administrations in their discretion may or may not grant this request.
Tax
administrations may also consider such requests in the context of mutual
agreement procedures and corresponding adjustments (see Chapter IV).
ix) Use of customs valuations
1.65 The arm's length principle is applied, broadly speaking, by many
customs administrations as a principle of comparison between the value
attributable to goods imported by associated enterprises and the value
for similar
goods imported by independent enterprises.
1.66 Both customs officials and tax administrations, however, generally
seek
to determine the value of the products at the time they were transferred
or
imported. (For tax administrations, the relevant time is generally when
the
contract for transfer is concluded, but in many cases this coincides
with the time
of transfer). Thus, customs valuations, because they may occur at or
about the
same time the transfer takes place, may be useful to tax administrations
in
evaluating the arm's length character of a controlled transaction
transfer price. In
particular, customs officials may have contemporaneous documentation
regarding the transaction that could be relevant for transfer pricing
purposes,
especially if prepared by the taxpayer.
1.67 Although customs officials and tax administrations may have a
similar
purpose in examining the reported values of cross-border controlled
transactions,
taxpayers may have competing incentives in setting values for customs
and tax
purposes. In general, a taxpayer importing goods is interested in
setting a low
price for the transaction for customs purposes so that the customs duty
imposed
will be low. (There could be similar considerations arising with respect
to value
added taxes, sales taxes, and excise taxes.) For tax purposes, however,
the
taxpayer may want to report a higher price paid for those same goods in
order to
increase deductible costs. Cooperation between income tax and customs
administrations within a country in evaluating transfer prices is
becoming more
common and this should help to reduce the number of cases where customs
valuations are found unacceptable for tax purposes or vice versa.
Greater
cooperation in the area of exchange of information would be particularly
useful,
and should not be difficult to achieve in countries that already have
integrated
ARMÕS LENGTH PRINCIPLE
July 1995 I-27
©OECD
administrations for income taxes and customs duties. Countries that have
separate administrations may wish to consider modifying the exchange of
information rules so that the information can flow more easily between
the
different administrations.
x) Use of transfer pricing methods
1.68 The methods set forth in Chapters II and III establish whether the
conditions imposed in the commercial or financial relations between
associated
enterprises are consistent with the arm's length principle. No one
method is
suitable in every possible situation and the applicability of any
particular method
need not be disproved. Tax administrators should hesitate from making
minor or
marginal adjustments. Moreover, MNE groups retain the freedom to apply
methods not described in this Report to establish prices provided those
prices
satisfy the arm's length principle in accordance with these Guidelines.
However,
a taxpayer should maintain and be prepared to provide documentation
regarding
how its transfer prices were established. For a discussion of
documentation, see
Chapter V.
1.69 The arm's length principle does not require the application of more
than
one method, and in fact undue reliance on such an approach could create
a
significant burden for taxpayers. Thus, this Report does not require
either the tax
examiner or taxpayer to perform analyses under more than one method.
While in
some cases the choice 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.
However, for difficult cases, where no one approach is conclusive, a
flexible
approach would allow the evidence of various methods to be used in
conjunction.
In such cases, an attempt should be made to reach a conclusion
consistent with
the arm's length principle that is satisfactory from a practical viewpoint
to all the
parties involved, taking into account the facts and circumstances of the
case, the
mix of evidence available, and the relative reliability of the various
methods
under consideration.
1.70 It is not possible to provide specific rules that will cover every
case. In
general, the parties should attempt to reach a reasonable accommodation
keeping
in mind the imprecision of the various methods and the preference for
higher
degrees of comparability and a more direct and closer relationship to the
OECD TRANSFER PRICING GUIDELINES
I-28 July 1995
©OECD
transaction. It should not be the case that useful information, such as
might be
drawn from uncontrolled transactions that are not identical to the
controlled
transactions, should be dismissed simply because some rigid standard of
comparability is not fully met. Similarly, evidence from enterprises
engaged in
controlled transactions with associated enterprises may be useful in
understanding the transaction under review or as a pointer to further
investigation. Further, any method should be permitted where its
application is
agreeable to the members of the MNE group involved with the transaction
or
transactions to which the methodology applies and also to the tax
administrations
in the jurisdictions of all those members.
July 1995 II-1
©OECD
Chapter II
Traditional Transaction Methods
A. Introduction
2.1 This Chapter provides a detailed description of traditional
transaction
methods that are used to apply the arm's length principle. These methods
are the
comparable uncontrolled price method or CUP method, the resale price
method,
and the cost plus method.
B. Relationship to Article 9
2.2 As stated in Chapter I, paragraph 1 of Article 9 of the OECD Model
Tax 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."
2.3 The Commentary on paragraph 1 of Article 9 indicates that paragraph
1
authorizes a tax administration "for the purpose of calculating tax
liabilities [to]
re-write the accounts of the [associated] enterprises if as a result of
the special
relations between the enterprises the accounts do not show the true
taxable profits
arising in that State." The "true taxable profits" are
those that would have been
achieved in the absence of the conditions that are not arm's length. The
Commentary emphasizes that the Article does not apply where transactions
have
occurred on "normal open market commercial terms (on an arm's
length basis)";
accounts may be rewritten "only if special conditions have been
made or imposed
between the two enterprises." Thus, the issue under Article 9 is
whether the
conditions in the commercial or financial relations of associated
enterprises are
arm's length or whether instead one or more "special
conditions" exist
(i.e. conditions that are not arm's length).
2.4 The commercial or financial relations between associated enterprises
can take many forms. These include entering into controlled transactions
at an
agreed transfer price and/or under certain terms and conditions and
arrangements
OECD TRANSFER PRICING GUIDELINES
II-2 July 1995
©OECD
providing benefits to other group members for no consideration.
Commercial and
financial relations can affect not only a controlled transaction for
which a specific
transfer price would be at issue, but also the essential characteristics
of the
business, for example, the proportions and amounts of debt and equity by
which
an enterprise is capitalised to conduct its business. The issue of thin
capitalisation
will be discussed in subsequent work.
2.5 The most direct way to establish whether the conditions made or
imposed between associated enterprises are arm's length is to compare
the prices
charged in controlled transactions undertaken between those enterprises
with
prices charged in comparable transactions undertaken between independent
enterprises. This approach is the most direct because any difference in
the price
of a controlled transaction from the price in a comparable uncontrolled
transaction can normally be traced directly to the commercial and
financial
relations made or imposed between the enterprises, and the arm's length
conditions can be established by directly substituting the price in the
comparable
uncontrolled transaction for the price of the controlled transaction.
However,
there will not always be comparable transactions available to allow
reliance on
this direct approach alone, and so it may be necessary to compare other
less direct
indicia, such as gross margins, from controlled and uncontrolled
transactions to
establish whether the conditions between associated enterprises are
arm's length.
These approaches, direct and indirect, are reflected in the traditional
transaction
methods described below.
C. Types of traditional transaction methods
i) Comparable uncontrolled price method
2.6 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.
2.7 Following the principles in Chapter I, an uncontrolled transaction
is
comparable to a controlled transaction (i.e. it is a comparable
uncontrolled
TRADITIONAL METHODS
July 1995 II-3
©OECD
transaction) for purposes of the CUP method if one of two conditions is
met:
1. 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 2. reasonably
accurate adjustments can be made to
eliminate the material effects of such differences. Where it is possible
to locate
comparable uncontrolled transactions, the CUP Method is the most direct
and
reliable way to apply the arm's length principle. Consequently, in such
cases the
CUP Method is preferable over all other methods.
2.8 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. When
this is the
case, some adjustments will be appropriate. As discussed below in
paragraph 2.9,
the extent and reliability of such adjustments will affect the relative
reliability of
the analysis under the CUP method.
2.9 In considering whether controlled and uncontrolled transactions are
comparable, regard should be had to the effect on price of broader
business
functions other than just product comparability (i.e. factors relevant
to
determining comparability under Chapter I). Where differences exist
between the
controlled and uncontrolled transactions or between the enterprises
undertaking
those transactions, it may be difficult to determine reasonably accurate
adjustments to eliminate the effect on price. The difficulties that
arise in
attempting to make reasonably accurate adjustments should not routinely
preclude the possible application of the CUP method. Practical
considerations
dictate a more flexible approach to enable the CUP Method to be used and
to be
supplemented as necessary by other appropriate methods, all of which
should be
evaluated according to their relative accuracy. Every effort should be
made to
adjust the data so that it may be used appropriately in a CUP method. As
for any
method, the relative reliability of the CUP Method is affected by the
degree of
accuracy with which adjustments can be made to achieve comparability.
OECD TRANSFER PRICING GUIDELINES
II-4 July 1995
©OECD
Examples of the application of the CUP Method
2.10 The following examples illustrate the application of the CUP
method,
including situations where adjustments may need to be made to
uncontrolled
transactions to make them comparable uncontrolled transactions.
2.11 The CUP method is a particularly reliable method where an
independent enterprise sells the same product as is sold between two
associated
enterprise. 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
combine the CUP method with other less direct methods, or to use such
methods
instead.
2.12 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.
2.13 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.
TRADITIONAL METHODS
July 1995 II-5
©OECD
ii) Resale price method
2.14 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 (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. This
method is
probably most useful where it is applied to marketing operations.
2.15 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.
Also, the
resale price margin earned by an independent enterprise in comparable
uncontrolled transactions may serve as a guide. Where the reseller is
carrying on
a general brokerage business, the resale price margin may be related to
a
brokerage fee, which is usually calculated as a percentage of the sales
price of the
product sold. The determination of the resale price margin in such a
case should
take into account whether the broker is acting as an agent or a
principal.
2.16 Following the principles in Chapter I, an uncontrolled transaction
is
comparable to a controlled transaction (i.e. it is a comparable
uncontrolled
transaction) for purposes of the resale price method if one of two conditions
is
met: 1. none of the differences (if any) between
the transactions being compared
or between the enterprises undertaking those transactions could
materially affect
the resale price margin in the open market; or 2. reasonably accurate adjustments
can be made to eliminate the material effects of such differences. In
making
comparisons for purposes of the resale price method, fewer adjustments
are
normally needed to account for product differences than under the CUP
Method,
because minor product differences are less likely to have as material an
effect on
profit margins as they do on price.
2.17 In a market economy, the compensation for performing similar
functions would tend to be equalized across different activities. In
contrast,
OECD TRANSFER PRICING GUIDELINES
II-6 July 1995
©OECD
prices for different products would tend to equalize only to the extent
that those
products were substitutes for one another. Because gross profit margins
represent
gross compensation, after the cost of sales for specific functions
performed
(taking into account assets used and risks assumed), product differences
are less
significant. For example, the facts may indicate that a distribution
company
performs the same functions (taking into account assets used and risks
assumed)
selling toasters as it would selling blenders, and hence in a market
economy there
should be a similar level of compensation for the two activities.
However,
consumers would not consider toasters and blenders to be particularly
close
substitutes, and hence there would be no reason to expect their prices
to be the
same.
2.18 Although broader product differences can be allowed in the resale
price
method, the property transferred in the controlled transaction must
still be
compared to that being transferred in the uncontrolled transaction.
Broader
differences are more likely to be reflected in differences in functions
performed
between the parties to the controlled and uncontrolled transactions.
While less
product comparability may be required in using the resale price method,
it
remains the case that closer comparability of products will produce a
better result.
For example, where there is a high-value or relatively unique intangible
involved
in the transaction, product similarity may assume greater importance and
particular attention should be paid to it to ensure that the comparison
is valid.
2.19 It may be appropriate to give more weight to other attributes of
comparability discussed in Chapter I (i.e. functions performed, economic
circumstances, etc.) when the profit margin relates primarily to those
other
attributes and only secondarily to the particular product being
transferred. This
circumstance will usually exist where the profit margin is determined
for an
associated enterprise that has not used relatively unique assets (such
as highly
valuable intangibles) to add significant value to the product being
transferred.
Thus, where uncontrolled and controlled transactions are comparable in
all
characteristics other than the product itself, the resale price method
might
produce a more reliable measure of arm's length conditions than the CUP
method,
unless reasonably accurate adjustments could be made to account for
differences
in the products transferred. The same point is true for the cost plus
method,
discussed below.
TRADITIONAL METHODS
July 1995 II-7
©OECD
2.20 When the resale price margin used is that of an independent
enterprise
in a comparable transaction, the reliability of the resale price method
may be
affected if there are material differences in the ways the associated
enterprises
and independent enterprises carry out their businesses. Such differences
could
include those that affect the level of costs taken into account (e.g.
the differences
could include the effect of management efficiency on levels and ranges
of
inventory maintenance), which may well have an impact on the
profitability of an
enterprise but which may not necessarily affect the price at which it
buys or sells
its goods or services in the open market. These types of characteristics
should be
analyzed in determining whether an uncontrolled transaction is
comparable for
purposes of applying the resale price method.
2.21 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 realized. 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. The
extent and reliability of those adjustments will affect the relative
reliability of the
analysis under the resale price method in any particular case.
2.22 An appropriate resale price margin is easiest to determine where
the
reseller does not add substantially to the value of the product. In
contrast, it may
be more difficult to use the resale price method to arrive at an arm's
length price
where, before resale, the goods are further processed or incorporated
into a more
complicated product so that their identity is lost or transformed (e.g.
where
components are joined together in finished or semi-finished goods).
Another
example where the resale price margin requires particular care is where
the
reseller contributes substantially to the creation or maintenance of
intangible
property associated with the product (e.g. trademarks or tradenames)
which are
owned by an associated enterprise. In such cases, the contribution of
the goods
originally transferred to the value of the final product cannot be
easily evaluated.
2.23 A resale price margin is more accurate where it is realized within
a
short time of the reseller's purchase of the goods. The more time that
elapses
OECD TRANSFER PRICING GUIDELINES
II-8 July 1995
©OECD
between the original purchase and resale the more likely it is that
other factors --
changes in the market, in rates of exchange, in costs, etc. -- will need
to be taken
into account in any comparison.
2.24 It should be expected that the amount of the resale price margin
will be
influenced by the level of activities performed by the reseller. This
level of
activities can range widely from the case where the reseller performs
only
minimal services as a forwarding agent to the case where the reseller
takes on the
full risk of ownership together with the full responsibility for and the
risks
involved in advertising, marketing, distributing and guaranteeing the
goods,
financing stocks, and other connected services. If the reseller in the
controlled
transaction does not carry on a substantial commercial activity but only
transfers
the goods to a third party, the resale price margin could, in light of
the functions
performed, be a small one. The resale price margin could be higher where
it can
be demonstrated that the reseller has some special expertise in the
marketing of
such goods, in effect bears special risks, or contributes substantially
to the
creation or maintenance of intangible property associated with the
product.
However, the level of activity performed by the reseller, whether
minimal or
substantial, would need to be well supported by relevant evidence. This
would
include justification for marketing expenditures that might be
considered
unreasonably high; for example, when part or most of the promotional
expenditure was clearly incurred as a service performed in favour of the
legal
owner of the trademark. In such a case the cost plus method may well
supplement the resale price method.
2.25 Where the reseller is clearly carrying on a substantial commercial
activity in addition to the resale activity itself, then a reasonably
substantial resale
price margin might be expected. If the reseller in its activities
employs
reasonably valuable and possibly unique assets (e.g. intangible property
of the
reseller, such as its marketing organisation), it may be inappropriate
to evaluate
the arm's length conditions in the controlled transaction using an
unadjusted
resale price margin derived from uncontrolled transactions in which the
uncontrolled reseller does not employ similar assets. If the reseller
possesses
valuable marketing intangibles, the resale price margin in the
uncontrolled
transaction may underestimate the profit to which the reseller in the
controlled
transaction is entitled, unless the comparable uncontrolled transaction
involves
the same reseller or a reseller with similarly valuable marketing
intangibles.
TRADITIONAL METHODS
July 1995 II-9
©OECD
2.26 In a case where there is a chain of distribution of goods through
an
intermediate company, it may be relevant for tax administrations to look
not only
at the resale price of goods that have been purchased from the
intermediate
company but also at the price that such company pays to its own supplier
and the
functions that the intermediate company undertakes. There could well be
practical difficulties in obtaining this information and the true
function of the
intermediate company may be difficult to determine. If it cannot be
demonstrated
that the intermediate company either bears a real risk or performs an
economic
function in the chain that has increased the value of the goods, then
any element
in the price that is claimed to be attributable to the activities of the
intermediate
company would reasonably be attributed elsewhere in the MNE group,
because
independent enterprises would not normally have allowed such a company
to
share in the profits of the transaction.
2.27 The resale price margin should also be expected to vary according
to
whether the reseller has the exclusive right to resell the goods.
Arrangements of
this kind are found in transactions between independent enterprises and
may
influence the margin. Thus, this type of exclusive right should be taken
into
account in any comparison. The value to be attributed to such an
exclusive right
will depend to some extent upon its geographical scope and the existence
and
relative competitiveness of possible substitute goods. The arrangement
may be
valuable to both the supplier and the reseller in an arm's length
transaction. For
instance, it may stimulate the reseller to greater efforts to sell the
supplier's
particular line of goods. On the other hand, such an arrangement may
provide the
reseller with a kind of monopoly with the result that the reseller
possibly can
realize a substantial turn over without great effort. Accordingly, the
effect of this
factor upon the appropriate resale price margin must be examined with
care in
each case.
2.28 Where the accounting practices differ from the controlled
transaction to
the uncontrolled transaction, appropriate adjustments should be made to
the data
used in calculating the resale price margin in order to ensure that the
same types
of costs are used in each case to arrive at the gross margin. For
example, costs of
R&D may be reflected in operating expenses or in costs of sales. The
respective
gross margins would not be comparable without appropriate adjustments.
OECD TRANSFER PRICING GUIDELINES
II-10 July 1995
©OECD
Examples of the application of the resale price method
2.29 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 an adjustment is made to account for
that
difference.
2.30 Assume that a warranty is offered with respect to all products so
that
the downstream price is uniform. Distributor C performs the warranty
function
but is, in fact, compensated by the supplier through a lower price.
Distributor D
does not perform the warranty function which is performed by the
supplier
(products are sent back to the factory). However, Distributor D's
supplier charges
D a higher price than is charged to Distributor C. If Distributor C
accounts for
the cost of performing the warranty function as a cost of goods sold,
then the
adjustment in the gross profit margins for the differences is automatic.
However,
if the warranty expenses are accounted for as operating expenses, there
is a
distortion in the margins which must be corrected. The reasoning in this
case
would be that, if D performed the warranty itself, its supplier would
reduce the
transfer price, and therefore, D's gross profit margin would be greater.
2.31 A company sells a product through independent distributors in five
countries in which it has no subsidiaries. The distributors simply
market the
product and do not perform any additional work. In one country, the
company
has set up a subsidiary. Because this particular market is of strategic
importance,
the company requires its subsidiary to sell only its product and to
perform
technical applications for the customers. Even if all other facts and
circumstances
are similar, if the margins are derived from independent enterprises
that do not
have exclusive sales arrangements or perform technical applications like
those
undertaken by the subsidiary, it is necessary to consider whether any
adjustments
must be made to achieve comparability.
TRADITIONAL METHODS
July 1995 II-11
©OECD
iii) Cost plus method
2.32 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 a related 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 semifinished
goods are sold between related parties, where related parties have
concluded joint facility agreements or long-term buy-and-supply
arrangements,
or where the controlled transaction is the provision of services.
2.33 The cost plus mark up of the supplier in the controlled transaction
should ideally be established by reference to the cost plus mark up that
the same
supplier earns in comparable uncontrolled transactions. In addition, the
cost plus
mark up that would have been earned in comparable transactions by an
independent enterprise may serve as a guide.
2.34 Following the principles in Chapter I, an uncontrolled transaction
is
comparable to a controlled transaction (i.e. it is a comparable
uncontrolled
transaction) for purposes of the cost plus method if one of two
conditions is met:
1. none of the differences (if any) between
the transactions being compared or
between the enterprises undertaking those transactions materially affect
the cost
plus mark up in the open market; or 2. reasonably accurate adjustments can be
made to eliminate the material effects of such differences. In
determining
whether a transaction is a comparable uncontrolled transaction for the
purposes of
the cost plus method, the same principles apply as described in
paragraphs 2.16-
2.21 for the resale price method. Thus, fewer adjustments may be
necessary to
account for product differences under the cost plus method than the CUP
Method,
and it may be appropriate to give more weight to other factors of
comparability
described in Chapter I, some of which may have a more significant effect
on the
cost plus mark up than they do on price. As under the resale price
method (see
paragraph 2.21), where there are differences that materially affect the
cost plus
mark ups earned in the controlled and uncontrolled transactions (for
example in
the nature of the functions performed by the parties to the
transactions),
adjustments should be made to account for such differences. The extent
and
OECD TRANSFER PRICING GUIDELINES
II-12 July 1995
©OECD
reliability of those adjustments will affect the relative reliability of
the analysis
under the cost plus method in particular cases.
2.35 For example, assume that Company A sells toasters to a distributor
that
is an associated enterprise, that Company B sells irons to a distributor
that is an
independent enterprise, and that the profit margins on the manufacture
of basic
toasters and irons are generally the same in the small household
appliance
industry. (The use of the cost plus method here presumes that there are
no highly
similar toaster manufacturers). If the cost plus method were being
applied, the
profit margins being compared in the controlled and uncontrolled
transactions
would be the difference between the selling price by the manufacturer to
the
distributor and the costs of manufacturing the product. However, Company
A
may be much more efficient in its manufacturing processes than Company B
thereby enabling it to have lower costs. As a result, even if Company A
were
making irons instead of toasters and charging the same price as Company
B is
charging for irons (i.e. no special condition were to exist), it would
be appropriate
for Company A's profit margin to be higher than that of Company B. Thus,
unless it is possible to adjust for the effect of this difference on the
profit margin,
the application of the cost plus method would not be wholly reliable in
this
context.
2.36 The cost plus method presents some difficulties in proper
application,
particularly in the determination of costs. Although it is true that an
enterprise
must cover its costs over a period of time to remain in business, those
costs may
not be the determinant of the appropriate profit in a specific case for
any one year.
While in many cases companies are driven by competition to scale down
prices
by reference to the cost of creating the relevant goods or providing the
relevant
service, there are other circumstances where there is no discernible
link between
the level of costs incurred and a market price (e.g. where a valuable
discovery has
been made and the owner has incurred only small research costs in making
it).
2.37 In addition, when applying the cost plus method one should pay
attention to apply a comparable mark up to a comparable cost basis. For instance,
if the supplier to which reference is made in applying the cost plus
method in
carrying out its activities employs leased business assets, the cost
basis might not
be comparable without adjustment if the supplier in the controlled
transaction
owns its business assets. As with the resale price method, the cost plus
method
relies upon a comparison of the mark up on costs achieved by the
controlled
TRADITIONAL METHODS
July 1995 II-13
©OECD
supplier of goods or services and the mark up achieved by one or more
uncontrolled entities on their costs with respect to comparable
transactions.
Therefore, differences between the controlled and uncontrolled
transactions that
have an effect on the size of the mark up must be analyzed to determine
what
adjustments should be made to the uncontrolled transactions' respective
mark up.
2.38 For this purpose, it is particularly important to consider
differences in
the level and types of expenses -- operating expenses and non-operating
expenses including financing expenditures -- associated with functions
performed
and risks assumed by the parties or transactions being compared.
Consideration
of these differences may indicate the following:
1. If expenses reflect a functional difference (taking into account
assets used and risks assumed) which has not been taken into
account in applying the method, an adjustment to the cost plus mark
up may be required.
2. If the expenses reflect additional functions that are distinct from
the
activities tested by the method, separate compensation for those
functions may need to be determined. Such functions may for
example amount to the provision of services for which an
appropriate reward may be determined. Similarly, expenses that are
the result of capital structures reflecting non-arm's length
arrangements may require separate adjustment.
3. If differences in the expenses of the parties being compared merely
reflect efficiencies or inefficiencies of the enterprises, as would
normally be the case for supervisory, general, and administrative
expenses, then no adjustment to the gross margin may be
appropriate.
In any of the above circumstances it may be appropriate to supplement
the cost
plus and resale price methods by considering the results obtained from
applying
other methods (see paragraphs 1.69-1.70).
2.39 Another important aspect of comparability is accounting
consistency.
Where the accounting practices differ in the controlled transaction and
the
uncontrolled transaction, appropriate adjustments should be made to the
data used
OECD TRANSFER PRICING GUIDELINES
II-14 July 1995
©OECD
to ensure that the same type of costs are used in each case to ensure
consistency.
The gross profit mark ups must be measured consistently between the
associated
enterprise and the independent enterprise. In addition, there may be
differences
across enterprises in the treatment of costs that affect gross profit
mark ups that
would need to be accounted for in order to achieve reliable
comparability. In
some cases it may be necessary to take into account certain operating
expenses in
order to achieve consistency and comparability; in these circumstances
the cost
plus method starts to approach a net rather than gross margin. To the
extent that
the analysis takes into account operating expenses, the reliability of the
analysis
may be adversely affected, for the reasons set forth in paragraphs
3.29-3.32.
Thus, the safeguards described in paragraphs 3.34-3.40 may be relevant
in
assessing the reliability of such analyses.
2.40 While precise accounting standards and terms may vary, in general
the
costs and expenses of an enterprise are understood to be divisible into
three broad
categories. First, there are the direct costs of producing a product or
service, such
as the cost of raw materials. Second, there are indirect costs of
production, which
although closely related to the production process may be common to
several
products or services (e.g. the costs of a repair department that
services equipment
used to produce different products). Finally, there are the operating expenses
of
the enterprise as a whole, such as supervisory, general, and
administrative
expenses.
2.41 The distinction between gross and net margin analyses may be
understood in the following terms. In general, the cost plus method will
use
margins computed after direct and indirect costs of production, while a
net
margin method will use margins computed after operating expenses of the
enterprise as well. It must be recognised that because of the variations
in practice
among countries, it is difficult to draw any precise lines between the
three
categories described above. Thus, for example, an application of the
cost plus
method may in a particular case include the consideration of some
expenses that
might be considered operating expenses, as discussed in paragraph 2.39.
Nevertheless, the problems in delineating with mathematical precision
the
boundaries of the three categories described above do not alter the
basic practical
distinction between the gross and net margin approaches.
2.42 In principle historical costs should be attributed to individual
units of
production, although admittedly the cost plus method may over-emphasize
TRADITIONAL METHODS
July 1995 II-15
©OECD
historical costs. Some costs, for example costs of materials, labour,
and transport
will vary over a period and in such a case it may be appropriate to
average the
costs over the period. Averaging also may be appropriate across product
groups
or over a particular line of production. Further, averaging may be
appropriate
with respect to the costs of fixed assets where the production or
processing of
different products is carried on simultaneously and the volume of
activity
fluctuates. Costs such as replacement costs and marginal costs also may
need to
be considered where these can be measured and they result in a more
accurate
estimate of the appropriate profit margin.
2.43 The costs that may be considered in applying the cost plus method
are
limited to those of the supplier of goods or services. This limitation
may raise a
problem of how to allocate some costs between suppliers and purchasers.
There
is a possibility that some costs will be borne by the purchaser in order
to diminish
the supplier's cost base on which the mark up will be calculated. In
practice, this
may be achieved by not allocating to the supplier an appropriate share
of
overheads and other costs borne by the purchaser (often the parent
company) for
the benefit of the supplier (often a subsidiary). The allocation should
be
undertaken based on an analysis of functions performed (taking into
account
assets used and risks assumed) by the respective parties as provided in
Chapter I.
A related problem is how overhead costs should be apportioned, whether
by
reference to turnover, number or cost of employees, or some other
criterion. The
issue of cost allocation will also be discussed subsequently in a
chapter on cost
contribution arrangements.
2.44 In some cases, there may be a basis for using only variable or
incremental (e.g. marginal) costs, because the transactions represent a
disposal of
marginal production. Such a claim could be justified if the goods could
not be
sold at a higher price in the relevant foreign market (see also the
discussion of
market penetration in Chapter I). Factors that could be taken into
account in
evaluating such a claim include information on whether the taxpayer has
any
other sales of the same or similar products in that particular foreign
market, the
percentage of the taxpayers' production (in both volume and value terms)
that the
claimed "marginal production" represents, the term of the
arrangement, and
details of the marketing analysis that was undertaken by the taxpayer or
MNE
group which led to the conclusion that the goods could not be sold at a
higher
price in that foreign market.
OECD TRANSFER PRICING GUIDELINES
II-16 July 1995
©OECD
2.45 No general rule can be set out that deals with all cases. The
various
methods for determining costs should be consistent as between the
controlled and
uncontrolled transactions and consistent over time in relation to particular
enterprises. For example, in determining the appropriate cost plus mark
up, it
may be necessary to take into account whether products can be supplied
by
various sources at widely differing costs. Related parties may choose to
calculate
their cost plus basis on a standardised basis. An unrelated party
probably would
not accept to pay a higher price resulting from the inefficiency of the
other party.
On the other hand, if the other party is more efficient than can be
expected under
normal circumstances, this other party should benefit from that
advantage. The
associated enterprise may agree in advance which costs would be
acceptable as a
basis for the cost plus method.
Examples of the application of the cost plus method
2.46 A is a domestic manufacturer of timing mechanisms for mass-market
clocks. A sells this product to its foreign subsidiary B. A earns a 5
percent gross
profit mark up with respect to its manufacturing operation. X, Y, and Z
are
unrelated domestic manufacturers of timing mechanisms for mass-market
watches. X, Y, and Z sell to unrelated foreign purchasers. X, Y, and Z
earn gross
profit mark ups with respect to their manufacturing operations that
range from 3
to 5 percent. A accounts for supervisory, general, and administrative
costs as
operating expenses, and thus these costs are not reflected in cost of
goods sold.
The gross profit mark ups of X, Y, and Z, however, reflect supervisory,
general,
and administrative costs as part of costs of goods sold. Therefore, the
gross profit
mark ups of X, Y, and Z must be adjusted to provide accounting
consistency.
2.47 Company C in country D is a 100% subsidiary of company E, located
in country F. In comparison with country F, wages are very low in
country D. At
the expense and risk of company E, television sets are assembled by
company C.
All the necessary components, know-how, etc. are provided by company E.
The
purchase of the assembled product is guaranteed by company E in case the
television sets fail to meet a certain quality standard. After the
quality check the
television sets are brought -- at the expense and risk of company E --
to
distribution centres company E has in several countries. The function of
company C can be described as a purely cost manufacturing function. The
risks
company C could bear are eventual differences in the agreed quality and
quantity.
TRADITIONAL METHODS
July 1995 II-17
©OECD
The basis for applying the cost plus method will be formed by all the
costs
connected to the assembling activities.
2.48 Company A of an MNE group agrees with company B of the same
MNE group to carry out contract research for company B. All risks of a
failure of
the research are born by company B. This company also owns all the
intangibles
developed through the research and therefore has also the profit chances
resulting
from the research. This is a typical setup for applying a cost plus
method. All
costs for the research, which the related parties have agreed upon, have
to be
compensated. The additional cost plus may reflect how innovative and complex
the research carried out is.
D. Relationship to other methods
2.49 Traditional transaction methods are the most direct means of
establishing whether conditions in the commercial and financial
relations
between associated enterprises are arm's length. As a result,
traditional
transaction methods are preferable to other methods. However, the
complexities
of real life business situations may put practical difficulties in the
way of the
application of the traditional transaction methods. In those exceptional
situations,
where there are no data available or the available data are not of
sufficient quality
to rely solely or at all on the traditional transaction methods, it may
become
necessary to address whether and under what conditions other methods may
be
used. This issue, in particular the role of transactional profit methods
and
conclusions about their use, is discussed in Chapter III.
July 1995 III-1
©OECD
Chapter III
Other Methods
A. Introduction
3.1 Part B of this Chapter provides a discussion of other approaches
that
might be used to approximate arm's length conditions when traditional
transaction methods cannot be reliably applied alone or exceptionally
cannot be
applied at all. The other approaches are referred to in the discussion
here as
"transactional profit methods," i.e. methods that examine the
profits that arise
from particular transactions among associated enterprises. The only
profit
methods that satisfy the arm's length principle are those that are
consistent with
the profit split method or the transactional net margin method as
described in
these Guidelines. In particular, so-called "comparable profits
methods" or
"modified cost plus/resale price methods" are acceptable only
to the extent that
they are consistent with these Guidelines. Part C discusses an approach
that
cannot reliably approximate arm's length conditions: global formulary
apportionment. OECD Member countries reiterate their support for the
arm's
length principle and so reject the use of global formulary
apportionment.
B. Transactional profit methods
3.2 A transactional profit method examines the profits that arise from
particular controlled transactions. The transactional profit methods for
purposes
of these Guidelines are the profit split method and the transactional
net margin
method. It is unusual to find enterprises entering into transactions in
which profit
is a condition "made or imposed" in the transactions. In fact,
enterprises rarely if
ever use a transactional profit method to establish their prices.
Nonetheless,
profit arising from a controlled transaction can be a relevant indicator
of whether
the transaction was affected by conditions that differ from those that
would have
been made by independent enterprises in otherwise comparable
circumstances.
Thus, in those exceptional cases in which the complexities of real life
business
put practical difficulties in the way of the application of the
traditional transaction
methods and provided all the safeguards set out in this Chapter are
observed,
application of the transactional profit methods (profit split and
transactional net
margin method) may provide an approximation of transfer pricing in a
manner
OECD TRANSFER PRICING GUIDELINES
III-2 July 1995
©OECD
consistent with the arm's length principle. However, the transactional
profit
methods may not be applied automatically simply because there is a
difficulty in
obtaining data. The same factors that led to the conclusion that it was
not
possible to reliably apply a traditional transaction method must be
reconsidered
when evaluating the reliability of a transactional profit method.
Rather, the
reliability of a method should be assessed taking into account the
principles
discussed in this Report, including the extent and the reliability of
adjustments to
the data used.
3.3 Methods that are based on profits can be accepted only insofar as
they
are compatible with Article 9 of the OECD Model Tax Convention,
especially
with regard to comparability. This is achieved by applying the methods
in a
manner that approximates arm's length pricing, which requires that the
profits
arising from particular controlled transactions be compared to the
profits arising
from comparable transactions between independent enterprises.
3.4 In no case should transactional profit methods be used so as to result
in
over-taxing enterprises mainly because they make profits lower than the
average,
or in under-taxing enterprises that make higher than average profits.
There is no
justification under the arm's length principle for imposing additional
tax on
enterprises that are less successful than average when the reason for
their lack of
success is attributable to commercial factors.
i) Profit split method
a) In general
3.5 Where transactions are very interrelated it might be that they
cannot be
evaluated on a separate basis. Under similar circumstances, independent
enterprises might decide to set up a form of partnership and agree to a
form of
profit split. Accordingly, 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 under the
principles of
Chapter I) by determining the division of profits that independent
enterprises
would have expected to realise 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
OTHER METHODS
July 1995 III-3
©OECD
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
as
described in Chapter I, and valued to the extent possible by any
available reliable
external market data. The functional analysis is an analysis of the
functions
performed (taking into account assets used and risks assumed) by each
enterprise.
The external market criteria may include, for example, profit split
percentages or
returns observed among independent enterprises with comparable
functions.
Subsection c) of this Section provides
guidance for applying the profit split
method.
b) Strengths and weaknesses
3.6 One strength of the profit split method is that it generally does
not rely
directly on closely comparable transactions, and it can therefore be
used in cases
when no such transactions between independent enterprises can be identified.
The allocation of profit is based on the division of functions between
the
associated enterprises themselves. External data from independent
enterprises is
relevant in the profit split analysis primarily to assess the value of
the
contributions that each associated enterprise makes to the transactions,
and not to
determine directly the division of profit. As a consequence, the profit
split
method offers flexibility by taking into account specific, possibly
unique, facts
and circumstances of the associated enterprises that are not present in
independent enterprises, while still constituting an arm's length
approach to the
extent that it reflects what independent enterprises reasonably would
have done if
faced with the same circumstances.
3.7 Another strength is that under the profit split method, it is less
likely
that either party to the controlled transaction will be left with an
extreme and
improbable profit result, since both parties to the transaction are
evaluated. This
aspect can be particularly important when analysing the contributions by
the
parties in respect of the intangible property employed in the controlled
transactions. This two-sided approach may also be used to achieve a
division of
the profits from economies of scale or other joint efficiencies that
satisfies both
the taxpayer and tax administrations.
OECD TRANSFER PRICING GUIDELINES
III-4 July 1995
©OECD
3.8 There are also a number of weaknesses to the profit split method.
One
such weakness is that the external market data considered in valuing the
contribution each associated enterprise makes to the controlled
transactions will
be less closely connected to those transactions than is the case with
the other
available methods. The more tenuous the nature of the external market
data used
when applying the profit split method, the more subjective will be the
resulting
allocation of profits.
3.9 A second weakness relates to difficulties in applying the profit
split
method. On first review, the profit split method may appear readily
accessible to
both taxpayers and tax administrations because it tends to rely less on
information
about independent enterprises. However, associated enterprises and tax
administrations alike may have difficulty accessing information from
foreign
affiliates. Moreover, independent enterprises do not ordinarily use the
profit split
method to determine their transfer pricing (except perhaps in joint
ventures). In
addition, it may be difficult to measure combined revenue and costs for
all the
associated enterprises participating in the controlled transactions,
which would
require stating books and records on a common basis and making
adjustments in
accounting practices and currencies. Further, when the profit split
method is
applied to operating profit, it may be difficult to identify the
appropriate operating
expenses associated with the transactions and to allocate costs between
the
transactions and the associated enterprises' other activities.
3.10 The foregoing considerations should be taken into account in
determining whether any particular application of the profit split
method is
appropriate given the facts and circumstances. More importantly, because
of the
foregoing considerations, the application of the profit split method is
subject to
the conclusions and limitations on transactional profit methods set
forth in
Section iii).
c) Guidance for application
3.11 If the profit split method were to be used by associated
enterprises to
establish transfer pricing in controlled transactions, then each
associated
enterprise would seek to achieve the division of profits that
independent
enterprises would have expected to realize in a joint venture
relationship.
Generally, conditions established in this manner would have to be based
upon
OTHER METHODS
July 1995 III-5
©OECD
projected profits rather than actual profits, because it is not possible
for the
taxpayers to know what the profits of the business activity would be at
the time
the conditions are established.
3.12 When a tax administration examines the application of the method to
evaluate whether the method has reliably approximated arm's length
transfer
pricing, it is critical for the tax administration to acknowledge that
the taxpayer
could not have known what the actual profit experience of the business
activity
would be at the time that the conditions of the controlled transaction
were
established. Without such an acknowledgement, the application of the
profit split
method could penalize or reward a taxpayer by focusing on circumstances
that
the taxpayer could not reasonably have foreseen. Such an application
would be
contrary to the arm's length principle, because independent enterprises
in similar
circumstances could only have relied upon projections and could not have
known
the actual profit experience.
3.13 In using the profit split method to establish the conditions of
controlled
transactions, the associated enterprises would seek to achieve the
division of
profit that independent enterprises would have realized. The evaluation
of the
conditions of the controlled transactions of associated enterprises
using a profit
split method will be easiest for a tax administration where the
associated
enterprises have originally determined such conditions on the same
basis. The
evaluation may then begin on the same basis to verify whether the
division of
actual profits is in accordance with the arm's length principle.
3.14 Where the associated enterprises have determined the conditions in
their controlled transactions on a basis other than the profit split
method (as will
almost always be the case), the tax administration would evaluate such
conditions
on the basis of the actual profit experience of the enterprise. However,
care
would need to be exercised to ensure that the application of a profit
split method
is performed in a context that is similar to what the associated
enterprises would
have experienced, i.e. on the basis of information known or reasonably
foreseeable by the associated enterprises at the time the transactions
were entered
into, in order to avoid the use of hindsight.
3.15 There are a number of approaches for estimating the division of
profits,
based on either projected or actual profits, as may be appropriate, that
independent enterprises would have expected, two of which are discussed
in the
OECD TRANSFER PRICING GUIDELINES
III-6 July 1995
©OECD
following paragraphs. These approaches -- contribution analysis and
residual
analysis -- are not necessarily exhaustive or mutually exclusive.
3.16 Under a contribution analysis, the combined profits, which are the
total
profits from the controlled transactions under examination, would be
divided
between the associated enterprises based upon the relative value of the
functions
performed by each of the associated enterprises participating in the
controlled
transactions, supplemented as much as possible by external market data
that
indicate how independent enterprises would have divided profits in
similar
circumstances. In cases where the relative value of the contributions
can be
measured directly, it may not be necessary to estimate the actual market
value of
each participant's contributions.
3.17 Generally, the profit to be combined and divided under the
contribution
analysis is operating profit. Applying the profit split in this manner
ensures that
both income and expenses of the MNE are attributed to the relevant
associated
enterprise on a consistent basis. However, occasionally, it may be
appropriate to
carry out a split of gross profits and then deduct the expenses incurred
in or
attributable to each relevant enterprise (and excluding expenses taken
into
account in computing gross profits). In such cases, where different
analyses are
being applied to divide the gross income and the deductions of the MNE
among
associated enterprises, care must be taken to ensure that the expenses
incurred in
or attributable to each enterprise are consistent with the activities
and risks
undertaken there, and that the allocation of gross profits is likewise
consistent
with the placement of activities and risks. For example, in the case of
an MNE
that engages in highly integrated worldwide trading operations,
involving various
types of property, it may be possible to determine the enterprises in
which
expenses are incurred (or attributed), but not to accurately determine
the
particular trading activities to which those expenses relate. In such a
case, it may
be appropriate to split the gross profits from each trading activity and
then deduct
from the resulting overall gross profits the expenses incurred in or
attributable to
each enterprise, bearing in mind the caution noted above.
3.18 It can be difficult to determine the relative value of the
contribution that
each of the related participants makes to the controlled transactions,
and the
approach will often depend on the facts and circumstances of each case.
The
determination might be made by comparing the nature and degree of each
party's
contribution of differing types (for example, provision of services,
development
OTHER METHODS
July 1995 III-7
©OECD
expenses incurred, capital invested) and assigning a percentage based
upon the
relative comparison and external market data.
3.19 A residual analysis divides the combined profit from the controlled
transactions under examination in two stages. In the first stage, each
participant
is allocated sufficient profit to provide it with a basic return
appropriate for the
type of transactions in which it is engaged. Ordinarily this basic
return would be
determined by reference to the market returns achieved for similar types
of
transactions by independent enterprises. Thus, the basic return would
generally
not account for the return that would be generated by any unique and
valuable
assets possessed by the participants. In the second stage, any residual
profit (or
loss) remaining after the first stage division would be allocated among
the parties
based on an analysis of the facts and circumstances that might indicate
how this
residual would have been divided between independent enterprises.
Indicators of
the parties' contributions of intangible property and relative
bargaining positions
could be particularly useful in this context.
3.20 The residual could derive from the application of other methods.
For
example, market data from traditional transaction methods could assist
in the
preliminary ascertainment of normal profits attributable to associated
enterprises
where one enterprise manufactures a unique product using proprietary
processes
and then transfers the product to another associated enterprise for
further
processing using other proprietary processes and for distribution.
3.21 One approach to a residual analysis would seek to replicate the
outcome
of bargaining between independent enterprises in the free market. In
this context,
the basic return provided to each participant would correspond to the
lowest price
an independent seller reasonably would accept in the circumstances and
the
highest price that the buyer would be reasonably willing to pay. Any
discrepancy
between these two figures could result in the residual profit over which
independent enterprises would bargain. The residual analysis therefore
could
divide this pool of profit based on an analysis of any factors relevant
to the
associated enterprises that would indicate how independent enterprises
might
have split the difference between the seller's minimum price and the
buyer's
maximum price.
3.22 In some cases an analysis could be performed, perhaps as part of a
residual profit split or as a method of splitting profits in its own
right, by taking
OECD TRANSFER PRICING GUIDELINES
III-8 July 1995
©OECD
into account the discounted cash flow to the parties to the controlled
transactions
over the anticipated life of the business. This may be an effective
method in the
following circumstances: where a start-up is involved, cash flow
projections were
carried out as part of assessing the viability of the project, and
capital investment
and sales could be estimated with a reasonable degree of certainty.
However, the
reliability of such an approach will depend on the use of an appropriate
discount
rate, which should be based on market benchmarks. In this regard, it
should be
noted that industry-wide risk premiums used to calculate the discount do
not
distinguish between particular companies let alone segments of
businesses, and
estimates of the relative timing of receipts can be problematic. Such an
approach,
therefore, would require considerable caution and should be supplemented
where
possible by information derived from other methods.
3.23 This Report does not seek to provide an exhaustive catalogue of ways
in which the profit split method may be applied. Application of the
method will
depend on the circumstances of the case and the information available,
but the
overriding objective should be to approximate as closely as possible the
split of
profits that would have been realised had the parties been independent
enterprises
operating at arm's length.
3.24 One possible approach not discussed above is to split the combined
profit so that each of the associated enterprises participating in the
controlled
transactions earns the same rate of return on the capital it employs in
that
transaction. This method assumes that each participant's capital
investment in the
transaction is subject to a similar level of risk, so that one might
expect the
participants to earn similar rates of return if they were operating in
the open
market. However, this assumption may not be realistic. For example, it
would
not account for conditions in capital markets and could ignore other
relevant
aspects that would be revealed by a functional analysis and that should
be taken
into account in a profit split. Therefore, this method should be used
with great
care and, in any event, other profit split methods should be considered
before
electing its use.
3.25 Another possibility is to determine the profit split based on the
division
of profits that actually results from comparable transactions among
independent
enterprises. In most cases where traditional transaction methods would
not be
used, it will be difficult to find independent enterprises engaged in
transactions
that are sufficiently comparable to use this approach as the primary
method.
OTHER METHODS
July 1995 III-9
©OECD
Even where such transactions exist, adequate information on the
independent
enterprises might not be available to taxpayers and tax administrations.
However,
co-operative arrangements are not confined to associated enterprises,
but also
sometimes occur between independent enterprises. Independent enterprises
may
set up joint-venture-like arrangements because they want to carry out,
for
example, a specific research project. In such a situation, independent
enterprises
might come to an arrangement in which prices are corrected afterwards,
for
instance because the profitability is unpredictable and because they
want to share
the risks or the costs involved. Independent enterprises might choose to
set up a
real joint venture, and in such a case probably would agree to some form
of profit
split.
ii) Transactional net margin method
a) In general
3.26 The transactional net margin method 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
aggregate
under the principles of Chapter I). Thus, a transactional net margin
method
operates in a manner similar to the cost plus and resale price methods.
This
similarity means that in order to be applied reliably, the transactional
net
margin method must be applied in a manner consistent with the manner in
which the resale price or cost plus method is applied. This means in
particular
that the net margin of the taxpayer from the controlled transaction (or
transactions that are appropriate to aggregate under the principles of
Chapter I)
should ideally be established by reference to the net margin that the
same
taxpayer earns in comparable uncontrolled transactions. Where this is
not
possible, the net margin that would have been earned in comparable
transactions by an independent enterprise may serve as a guide. A
functional
analysis of the associated enterprise and, in the latter case, the
independent
enterprise is required to determine whether the transactions are
comparable and
what adjustments may be necessary to obtain reliable results. Further,
the other
requirements for comparability, and in particular those of paragraphs
3.34-3.40,
must be applied.
OECD TRANSFER PRICING GUIDELINES
III-10 July 1995
©OECD
b) Strengths and weaknesses
3.27 One strength of the transactional net margin method is that net
margins
(e.g. return on assets, operating income to sales, and possibly other
measures of
net profit) are less affected by transactional differences than is the
case with price,
as used in the CUP Method. The net margins also may be more tolerant to
some
functional differences between the controlled and uncontrolled
transactions than
gross profit margins. Differences in the functions performed between
enterprises
are often reflected in variations in operating expenses. Consequently,
enterprises
may have a wide range of gross profit margins but still earn broadly
similar levels
of net profits.
3.28 Another practical strength is that it is not necessary to determine
the
functions performed and responsibilities assumed by more than one of the
associated enterprises. Similarly, it is often not necessary to state
the books and
records of all participants in the business activity on a common basis
or to
allocate costs for all participants. This can be practically
advantageous when one
of the parties to the transaction is complex and has many interrelated
activities or
when it is difficult to obtain reliable information about one of the
parties.
3.29 There are also a number of weaknesses to the transactional net
margin
method. Perhaps the greatest weakness is that the net margin of a
taxpayer can be
influenced by some factors that either do not have an effect, or have a
less
substantial or direct effect, on price or gross margins. These aspects
make
accurate and reliable determinations of arm's length net margins
difficult. Thus,
it is important to provide some detailed guidance on establishing
comparability
for the transactional net margin method, as set forth in subsection c)(1) below.
3.30 Application of any arm's length method requires information on
uncontrolled transactions that may not be available at the time of the
controlled
transactions. This may make it particularly difficult for taxpayers that
attempt to
apply the transactional net margin method at the time of the controlled
transactions (although use of multiple year averages as discussed in
paragraphs 1.49 through 1.51 may mitigate this concern). In addition,
taxpayers
may not have access to enough specific information on the profits
attributable to
uncontrolled transactions to make a valid application of the method. It
also may
be difficult to ascertain revenue and operating expenses related to the
controlled
transactions to establish the financial return used as the profit
measure for the
OTHER METHODS
July 1995 III-11
©OECD
transactions. Tax administrators may have more information available to
them
from examinations of other taxpayers. However, as with any other method,
it
would be unfair to apply the transactional net margin method on the
basis of such
data unless the data can be disclosed (within the limits of the
confidentiality
requirements of tax laws) to the taxpayer so that there is an adequate
opportunity
for the taxpayer to defend its own position and to safeguard effective
judicial
control by the courts.
3.31 One other issue that arises for the transactional net margin method
is
that the method is typically applied to only one of the associated
enterprises. This
one-sided aspect does not distinguish the method from most other
methods, given
that the resale price and cost plus methods also have this feature.
However, the
fact that many factors unrelated to transfer prices can affect net
margins and can
render the transactional net margin method less reliable heightens the
concerns
over a one-sided analysis. A one-sided analysis may not take into
account the
overall profitability of the MNE group from the controlled transactions
for
purposes of comparability. A one-sided analysis potentially can
attribute to one
member of an MNE group a level of profit that implicitly leaves other
members
of the group with implausibly low or high profit levels. While the
impact on the
profits of the other parties to a transaction is not always a conclusive
factor in
determining the pricing of a transaction, it may act as a counter-check
of the
conclusions reached.
3.32 There may also be serious difficulties in determining an
appropriate
corresponding adjustment when applying the transactional net margin
method,
particularly where it is not possible to work back to a transfer price.
This could
be the case, for example, where the taxpayer deals with associated
enterprises on
both the buying and the selling sides of the controlled transaction. In
such a case,
if the transactional net margin method indicates that the taxpayer's
profit should
be adjusted upwards, there may be some uncertainty about which of the
associated enterprises' profits should be reduced.
3.33 The foregoing considerations should be taken into account in
determining whether any particular application of the transactional net
margin
method is appropriate given the facts and circumstances of a case. More
importantly, because of the foregoing considerations, the application of
the
transactional net margin method is subject to the conclusions and
limitations on
transactional profit methods set forth in Section iii).
OECD TRANSFER PRICING GUIDELINES
III-12 July 1995
©OECD
c) Guidance for application
1. The comparability standard to be applied to the transactional net
margin method
3.34 Prices are likely to be affected by differences in products, and
gross
margins are likely to be affected by differences in functions, but
operating profits
are less adversely affected by such differences. As with the resale
price and cost
plus methods that the transactional net margin method resembles, this,
however,
does not mean that a mere similarity of functions between two
enterprises will
necessarily lead to reliable comparisons. Assuming similar functions can
be
isolated from among the wide range of functions that enterprises may
exercise, in
order to apply the method, the profit margins related to such functions
may still
not be automatically comparable where, for instance, the enterprises
concerned
carry on those functions in different economic sectors or markets with
different
levels of profitability. When the comparable uncontrolled transactions
being
used are those of an independent enterprise, a high degree of similarity
is required
in a number of aspects of the associated enterprise and the independent
enterprise
involved in the transactions in order for the controlled transactions to
be
comparable; there are various factors other than products and functions
that can
significantly influence net margins.
3.35 The use of net margins can potentially introduce a greater element
of
volatility into the determination of transfer prices for two reasons.
First, net
margins can be influenced by some factors that do not have an effect (or
have a
less substantial or direct effect) on gross margins and prices, because
of the
potential for variation of operating expenses across enterprises. Second,
net
margins can be influenced by some of the same factors, such as
competitive
position, that can influence price and gross margins, but the effect of
these factors
may not be as readily eliminated. In the traditional transaction
methods, the
effect of these factors may be eliminated as a natural consequence of
insisting
upon greater product and function similarity.
3.36 Net margins may be directly affected by such forces operating in
the
industry as follows: threat of new entrants, competitive position,
management
efficiency and individual strategies, threat of substitute products,
varying cost
structures (as reflected, for example, in the age of plant and
equipment),
differences in the cost of capital (e.g. self financing versus
borrowing), and the
OTHER METHODS
July 1995 III-13
©OECD
degree of business experience (e.g. whether the business is in a
start-up phase or
is mature). Each of these factors in turn can be influenced by numerous
other
elements. For example, the level of the threat of new entrants will be
determined
by such elements as product differentiation, capital requirements, and
government subsidies and regulations. Some of these elements also may
impact
the application of the traditional transaction methods.
3.37 Assume, for example, that a taxpayer sells top quality video
cassette
recorders to an associated enterprise, and the only profit information
available on
comparable business activities is on generic medium quality VCR sales.
Assume
that the top quality VCR market is growing in its sales, has a high
entry barrier,
has a small number of competitors, and is with wide possibilities for
product
differentiation . All of the differences are likely to have material
effect on the
profitability of the examined activities and compared activities, and in
such a case
would require adjustment. As with other methods, the reliability of the
necessary
adjustments will affect the reliability of the analysis. It should be
noted that even
if two enterprises are in exactly the same industry, the profitability
may differ
depending on their market shares, competitive positions, etc.
3.38 It might be argued that the potential inaccuracies resulting from
the
above factors can be reflected in the size of the arm's length range.
The use of a
range may to some extent mitigate the level of inaccuracy, but may not
account
for situations where a taxpayer's profits are reduced by a factor unique
to that
taxpayer. In such a case, the range may not include points representing
the profits
of independent enterprises that are affected in a similar manner by a
unique
factor. The use of a range, therefore, may not always solve the
difficulties
discussed above.
3.39 The transactional net margin method may afford a practical solution
to
otherwise insoluble transfer pricing problems if it is used sensibly and
with
appropriate adjustments to account for differences of the type referred
to above.
The transactional net margin method should not be used unless the net
margins
are determined from uncontrolled transactions of the same taxpayer in
comparable circumstances or, where the comparable uncontrolled
transactions are
those of an independent enterprise, the differences between the
associated
enterprises and the independent enterprises that have a material effect
on the net
margin being used are adequately taken into account. Many countries are
OECD TRANSFER PRICING GUIDELINES
III-14 July 1995
©OECD
concerned that the safeguards established for the traditional
transaction methods
may be overlooked in applying the transactional net margin method. Thus
where
differences in the characteristics of the enterprises being compared
have a
material effect on the net margins being used, it would not be
appropriate to apply
the transactional net margin method without making adjustments for such
differences. The extent and reliability of those adjustments will affect
the relative
reliability of the analysis under the transactional net margin method.
3.40 Another important aspect of comparability is measurement
consistency.
The net margins must be measured consistently between the associated
enterprise
and the independent enterprise. In addition, there may be differences in
the
treatment across enterprises of operating expenses and non-operating
expenses
affecting the net margins such as depreciation and reserves or
provisions that
would need to be accounted for in order to achieve reliable
comparability.
2. Other guidance
3.41 In applying the transactional net margin method, various
considerations
should influence the choice of margin used. For example, these
considerations
would include how well the value of assets employed in the calculations
is
measured (e.g. to what extent there is intangible property the value of
which is
not captured on the books of the enterprise), and the factors affecting
whether
specific costs should be passed through, marked up, or excluded entirely
from the
calculation.
3.42 An analysis under the transactional net margin method should
consider
only the profits of the associated enterprise that are attributable to
particular
controlled transactions. Therefore, it would be inappropriate to apply
the
transactional net margin method on a company-wide basis if the company
engages in a variety of different controlled transactions that cannot be
appropriately compared on an aggregate basis with those of an
independent
enterprise. Similarly, when analysing the transactions between the
independent
enterprises to the extent they are needed, profits attributable to
transactions that
are not similar to the controlled transactions under examination should
be
excluded from the comparison. Finally, when profit margins of an
independent
enterprise are used, the profits attributable to the transactions of the
independent
enterprise must not be distorted by controlled transactions of that enterprise.
OTHER METHODS
July 1995 III-15
©OECD
3.43 The associated enterprise to which the transactional net margin
method
is applied should be the enterprise for which reliable data on the most
closely
comparable transactions can be identified. This will often entail
selecting the
associated enterprise that is the least complex of the enterprises
involved in the
controlled transaction and that does not own valuable intangible
property or
unique assets. However, the choice may be restricted by limited data
availability
regarding the transactions undertaken by enterprises located in a
foreign tax
jurisdiction.
3.44 Multiple year data should be considered in the transactional net
margin
method for both the enterprise under examination and independent
enterprises to
the extent their net margins are being compared, to take into account
the effects
on profits of product life cycles and short term economic conditions.
For
example, multiple year data could show whether the independent
enterprises that
engaged in comparable uncontrolled transactions had suffered from the
effects of
market conditions in the same way and over a similar period as the
associated
enterprise under examination. Such data could also show whether similar
business patterns over a similar length of time affected the profits of
comparable
independent enterprises in the same way as the enterprise under
examination.
3.45 It also is important to take into account a range of results when
using
the transactional net margin method. The use of the range in this
context could
help reduce the effects of differences in the business characteristics
of associated
enterprises and any independent enterprises engaged in comparable
uncontrolled
transactions, because the range would permit results that would occur
under a
variety of commercial and financial conditions.
Examples of the application of the transactional net margin method
3.46 By way of illustration, the example of cost plus at paragraph 2.46
demonstrates the need to adjust the gross mark up arising from
transactions in
order to achieve consistent and reliable comparison. Such adjustments
may be
made without difficulty where the relevant costs can be readily
analyzed. Where,
however, it is known that an adjustment is required, but it is not
possible to
identify the particular costs for which an adjustment is required, it
may,
nevertheless, be possible to identify the net margin arising on the
transaction and
thereby ensure that a consistent measure is used. For example, if the
supervisory,
general, and administrative costs that are treated as part of costs of
goods sold for
OECD TRANSFER PRICING GUIDELINES
III-16 July 1995
©OECD
the independent enterprises X,Y, and Z cannot be identified so as to
adjust the
gross margin in a reliable application of cost plus, it may be necessary
to examine
net margins in the absence of more reliable comparisons.
3.47 A similar approach may be required when there are differences in
functions performed by the parties being compared. Assume that the facts
are the
same as in the example at paragraph 2.31 except that it is the
comparable
independent enterprises that perform the additional function of
technical support
and not the associated enterprise, and that these costs are reported in
the cost of
goods sold but cannot be separately identified. Because of product and
market
differences it may not be possible to find a CUP, and a resale price
method would
be unreliable since the gross margin of the independent enterprises
would need to
be higher that of the associated enterprise in order to reflect the
additional
function and to cover the unknown additional costs. In this example, it
may be
more reliable to examine net margins in order to assess the difference
in the
transfer price that would reflect the difference in function. The use of
net
margins in such a case needs to take account of comparability and may
not be
reliable if there would be a material effect on net margin as a result
of the
additional function or as a result of market differences.
3.48 The facts are the same as in paragraph 2.30. However, the amount of
the warranty expenses incurred by Distributor A proves impossible to
ascertain so
that it is not possible to reliably adjust the gross profit of A to make
the gross
profit margin properly comparable with that of B. However, if there are
no other
material functional differences between A and B and the net profit of A
relative
to its sales is known, it might be possible to apply the transactional
net margin
method to B by comparing the margin relative to A's sales to net profits
with the
margin calculated on the same basis for B.
iii) Conclusions on transactional profit methods
3.49 Traditional transaction methods are to be preferred over
transactional
profit methods as a means of establishing whether a transfer price is at
arm's
length, i.e. whether there is a special condition affecting the level of
profits
between associated enterprises. To date, practical experience has shown
that in
the majority of cases, it is possible to apply traditional transaction
methods.
OTHER METHODS
July 1995 III-17
©OECD
3.50 There are, however, cases where traditional transaction methods
cannot
be reliably applied alone or exceptionally cannot be applied at all.
These would
be considered cases of last resort. Such cases arise only where there is
insufficient data on uncontrolled transactions (possibly because of
uncooperative
behaviour on the part of the taxpayer relative to these Guidelines), or
where such
data are considered unreliable, or due to the nature of the business
situation. In
such cases of last resort, practical considerations may suggest
application of a
transactional profit method either in conjunction with traditional
transaction
methods or on its own. However, even in a case of last resort, it would
be
inappropriate to automatically apply a transactional profit method
without first
considering the reliability of that method. See in particular paragraphs
3.9
and 3.31. The same factors that led to the conclusion that it was not
possible to
reliably apply a traditional transaction method must be reconsidered
when
evaluating the reliability of a transactional profit method. Thus, if it
is necessary
to aggregate transactions to apply a transactional profit method and if
it is
possible to aggregate the same transactions and apply a traditional
transaction
method, the effect of such aggregation on the reliability of both
methods must be
considered. Therefore, for the reasons set out in this Report and
particularly
those in paragraphs 3.52-3.57 below, as a general matter the use of
transactional
profit methods is discouraged.
3.51 A transactional profit method also may be used in cases where
application of the method is agreed to be appropriate by the associated
enterprises
affected by the transactions and by the tax administrations in the
jurisdictions of
those associated enterprises. Transactional profit methods may also
provide a
useful means of identifying cases that may require further
investigation.
3.52 In most countries the application of transactional profit methods
has
been limited to the profit split method, the use of which has not been
frequent and
has taken place largely in bilateral agreement procedures -- situations
where the
risk of unrelieved double taxation is minimal. Very few countries have
much
experience in the application of the transactional net margin method and
most
consider it experimental and therefore prefer to use the profit split
method in
cases of last resort.
3.53 As discussed in this Report, there are substantial concerns
regarding the
use of the transactional net margin method, in particular that it may be
applied
without adequately taking into account the relevant differences between
the
OECD TRANSFER PRICING GUIDELINES
III-18 July 1995
©OECD
associated enterprises and the independent enterprises being compared.
Many
countries are concerned that the safeguards established for the
traditional
transaction methods may be overlooked in applying the transactional net
margin
method. Thus, where differences in the characteristics of the
enterprises being
compared have a material effect on the net margins being used, it would
not be
appropriate to apply the transactional net margin method without making
adjustments for such differences. See Paragraphs 3.34-3.40 (the
comparability
standard to be applied to the transactional net margin method).
3.54 The recognition that the use of transactional profit methods may be
necessary is not intended to suggest that independent enterprises would
use these
methods to set prices. Instead, transactional profit methods are being
recognised
as methods that assist in determining in cases of last resort whether
transfer
pricing complies with the arm's length principle. As with any method, it
is
important that it be possible to calculate appropriate corresponding
adjustments
when transactional profit methods are used, recognising that in certain
cases
corresponding adjustments may be determined on an aggregate basis
consistent
with the aggregation principles in Chapter I.
3.55 The present lack of experience with the application of transactional
profit methods across a representative number of OECD Member countries
makes it difficult to fix, with precision, all the limitations on the
use of these
methods that it may prove appropriate to establish. For this reason, and
because
of concerns with transactional profit methods more generally, the
Committee on
Fiscal Affairs will undertake an intensive period of monitoring the
application of
both traditional transaction methods and transactional profit methods
over the
coming years, with a view to revising this Report periodically, as
necessary, to
take into account the results of the monitoring. It is anticipated that
the
monitoring will include not only peer reviews of the practices of OECD
Member
countries but also a review of any problematic cases that tax
administrations or
taxpayers may identify for consideration by the Committee during the
review
period. To facilitate this process, countries are encouraged to keep
such records
as are feasible on the application of transfer pricing methods, the
frequency with
which transactional profit methods are applied, and why recourse was had
to
those methods. More generally all countries should be aware of the need
to apply
the guidelines set out in this Report in an equitable and balanced
manner as
between the States concerned in order to avoid double taxation.
OTHER METHODS
July 1995 III-19
©OECD
3.56 In all cases, considerable caution must be used to determine
whether a
transactional profit method as applied to a particular aspect of a case
can produce
an arm's length answer, either in conjunction with a traditional
transaction
method or on its own (see paragraph 3.50). The question ultimately can
be
resolved only on a case-by-case basis taking into account the strengths
and
weaknesses set forth above for a particular transactional profit method
to be
applied. In addition, these conclusions assume that countries will have
a certain
degree of sophistication in their underlying tax systems before applying
these
methods. Consequently, transactional profit methods should never be used
by tax
administrations if they do not yet have the necessary institutional
legal
framework to ensure that the proper precautions are taken. This would
include
the existence of an effective administrative appeals mechanism. The
Committee
on Fiscal Affairs intends to engage the major non-Member countries in a
dialogue
on the application of the principles and methods set out in this Report
and any
revisions hereto.
3.57 A tax administration that is asserting the application of a
transactional
profit method should be particularly conscious of its burden in
demonstrating to
the tax administration of the other State in any mutual agreement
proceedings that
such approach is being appropriately applied and achieves the best
approximation
of arm's length pricing in all the facts and circumstances of the case.
Tax
administrations also should be conscious of relevant burden of proof
rules in
applicable arbitration proceedings.
C. A non-arm's-length approach: global formulary apportionment
i) Background and description of method
3.58 Global formulary apportionment has sometimes been suggested as an
alternative to the arm's length principle as a means of determining the
proper
level of profits across national taxing jurisdictions. The method has
not been
applied as between countries although it has been attempted by some
local taxing
jurisdictions.
3.59 A global formulary apportionment method would allocate the global
profits of an MNE group on a consolidated basis among the associated
enterprises
in different countries on the basis of a predetermined and mechanistic
formula.
There would be three essential components to applying a global formulary
OECD TRANSFER PRICING GUIDELINES
III-20 July 1995
©OECD
apportionment method: determining the unit to be taxed, i.e. which of
the
subsidiaries and branches of an MNE group should comprise the global
taxable
entity; accurately determining the global profits; and establishing the
formula to
be used to allocate the global profits of the unit. The formula would
most likely
be based on some combination of costs, assets, payroll, and sales.
3.60 Global formulary apportionment methods should not be confused with
the transactional profit methods discussed in Part B of this Chapter.
The former
methods would use a formula that is predetermined for all taxpayers to
allocate
profits whereas transactional profit methods compare, on a case-by-case
basis, the
profits of one or more associated enterprises with the profit experience
that
comparable independent enterprises would have sought to achieve in
comparable
circumstances. Global formulary apportionment methods also should not be
confused with the selected application of a formula developed by both
tax
administrations in cooperation with a specific taxpayer or MNE group
after
careful analysis of the particular facts and circumstances, such as
might be used
in a mutual agreement procedure, advance transfer pricing agreement, or
other
bilateral or multilateral determination. Such a formula is derived from
the
particular facts and circumstances of the taxpayer and thus avoids the
globally
pre-determined and mechanistic nature of global formulary apportionment
methods.
ii) Comparison with the arm's length principle
3.61 Global formulary apportionment has been promoted as an alternative
to
the arm's length principle by advocates who claim that it would provide
greater
administrative convenience and certainty for taxpayers. These advocates
also
take the position that global formulary apportionment methods are more
in
keeping with economic reality. They argue that an MNE group must be
considered on a group-wide or consolidated basis to reflect the business
realities
of the relationships among the associated enterprises in the group. They
assert
that the separate accounting method is inappropriate for highly
integrated groups
because it is difficult to determine what contribution each associated
enterprise
makes to the overall profit of the MNE group.
3.62 Apart from these arguments, advocates contend that a global
formulary
apportionment approach reduces compliance costs for taxpayers since in
principle
OTHER METHODS
July 1995 III-21
©OECD
only one set of accounts would be prepared for the group for domestic
tax
purposes.
3.63 OECD Member countries do not accept these propositions and do not
consider global formulary apportionment a realistic alternative to the
arm's length
principle, for the reasons discussed below.
3.64 The most significant concern with global formulary apportionment is
the difficulty of implementing the system in a manner that both protects
against
double taxation and ensures single taxation. To achieve this would
require
substantial international coordination and consensus on the
predetermined
formulae to be used and on the composition of the group in question. For
example, to avoid double taxation there would have to be common
agreement to
adopt the method in the first instance, followed by agreement on the
measurement of the global tax base of an MNE group, on the use of a
common
accounting system, on the factors that should be used to apportion the
tax base
among different jurisdictions (including non-Member countries), and on
how to
measure and weight those factors. Reaching such agreement would be
timeconsuming
and extremely difficult. It is far from clear that countries would be
willing to agree to a universal formula.
3.65 Even if some countries were willing to accept global formulary
apportionment there would be disagreements because each country may want
to
emphasize or include different factors in the formula based on the
activities or
factors that predominate in its jurisdiction. Each country would have a
strong
incentive to devise formulae or formula weights that would maximise that
country's own revenue. In addition, tax administrations would have to
consider
jointly how to address the potential for artificially shifting the
production factors
used in the formula (e.g. sales, capital) to low tax countries. There
could be tax
avoidance to the extent that the components of the relevant formula can
be
manipulated, e.g. by entering into unnecessary financial transactions,
by the
deliberate location of mobile assets, by requiring that particular
companies within
an MNE group maintain inventory levels in excess of what normally would
be
encountered in an uncontrolled company of that type, and so on.
3.66 The transition to a global formulary apportionment system therefore
would present enormous political and administrative complexity and
require a
level of international cooperation that is unrealistic to expect in the
field of
OECD TRANSFER PRICING GUIDELINES
III-22 July 1995
©OECD
international taxation. Such multilateral coordination would require the
inclusion
of all major countries where MNEs operate. If all the major countries
failed to
agree to move to global formulary apportionment, MNEs would be faced
with the
burden of complying with two totally different systems. In other words,
for the
same set of transactions they would be forced to calculate the profits
accruing to
their members under two completely different standards. Such a result
would
create the potential for double taxation (or under-taxation) in every
case.
3.67 There are other significant concerns in addition to the double
taxation
issues discussed above. One such concern is that predetermined formulae
are
arbitrary and disregard market conditions, the particular circumstances
of the
individual enterprises, and management's own allocation of resources,
thus
producing an allocation of profits that may bear no sound relationship
to the
specific facts surrounding the transaction. More specifically, a formula
based on
a combination of cost, assets, payroll, and sales implicitly imputes a
fixed rate of
profit per currency unit (e.g. dollar, franc, mark) of each component to
every
member of the group and in every tax jurisdiction, regardless of
differences in
functions, assets, risks, and efficiencies and among members of the MNE
group.
Such methods could potentially assign profits to an entity that would
incur losses
if it were an independent enterprise.
3.68 Another issue for the global formulary apportionment approach is
dealing with exchange rate movements. Although exchange rate movements
can
complicate application of the arm's length principle they do not have
the same
impact as for the global formulary apportionment approach; the arm's
length
principle is better equipped to deal with the economic consequences of
exchange
rate movements because it requires the analysis of the specific facts
and
circumstances of the taxpayer. If the formula relies on costs, the
result of
applying a global formulary apportionment approach would be that as a
particular
currency strengthens in one country consistently against another
currency in
which an associated enterprise keeps its accounts, a greater share of
the profit
would be attributed to the enterprise in the first country to reflect
the costs of its
payroll nominally increased by the currency fluctuation. Thus, under a
global
formulary apportionment approach, the exchange rate movement in this
example
would lead to increasing the profits of the associated enterprise
operating with the
stronger currency whereas in the long run a strengthening currency makes
exports
less competitive and leads to a downward pressure on profits.
OTHER METHODS
July 1995 III-23
©OECD
3.69 Contrary to the assertions of its advocates, global formulary
apportionment methods may in fact present intolerable compliance costs
and data
requirements because information would have to be gathered about the
entire
MNE group and presented in each jurisdiction on the basis of the
currency and
the book and tax accounting rules of that particular jurisdiction. Thus,
the
documentation and compliance requirements for an application of a global
formulary apportionment approach would generally be more burdensome than
under the separate entity approach of the arm's length principle. The
costs of a
global formulary apportionment approach would be further magnified if
not all
countries could agree on the components of the formula or on the way the
components are measured.
3.70 Difficulties also would arise in determining the sales of each
member
and in the valuation of assets (e.g. historic cost versus market value),
especially in
the valuation of intangible property. These difficulties would be
compounded by
the existence across taxing jurisdictions of different accounting
standards and of
multiple currencies. Accounting standards among all countries would have
to be
conformed in order to arrive at a meaningful measure of profit for the
entire MNE
group. Of course, some of these difficulties, for example the valuation
of assets
and intangibles, also exist under the arm's length principle, although
significant
progress in respect of the latter has been made, whereas no credible
solutions
have been put forward under global formulary apportionment.
3.71 A global formulary apportionment method would have the effect of
taxing an MNE group on a consolidated basis and therefore abandons the
separate
entity approach. As a consequence, a global formulary apportionment method
cannot, as a practical matter, recognize important geographical
differences,
separate company efficiencies, and other factors specific to one company
or subgrouping
within the MNE group that may legitimately play a role in determining
the division of profits between enterprises in different tax
jurisdictions. The arm's
length principle, in contrast, recognizes that an associated enterprise
may be a
separate profit or loss centre with individual characteristics and
economically
may be earning a profit even when the rest of the MNE group is incurring
a loss.
A global formulary apportionment approach does not have the flexibility
to
account properly for this possibility.
3.72 By disregarding intra-group transactions for the purpose of
computing
consolidated profits, a global formulary apportionment method would
raise
OECD TRANSFER PRICING GUIDELINES
III-24 July 1995
©OECD
questions about the relevance of imposing withholding taxes on
cross-border
payments between group members and would involve a rejection of a number
of
rules incorporated in bilateral tax treaties.
3.73 Unless the global formulary apportionment approach includes every
member of an MNE group, it must retain a separate entity rule for the
interface
between that part of the group subject to global formulary apportionment
and the
rest of the MNE group. Global formulary apportionment could not be used
to
value the transactions between the global formulary apportionment group
and the
rest of the MNE group. Thus, a clear disadvantage with global formulary
apportionment is that it does not provide a complete solution to the
allocation of
profits of an MNE group unless global formulary apportionment is applied
on the
basis of the whole enterprise. This exercise would be a serious
undertaking for a
single tax administration given the size and scale of operations of
major MNE
groups and the information that would be required. The MNE group would
also
be required, in any event, to maintain separate accounting for
corporations that
are not members of the MNE group for global formulary apportionment tax
purposes but that are still associated enterprises of one or more
members of the
MNE group. In fact, many domestic commercial and accountancy rules would
still require the use of arm's length prices (e.g. customs rules), so
that irrespective
of the tax provisions a taxpayer would have to book properly every
transaction at
arm's length prices.
iii) Rejection of non-arm's-length methods
3.74 For the foregoing reasons, OECD Member countries reiterate their
support for the consensus on the use of the arm's length principle that
has
emerged over the years among Member and non-Member countries and agree
that the theoretical alternative to the arm's length principle
represented by global
formulary apportionment should be rejected.
July 1995 IV-1
©OECD
Chapter IV
Administrative Approaches to Avoiding and Resolving
Transfer Pricing Disputes
A. Introduction
4.1 This chapter examines various administrative procedures that could
be applied to minimise transfer pricing disputes and to help resolve
them when
they do arise between taxpayers and their tax administrations, and
between
different tax administrations. Such disputes may arise even though the
guidance in this Report is followed in a conscientious effort to apply
the arm's
length principle. It is possible that taxpayers and tax administrations
may reach
differing determinations of the arm's length conditions for the
controlled
transactions under examination given the complexity of some transfer
pricing
issues and the difficulties in interpreting and evaluating the
circumstances of
individual cases.
4.2 Where two or more tax administrations take different positions in
determining arm's length conditions, double taxation may occur. Double
taxation means the inclusion of the same income in the tax base by more
than
one tax administration, when either the income is in the hands of
different
taxpayers (economic double taxation, for associated enterprises) or the
income
is in the hands of the same juridical entity (juridical double taxation,
for
permanent establishments). Double taxation is undesirable and should be
eliminated whenever possible, because it constitutes a potential barrier
to the
development of international trade and investment flows. The double
inclusion
of income in the tax base of more than one jurisdiction does not always
mean
that the income will actually be taxed twice.
4.3 This Chapter discusses several administrative approaches to
resolving
disputes caused by transfer pricing adjustments and for avoiding double
taxation. Section B discusses transfer pricing compliance practices by
tax
administrations, in particular examination practices, the burden of
proof, and
penalties. Section C discusses corresponding adjustments (Paragraph 2 of
Article 9 of the OECD Model Tax Convention) and the mutual agreement
procedure (Article 25). Section D describes the use of simultaneous tax
examinations by two (or more) tax administrations to expedite the
identification, processing, and resolution of transfer pricing issues (and
other
OECD TRANSFER PRICING GUIDELINES
IV-2 July 1995
©OECD
international tax issues). Sections E and F describe some possibilities
for
minimising transfer pricing disputes between taxpayers and their tax
administrations. Section E addresses the possibility of developing safe
harbours for certain taxpayers, and Section F deals with Advance Pricing
Arrangements, which address the possibility of determining in advance a
transfer pricing methodology or conditions for the taxpayer to apply to
specified controlled transactions. Section G considers briefly the use
of
arbitration procedures to resolve transfer pricing disputes between
countries.
B. Transfer pricing compliance practices
4.4 Tax compliance practices are developed and implemented in each
Member country according to its own domestic legislation and
administrative
procedures. Many domestic tax compliance practices have three main
elements:
1. to reduce opportunities for non-compliance
(e.g. through withholding taxes and
information reporting); 2. to provide
positive assistance for compliance (e.g.
through education and published guidance); and 3. to provide disincentives for
non-compliance. As a matter of domestic sovereignty and to accommodate
the
particularities of widely varying tax systems, tax compliance practices
remain
within the province of each country. Nevertheless a fair application of
the arm's
length principle requires clear procedural rules to ensure adequate
protection of
the taxpayer and to make sure that tax revenue is not shifted to countries
with
overly harsh procedural rules. However, when a taxpayer under
examination in
one country is a member of an MNE group, it is possible that the
domestic tax
compliance practices in a country examining a taxpayer will have
consequences
in other tax jurisdictions. This may be particularly the case when
cross-border
transfer pricing issues are involved, because the transfer pricing has
implications
for the tax collected in the tax jurisdictions of the associated
enterprises involved
in the controlled transaction. If the same transfer pricing is not
accepted in the
other tax jurisdictions, the MNE group may be subject to double taxation
as
explained in paragraph 4.26. Thus, tax administrations should be
conscious of
the arm's length principle when applying their domestic compliance
practices and
the potential implications of their transfer pricing compliance rules
for other tax
jurisdictions, and seek to facilitate both the equitable allocation of
taxes between
jurisdictions and the prevention of double taxation for taxpayers.
4.5 This section describes three aspects of transfer pricing compliance
that
should receive special consideration to help tax jurisdictions
administer their
ADMINISTRATIVE APPROACHES
July 1995 IV-3
©OECD
transfer pricing rules in a manner that is fair to taxpayers and other
jurisdictions. While other tax law compliance practices are in common
use in
OECD Member countries -- for example, the use of litigation and
evidentiary
sanctions where information may be sought by a tax administration but is
not
provided -- these three aspects will often impact on how tax
administrations in
other jurisdictions approach the mutual agreement procedure process and
determine their administrative response to ensuring compliance with
their own
transfer pricing rules. The three aspects are: examination practices,
the burden
of proof, and penalty systems. The evaluation of these three aspects
will
necessarily differ depending on the characteristics of the tax system
involved,
and so it is not possible to describe a uniform set of principles or
issues that
will be relevant in all cases. Instead, this section seeks to provide
general
guidance on the types of problems that may arise and reasonable
approaches
for achieving a balance of the interests of the taxpayers and tax
administrations
involved in a transfer pricing inquiry.
i) Examination practices
4.6 Examination practices vary widely among OECD Member countries.
Differences in procedures may be prompted by such factors as the system
and
the structure of the tax administration, the geographic size and
population of
the country, the level of domestic and international trade, and cultural
and
historical influences.
4.7 Transfer pricing cases can present special challenges to the normal
audit or examination practices, both for the tax administration and for
the
taxpayer. Transfer pricing cases are fact-intensive and may involve
difficult
evaluations of comparability, markets, and financial or other industry
information. Consequently, a number of tax administrations have
examiners
who specialize in transfer pricing, and transfer pricing examinations
themselves
may take longer than other examinations and follow separate procedures.
4.8 Because transfer pricing is not an exact science, it will not always
be
possible to determine the single correct arm's length price; rather, as
Chapter I
recognizes, the correct price may have to be estimated within a range of
acceptable figures. Also, the choice of methodology for establishing
arm's
length transfer pricing will not often be unambiguously clear. Taxpayers
may
experience particular difficulties when the tax administration proposes
to use a
OECD TRANSFER PRICING GUIDELINES
IV-4 July 1995
©OECD
methodology, for example a transactional profit method, that is not the
same as
that used by the taxpayer.
4.9 In a difficult transfer pricing case, because of the complexity of
the
facts to be evaluated, even the best-intentioned taxpayer can make an
honest
mistake. Moreover, even the best-intentioned tax examiner may draw the
wrong conclusion from the facts. Tax administrations are encouraged to
take
this observation into account in conducting their transfer pricing
examinations.
This involves two implications. First, tax examiners are encouraged to
be
flexible in their approach and not demand from taxpayers in their
transfer
pricing a precision that is unrealistic under all the facts and
circumstances.
Second, tax examiners are encouraged to take into account the taxpayer's
commercial judgment about the application of the arm's length principle,
so
that the transfer pricing analysis is tied to business realities.
Therefore, tax
examiners should undertake to begin their analyses of transfer pricing
from the
perspective of the method that the taxpayer has chosen in setting its prices.
The
guidance provided in Chapter I in the section dealing with the use of
transfer
pricing methods (paragraphs 1.68-1.70) also may assist in this regard.
4.10 A tax administration should keep in mind in allocating its audit
resources the taxpayer's process of setting prices, for example whether
the
MNE group operates on a profit center basis. See paragraph 1.5.
ii) Burden of proof
4.11 Like examination practices, the burden of proof rules for tax cases
also differ among OECD Member countries. In most jurisdictions, the tax
administration bears the burden of proof both in its own internal
dealings with
the taxpayer (e.g. assessment and appeals) and in litigation. In some of
these
countries, the burden of proof can be reversed, allowing the tax
administration
to estimate taxable income, if the taxpayer is found not to have acted
in good
faith, for example, by not cooperating or complying with reasonable
documentation requests or by filing false or misleading returns. In
other
countries, the burden of proof is on the taxpayer. In this respect,
however, the
conclusions of paragraphs 4.16 and 4.17 should be noted.
4.12 The implication for the behaviour of the tax administration and the
taxpayer of the rules governing burden of proof should be taken into
account. For
ADMINISTRATIVE APPROACHES
July 1995 IV-5
©OECD
example, where as a matter of domestic law the burden of proof is on the
tax
administration, the taxpayer may not have any legal obligation to prove
the
correctness of its transfer pricing unless the tax administration makes
a prima
facie showing that the pricing is inconsistent with the arm's length
principle.
Even in such a case, of course, the tax administration might still
reasonably
oblige the taxpayer to produce its records that would enable the tax
administration to undertake its examination. In some countries,
taxpayers have a
duty to cooperate with the tax administration imposed on them by law. In
the
event that a taxpayer fails to cooperate, the tax administration may be
given the
authority to estimate the taxpayer's income and to assume relevant facts
based on
experience. In these cases, tax administrations should not seek to
impose such a
high level of cooperation that would make it too difficult for
reasonable taxpayers
to comply.
4.13 In jurisdictions where the burden of proof is on the taxpayer, tax
administrations are generally not at liberty to raise assessments
against taxpayers
which are not soundly based in law. A tax administration in an OECD
Member
country, for example, could not raise an assessment based on a taxable
income
calculated as a fixed percentage of turnover and simply ignore the arm's
length
principle. In the context of litigation in countries where the burden of
proof is on
the taxpayer, the burden of proof is often seen as a shifting burden.
Where the
taxpayer presents to a court a reasonable argument and evidence to
suggest that
its transfer pricing was arm's length, the burden of proof may legally
or de facto
shift to the tax administration to counter the taxpayer's position and
to present
argument and evidence as to why the taxpayer's transfer pricing was not
arm's
length and why the assessment is correct. On the other hand, where a
taxpayer
makes little effort to show that its transfer pricing was arm's length,
the burden
imposed on the taxpayer would not be satisfied where a tax
administration raised
an assessment which was soundly based in law.
4.14 When transfer pricing issues are present, the divergent rules on
burden
of proof among OECD Member countries will present serious problems if
the
strict legal rights implied by those rules are used as a guide for
appropriate
behaviour. For example, consider the case where the controlled
transaction under
examination involves one jurisdiction in which the burden of proof is on
the
taxpayer and a second jurisdiction in which the burden of proof is on
the tax
administration. If the burden of proof is guiding behaviour, the tax
administration in the first jurisdiction might make an unsubstantiated
assertion
OECD TRANSFER PRICING GUIDELINES
IV-6 July 1995
©OECD
about the transfer pricing, which the taxpayer might accept, and the tax
administration in the second jurisdiction would have the burden of
disproving the
pricing. It could be that neither the taxpayer in the second jurisdiction
nor the tax
administration in the first jurisdiction would be making efforts to
establish an
acceptable arm's length price. This type of behaviour would set the
stage for
significant conflict as well as double taxation.
4.15 Consider the same facts as in the example in the preceding
paragraph.
If the burden of proof is again guiding behaviour, a taxpayer in the
first
jurisdiction being a subsidiary of a taxpayer in the second jurisdiction
(notwithstanding the burden of proof and these Guidelines), may be
unable or
unwilling to show that its transfer prices are arm's length. The tax
administration
in the first jurisdiction after examination makes an adjustment in good
faith based
on the information available to it. The parent company in the second
jurisdiction
is not obliged to provide to its tax administration any information to
show that the
transfer pricing was arm's length as the burden of proof rests with the
tax
administration. This will make it difficult for the two tax
administrations to reach
agreement in competent authority proceedings.
4.16 In practice, neither countries nor taxpayers should misuse the
burden of
proof in the manner described above. Because of the difficulties with
transfer
pricing analyses, it would be appropriate for both taxpayers and tax
administrations to take special care and to use restraint in relying on
the burden of
proof in the course of the examination of a transfer pricing case. More
particularly, as a matter of good practice, the burden of proof should
not be
misused by tax administrations or taxpayers as a justification for
making
groundless or unverifiable assertions about transfer pricing. A tax
administration
should be prepared to make a good faith showing that its determination
of transfer
pricing is consistent with the arm's length principle even where the
burden of
proof is on the taxpayer, and taxpayers similarly should be prepared to
make a
good faith showing that their transfer pricing is consistent with the
arm's length
principle regardless of where the burden of proof lies.
4.17 The Commentary on paragraph 2 of Article 9 of the OECD Model Tax
Convention makes clear that the State from which a corresponding
adjustment is
requested should comply with the request only if that State
"considers that the
figure of adjusted profits correctly reflects what the profits would
have been if the
transactions had been at arm's length". This means that in
competent authority
ADMINISTRATIVE APPROACHES
July 1995 IV-7
©OECD
proceedings the State that has proposed the primary adjustment bears the
burden
of demonstrating to the other State that the adjustment "is
justified both in
principle and as regards the amount." Both competent authorities
are expected to
take a cooperative approach in resolving mutual agreement cases.
iii) Penalties
4.18 Penalties are most often directed toward providing disincentives
for
non-compliance, where the compliance at issue may relate to procedural
requirements such as providing necessary information or filing returns,
or to the
substantive determination of tax liability. Penalties are generally
designed to
make tax underpayments and other types of non-compliance more costly
than
compliance. The Committee on Fiscal Affairs has recognized that
promoting
compliance should be the primary objective of civil tax penalties. OECD
Report
Taxpayers' Rights and Obligations (1990).
If a mutual agreement between two
countries results in a withdrawal or reduction of an adjustment, it is
important
that there exist possibilities to cancel or mitigate a penalty imposed
by the tax
administrations.
4.19 Care should be taken in comparing different national penalty
practices
and policies with one another. First, any comparison needs to take into
account
that there may be different names used in the various countries for penalties
that
accomplish the same purposes. Second, the overall compliance measures of
an
OECD Member country should be taken into account. National tax
compliance
practices depend, as indicated above, on the overall tax system in the
country, and
they are designed on the basis of domestic need and balance, such as the
choice
between the use of taxation measures that remove or limit opportunities
for noncompliance
(e.g. imposing a duty on taxpayers to cooperate with the tax
administration or reversing the burden of proof in situations where a
taxpayer is
found not to have acted in good faith) and the use of monetary
deterrents
(e.g. additional tax imposed as a consequence of underpayments of tax in
addition
to the amount of the underpayment). The nature of tax penalties may also
be
affected by the judicial system of a country. Most countries do not
apply no-fault
penalties; in some countries, for example, the imposition of a no-fault
penalty
would be against the underlying principles of their legal system.
4.20 There are a number of different types of penalties that tax
jurisdictions
have adopted. Penalties can involve either civil or criminal sanctions
-- criminal
OECD TRANSFER PRICING GUIDELINES
IV-8 July 1995
©OECD
penalties are virtually always reserved for cases of very significant
fraud, and
they usually carry a very high burden of proof for the party asserting
the penalty
(i.e. the tax administration). Criminal penalties are not the principal
means to
promote compliance in any of the OECD Member countries. Civil (or
administrative) penalties are more common, and they typically involve a
monetary sanction (although as discussed above there may be a
non-monetary
sanction such as a shifting of the burden of proof when, e.g.,
procedural
requirements are not met or the taxpayer is uncooperative and an
effective
penalty results from a discretionary adjustment).
4.21 Some civil penalties are directed towards procedural compliance,
such
as timely filing of returns and information reporting. The amount of
such
penalties is often small and based on a fixed amount that may be
assessed for
each day in which, e.g. the failure to file continues. The more
significant civil
penalties are those directed at the understatement of tax liability.
4.22 Although some countries may refer to a "penalty", the
same or similar
imposition by another country may be classified as "interest".
Some countries'
"penalty" regimes may therefore include an "additional
tax", or "interest", for
understatements which result in late payments of tax beyond the due
date. This is
often designed to ensure the revenue recovers at least the real time
value of
money (taxes) lost.
4.23 Civil monetary penalties for tax understatement are frequently
triggered
by one or more of the following: an understatement of tax liability
exceeding a
threshold amount, negligence of the taxpayer, or wilful intent to evade
tax (and
also fraud, although fraud can trigger much more serious criminal
penalties).
Many OECD Member countries impose civil monetary penalties for negligence
or wilful intent, while only a few countries penalise
"no-fault" understatements of
tax liability.
4.24 It is difficult to evaluate in the abstract whether the amount of a
civil
monetary penalty is excessive. Among OECD Member countries, civil monetary
penalties for tax understatement are frequently calculated as a
percentage of the
tax understatement, where the percentage most often ranges from 10
percent to
200 percent. In most OECD Member countries, the rate of the penalty
increases
as the conditions for imposing the penalty increase. For instance, the
higher rate
penalties often can be imposed only by showing a high degree of taxpayer
ADMINISTRATIVE APPROACHES
July 1995 IV-9
©OECD
culpability, such as a wilful intent to evade. "No-fault"
penalties, where used,
tend to be at lower rates than those triggered by taxpayer culpability
(see
paragraph 4.28).
4.25 Improved compliance in the transfer pricing area is of some concern
to
OECD Member countries and the appropriate use of penalties may play a
role in
addressing this concern. However, owing to the nature of transfer
pricing
problems, care should be taken to ensure that the administration of a
penalty
system as applied in such cases is fair and not unduly onerous for
taxpayers.
4.26 Because cross-border transfer pricing issues implicate the tax base
of
two jurisdictions, an overly harsh penalty system in one jurisdiction
may give
taxpayers an incentive to overstate taxable income in that jurisdiction
contrary to
Article 9. If this happens, the penalty system fails in its primary
objective to
promote compliance and instead leads to non-compliance of a different
sort --
non-compliance with the arm's length principle and under-reporting in
the other
jurisdiction. Each OECD Member country should ensure that its transfer
pricing
compliance practices are not enforced in a manner inconsistent with the
objectives of the OECD Model Tax Convention, avoiding the distortions
noted
above.
4.27 It is generally regarded by OECD Member countries that the fairness
of
the penalty system should be considered by reference to whether the
penalties are
proportionate to the offence. This would mean, for example, that the
severity of a
penalty would be balanced against the conditions under which it would be
imposed, and that the harsher the penalty the more limited the
conditions in
which it would apply.
4.28 Since penalties are only one of many administrative and procedural
aspects of a tax system, it is difficult to conclude whether a
particular penalty is
fair or not without considering the other aspects of the tax system.
Nonetheless,
OECD Member countries agree that the following conclusions can be drawn
regardless of the other aspects of the tax system in place in a
particular country.
First, imposition of a sizable "no-fault" penalty based on the
mere existence of an
understatement of a certain amount would be unduly harsh when it is
attributable
to good faith error rather than negligence or an actual intent to avoid
tax. Second,
it would be unfair to impose sizable penalties on taxpayers that made a
reasonable
effort in good faith to set the terms of their transactions with related
parties in a
OECD TRANSFER PRICING GUIDELINES
IV-10 July 1995
©OECD
manner consistent with the arm's length principle. In particular, it
would be
inappropriate to impose a transfer pricing penalty on a taxpayer for
failing to
consider data to which it did not have access, or for failure to apply a
transfer
pricing method that would have required data that was not available to
the
taxpayer. Tax administrations are encouraged to take these observations
into
account in the implementation of their penalty provisions.
C. Corresponding adjustments and the mutual agreement procedure:
Articles 9 and 25 of the OECD Model Tax Convention
i) The mutual agreement procedure
4.29 The mutual agreement procedure is a well-established means through
which tax administrations consult to resolve disputes regarding the
application of
double tax conventions. This
procedure, described and authorized by Article 25
of the OECD Model Tax Convention, can be used to eliminate double
taxation
that could arise from a transfer pricing adjustment.
4.30 Article 25 sets out three different areas where mutual agreement
procedures are generally used. The first area includes instances of
"taxation not
in accordance with the provisions of the Convention" and is covered
in
paragraphs 1 and 2 of the Article. Procedures in this area are typically
initiated
by the taxpayer. The other two areas, which do not necessarily involve
the
taxpayer, are dealt with in paragraph 3 and involve questions of
"interpretation or
application of the Convention" and the elimination of double
taxation in cases not
otherwise provided for in the Convention. Paragraph 9 of the Commentary
on
Article 25 makes clear that Article 25 is intended to be used by
competent
authorities in resolving juridical and economic double taxation issues
arising
from transfer pricing adjustments made pursuant to paragraphs 1 and 2 of
Article 9.
4.31 The mutual agreement procedure does not compel competent
authorities to reach an agreement and resolve their tax disputes. The
competent
authorities are obliged only to endeavour to reach an agreement. The
competent
authorities may be unable to come to an agreement because of conflicting
domestic laws or restrictions imposed by domestic law on the tax
administration's
power of compromise. Some unresolved cases may have recourse to
arbitration,
although such procedures are new and not universally accepted by all
OECD
ADMINISTRATIVE APPROACHES
July 1995 IV-11
©OECD
Member countries. The Member States of the European Communities signed
on
23 July 1990 their multilateral Arbitration Convention, which entered
into force
on 1 January 1995.
ii) Corresponding adjustments: Paragraph 2 of Article 9
4.32 To eliminate double taxation in transfer pricing cases, tax
administrations may consider requests for corresponding adjustments as
described in paragraph 2 of Article 9. A corresponding adjustment, which
in
practice may be undertaken as part of the mutual agreement procedure,
can
mitigate or eliminate double taxation in cases where one tax
administration
increases a company's taxable profits (i.e. makes a primary adjustment)
as a result
of applying the arm's length principle to transactions involving an associated
enterprise in a second tax jurisdiction. The corresponding adjustment in
such a
case is a downward adjustment to the tax liability of that associated
enterprise,
made by the tax administration of the second jurisdiction, so that the
allocation of
profits between the two jurisdictions is consistent with the primary
adjustment
and no double taxation occurs. It is also possible that the first tax
administration
will agree to decrease (or eliminate) the primary adjustment as part of
the
consultative process with the second tax administration, in which case
the
corresponding adjustment would be smaller (or perhaps unnecessary). It
should
be noted that a corresponding adjustment is not intended to provide a
benefit to
the MNE group greater than would have been the case if the controlled
transactions had been undertaken at arm's length conditions in the first
instance.
4.33 Paragraph 2 of Article 9 specifically recommends that the competent
authorities consult each other if necessary to determine corresponding
adjustments. This demonstrates that the mutual agreement procedure of
Article 25 may be used to consider corresponding adjustment requests.
However,
the overlap between the two Articles has caused OECD Member countries to
consider whether the mutual agreement procedure can be used to achieve
corresponding adjustments where the bilateral income tax convention
between
two Contracting States does not include a provision comparable to
paragraph 2 of
Article 9. Paragraph 10 of the Commentary on Article 25 of the OECD
Model
Tax Convention now expressly states the view of most OECD Member
countries
that the mutual agreement procedure is considered to apply to transfer
pricing
adjustment cases even in the absence of a provision comparable to
paragraph 2 of
Article 9. Paragraph 10 also notes that those OECD Member countries that
do
OECD TRANSFER PRICING GUIDELINES
IV-12 July 1995
©OECD
not agree with this view in practice apply domestic laws in most cases
to alleviate
double taxation of bona fide enterprises
.
4.34 Under paragraph 2 of Article 9, a corresponding adjustment may be
made by a contracting state either by recalculating the profits subject
to tax for
the associated enterprise in that country using the relevant revised
price or by
letting the calculation stand and giving the associated enterprise
relief against its
own tax paid in that State for the additional tax charged to the
associated
enterprise by the adjusting State as a consequence of the revised
transfer price.
The former method is by far the more common among OECD Member countries.
4.35 Corresponding adjustments are not mandatory, mirroring the rule
that
tax administrations are not required to reach agreement under the mutual
agreement procedure. Under paragraph 2 of Article 9, a tax
administration
should make a corresponding adjustment only insofar as it considers the
primary
adjustment to be justified both in principle and in amount. The
non-mandatory
nature of corresponding adjustments is necessary so that one tax
administration is
not forced to accept the consequences of an arbitrary or capricious
adjustment by
another State. It also is important to maintaining the fiscal
sovereignty of each
OECD Member country.
4.36 Once a tax administration has agreed to make a corresponding
adjustment it is necessary to establish whether the adjustment is to be
attributed to
the year in which the controlled transactions giving rise to the
adjustment took
place or to an alternative year, such as the year in which the primary
adjustment
is determined. This issue also often raises the question of a taxpayer's
entitlement
to interest on the overpayment of tax in the jurisdiction which has
agreed to make
the corresponding adjustment (discussed in paragraphs 4.64-4.66). The
first
approach is more appropriate because it achieves a matching of income
and
expenses and better reflects the economic situation as it would have
been if the
controlled transactions had been at arm's length. However, in cases
involving
lengthy delays between the year covered by the adjustment and the year
of its
acceptance of by the taxpayer or a final court decision, the tax
administration
should have the flexibility to agree to make corresponding adjustments
for the
year of acceptance of or decision on the primary adjustment. This
approach
would need to rely on domestic law for implementation. While not
ordinarily
preferred, it could be appropriate as an equitable measure in
exceptional cases to
facilitate implementation and to avoid time limit barriers.
ADMINISTRATIVE APPROACHES
July 1995 IV-13
©OECD
4.37 Corresponding adjustments can be a very effective means of
obtaining
relief from double taxation resulting from transfer pricing adjustments.
OECD
Member countries generally strive in good faith to reach agreement
whenever the
mutual agreement procedure is invoked. Through the mutual agreement
procedure, tax administrations can address issues in a non-adversarial
proceeding,
often achieving a negotiated settlement in the interests of all parties.
It also
allows tax administrations to take into account other taxing rights
issues, such as
withholding taxes.
4.38 At least one OECD Member country has a procedure that may reduce
the need for primary adjustments by allowing the taxpayer to report a
transfer
price for tax purposes that is, in the taxpayer's opinion, an arm's
length price for a
controlled transaction, even though this price differs from the amount
actually
charged between the associated enterprises. This adjustment, sometimes
known
as a "compensating adjustment", would be made before the tax
return is filed.
Compensating adjustments may facilitate the reporting of taxable income
by
taxpayers in accordance with the arm's length principle, recognizing
that
information about comparable uncontrolled transactions may not be
available at
the time associated enterprises establish the prices for their
controlled
transactions. Thus, for the purpose of lodging a correct tax return, a
taxpayer
would be permitted to make a compensating adjustment that would record
the
difference between the arm's length price and the actual price recorded
in its
books and records.
4.39 However, compensating adjustments are not recognized by most OECD
Member countries, on the grounds that the tax return should reflect the
actual
transactions. If compensating adjustments are permitted in the country
of one
associated enterprise but not permitted in the country of the other
associated
enterprise, double taxation may result because corresponding adjustment
relief
may not be available if no primary adjustment is made. It may be
possible to use
the mutual agreement procedure to resolve difficulties presented by
compensating
adjustments.
iii) Concerns with the procedures
4.40 While corresponding adjustment and mutual agreement procedures are
able to resolve most transfer pricing conflicts, serious concerns have
been
expressed by taxpayers. For example, because transfer pricing issues are
so
OECD TRANSFER PRICING GUIDELINES
IV-14 July 1995
©OECD
complex, taxpayers fear that there may not be sufficient safeguards in
the
procedures against double taxation. These concerns are addressed in the
Commentary on Article 25, which discusses the use of advisory opinions
from an
impartial third party, submission of questions to the Committee on
Fiscal Affairs,
or arbitration as alternative methods.
4.41 Taxpayers have also expressed fears that their cases may be settled
not
on their individual merits but by reference to a balance of the results
in other
cases. Similarly, there may be a fear of retaliation or offsetting
adjustments by
the country from which the corresponding adjustment has been requested.
It is
not the intention of tax administrations to take retaliatory action; the
fears of
taxpayers may be a result of inadequate communication of this fact. Tax
administrations should take steps to assure taxpayers that they need not
fear
retaliatory action and that, consistent with the arm's length principle,
each case is
resolved on its own merits. Taxpayers should not be deterred from
initiating
mutual agreement procedures where Article 25 is applicable.
4.42 Perhaps the most significant concerns that have been expressed with
the
mutual agreement procedure, as it affects corresponding adjustments, are
the
following, which are discussed separately in the sections below:
a) time limits under domestic law may make
corresponding
adjustments unavailable if those limits are not waived in the
relevant tax treaty;
b) mutual agreement procedures may take too
long to complete;
c) taxpayer participation may be limited;
d) published procedures may not be readily
available to instruct
taxpayers on how the procedure may be used; and
e) there may be no procedures to suspend the
collection of tax
deficiencies or the accrual of interest pending resolution of the
mutual agreement procedure.
ADMINISTRATIVE APPROACHES
July 1995 IV-15
©OECD
iv) Recommendations to address concerns
a) Time limits
4.43 Relief under Article 9(2) may be unavailable if the time limit
provided
by treaty or domestic law for making corresponding adjustments has
expired.
Paragraph 2 of Article 9 does not specify whether there should be a time
limit
after which corresponding adjustments should not be made. Some countries
prefer an open-ended approach so that double taxation may be mitigated.
Other
countries consider the open-ended approach to be unreasonable for
administrative
purposes. Thus, relief may depend on whether the applicable treaty
overrides
domestic time limitations, establishes other time limits, or has no
effect on
domestic time limits.
4.44 Time limits for finalizing a taxpayer's tax liability are necessary
to
provide certainty for taxpayers and tax administrations. In a transfer
pricing case
a country may be legally unable to make a corresponding adjustment if
the time
has expired for finalising the tax liability of the relevant associated
enterprise.
Thus, the existence of such time limits and the fact that they vary from
country to
country should be considered in order to minimize double taxation.
4.45 Paragraph 2 of Article 25 of the OECD Model Tax Convention
addresses the time limit issue by requiring that an agreement reached
pursuant to
the mutual agreement procedure be implemented regardless of any time
limits in
the domestic law of the Contracting States. Time limits therefore do not
impede
the making of corresponding adjustments where a bilateral treaty
includes this
provision. Some countries, however, may be unwilling or unable to
override their
domestic time limits in this way and have entered explicit reservations
on this
point. OECD Member countries therefore are encouraged as far as possible
to
extend domestic time limits for purposes of making corresponding
adjustments
when mutual agreement procedures have been invoked.
4.46 Where a bilateral treaty does not override domestic time limits for
the
purposes of the mutual agreement procedure, tax administrations should
be ready
to initiate discussions quickly upon the taxpayer's request, well before
the
expiration of any time limits that would preclude the making of an
adjustment.
Furthermore, OECD Member countries are encouraged to adopt domestic law
OECD TRANSFER PRICING GUIDELINES
IV-16 July 1995
©OECD
that would allow the suspension of time limits on determining tax
liability until
the discussions have been concluded.
4.47 The time limit issue might also be addressed through rules
governing
primary adjustments rather than corresponding adjustments. The problem
of time
limits on corresponding adjustments is at times due to the fact that the
initial
assessments for primary adjustments for a taxable year are not made
until many
years later. Thus, one proposal favoured by some countries is to
incorporate in
bilateral treaties a provision that would prohibit the issuance of an
initial
assessment after the expiration of a specified period. Many countries,
however,
have objected to this approach. Tax administrations may need a long time
to
make the necessary investigations to establish an adjustment. It would
be
difficult for many tax administrations to ignore the need for an
adjustment,
regardless of when it becomes apparent, provided that they were not
prevented by
their domestic time limits from making the adjustment. While it is not
possible at
this stage to recommend generally a time limit on initial assessments,
tax
administrations are encouraged to make these assessments within their
own
domestic time limits without extension. If the complexity of the case or
lack of
cooperation from the taxpayer necessitates an extension, the extension
should be
made for a minimum and specified time period. Further, where domestic
time
limits can be extended with the agreement of the taxpayer, such an
extension
should be made only when the taxpayer's consent is truly voluntary. Tax
examiners are encouraged to indicate to taxpayers at an early stage
their intent to
make an assessment based on cross-border transfer pricing, so that the
taxpayer
can, if it so chooses, inform the tax administration in the other
interested state so
it can begin considering the issue in the context of a prospective
mutual
agreement procedure.
4.48 Another time limit that must be considered is the three year time
limit
within which a taxpayer must invoke the mutual agreement procedure under
Article 25 of the OECD Model Tax Convention. The three year period
begins to
run from the time the tax administration first notifies the taxpayer of
the proposed
adjustment, described as the "adjustment action". Although
some countries
consider three years too short a period for invoking the procedure,
other countries
consider it too long and have entered reservations on this point. The
Commentary on Article 25 indicates that the time limit "must be
regarded as a
minimum so that Contracting States are left free to agree in their
bilateral
conventions upon a longer period in the interests of taxpayers".
ADMINISTRATIVE APPROACHES
July 1995 IV-17
©OECD
4.49 The three year time limit raises an issue about determining the
date of
the adjustment action. Paragraph 18 of the Commentary on Article 25
states that
the three year time period "should be interpreted in the way most
favourable to
the taxpayer". In addition, it clarifies that "where it is the
combination of
decisions or actions taken in both Contracting States resulting in
taxation not in
accordance with the Convention, it begins to run only from the first
notification
of the most recent decision or action."
4.50 In order to minimise the possibility that time limits may prevent
the
mutual agreement procedure from effectively ensuring relief from or
avoidance
of double taxation, taxpayers should be permitted to avail themselves of
the
procedure at the earliest possible stage, which is as soon as an
adjustment appears
likely. If this were done, the process of consultation could be begun
before any
irrevocable steps were taken by either tax administration, with the
prospect that
there would be as few procedural obstacles as possible in the way of
achieving a
mutually acceptable conclusion to the discussions. However, some
competent
authorities may not like to be involved at such an early stage because a
proposed
adjustment may not result in final action or may not trigger a claim for
a
corresponding adjustment. Consequently, too early an invocation of the
mutual
agreement process may create unnecessary work.
4.51 Nevertheless, the competent authorities should be prepared to enter
into
discussions under the mutual agreement procedure relating to transfer
pricing
issues at as early a stage as is compatible with the economical use of
their
resources.
b) Duration of mutual agreement proceedings
4.52 Once discussions under the mutual agreement procedure have
commenced, the proceedings may turn out to be lengthy. The complexity of
transfer pricing cases may make it difficult for the tax administrations
to reach a
swift resolution. Distance may make it difficult for the tax
administrations to
meet frequently, and correspondence is often an unsatisfactory
substitute for faceto-
face discussions. Difficulties also arise from differences in language,
procedures, and legal and accounting systems, and these may lengthen the
duration of the process. The process also may be prolonged if the
taxpayer delays
in providing all the information the tax administrations require for a
full
OECD TRANSFER PRICING GUIDELINES
IV-18 July 1995
©OECD
understanding of the transfer pricing issue. However, delays do not
always occur
and, in practice, the consultations often result in a settlement of the
problem in a
relatively short time.
4.53 It may be possible to reduce the amount of time involved to
conclude a
mutual agreement procedure. Reducing the formalities required to operate
the
procedure may expedite the process. In this regard, personal contacts or
conferences by telephone may be useful to establish more quickly whether
an
adjustment by one country may give rise to difficulty in another
country. Such
contacts are expensive but in the long run may prove to be more
cost-effective
than the time-consuming process of just a formal written communication.
4.54 The procedure could be expedited by delegating the authority to
engage
in mutual agreement procedure consultations on transfer pricing issues
to
knowledgeable senior officials below the competent authority itself. The
mutual
agreement procedure has generally been regarded as requiring that
high-level
officials of the tax administrations be involved. Reasons for this
approach are
sound; the fewer officials that are involved, the greater the likelihood
of ensuring
a consistent approach and the confidentiality of taxpayer information.
Indeed,
without the supervisory control of experts in a central and high-level
position,
there would be a real danger of inconsistent decisions and, as a result,
of failure to
achieve equitable results. It is therefore recommended that any
delegation of
authority below the competent authority itself should be limited to a
small
number of senior officials. An ancillary matter generally agreed upon by
OECD
Member countries is that when considering to which officials any
delegation of
the competent authority's role should be given, the officer responsible
for the
development of the primary adjustment should not be placed in charge of
proceedings but might, quite appropriately, advise and participate in
the
proceedings. This approach reinforces the independence of the mutual
agreement
procedure and of the role of the competent authority.
4.55 A number of countries have found that the delegation of authority
can
be a useful expedient once a mutual agreement procedure has been
initiated
between competent authorities. For example, the following procedure has
been
used successfully between some countries. The competent authorities ask
their
case officers in the field to prepare a joint report on the case under
investigation
on, inter alia, the following lines:
the case officers establish the facts and coordinate
their findings so that both countries will base their decisions on the
same
ADMINISTRATIVE APPROACHES
July 1995 IV-19
©OECD
facts and circumstances; they then specify those questions of law (if
any) on
which the reporting authorities disagree, and, where problems of
evaluation are
involved, may set up agreed lower and upper limits for the appropriate
price
(where possible), thus providing a range within which the competent
authorities
can reach a decision. In this way both delegation to lower levels and
supervisory
control by the competent authorities have been satisfactorily achieved.
This kind
of procedure may not be appropriate in all cases, however. In
particular, a joint
report of case officers can be administratively burdensome and may even
present
legal problems for some countries outside the context of a simultaneous
examination procedure.
c) Taxpayer participation
4.56 Paragraph 1 of Article 25 of the OECD Model Tax Convention gives
taxpayers the right to submit a request to initiate a mutual agreement
procedure.
Paragraph 23 of the Commentary on Article 25 provides that such requests
should
not be rejected without good reason.
4.57 However, although the taxpayer has the right to initiate the
procedure,
the taxpayer has no specific right to participate in the process. It has
been argued
that the taxpayer also should have a right to take part in the mutual
agreement
procedure, including the right at least to present its case to both
competent
authorities, and to be informed of the progress of the discussions. It
should be
noted in this respect that implementation of a mutual agreement in
practice is
subject to the taxpayer's acceptance. Some taxpayer representatives have
suggested that the taxpayer also should have a right to be present at
face-to-face
discussions between the competent authorities. The purpose would be to
ensure
that there is no misunderstanding by the competent authorities of the
facts and
arguments that are relevant to the taxpayer's case.
4.58 The mutual agreement procedure envisaged in Article 25 of the OECD
Model Tax Convention and adopted in many bilateral agreements is not a
process
of litigation. While input from the taxpayer in some cases can be
helpful to the
procedure, the taxpayer's ability to participate should be subject to
the discretion
of the competent authorities.
4.59 Outside the context of the actual discussions between the competent
authorities, it is essential for the taxpayer to give the competent
authorities all the
OECD TRANSFER PRICING GUIDELINES
IV-20 July 1995
©OECD
information that is relevant to the issue in a timely manner. Tax
administrations
have limited resources and taxpayers should make every effort to
facilitate the
process. Further, because the mutual agreement procedure is
fundamentally
designed as a means of providing assistance to a taxpayer, the tax administrations
should allow taxpayers every reasonable opportunity to present the
relevant facts
and arguments to them to ensure as far as possible that the matter is
not subject to
misunderstanding.
4.60 In practice, the tax administrations of many OECD Member countries
routinely give taxpayers such opportunities, keep them informed of the
progress
of the discussions, and often ask them during the course of the
discussions
whether they can accept the settlements contemplated by the competent
authorities. These practices, already standard procedure in most
countries, should
be adopted as widely as possible.
d) Publication of applicable procedures
4.61 It would be helpful to taxpayers if competent authorities were to
develop and publicise their own domestic rules or procedures for
utilizing the
mutual agreement procedure so that taxpayers may more readily understand
the
process. The development and publication of such rules could also be
helpful to
tax administrations, especially if they are faced with the possibility
of a large or
growing number of cases in which mutual agreement with other tax
administrations may be necessary or desirable, possibly saving them the
need to
answer a variety of enquiries or to develop procedures afresh in every
case.
4.62 In publicising such rules and procedures it could be made clear,
for
example, how the taxpayer may bring a problem to the attention of the
competent
authority in order to start a discussion with the other country's
competent
authorities. The publication could indicate the official address to
which the
problem should be referred, the stage at which the competent authority
would be
prepared to take the matter up, the nature of the information necessary
or helpful
to the competent authority in handling the case, and so on. It could be
helpful
also to give guidance on the policy of the competent authorities
regarding
questions of transfer pricing and corresponding adjustments. This
possibility
could be explored unilaterally by competent authorities and, where
appropriate,
descriptions of their rules and procedures should be given suitable
domestic
publicity (respecting, however, taxpayer confidentiality).
ADMINISTRATIVE APPROACHES
July 1995 IV-21
©OECD
4.63 There is no need for the competent authorities to agree to rules or
guidelines governing the procedure, since the rules or guidelines would
be limited
in effect to the competent authority's domestic relationship with its
own taxpayers.
However, competent authorities should routinely communicate such
unilateral rules
or guidelines to the competent authorities of the other countries with
which mutual
agreement procedures are undertaken.
e) Problems concerning collection of tax deficiencies and accrual of
interest
4.64 The process of obtaining relief from double taxation through a
corresponding adjustment can be complicated by issues relating to the
collection of
tax deficiencies and the assessment of interest on those deficiencies or
overpayment. A first problem is that the assessed deficiency may be
collected
before the corresponding adjustment proceeding is completed, because of
a lack of
domestic procedures allowing the collection to be suspended. This may
cause the
MNE group to pay the same tax twice until the issues can be resolved.
This
problem arises not only in the context of the mutual agreement procedure
but also
for internal appeals. Countries that do not have procedures to suspend
collection
during a mutual agreement procedure are encouraged to adopt them where
permitted by domestic law, although subject to the right to seek
security as
protection against possible default by the taxpayer..
4.65 Whether or not collection of the deficiency is suspended or
partially
suspended, other complications may arise. Because of the lengthy time
period for
processing many transfer pricing cases, the interest due on a deficiency
or, if a
corresponding adjustment is allowed, on the overpayment of tax in the
other
country can equal or exceed the amount of the tax itself. Tax
administrations should
be aware that inconsistent interest rules across the two jurisdictions
may result in
additional cost for the MNE group, or in other cases provide a benefit
to the MNE
group (e.g. where the interest paid in the country making the
corresponding
adjustment exceeds the interest imposed in the country making the
primary
adjustment) that would not have been available if the controlled
transactions had
been undertaken on an arm's length basis originally, and this should be
taken into
account in their mutual agreement proceedings.
4.66 The amount of interest (as distinct from the rate at which it is
applied)
may also have more to do with the year in which the jurisdiction making
the
OECD TRANSFER PRICING GUIDELINES
IV-22 July 1995
©OECD
corresponding adjustment attributes the corresponding adjustment. The
jurisdiction making the corresponding adjustment may decide to make the
adjustment in the year in which the primary adjustment is determined in
which
case relatively little interest is likely to be paid (regardless of the
rate of interest
paid) whereas the jurisdiction making the primary adjustment may seek to
impose
interest on the understated and uncollected tax liability from the year
in which the
controlled transactions took place (notwithstanding that a relatively
low rate of
interest may be imposed). The issue of in which year to make a
corresponding
adjustment is raised in paragraph 4.36. Therefore, it may be appropriate
in
certain cases for both competent authorities to agree not to assess
interest from
the taxpayer or pay interest to the taxpayer in connection with the
adjustment at
issue, but this may not be possible in the absence of a specific
provision
addressing this issue in the relevant bilateral treaty. This approach
would also
reduce administrative complexities. However, as the interest on the
deficiency
and the interest on the overpayment are attributable to different
taxpayers in
different jurisdictions, there would be no assurance under such an
approach that a
proper economic result would be achieved.
v) Secondary adjustments
4.67 Corresponding adjustments are not the only adjustments that may be
triggered by a primary transfer pricing adjustment. Primary transfer
pricing
adjustments and their corresponding adjustments change the allocation of
taxable
profits of an MNE group for tax purposes but they do not alter the fact
that the
excess profits represented by the adjustment are not consistent with the
result that
would have arisen if the controlled transactions had been undertaken on
an arm's
length basis. To make the actual allocation of profits consistent with
the primary
transfer pricing adjustment, some countries having proposed a transfer
pricing
adjustment will assert under their domestic legislation a constructive
transaction
(a secondary transaction), whereby the excess profits resulting from a
primary
adjustment are treated as having been transferred in some other form and
taxed
accordingly. Ordinarily, the secondary transactions will take the form
of
constructive dividends, constructive equity contributions, or
constructive loans.
For example, a country making a primary adjustment to the income of a
subsidiary of a foreign parent may treat the excess profits in the hands
of the
foreign parent as having been transferred as a dividend, in which case
withholding tax may apply. It may be that the subsidiary paid an
excessive
transfer price to the foreign parent as a means of avoiding that
withholding tax.
ADMINISTRATIVE APPROACHES
July 1995 IV-23
©OECD
Thus, secondary adjustments attempt to account for the difference
between the
redetermined taxable profits and the originally booked profits. The
subjecting to
tax of a secondary transaction gives rise to a secondary transfer
pricing
adjustment (a secondary adjustment). Thus, secondary adjustments may
serve to
prevent tax avoidance. The exact form that a secondary transaction takes
and of
the consequent secondary adjustment will depend on the facts of the case
and on
the tax laws of the country that asserts the secondary adjustment.
4.68 Another example of a tax administration seeking to assert a
secondary
transaction may be where the tax administration making a primary
adjustment
treats the excess profits as being a constructive loan from one
associated
enterprise to the other associated enterprise. In this case, an
obligation to repay
the loan would be deemed to arise. The tax administration making the
primary
adjustment may then seek to apply the arm's length principle to this
secondary
transaction to impute an arm's length rate of interest. The interest
rate to be
applied, the timing to be attached to the making of interest payments,
if any, and
whether interest is to be capitalised would generally need to be
addressed. The
constructive loan approach may have an effect not only for the year to
which a
primary adjustment relates but to subsequent years until such time as
the
constructive loan is considered by the tax administration asserting the
secondary
adjustment to have been repaid.
4.69 A secondary adjustment may result in double taxation unless a
corresponding credit or some other form of relief is provided by the
other country
for the additional tax liability that may result from a secondary
adjustment.
Where a secondary adjustment takes the form of a constructive dividend
any
withholding tax which is then imposed may not be relievable because
there may
not be a deemed receipt under the domestic legislation of the other
country.
4.70 The Commentary on paragraph 2 of Article 9 of the OECD Model Tax
Convention notes that the Article does not deal with secondary
adjustments, and
thus it neither forbids nor requires tax administrations to make
secondary
adjustments. In a broad sense, the purpose of double tax agreements can
be
stated as being for the avoidance of double taxation and the prevention
of fiscal
evasion with respect to taxes on income and capital. Many countries do
not make
secondary adjustments either as a matter of practice or because their
respective
domestic provisions do not permit them to do so. Some countries might
refuse to
OECD TRANSFER PRICING GUIDELINES
IV-24 July 1995
©OECD
grant relief in respect of other countries' secondary adjustments and
indeed they
are not required to do so under Article 9.
4.71 Secondary adjustments are rejected by some countries because of the
practical difficulties they present. For example, if a primary
adjustment is made
between brother-sister companies, the secondary adjustment may involve a
hypothetical dividend from one of those companies up a chain to a common
parent, followed by constructive equity contributions down another chain
of
ownership to reach the other company involved in the transaction. Many
hypothetical transactions might be created, raising questions whether
tax
consequences should be triggered in other jurisdictions besides those
involved in
the transaction for which the primary adjustment was made. This might be
avoided if the secondary transaction were a loan, but constructive loans
are not
used by most countries for this purpose and they carry their own
complications
because of issues relating to imputed interest. It would be
inappropriate for
minority shareholders that are not parties to the controlled
transactions and that
have accordingly not received excess cash to be considered recipients of
a
constructive dividend, even though a non-pro-rata dividend might be considered
inconsistent with the requirements of applicable corporate law. In
addition, as a
result of the interaction with the foreign tax credit system, a
secondary adjustment
may excessively reduce the overall tax burden of the MNE group.
4.72 In light of the foregoing difficulties, tax administrations, when
secondary adjustments are considered necessary, are encouraged to
structure such
adjustments in a way that the possibility of double taxation as a
consequence
thereof would be minimised, except where the taxpayer's behaviour
suggests an
intent to disguise a dividend for purposes of avoiding withholding tax.
In
addition, countries in the process of formulating or reviewing policy on
this
matter are recommended to take into consideration the above-mentioned
difficulties.
4.73 Some countries that have adopted secondary adjustments also give
the
taxpayer receiving the primary adjustment another option that allows the
taxpayer
to avoid the secondary adjustment by having the taxpayer arrange for the
MNE
group of which it is a member repatriate the excess profits to enable
the taxpayer
to conform its accounts to the primary adjustment. The repatriation
could be
effected either by setting up an account receivable or by reclassifying
other
transfers, such as dividend payments where the adjustment is between
parent and
ADMINISTRATIVE APPROACHES
July 1995 IV-25
©OECD
subsidiary, as a payment of additional transfer price (where the
original price was
too low) or as a refund of transfer price (where the original price was
too high).
4.74 Where a repatriation involves reclassifying a dividend payment, the
amount of the dividend (up to the amount of the primary adjustment)
would be
excluded from the recipient's gross income (because it would already
have been
accounted for through the primary adjustment). The consequences would be
that
the recipient would lose any indirect tax credit (or benefit of a
dividend
exemption in an exemption system) and a credit for withholding tax that
had been
allowed on the dividend.
4.75 When the repatriation involves establishing an account receivable,
the
adjustments to actual cash flow will be made over time, although
domestic law
may limit the time within which the account can be satisfied. This
approach is
identical to using a constructive loan as a secondary transaction to
account for
excess profits in the hands of one of the parties to the controlled
transaction. The
accrual of interest on the account could have its own tax consequences,
however,
and this may complicate the process, depending upon when interest begins
to
accrue under domestic law (as discussed in paragraph 4.68). Some
countries may
be willing to waive the interest charge on these accounts as part of a
competent
authority agreement.
4.76 Where a repatriation is sought, a question arises about how such
payments or arrangements should be recorded in the accounts of the
taxpayer
repatriating the payment to its associated enterprise so that both it
and the tax
administration of that country are aware that a repatriation has occurred
or has
been set up. The actual recording of the repatriation in the accounts of
the
enterprise from whom the repatriation is sought will ultimately depend
on the
form the repatriation takes. For example, where a dividend receipt is to
be
regarded by the tax administration making the primary adjustment and the
taxpayer receiving the dividend as the repatriation, then this type of
arrangement
may not need to be specially recorded in the accounts of the associated
enterprise
paying the dividend, as such an arrangement may not affect the amount or
characterisation of the dividend in its hands. On the other hand, where
an account
payable is set up, both the taxpayer recording the account payable and
the tax
administration of that country will need to be aware that the account
payable
relates to a repatriation so that any repayments from the account or of
interest on
the outstanding balance in the account are clearly able to be identified
and treated
OECD TRANSFER PRICING GUIDELINES
IV-26 July 1995
©OECD
according to the domestic laws of that country. In addition, issues may
be
presented in relation to currency exchange gains and losses.
4.77 As most OECD Member countries at this time have not had much
experience with the use of repatriation, it is recommended that
agreements between
taxpayers and tax administrations for a repatriation to take place be
discussed in the
mutual agreement proceeding where it has been initiated for the related
primary
adjustment. The Committee on Fiscal Affairs is studying the issue of
secondary
adjustments and repatriation as necessary to develop additional guidance
that might
be given to taxpayers and tax administrations in this area.
D. Simultaneous Tax Examinations
i) Definition and background
4.78 A simultaneous tax examination is a form of mutual assistance, used
in
a wide range of international issues, that allows two or more countries
to
cooperate in tax investigations. Simultaneous tax examinations can be
particularly useful where information based in a third country is a key
to a tax
investigation, since they generally lead to more timely and more
effective
exchanges of information. Historically, simultaneous tax examinations of
transfer pricing issues have focused on cases where the true nature of
transactions
was obscured by the interposition of tax havens. However, in complex
transfer
pricing cases, it is suggested that simultaneous examinations could
serve a
broader role since they may improve the adequacy of data available to
the
participating tax administrations for transfer pricing analyses. It has
also been
suggested that simultaneous examinations could help reduce the
possibilities for
economic double taxation, reduce the compliance cost to taxpayers, and
speed up
the resolution of issues. In a simultaneous examination, if a
reassessment is
made, both countries involved should endeavour to reach a result that
avoids
double taxation for the MNE group.
4.79 Simultaneous tax examinations are defined in Part A of the OECD
Model Agreement for the Undertaking of Simultaneous Tax Examinations
("OECD Model Agreement"). According to this agreement, a
simultaneous tax
examination means an "arrangement between two or more parties to
examine
simultaneously and independently, each on its own territory, the tax
affairs of (a)
taxpayer(s) in which they have a common or related interest with a view
to
ADMINISTRATIVE APPROACHES
July 1995 IV-27
©OECD
exchanging any relevant information which they so obtain". This
form of mutual
assistance is not meant to be a substitute for the mutual agreement
procedure.
Any exchange of information as a result of the simultaneous tax
examination
continues to be exchanged via the competent authorities, with all the
safeguards
that are built into such exchanges.
4.80 While provisions that follow Article 26 of the OECD Model Tax
Convention may provide the legal basis for conducting simultaneous
examinations, competent authorities frequently conclude working
arrangements
that lay down the objectives of their simultaneous tax examination
programs and
practical procedures connected with the simultaneous tax examination and
exchange of information. Once such an agreement has been reached on the
general lines to be followed and specific cases have been selected, tax
examiners
and inspectors of each state will separately carry out their examination
within
their own jurisdiction and pursuant to their domestic law and
administrative
practice.
ii) Legal basis for simultaneous tax examinations
4.81 Simultaneous tax examinations are within the scope of the exchange
of
information provision based on Article 26 of the OECD Model Tax
Convention.
Article 26 provides for cooperation between the competent authorities of
the
Contracting States in the form of exchanges of information necessary for
carrying
out the provisions of the Convention or of their domestic laws
concerning taxes
covered by the Convention. Article 26 and the Commentary do not restrict
the
possibilities of assistance to the three methods of exchanging
information
mentioned in the Commentary (exchange on request, spontaneous exchanges,
and
automatic exchanges).
4.82 Simultaneous tax examinations may be authorized outside the context
of double tax treaties. For example, Article 12 of the Nordic Convention
on
Mutual Assistance in Tax Matters governs exchange of information and
assistance in tax collection between the Nordic countries and provides
for the
possibility of simultaneous tax examinations. This convention gives
common
guidelines for the selection of cases and for carrying out such
examinations.
Article 8 of the joint Council of Europe and OECD Convention on Mutual
Administrative Assistance in Tax Matters also provides expressly for the
possibility of simultaneous tax examinations.
OECD TRANSFER PRICING GUIDELINES
IV-28 July 1995
©OECD
4.83 In all cases the information obtained by the tax administration of
a state
has to be treated as confidential under its domestic legislation and may
be used
only for certain tax purposes and disclosed only to certain persons and
authorities
involved in specifically defined tax matters covered by the tax treaty
or mutual
assistance agreement. The taxpayers affected are normally notified of
the fact
that they have been selected for a simultaneous examination and in some
countries they may have the right to be informed when the tax
administrations are
considering a simultaneous tax examination or when information will be
transmitted in conformity with Article 26. In such cases, the competent
authority
should inform its counterpart in the foreign state that such disclosure
will occur.
iii) Simultaneous tax examinations and transfer pricing
4.84 In selecting transfer pricing cases for simultaneous examinations,
there
may be major obstacles caused by the differences in time limits for
conducting
examinations or making assessments in different countries and the
different tax
periods open for examination. However, these problems may be mitigated
by an
early exchange of examination schedules between the relevant competent
authorities to find out in which cases the tax examination periods
coincide and to
synchronize future examination periods. While at first glance an early
exchange
of examination schedules would seem beneficial, some countries have
found that
the chances of a treaty partner accepting a proposal are considerably
better when
one is able to present issues more comprehensively to justify a
simultaneous
examination.
4.85 Once a case is selected for a simultaneous examination it is
customary
for tax inspectors or examiners to meet, to plan, to coordinate and to
follow
closely the progress of the simultaneous tax examination. Especially in
complex
cases, meetings of the tax inspectors or examiners concerned may also be
held
with taxpayer participation to clarify factual issues. In those
countries where the
taxpayer has the right to be consulted before information is transferred
to another
tax administration, this procedure should also be followed in the
context of a
simultaneous examination. In this situation, that tax administration
should inform
in advance its treaty partners that it is subject to this requirement
before the
simultaneous examination is begun.
4.86 Simultaneous tax examinations may be a useful instrument to
determine
the correct tax liability of associated enterprises in cases where, for
example,
ADMINISTRATIVE APPROACHES
July 1995 IV-29
©OECD
costs are shared or charged and profits are allocated between taxpayers
in
different taxing jurisdictions or more generally where transfer pricing
issues are
involved. Simultaneous tax examinations may facilitate an exchange of
information on multinational business practices, complex transactions,
cost
contribution arrangements, and profit allocation methods in special
fields such as
global trading and innovative financial transactions. As a result, tax
administrations may acquire a better understanding of and insight into
the overall
activities of an MNE and obtain extended possibilities of comparison and
checking international transactions. Simultaneous tax examinations may
also
support the industry-wide exchange of information, which is aimed at
developing
knowledge of taxpayer behaviour, practices and trends within an
industry, and
other information that might be suitable beyond the specific cases
examined.
4.87 One objective of simultaneous tax examinations is to promote
compliance with transfer pricing regulations. Obtaining the necessary
information and determining the facts and circumstances about such
matters as
the transfer pricing conditions of controlled transactions between
associated
enterprises in two or more tax jurisdictions may be difficult for a tax
administration, especially in cases where the taxpayer in its
jurisdiction does not
cooperate or fails to provide the necessary information in due time. The
simultaneous tax examination process can help tax administrations to
establish
these facts faster and more effectively and economically.
4.88 The process also might allow for the identification of potential
transfer
pricing disputes at an early stage, thereby minimising litigation with
taxpayers.
This could happen when, based upon the information obtained in the
course of a
simultaneous tax examination, the participating tax examiners or
inspectors have
the opportunity to discuss any differences in opinion with regard to the
transfer
pricing conditions which exist between the associated enterprises and
are able to
reconcile these contentions. When such a process is undertaken, the tax
examiners or inspectors concerned should, as far as possible, arrive at
concurring
statements as to the determination and evaluation of the facts and
circumstances
of the controlled transactions between the associated enterprises,
stating any
disagreements about the evaluation of facts, and any differences with
respect to
the legal treatment of the transfer pricing conditions which exist
between the
associated enterprises. Such statements could then serve as a basis for
subsequent
mutual agreement procedures and perhaps obviate the problems caused by
one
country examining the affairs of a taxpayer long after the treaty
partner country
OECD TRANSFER PRICING GUIDELINES
IV-30 July 1995
©OECD
has finally settled the tax liability of the relevant associated
enterprise. For
example, such an approach could minimise mutual agreement procedure
difficulties due to the lack of relevant information.
4.89 In some cases the simultaneous tax examination procedure may allow
the participating tax administrations to reach an agreement on the
transfer pricing
conditions of a controlled transactions between the associated
enterprises. Where
an agreement is reached, corresponding adjustments may be made at an
early
stage, thus avoiding time-limit impediments and economic double taxation
to the
extent possible. In addition, if the agreement about the associated
enterprises'
transfer pricing is reached with the taxpayers' consent, time-consuming
and
expensive litigation may be avoided.
4.90 Even if no agreement between the tax administrations can be reached
in
the course of a simultaneous tax examination with respect to the
associated
enterprises' transfer pricing, the OECD Model Agreement envisions that
either
associated enterprise may be able to present a request for the opening
of a mutual
agreement procedure to avoid economic double taxation at an earlier
stage than it
would have if there were no simultaneous tax examination. If this is the
case,
then simultaneous tax examinations may significantly reduce the time
span
between a tax administration's adjustments made to a taxpayer's tax
liability and
the implementation of a mutual agreement procedure. Moreover, the OECD
Model Agreement envisions that simultaneous tax examinations may
facilitate
mutual agreement procedures, because tax administrations will be able to
build
up more complete factual evidence for those tax adjustments for which a
mutual
agreement procedure may be requested by a taxpayer. Based upon the
determination and evaluation of facts and the proposed tax treatment of
the
transfer pricing issues concerned as set forth in the tax
administrations' statements
described above, the practical operation of the mutual agreement
procedure may
be improved significantly, allowing the competent authorities to reach
an
agreement more easily.
4.91 The associated enterprises may also benefit from simultaneous tax
examinations from the savings of time and resources due to the
coordination of
inquiries from the tax administrations involved and the avoidance of
duplication.
In addition, the simultaneous involvement of two or more tax
administrations in
the examination of transfer pricing between associated enterprises may
provide
the opportunity for an MNE to take a more active role in resolving its
transfer
ADMINISTRATIVE APPROACHES
July 1995 IV-31
©OECD
pricing issues. By presenting the relevant facts and arguments to each
of the
participating tax administrations during the simultaneous tax
examination the
associated enterprises may help avoid misunderstandings and facilitate
the tax
administrations' concurring determination and evaluation of their
transfer pricing
conditions. Thus, the associated enterprises may obtain certainty with
regard to
their transfer pricing at an early stage. See paragraph 4.78.
iv) Recommendation on the use of simultaneous tax examinations
4.92 As a result of the increased use of simultaneous tax examinations
among OECD Member countries, the Committee on Fiscal Affairs decided it
would be useful to draft the OECD Model Agreement for those countries
that are
able and wish to engage in this type of cooperation. On 23 July 1992,
the Council
of the OECD made a recommendation to Member countries to use this Model
Agreement, which provides guidelines on the legal and practical aspects
of this
form of cooperation.
4.93 With the increasing internationalization of trade and business and
the
complexity of transactions of MNEs, transfer pricing issues have become
more
and more important. Simultaneous tax examinations can alleviate the
difficulties
experienced by both taxpayers and tax administrations connected with the
transfer pricing of MNEs. A greater use of simultaneous tax examinations
is
therefore recommended in the examination of transfer pricing cases and
to
facilitate exchange of information and the operation of mutual agreement
procedures. In a simultaneous examination, if a reassessment is made,
both
countries involved should endeavour to reach a result that avoids double
taxation
for the MNE group.
E. Safe harbours
i) Introduction
4.94 Applying the arm's length principle can be a fact-intensive process
and
can require proper judgment. It may present uncertainty and may impose a
heavy
administrative burden on taxpayers and tax administrations that can be
exacerbated by both legislative and compliance complexity. These facts
have
lead OECD Member countries to consider whether safe harbour rules would
be
appropriate in the transfer pricing area.
OECD TRANSFER PRICING GUIDELINES
IV-32 July 1995
©OECD
ii) Definition and concept of safe harbours
4.95 The difficulties in applying the arm's length principle may be
ameliorated by providing circumstances in which taxpayers could follow a
simple
set of rules under which transfer prices would be automatically accepted
by the
national tax administration. Such provisions would be referred to as a
"safe
harbour" or "safe haven". Formally, in the context of
taxation, a safe harbour is a
statutory provision that applies to a given category of taxpayers and
that relieves
eligible taxpayers from certain obligations otherwise imposed by the tax
code by
substituting exceptional, usually simpler obligations. In the specific
instance of
transfer pricing, the administrative requirements of a safe harbour may
vary from
a total relief of targeted taxpayers from the obligation to conform with
a
country's transfer pricing legislation and regulations to the obligation
to comply
with various procedural rules as a condition for qualifying for the safe
harbour.
These rules could, for example, require taxpayers to establish transfer
prices or
results in a specific way, e.g. by applying a simplified transfer
pricing method
provided by the tax administration, or satisfy specific information
reporting and
record maintenance provisions with regard to controlled transactions.
Such an
approach requires a more substantial involvement from the tax
administration,
since the taxpayer's compliance with the procedural rules may need to be
monitored.
4.96 A safe harbour may have two variants regarding the taxpayer's
conditions of controlled transactions: certain transactions are excluded
from the
scope of application of transfer pricing provisions (in particular by
setting
thresholds), or the rules applying to them are simplified (for example
by
designating ranges within which prices or profits must fall). Both safe
harbour
targets may need to be revised and published periodically by the tax
authorities.
Safe harbours do not include procedures whereby a tax administration and
a
taxpayer agree on transfer pricing in advance of the controlled
transactions
(advance pricing arrangements), which are discussed in Section F of this
chapter.
The discussion in this section does not extend to tax provisions
designed to
prevent "excessive" debt in a foreign subsidiary ("thin
capitalisation" rules),
which will be the subject of subsequent work.
4.97 The provision of safe harbours raises significant questions about
the
degree of arbitrariness that would be created in determining transfer
prices by
ADMINISTRATIVE APPROACHES
July 1995 IV-33
©OECD
eligible taxpayers, tax planning opportunities, and the potential for
double
taxation resulting from the possible incompatibility of the safe
harbours with the
arm's length principle.
iii) Factors supporting use of safe harbours
4.98 The basic objectives of safe harbours are as follows: simplifying
compliance for eligible taxpayers in determining arm's length conditions
for
controlled transactions; providing assurance to a category of taxpayers
that the
price charged or received on controlled transactions will be accepted by
the tax
administration without further review; and relieving the tax
administration from
the task of conducting further examination and audits of such taxpayers
with
respect to their transfer pricing.
a) Compliance relief
4.99 Application of the arm's length principle may require collection
and
analysis of data that may be difficult to obtain and/or evaluate. In
certain cases,
such complexity may be disproportionate to the size of the corporation
or its level
of controlled transactions.
4.100 Safe harbours could significantly ease compliance by exempting
taxpayers from such provisions. Designed as a comfort mechanism, they
allow
greater flexibility especially in the areas where there are no matching
or comparable
arm's length prices. Under a safe harbour, taxpayers would know in
advance the
range of prices or profit rates within which the corporation must fall
in order to
qualify for the safe harbour. Meeting such conditions would merely
require the
application of a simplified method, predominantly a measure of
profitability, which
would spare the taxpayer the search for comparables, thus saving time
and
resources which would otherwise be devoted to determining transfer
prices.
b) Certainty
4.101 Another advantage provided by a safe harbour would be the
certainty
that the taxpayer's transfer prices will be accepted by the tax
administration.
Qualifying taxpayers would have the assurance that they would not be
subject to
an audit or reassessment in connection with their transfer prices. The
tax
administration would accept without any further scrutiny any price or
result
OECD TRANSFER PRICING GUIDELINES
IV-34 July 1995
©OECD
exceeding a minimum threshold or falling within a predetermined range.
For that
purpose, taxpayers could be provided with relevant parameters which
would
provide a transfer price or a result deemed appropriate to the tax
administration.
This could be, for example, a series of sector-specific mark-ups or
profit
indicators.
c) Administrative simplicity
4.102 A safe harbour would result in a degree of administrative
simplicity for
the tax administration. Once the eligibility of certain taxpayers to the
safe harbour
has been established, those taxpayers would require minimal examination
with
respect to transfer prices or results of controlled transactions. Tax
administrations could then allocate more resources to the examination of
other
transactions and taxpayers.
iv) Problems presented by use of safe harbours
4.103 The availability of safe harbours for a given category of
taxpayers
would have a number of adverse consequences which must carefully be
weighed
by tax administrations against the expected benefits. These concerns
stem from
the facts that:
a) the implementation of a safe harbour in a
given country would not only
affect tax calculations within that jurisdiction, but would also impinge
on the tax calculations of associated enterprises in other
jurisdictions,
and
b) it is difficult to establish satisfactory
criteria for defining safe harbours,
and accordingly they can potentially produce prices or results that may
not be consistent with the arm's length principle.
The issue can be examined from several perspectives.
4.104 Under a safe harbour, taxpayers may not be required to follow a
specific pricing method, or even have a pricing method for tax purposes.
Where a
safe harbour imposes a simplified transfer pricing method, it would be
unlikely to
correspond in all cases to the most appropriate method applicable to the
facts and
circumstances of the taxpayer under the regular transfer pricing
provisions. For
ADMINISTRATIVE APPROACHES
July 1995 IV-35
©OECD
example, a safe harbour may impose a minimum profit percentage under a
profit
method when the taxpayer could have used the comparable uncontrolled
price
method or other transaction-based methods.
4.105 Such an occurrence could be considered as inconsistent with the
arm's
length principle, which requires the use of a pricing method that is
consistent with
the conditions that independent parties engaged in comparable
transactions under
comparable conditions would have agreed upon in the open market. Some
sectors where goods, commodities or services are standard and market
prices are
widely publicised such as, for example, the oil and mining industries
and the
financial services sector could conceivably apply a safe harbour with a
higher
degree of precision and, thus, a lesser departure from the arm's length
principle.
But even these industry segments produce a wide range of results which a
safe
harbour would be unlikely to be able to accommodate to the satisfaction
of the
tax administrations. And the existence of published market prices would
presumably also facilitate the use of transaction-based methods, in
which case
there may be no need for a safe harbour.
4.106 Even assuming that the pricing method imposed under a specific
safe
harbour is appropriate to the facts and circumstances of particular
cases, the
application of the safe harbour would nonetheless sacrifice accuracy in
the
reporting of transfer prices. This is inherent in safe harbours, under
which
transfer prices are predominantly established by reference to a standard
target as
opposed to the individual facts and circumstances of the transaction, as
under the
arm's length principle. It follows that the prices or results that
produce
compliance with the standard target may not be arm's length prices or
results.
4.107 Safe harbours are likely to be arbitrary since they rarely fit
exactly the
varying facts and circumstances even of enterprises in the same trade or
business.
This arbitrariness could be minimized only with great difficulty by
devoting a
considerable amount of skilled labour to collecting, collating, and
continuously
revising a pool of information about prices and pricing developments.
Obtaining
relevant information for establishing and monitoring safe harbour
parameters
may therefore impose administrative burdens on tax administrations,
because
such information may not be readily available and may be accessible only
through in-depth transfer pricing inquiries. Therefore, the extensive
research
necessary to set the safe harbour parameters accurately enough to
satisfy the
OECD TRANSFER PRICING GUIDELINES
IV-36 July 1995
©OECD
arm's length principle would jeopardize one of the purposes of a safe
harbour,
that of administrative simplicity.
a) Risk of double taxation and mutual agreement procedure
difficulties
4.108 From a practical point of view, the most important concern raised
by a
safe harbour is its international impact. Safe harbours could affect the
pricing
strategy of corporations. The existence of safe harbour
"targets" may induce
taxpayers to modify the prices that they would otherwise have charged to
controlled parties, in order to increase profits to meet the targets and
thereby
avoid transfer pricing scrutiny on audit. The concern of possible
overstatement of
taxable income in the country providing the safe harbour is greater
where that
country imposes significant penalties for understatement of tax or
failure to meet
documentation requirements, with the result that there may be added
incentive to
ensure that the transfer pricing is accepted without further review.
4.109 Taxpayers may value the certainty provided by the safe harbour to
the
point where they would raise the prices charged to associated
enterprises for the
purpose of qualifying for the safe harbour, notwithstanding the fact
that those
transfer prices would be above the relevant taxpayer's arm's length
prices taking
into account its specific circumstances. In that case, the safe harbour
would work
to the benefit of the tax administration providing the safe harbour, as
more
taxable income would be reported by such domestic taxpayers. On the
other
hand, the safe harbour would penalize both the foreign associated
enterprises and
their tax administrations, since less profits and taxable income would
be reported
in their respective jurisdictions. This would create an issue with
respect to the
proper sharing of tax revenue between tax jurisdictions.
4.110 Indeed, in such cases, the tax administration of the jurisdiction
adversely affected may not be in a position to accept the prices charged
to their
taxpayers in connection with transactions with associated enterprises in
the safe
harbour country. The prices may differ from those obtained in these
jurisdictions
by the application of transfer pricing methods consistent with the arm's
length
principle. It would be expected that foreign tax administrations would
challenge
prices derived from the application of a safe harbour, with the result
that the
taxpayer would face the prospect of double taxation.
ADMINISTRATIVE APPROACHES
July 1995 IV-37
©OECD
4.111 At the outset, one would argue that the possibility of double
taxation
would nullify the objectives of certainty and simplicity originally
pursued by the
taxpayer in electing the safe harbour. However, taxpayers may consider
that a
moderate level of double taxation is an acceptable price to be paid in
order to
obtain relief from the necessity of complying with complex transfer
pricing rules.
4.112 It follows that double taxation may not, in itself, be a
disqualifying
factor against safe harbours. One may argue that the taxpayer alone
should be
required to make its own decision if the possibility of double taxation
is
acceptable in electing the safe harbour or not. However, in order to
ensure that
taxpayers make such a decision clearly on the basis of this trade-off,
the country
offering the safe harbour would need to make it explicit whether or not
it would
attempt to alleviate any eventual double taxation resulting from the use
of the safe
harbour. Since the safe harbour provides taxpayers with the privilege of
avoiding
any subsequent review or audit of their transfer prices resulting from
the
application of a safe harbour and given the nature of safe harbours,
whose prices
or results are, by design, only a proxy for those obtained under the
arm's length
principle, it is only appropriate that the taxpayer should equally be
prepared, in
electing the safe harbour, to bear any ensuing international double
taxation
resulting from the non-acceptance by a foreign tax administration of the
transfer
prices reported under the safe harbour. This would logically imply that
taxpayers
electing the safe harbour should generally be prohibited from bringing
double
taxation issues before the competent authorities should the use of the
safe harbour
result in international double taxation. Tax relief from double taxation
attributable to a taxpayer's election of a safe harbour should be
granted in the
foreign country only if the taxpayer can prove that the results of
meeting the safe
harbour are consistent with the arm's length principle.
4.113 However, transfer pricing adjustments of foreign tax administrations
will be complicated when the MNE has chosen a safe harbour in another
country,
because the taxpayer is likely to dispute the adjustment to prevent
double
taxation. The prospect that mutual agreement procedures are generally
not
available to adjust prices or results downwards that have been set under
a safe
harbour regime may therefore have a detrimental effect on the tax
administration
in the foreign countries.
4.114 The adoption of safe harbour regimes in one country may require
that
the other countries' tax administrations examine the transfer pricing
policy of all
OECD TRANSFER PRICING GUIDELINES
IV-38 July 1995
©OECD
companies associated with enterprises that have elected a safe harbour
in order to
identify all cases of potential inconsistency with the arm's length
principle.
Failure to do so could amount to a transfer of tax revenue from those
countries to
the country providing the safe harbour. Consequently, any administrative
simplicity gained by the tax administration of the safe harbour country
would be
obtained at the expense of other countries, which, in order to protect
their own tax
base, would have to determine systematically whether the prices or
results
permitted under the safe harbour are consistent with what would be
obtained by
the application of their own transfer pricing rules. The administrative
burden
saved by the country offering the safe harbour would therefore be
shifted to the
foreign jurisdictions.
4.115 Double taxation possibilities would exist not only where a single
country adopts a safe harbour. Adoption of a safe harbour by more than
one
country would not avoid double taxation if each taxing jurisdiction were
to adopt
conflicting approaches and methods. The parameters of two countries'
safe
harbours for specific industry segments are likely to deviate since both
countries
would want to safeguard their revenues. In theory, international
coordination
could achieve the degree of harmonization among national systems that
would be
required to prevent double taxation. However, in practice, it is most
unlikely that
two jurisdictions could harmonize conflicting safe harbours that would
eliminate
double taxation.
b) Possibility of opening avenues for tax planning
4.116 Safe harbours would also provide taxpayers with tax planning
opportunities. Enterprises may have an incentive to modify their
transfer prices in
order to shift taxable income to other jurisdictions. This may also
possibly
induce tax avoidance, to the extent that artificial arrangements are
entered into for
the purpose of exploiting the safe harbour provisions.
4.117 If a safe harbour were based on an industry average, tax planning
opportunities might exist for taxpayers with better than average
profitability. For
example, a cost-efficient company selling at the arm's length price may
be
earning a mark up of 15 percent on controlled sales. This corporation
would have
an incentive to elect a safe harbour providing for a 10 percent mark up.
The
company would, under the safe harbour, be taxed on a scaled-down profits
figure,
notwithstanding the fact that the underlying transfer prices on
controlled
ADMINISTRATIVE APPROACHES
July 1995 IV-39
©OECD
transactions would be significantly below the arm's length prices.
Consequently,
taxable income would be shifted out of the country. When applied on a
large
scale, this could mean significant revenue lost for the country offering
the safe
harbour. By design, the tax administration would have no recourse to
counter
such instances of profit shifting.
4.118 Safe harbours may potentially result in the international
under-taxation
of income, to the extent that they result in prices or profits not
approximating the
arm's length principle and allow taxable income to be shifted to low tax
countries
or tax havens.
4.119 Whether a country is prepared possibly to suffer some erosion of
its
own tax base in implementing a safe harbour is for that country to
decide. The
basic trade-off in making such a policy decision is between the scope
and
attractiveness of the safe harbour for taxpayers on the one hand, and
tax revenue
erosion on the other. The more attractive a safe harbour is for a
taxpayer, the
more taxpayers will elect to use it, thereby reducing the taxation
authority's
administrative burden. On the other hand, the more attractive the safe harbour
is,
the more tax revenue is likely to be lost due to under-reporting of
income.
However, the magnitude of the respective costs and benefits of such a
trade-off is
irrelevant if the tax administration is not prepared, as a matter of
principle, to
surrender any discretionary power with respect to the assessment of a
taxpayer's
liability.
c) Equity and uniformity issues
4.120 Finally, safe harbours raise equity and uniformity issues. By
implementing a safe harbour, one would create two distinct sets of rules
in the
transfer pricing area, one requiring conformity of prices with the arm's
length
principle and another requiring conformity with a different and
simplified set of
conditions. Since criteria would necessarily be required to
differentiate those
taxpayers eligible for the safe harbour, similar and possibly competing
taxpayers
could, in some circumstances, find themselves on opposite sides of the
safe
harbour threshold, thus resulting in similar taxpayers enjoying
different tax
treatment: one meeting the safe harbour rules and thus being relieved
from
regular compliance provisions and the other being obliged to do business
exclusively in conformity with the arm's length principle (either
because the
enterprise in fact deals at arm's length or because it is subject to
transfer pricing
OECD TRANSFER PRICING GUIDELINES
IV-40 July 1995
©OECD
legislation that is based on the arm's length principle). Preferential
tax treatment
under safe harbour regimes for a specific category of taxpayers could
entail
discrimination and competitive distortions.
v) Recommendations on use of safe harbours
4.121 The foregoing analysis suggests that while safe harbours could
accomplish a number of objectives relating to the compliance with and
administration of transfer pricing provisions, they raise fundamental
problems.
They could potentially have perverse effects on the pricing decisions of
enterprises
engaged in controlled transactions. They may also have a negative impact
on the
tax revenues of the country implementing the safe harbour as well as on
the
countries whose associated enterprises engage in controlled transactions
with
taxpayers electing a safe harbour. More importantly, safe harbours are
generally
not compatible with the enforcement of transfer prices consistent with
the arm's
length principle. These drawbacks must be measured against the expected
benefits
of safe harbours, certainty, and compliance simplicity on the taxpayer's
side and
relief from administrative burden on the tax administration's side.
4.122 Under the normal administration of tax laws, certainty cannot be
guaranteed for the taxpayer, because administrations must retain the
ability to
review any aspect of a taxpayer's income tax assessment, including the
area of
transfer pricing. Fundamentally, the introduction of a safe harbour
means that the
tax administration surrenders a portion of its discretionary power in
favour of
automatic rules. Tax administrations may not be prepared to go that far,
and may
consider it essential to retain the ability to verify the accuracy of a
taxpayer's selfassessed
tax liability and its basis. Compliance simplicity may also often be
subordinated to other tax policy objectives such as reasonable and
adequate
documentation and reporting and the prevention of tax avoidance.
4.123 On the other hand, tax administrations have considerable
flexibility in
administering tax law. They can choose to concentrate more resources on
cases
involving large taxpayers or an important proportion of controlled
transactions
and show more tolerance towards smaller taxpayers. While more flexible
administrative practices towards smaller taxpayers are not a substitute
for a
formal safe harbour, they may achieve, to a lesser extent, the same
objectives
pursued by safe harbours. In view of the above considerations, special
statutory
derogations for categories of taxpayers in the determination of transfer
pricing are
ADMINISTRATIVE APPROACHES
July 1995 IV-41
©OECD
not generally considered advisable, and consequently the use of safe
harbours is
not recommended.
F. Advance pricing arrangements
i) Definition and concept of advance pricing arrangements
4.124 An advance pricing arrangement ("APA") is an arrangement
that
determines, in advance of controlled transactions, an appropriate set of
criteria
(e.g. method, comparables and appropriate adjustments thereto, critical
assumptions as to future events) 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.
4.125 One key issue in the concept of APAs is how specific they can be
in
prescribing a taxpayer's transfer pricing over a period of years, for
example
whether only the transfer pricing methodology or more particular results
can be
fixed in a particular case. In general, great care must be taken if the
APA goes
beyond the methodology, the way it will be applied, and the critical
assumptions,
because more specific conclusions rely on predictions about future
events.
4.126 The reliability of any prediction used in an APA depends both on
the
nature of the prediction and the critical assumptions on which the
prediction is
based. For example, it would not be reasonable to assert that the arm's
length
short-term borrowing rate for a certain corporation on intra-group
borrowings
will remain at six percent during the entire coming three years. It
would be more
plausible to predict that the rate will be LIBOR plus a fixed
percentage. The
prediction would become even more reliable if an appropriate critical
assumption
were added regarding the company's credit rating (e.g. the addition to
LIBOR will
change if the credit rating changes).
4.127 As another example, it would not be appropriate to specify a profit
split
formula between associated enterprises if it is expected that the
allocation of
functions between the enterprises will be unstable. It would, however,
be
OECD TRANSFER PRICING GUIDELINES
IV-42 July 1995
©OECD
possible to prescribe a profit split formula if the role of each
enterprise were
articulated in critical assumptions. In certain cases, it might even be
possible to
make a reasonable prediction on the appropriateness of an actual profit
split ratio
if enough assumptions were provided.
4.128 In deciding how specific an APA can be in a particular case, tax
administrations should recognize that predictions of absolute future
profit
experience seems least plausible. It may be possible to use profit
ratios of
independent enterprises as comparables, but these also are often
volatile and hard
to predict. Use of appropriate critical assumptions and use of ranges
may
enhance the reliability of predictions. Historical data in the industry
in question
can also be a guide.
4.129 In sum, the reliability of a prediction depends on the facts and
circumstances of each actual case. Taxpayers and tax administrations
need to pay
close attention to the reliability of a prediction when considering the
scope of an
APA. Unreliable predictions should not be included in APAs. The
appropriateness of a method and its application can usually be
predicted, and the
relevant critical assumptions made, with more reliability than future
results (price
or profit level).
4.130 Some countries allow for unilateral arrangements where the tax
administration and the taxpayer in its jurisdiction establish an
arrangement
without the involvement of other interested tax administrations.
However, a
unilateral APA may affect the tax liability of associated enterprises in
other tax
jurisdictions. Where unilateral APAs are permitted, the competent
authorities of
other interested jurisdictions should be informed about the procedure as
early as
possible to determine whether they are willing and able to consider a
bilateral
arrangement under the mutual agreement procedure.
4.131 Because of concerns over double taxation, most countries prefer
bilateral or multilateral APAs (i.e. an arrangement in which two or more
countries concur), and indeed some countries will not grant a unilateral
APA (i.e.
an arrangement between the taxpayer and one tax administration) to
taxpayers in
their jurisdiction. The bilateral (or multilateral) approach is far more
likely to
ensure that the arrangements will reduce the risk of double taxation,
will be
equitable to all tax administrations and taxpayers involved, and will
provide
greater certainty to the taxpayers concerned. It is also the case in
some countries
ADMINISTRATIVE APPROACHES
July 1995 IV-43
©OECD
that domestic provisions do not permit the tax administrations to enter
into
binding agreements directly with the taxpayers, so that APAs can be
concluded
with the competent authority of a treaty partner only under the mutual
agreement
procedure. For purposes of the discussion in this Part, an APA is not
intended to
include a unilateral arrangement except where specific reference to a
unilateral
APA is made.
4.132 Tax administrations may find APAs particularly useful in profit
allocation or income attribution issues arising in the context of global
securities
and commodity trading operations, and also in handling multilateral cost
contribution arrangements. The concept of APAs also may be useful in
resolving
issues raised under Article 7 of the OECD Model Tax Convention relating
to
allocation problems, permanent establishments, and branch operations.
4.133 APAs, including unilateral ones, differ in some ways from more
traditional private rulings that some tax administrations issue to
taxpayers. An
APA generally deals with factual issues, whereas more traditional
private rulings
tend to be limited to addressing questions of a legal nature based on
facts
presented by a taxpayer. The facts underlying a private ruling request
may not be
questioned by the tax administration, whereas in an APA the facts are
likely to be
thoroughly analysed and investigated. In addition, an APA usually covers
several
transactions, several types of transactions on a continuing basis, or
all of a
taxpayer's international transactions for a given period of time. In
contrast, a
private ruling request usually is binding only for a particular
transaction.
4.134 The cooperation of the associated enterprises is vital to a
successful
APA negotiation. For example, the associated enterprises ordinarily
would be
expected to provide the tax administrations with the methodology that
they
consider most reasonable under the particular facts and circumstances.
The
associated enterprises also should submit documentation supporting the
reasonableness of their proposal, which would include, for example, data
relating
to the industry, markets, and countries to be covered by the agreement.
In
addition, the associated enterprises may identify uncontrolled
businesses that are
comparable or similar to the associated enterprises' businesses in terms
of the
economic activities performed and the transfer pricing conditions, e.g.
economic
costs and risks incurred, etc., and perform a functional analysis as
described in
Chapter I of this Report.
OECD TRANSFER PRICING GUIDELINES
IV-44 July 1995
©OECD
4.135 Typically, associated enterprises are allowed to participate in
the
process of obtaining an APA, by presenting the case to and negotiating
with the
tax administrations concerned, providing necessary information, and
reaching
agreement on the transfer pricing issues. From the associated
enterprises'
perspective, this ability to participate may be seen as an advantage
over the
conventional mutual agreement procedure.
4.136 At the conclusion of an APA process, the tax administrations
should
provide confirmation to the associated enterprises in their jurisdiction
that no
transfer pricing adjustment will be made as long as the taxpayer follows
the terms
of the arrangements. There should also be a provision in an APA (perhaps
by
reference to a range) that provides for possible revision or
cancellation of the
arrangement for future years when business operations change
significantly, or
when uncontrolled economic circumstances (e.g., significant changes in
currency
exchange rates) critically affect the reliability of the methodology in
a manner
that independent enterprises would consider significant for purposes of
their
transfer pricing.
4.137 An APA may cover all of the transfer pricing issues of a taxpayer
(as is
preferred by some countries) or may provide a flexibility to the
taxpayer to limit
the APA request to specified affiliates and intercompany transactions.
An APA
would apply to prospective years and transactions and the actual term
would
depend on the industry, products or transactions involved. The
associated
enterprises may limit their request to specified prospective tax years.
An APA can
provide an opportunity to apply the agreed transfer pricing methodology
to
resolve similar transfer pricing issues in open prior years. However,
this
application would require the agreement of the tax administration, the
taxpayer,
and, where appropriate, the treaty partner.
4.138 Each tax administration involved in the APA will naturally wish to
monitor compliance with the APA by the taxpayers in its jurisdiction,
and this is
generally done in two ways. First, it may require a taxpayer that has
entered into
an APA to file annual reports demonstrating the extent of its compliance
with the
terms and conditions of the APA and that critical assumptions remain
relevant.
Second, the tax administration may continue to examine the taxpayer as
part of
the regular audit cycle but without reevaluating the methodology.
Instead, the tax
administration may limit the examination of the transfer pricing to
verifying the
initial data relevant to the APA proposal and determining whether or not
the
ADMINISTRATIVE APPROACHES
July 1995 IV-45
©OECD
taxpayer has complied with the terms and conditions of the APA. With
regard to
transfer pricing, a tax administration may also examine the reliability
and
accuracy of the representations in the APA and annual reports and the
accuracy
and consistency of how the particular methodology has been applied. All
other
issues not associated with the APA fall under regular audit
jurisdiction.
4.139 An APA should be subject to cancellation, even retroactively, in
the
case of fraud or misrepresentation of information during an APA
negotiation, or
when a taxpayer fails to comply with the terms and conditions of an APA.
Where
an APA is proposed to be cancelled or revoked, the tax administration
proposing
the action should notify the other tax administrations of its intention
and of the
reasons for such action.
ii) Possible approaches for legal and administrative rules
governing
advance pricing arrangements
4.140 APAs involving the competent authority of a treaty partner should
be
considered within the scope of the mutual agreement procedure under
Article 25
of the OECD Model Tax Convention, even though such arrangements are not
expressly mentioned there. Paragraph 3 of that Article provides that the
competent authorities shall endeavour to resolve by mutual agreement any
difficulties or doubts arising as to the interpretation or application
of the
Convention. Although paragraph 32 of the Commentary indicates that the
matters covered by this paragraph are difficulties of a general nature
concerning a
category of taxpayers, it specifically acknowledges that the issues may
arise in
connection with an individual case. In a number of cases, APAs arise
from cases
where the application of transfer pricing to a particular category of
taxpayer gives
rise to doubts and difficulties. Paragraph 3 of Article 25 also
indicates that the
competent authorities may consult together for the elimination of double
taxation
in cases not provided for in the Convention. Bilateral APAs should fall
within
this provision because they have as one of their objectives the
avoidance of
double taxation. Even though the Convention provides for transfer
pricing
adjustments, it specifies no particular methodologies or procedures other
than the
arm's length principle as set out in Article 9. Thus, it could be
considered that
APAs are authorised by paragraph 3 of Article 25 because the specific
transfer
pricing cases subject to an APA are not otherwise provided for in the
Convention.
The exchange of information provision in Article 26 also could
facilitate APAs,
OECD TRANSFER PRICING GUIDELINES
IV-46 July 1995
©OECD
as it provides for cooperation between competent authorities in the form
of
exchanges of information.
4.141 Tax administrations might additionally rely on general domestic
authority to administer taxes as the authority for entering into APAs.
In some
countries tax administrations may be able to issue specific
administrative or
procedural guidelines to taxpayers describing the appropriate tax
treatment of
transactions and the appropriate pricing methodology. As mentioned
above, the
tax codes of some OECD Member countries include provisions that allow
taxpayers to obtain specific rulings for different purposes. Even though
these
rulings were not designed specifically to cover APAs, they may be broad
enough
to be used to include APAs.
4.142 Some countries lack the basis in their domestic law to enter into
APAs.
However, when a tax convention contains a clause regarding the mutual
agreement procedure similar to Article 25 of the OECD Model Tax
Convention,
the competent authorities generally should be allowed to conclude an
APA, if
transfer pricing issues were otherwise likely to result in double
taxation, or would
raise difficulties or doubts as to the interpretation or application of
the
Convention. Such an arrangement would be legally binding for both States
and
would create rights for the taxpayers involved. Inasmuch as double tax
treaties
take precedence over domestic law, the lack of a basis in domestic law
to enter
into APAs would not prevent application of APAs on the basis of a mutual
agreement procedure.
iii) Advantages of advance pricing arrangements
4.143 An APA programme can assist taxpayers by eliminating uncertainty
through enhancing the predictability of tax treatment in international
transactions.
Provided the critical assumptions are met, an APA can provide the
taxpayers
involved with certainty in the tax treatment of the transfer pricing
issues covered
by the APA for a specified period of time. In some cases, an APA may
also
provide an option to extend the period of time to which it applies. When
the term
of an APA expires, the opportunity may also exist for the relevant tax
administrations and taxpayers to renegotiate the APA. Because of the
certainty
provided by an APA, a taxpayer may be in a better position to predict
its tax
liabilities, thereby providing a tax environment that is favourable for
investment.
ADMINISTRATIVE APPROACHES
July 1995 IV-47
©OECD
4.144 APAs can provide an opportunity for both tax administrations and
taxpayers to consult and cooperate in a non-adversarial spirit and
environment.
The opportunity to discuss complex tax issues in a less confrontational
atmosphere than in a transfer pricing examination can stimulate a free
flow of
information among all parties involved for the purpose of coming to a
legally
correct and practicably workable result. The non-adversarial environment
may
also result in a more objective review of the submitted data and information
than
may occur in a more adversarial context (e.g. litigation). The close
consultation
and cooperation required between the tax administrations in an APA
program
also leads to closer relations with treaty partners on transfer pricing
issues.
4.145 An APA may prevent costly and time-consuming examinations and
litigation of major transfer pricing issues for taxpayers and tax
administrations.
Once an APA has been agreed, less resources may be needed for subsequent
examination of the taxpayer's return, because more information is known
about
the taxpayer. It may still be difficult, however, to monitor the
application of the
arrangement. The APA process itself may also present time savings for
both
taxpayers and tax administrations over the time that would be spent in a
conventional examination, although in the aggregate there may be no net
time
savings, for example, in jurisdictions that do not have an audit
procedure and
where the existence of an APA may not directly affect the amount of
resources
devoted to compliance.
4.146 Bilateral and multilateral APAs substantially reduce or eliminate
the
possibility of juridical or economic double or non taxation since all
the relevant
countries participate. By contrast, unilateral APAs do not provide
certainty in the
reduction of double taxation because tax administrations affected by the
transactions covered by the APA may consider that the methodology
adopted
does not give a result consistent with the arm's length principle. In
addition,
bilateral and multilateral APAs can enhance the mutual agreement
procedure by
significantly reducing the time needed to reach an agreement since
competent
authorities are dealing with current data as opposed to prior year data
that may be
difficult and time-consuming to produce.
4.147 The disclosure and information aspects of an APA programme as well
as the cooperative attitude under which an APA can be negotiated may
assist tax
administrations in gaining insight into complex international
transactions
undertaken by MNEs. An APA programme can improve knowledge and
OECD TRANSFER PRICING GUIDELINES
IV-48 July 1995
©OECD
understanding of highly technical and factual circumstances in areas
such as
global trading and the tax issues involved. The development of
specialist skills
that focus on particular industries or specific types of transactions
will enable tax
administrations to give better service to other taxpayers in similar
circumstances.
Through an APA programme tax administrations have access to useful
industry
data and analysis of pricing methodologies in a cooperative environment.
iv) Disadvantages relating to advance pricing arrangements
4.148 Unilateral APAs may present significant problems for tax
administrations
and taxpayers alike. From the point of view of other tax administrations,
problems
arise because they may disagree with the APA's conclusions. From the
point of
view of the associated enterprises involved, one problem is the possible
effect on
the behaviour of the associated enterprises. Unlike bilateral or multilateral
APAs,
the use of unilateral APAs may not lead to an increased level of
certainty for the
taxpayer involved and a reduction in economic or juridical double
taxation for the
MNE group. If the taxpayer accepts an arrangement that over-allocates
income to
the country making the APA in order to avoid lengthy and expensive
transfer
pricing enquiries or excessive penalties, the administrative burden
shifts from the
country providing the APA to other tax jurisdictions. Taxpayers should
not feel
compelled to enter into APAs for these reasons.
4.149 Another problem with a unilateral APA is the issue of
corresponding
adjustments. The flexibility of an APA may lead the taxpayer and the
related
party to accommodate their pricing to the range of permissible pricing in
the
APA. In a unilateral APA, it is critical that this flexibility preserve
the arm's
length principle since a foreign competent authority is not likely to
allow a
corresponding adjustment arising out of an APA that is inconsistent, in
its view,
with the arm's length principle.
4.150 Another possible disadvantage would arise if an APA involved an
unreliable prediction on changing market conditions without adequate
critical
assumptions, as discussed above. To avoid the risk of double taxation,
it is
necessary for an APA program to remain flexible, because a static APA
may not
satisfactorily reflect arm's length conditions.
4.151 An APA program may initially place a strain on transfer pricing
audit
resources, as tax administrations will generally have to divert
resources
ADMINISTRATIVE APPROACHES
July 1995 IV-49
©OECD
earmarked for other purposes (e.g. examination, advising, litigation,
etc.) to the
APA programme. Demands may be made on the resources of a tax
administration by taxpayers seeking the earliest possible conclusion to
an APA
request, keeping in mind their business objectives and time scales, and
the APA
programme as a whole will tend to be led by the demands of the business
community. These demands may not coincide with the resource planning of
the
tax administrations, thereby making it difficult to process efficiently
both the
APAs and other equally important work. Renewing an APA, however, is
likely to
be less time-consuming than the process of initiating an APA. The
renewal
process may focus on updating and adjusting facts, business and economic
criteria, and computations. In the case of bilateral arrangements, the
agreement of
the competent authorities of both Contracting States is to be obtained
on the
renewal of an APA to avoid double taxation (or non-taxation).
4.152 Another potential disadvantage could occur where one tax
administration has undertaken a number of bilateral APAs which involve
only
certain of the associated enterprises within an MNE group. A tendency
may exist
to harmonise the basis for concluding later APAs in a way similar to
those
previously concluded without sufficient regard being had to the
conditions
operating in other markets. Care should therefore be taken with
interpreting the
results of previously concluded APAs as being representative across all
markets.
4.153 Concerns have also been expressed that, because of the nature of
the
APA procedure, it will interest taxpayers with a good voluntary
compliance
history. Experience in some countries has shown that, most often, taxpayers
which would be interested in APAs are very large corporations which
would be
audited on a regular basis, with their pricing methodology then being
examined in
any event. The difference in the examination conducted of their transfer
pricing
would be one of timing rather than extent. As well, it has not been
demonstrated
that APAs will be of interest solely or principally to such taxpayers.
Indeed, there
are some early indications that taxpayers, having experienced difficulty
with tax
administrations on transfer pricing issues and not wishing these
difficulties to
continue, are often interested in applying for an APA. There is then a
serious
danger of audit resources and expertise being diverted to these
taxpayers and
away from the investigation of less compliant taxpayers, where these
resources
could be better deployed in reducing the risk of losing tax revenue. The
balance
of compliance resources may be particularly difficult to achieve since
an APA
programme tends to require highly experienced and often specialised
staff.
OECD TRANSFER PRICING GUIDELINES
IV-50 July 1995
©OECD
Requests for APAs may be concentrated in particular areas or sectors,
e.g. global
trading, and this can overstretch the specialist resources already
allocated to those
areas by the authorities. Tax administrations require time to train
experts in
specialist fields in order to meet unforeseeable demands from taxpayers
for APAs
in those areas.
4.154 In addition to the foregoing concerns, there are a number of
possible
pitfalls as described below that could arise if an APA program were
improperly
administered, and tax administrations who use APAs should make strong
efforts
to eliminate the occurrence of these problems as APA practice evolves.
4.155 For example, an APA might seek more detailed industry and taxpayer
specific information than would be requested in a transfer pricing
examination.
In principle, this should not be the case and the documentation required
for an
APA should not be more onerous than for an examination, except for the
fact that
in an APA the tax administration will need to have details of
predictions and the
basis for those predictions, which may not be central issues in a
transfer pricing
examination that focuses on completed transactions. In fact, an APA
should seek
to limit the documentation, as discussed above, and focus the
documentation
more closely on the issues in light of the taxpayer's business
practices. Tax
administrations need to recognize that :
a) publicly available information on
competitors and comparables is
limited;
b) not all taxpayers have the capacity to
undertake in-depth market
analyses; and
c) only parent companies may be knowledgeable
about group pricing
policies.
4.156 Another possible concern is that an APA may allow the tax
administration to make a closer study of the transactions at issue than
would
occur in the context of a transfer pricing examination, depending on the
facts and
circumstances. The taxpayer must provide detailed information relating
to its
transfer pricing and satisfy any other requirements imposed for the
verification of
compliance with the terms and conditions of the APA. At the same time,
the
taxpayer is not sheltered from normal and routine examinations by the
tax
ADMINISTRATIVE APPROACHES
July 1995 IV-51
©OECD
administration on other issues. An APA also does not shelter a taxpayer
from
examination of its transfer pricing activities. The taxpayer may still
have to
establish that it has complied in good faith with the terms and
conditions of the
APA, that the material representations in the APA remain valid, that the
supporting data used in applying the methodology were correct, that the
critical
assumptions underlying the APA are still valid and are applied
consistently, and
that the methodology is applied consistently. Tax administrations
should,
therefore, seek to ensure that APA procedures are not unnecessarily
cumbersome
and that they do not make more demand of taxpayers than are strictly
required by
the scope of the APA application.
4.157 Problems could also develop if tax administrations misuse
information
obtained in an APA in their examination practices. If the taxpayer
withdraws
from its APA request or if the taxpayer's application is rejected after
consideration of all of the facts, any nonfactual information provided
by the
taxpayer in connection with the APA request, such as settlement offers,
reasoning, opinions, and judgments, cannot be treated as relevant in any
respect
to the examination. In addition, the fact that a taxpayer has applied
unsuccessfully for an APA should not be taken into account by the tax
administration in determining whether to commence an examination of that
taxpayer.
4.158 Tax administrations also should ensure the confidentiality of
trade
secrets and other sensitive information and documentation submitted to
them in
the course of an APA proceeding. Therefore, domestic rules against
disclosure
should be applied. In a bilateral APA the confidentiality requirements
on treaty
partners would apply, thereby preventing public disclosure of confidential
data.
4.159 An APA program cannot be used by all taxpayers because the
procedure can be expensive and time-consuming and small taxpayers
generally
may not be able to afford it. This is especially true if independent
experts are
involved. APAs may therefore only assist in resolving mainly large
transfer
pricing cases. In addition, the resource implications of an APA program
may
limit the number of requests a tax administration can entertain. In
evaluating
APAs, tax administrations can alleviate these potential problems by
ensuring that
the level of inquiry is adjusted to the size of the international
transactions
involved.
OECD TRANSFER PRICING GUIDELINES
IV-52 July 1995
©OECD
v) Recommendations
a) In general
4.160 At present, only a few OECD Member Countries have experience with
APAs. Those countries which do have some experience seem to be satisfied
so
far, so that it can be expected that under the appropriate circumstances
the
experience with APAs will continue to expand. The success of APA programs
will depend on the care taken in determining the proper degree of
specificity for
the arrangement based on critical assumptions, the proper administration
of the
program, and the presence of adequate safeguards to avoid the pitfalls
described
above, in addition to the flexibility and openness with which all
parties approach
the process.
4.161 There are some continuing issues regarding the form and scope of
APAs that require greater experience for full resolution and agreement
among
Member countries, such as the question of unilateral APAs. While it is
too early
to make a final recommendation whether the expansion of such programmes
should be encouraged, it seems likely that in certain circumstances they
will aid
in resolving transfer pricing disputes. The Committee on Fiscal Affairs
intends to
monitor carefully any expanded use of APAs and to promote greater
consistency
in practice among those countries that choose to use them.
b) Coverage of an arrangement
4.162 When considering the scope of an APA, taxpayers and tax
administrations need to pay close attention to the reliability of any
predictions so
as to exclude unreliable predictions. In general, great care must be
taken if the
APA goes beyond the methodology, its application, and critical
assumptions. See
paragraphs 4.124-4.129.
c) Unilateral versus bilateral (multilateral) arrangements
4.163 Wherever possible, an APA should be concluded on a bilateral or
multilateral basis between competent authorities through the mutual
agreement
procedure of the relevant treaty. A bilateral APA carries less risk of
taxpayers
feeling compelled to enter into an APA or to accept a non-arm's-length
agreement
in order to avoid expensive and prolonged enquiries and possible
penalties. A
ADMINISTRATIVE APPROACHES
July 1995 IV-53
©OECD
bilateral APA also significantly reduces the chance of any profits
either escaping
tax altogether or being doubly taxed, Moreover, concluding an APA
through the
mutual agreement procedure may be the only form that can be adopted by a
tax
administration which lacks domestic legislation to conclude binding
agreements
directly with the taxpayer.
d) Equitable access to APAs for all taxpayers
4.164 As discussed above, the nature of APA proceedings may de facto limit
their accessibility to large taxpayers. The restriction of APAs to large
taxpayers
may raise questions of equality and uniformity, since taxpayers in
identical
situations should not be treated differently. A flexible allocation of
examination
resources may alleviate these concerns. Tax administrations also may
need to
consider the possibility of adopting a streamlined access for small
taxpayers. Tax
administrations should take care to adapt their levels of inquiry, in
evaluating
APAs, to the size of the international transactions involved.
e) Developing working agreements between competent authorities and
improved procedures
4.165 Between those countries that use APAs, greater uniformity in APA
practices could be beneficial to both tax administrations and taxpayers.
Accordingly, the tax administrations of such countries may wish to
consider
working agreements with the competent authorities for the undertaking of
APAs.
These agreements may set forth general guidelines and understandings for
the
reaching of mutual agreement in cases where a taxpayer has requested an
APA
involving transfer pricing issues.
4.166 In addition, bilateral APAs with treaty partners should conform to
certain requirements. For example, the same necessary and pertinent
information
should be made available to each tax administration at the same time,
and the
agreed upon methodology should be in accordance with the arm's length
principle.
G. Arbitration
4.167 As trade and investment have taken on an increasingly
international
character, the tax disputes that, on occasion, arise from such
activities have
OECD TRANSFER PRICING GUIDELINES
IV-54 July 1995
©OECD
likewise become increasingly international. And more particularly, the
disputes
no longer involve simply controversy between a taxpayer and its tax
administration but also concern disagreements between tax
administrations
themselves. In many of these situations, the MNE group is primarily a
stakeholder and the real parties in interest are the governments
involved.
Traditionally, problems of double taxation have been resolved through
the mutual
agreement procedures, as discussed in this Chapter. However, relief is
not
guaranteed under the mutual agreement procedure if the tax
administrations, after
consultation, can reach no agreement.
4.168 Similar problems of resolving conflicting governmental views have
arisen in other settings. In the context of international trade and
investment, the
General Agreement on Tariffs and Trade and its successor the World Trade
Organization have developed increasingly sophisticated procedures and
institutions to resolve international trade disputes. The basic
mechanism has been
the use of what is essentially an arbitral panel composed of independent
persons
who produced a reasoned legal ruling as to the issue in question.
Similarly, the
U.S.-Canada Free Trade Agreement and the expanded North American Free
Trade Agreement provide for an arbitration panel procedure to resolve
disputes
concerning antidumping or countervailing duty issues. Similar arbitral
arrangements are present in the Energy Charter Treaty.
4.169 In the tax area as well, there has been some interest in the use
of
arbitration to resolve tax disputes. Most publicized is the
"Convention dealing
with Transfer Pricing agreed by Member States of the European
Community's
(the "Arbitration Convention"), which came into force on 1
January 1995, but, in
addition, some bilateral tax conventions have provisions for
arbitration. Neither
the Arbitration Convention nor these bilateral treaty provisions have
yet been
applied.
4.170 The possibility of the use of arbitration in tax disputes has been
recognized for some time in the work on the OECD Model Tax Convention.
In
1977, the Commentary on Article 25 mentioned the possibility of
"independent
arbitrators" who could be asked to give "advisory opinions."
The current version
of the Commentary on Article 25 also refers to the possible
"solution" of
arbitration and the Arbitration Convention as well as the developments
in
bilateral conventions concerning arbitration.
ADMINISTRATIVE APPROACHES
July 1995 IV-55
©OECD
4.171 It is in the context of transfer pricing that arbitration has
received the
most attention by the OECD. The 1984 Report contains a discussion of the
use of
arbitration procedures to ensure that corresponding adjustments would be
made
on a consistent basis. After discussing some of the advantages and
disadvantages
of arbitration, the Report concluded that "for the time being"
it was not
appropriate to recommend an arbitration procedure. However, as indicated
above, a number of changes have taken place since the 1984 Report was
written.
The Arbitration Convention referred to above was at that time only in
draft form,
the trade agreement dispute resolution procedures had not been so fully
developed, bilateral tax conventions had not begun to adopt arbitration
procedures, and the dramatic increase of interest in transfer pricing
questions with
their attendant potential for tax controversy had not yet occurred.
Accordingly, it
seems appropriate to analyze again and in more detail whether the introduction
of
a tax arbitration procedure would be an appropriate addition to
international tax
relations. Therefore, the Committee on Fiscal Affairs has agreed to
undertake a
study of this topic and to supplement these Guidelines with the
conclusions of
that study when it is completed.
July 1995 V-1
©OECD
Chapter V
Documentation
A. Introduction
5.1 This Chapter provides general guidance for tax administrations to
take into account in developing rules and/or procedures on documentation
to be
obtained from taxpayers in connection with a transfer pricing inquiry.
It also
provides guidance to assist taxpayers in identifying documentation that
would
be most helpful in showing that their controlled transactions satisfy
the arm's
length principle and hence in resolving transfer pricing issues and
facilitating
tax examinations.
5.2 Documentation obligations may be affected by rules governing
burden of proof in the relevant jurisdiction. In most jurisdictions, the
tax
administration bears the burden of proof. Thus, the taxpayer need not
prove the
correctness of its transfer pricing in such cases unless the tax
administration
makes a prima facie case showing that the pricing is inconsistent with
the arm's
length principle. The discussion of documentation in this Chapter is not
intended to impose a greater burden on taxpayers than is required by
domestic
rules. However, it should be noted that even where the burden of proof
is on
the tax administration, the tax administration might still reasonably
oblige the
taxpayer to produce documentation about its transfer pricing, because
without
adequate information the tax administration would not be able to examine
the
case properly. In fact, where the taxpayer does not provide adequate
documentation, there may be a shifting of burden of proof in some
jurisdictions
in the manner of a rebuttable presumption in favour of the adjustment
proposed
by the tax administration. Perhaps more importantly, both the tax
administration and the taxpayer should endeavour to make a good faith
showing that their determinations of transfer pricing are consistent
with the
arm's length principle regardless of where the burden of proof lies. In
examination practices the behaviour of the tax administration should not
be
affected by the knowledge that the taxpayer bears the burden of proof
where
this is the case. The burden of proof should never be used by either tax
administrations or taxpayers as a justification for making groundless or
unverifiable assertions about transfer pricing.
OECD TRANSFER PRICING GUIDELINES
V-2 July 1995
©OECD
B. Guidance on documentation rules and procedures
5.3 Each taxpayer should endeavour to determine transfer pricing for tax
purposes in accordance with the arm's length principle, based upon
information
reasonably available at the time of the determination. Thus, a taxpayer
ordinarily should give consideration to whether its transfer pricing is
appropriate for tax purposes before the pricing is established. For
example, it
would be reasonable for a taxpayer to have made a determination
regarding
whether comparable data from uncontrolled transactions are available.
The
taxpayer also could be expected to examine, based on information
reasonably
available, whether the conditions used to establish transfer pricing in
prior
years have changed, if those conditions are to be used to determine
transfer
pricing for the current year.
5.4 The taxpayer's process of considering whether transfer pricing is
appropriate for tax purposes should be determined in accordance with the
same
prudent business management principles that would govern the process of
evaluating a business decision of a similar level of complexity and
importance.
It would be expected that the application of these principles will
require the
taxpayer to prepare or refer to written materials that could serve as
documentation of the efforts undertaken to comply with the arm's length
principle, including the information on which the transfer pricing was
based,
the factors taken into account, and the method selected. It would be reasonable
for tax administrations to expect taxpayers when establishing their
transfer
pricing for a particular business activity to prepare or to obtain such
materials
regarding the nature of the activity and the transfer pricing, and to
retain such
material for production if necessary in the course of a tax examination.
Such
actions should assist taxpayers in filing correct tax returns. Note,
however, that
there should be no contemporaneous obligation at the time the pricing is
determined or the tax return is filed to produce these types of
documents or to
prepare them for review by a tax administration. The documents that it
would
be appropriate to request with the tax return are described in paragraph
5.15.
5.5 Because the tax administration's ultimate interest would be
satisfied if
the necessary documents were submitted in a timely manner when requested
by
the tax administration in the course of an examination, the document
storage
process should be subject to the taxpayer's discretion. For instance,
the
taxpayer may choose to store relevant documents in the form of
unprocessed
DOCUMENTATION
July 1995 V-3
©OECD
originals or in a well-compiled book, and in whichever language it might
prefer, prior to the time the documents must be provided to the tax
administration. The taxpayer should, however, comply with reasonable
requests for translation of documents that are made available to the tax
administration.
5.6 In considering whether transfer pricing is appropriate for tax
purposes, it may be necessary in applying principles of prudent business
management for the taxpayer to prepare or refer to written materials
that would
not otherwise be prepared or referred to in the absence of tax
considerations,
including documents from foreign associated enterprises. When requesting
submission of these types of documents, the tax administration should
take
great care to balance its need for the documents against the cost and
administrative burden to the taxpayer of creating or obtaining them. For
example, the taxpayer should not be expected to incur disproportionately
high
costs and burdens to obtain documents from foreign associated
enterprises or to
engage in an exhaustive search for comparable data from uncontrolled
transactions if the taxpayer reasonably believes, having regard to the
principles
of this Report, either that no comparable data exists or that the cost
of locating
the comparable data would be disproportionately high relative to the
amounts at
issue. Tax administrations should also recognise that they can avail
themselves
of the exchange of information articles in bilateral double tax
conventions to
obtain such information, where it can be expected to be produced in a
timely
and efficient manner.
5.7 Thus, while some of the documents that might reasonably be used or
relied upon in determining arm's length transfer pricing for tax
purposes may
be of the type that would not have been prepared or obtained other than
for tax
purposes, the taxpayer should be expected to have prepared or obtained
such
documents only if they are indispensable for a reasonable assessment of
whether the transfer pricing satisfies the arm's length principle and
can be
obtained or prepared by the taxpayer without a disproportionately high
cost
being incurred. The taxpayer should not be expected to have prepared or
obtained documents beyond the minimum needed to make a reasonable
assessment of whether it has complied with the arm's length principle.
5.8 Consistent with the above guidance, taxpayers should not be
obligated to retain documents that were prepared or referred to in
connection
OECD TRANSFER PRICING GUIDELINES
V-4 July 1995
©OECD
with transactions occurring in years for which adjustment is time-barred
beyond a reasonable period of retention consistent with the body of
general
domestic law for similar types of documents. In addition, tax
administrations
ordinarily should not request documents relating to such years, even
where the
documentation has been retained. However, at times such documents may be
relevant to a transfer pricing inquiry for a subsequent year that is not
timebarred,
for example where taxpayers are voluntarily keeping such records in
relation to long-term contracts, or to determine whether comparability
standards relating to the application of a transfer pricing method in
that
subsequent year are satisfied. Tax administrations should bear in mind
the
difficulties in locating documents for prior years and should restrict
such
requests to instances where they have good reason in connection with the
transaction under examination for reviewing the documents in question.
5.9 Tax administrations also should limit requests for documents that
became available only after the transaction in question occurred to
those that
are reasonably likely to contain relevant information as determined
under
principles governing the use of multiple year data in Chapter I or
information
about the facts that existed at the time the transfer pricing was
determined. In
considering whether documentation is adequate, a tax administration
should
have regard to the extent to which that information reasonably could
have been
available to the taxpayer at the time transfer pricing was established.
5.10 Tax administrations further should not require taxpayers to produce
documents that are not in the actual possession or control of the
taxpayer or
otherwise reasonably available, e.g. information that cannot be legally
obtained, or that is not actually available to the taxpayer because it
is
confidential to the taxpayer's competitor or because it is unpublished
and
cannot be obtained by normal enquiry or market data.
5.11 In many cases, information about foreign associated enterprises is
essential to transfer pricing examinations. However, gathering such
information may present a taxpayer with difficulties that it does not
encounter
in producing its own documents. When the taxpayer is a subsidiary of a
foreign associated enterprise or is only a minority shareholder,
information
may be difficult to obtain because the taxpayer does not have control of
the
associated enterprise. In any case, accounting standards and legal
documentation requirements (including time limits for preparation and
DOCUMENTATION
July 1995 V-5
©OECD
submission) differ from country to country. The documents requested by
the
taxpayer may not be of the type that prudent business management
principles
would suggest the foreign associated enterprise would maintain, and
substantial
time and cost may be involved in translating and producing documents.
These
considerations should be taken into account in determining the
taxpayer's
enforceable documentation obligation.
5.12 It might not be necessary to extend the information required to all
associated enterprises involved in the controlled transactions under
review. For
example, in establishing a transfer price for a distributor with limited
functions
performed, it might be adequate to obtain information about those
functions
without extending the information requested to other members of the MNE
group.
5.13 Tax administrations should take care to ensure that there is no
public
disclosure of trade secrets, scientific secrets, or other confidential
data. Tax
administrations therefore should use discretion in requesting this type
of
information and should do so only if they can undertake that the information
will remain confidential from outside parties, except to the extent
disclosure is
required in public court proceedings or judicial decisions. Every
endeavour
should be made to ensure that confidentiality is maintained to the
extent
possible in such proceedings and decisions.
5.14 Taxpayers should recognize that notwithstanding limitations on
documentation requirements, a tax administration will have to make a
determination of arm's length transfer pricing even if the information
available
is incomplete. As a result, the taxpayer must take into consideration
that
adequate record-keeping practices and the voluntary production of
documents
can improve the persuasiveness of its approach to transfer pricing. This
will be
true whether the case is relatively straightforward or complex, but the
greater
the complexity and unusualness of the case, the more significance will
attach to
documentation.
5.15 Tax administrations should limit the amount of information that is
requested at the stage of filing the tax return. At that time, no
particular
transaction has been identified for transfer pricing review. It would be
quite
burdensome if detailed documentation were required at this stage on all
crossborder
transactions between associated enterprises, and on all enterprises
OECD TRANSFER PRICING GUIDELINES
V-6 July 1995
©OECD
engaging in such transactions. Therefore, it would be unreasonable to
require
the taxpayer to submit documents with the tax return specifically
demonstrating
the appropriateness of all transfer price determinations. The result
could be to
impede international trade and foreign investment. Any documentation
requirement at the tax return filing stage should be limited to
requiring the
taxpayer to provide information sufficient to allow the tax administration
to
determine approximately which taxpayers need further examination.
C. Useful information for determining transfer pricing
5.16 The information relevant to an individual transfer pricing enquiry
depends on the facts and circumstances of the case. For that reason it
is not
possible to define in any generalized way the precise extent and nature
of
information that would be reasonable for the tax administration to
require and
for the taxpayer to produce at the time of examination . However, there
are
certain features common to any transfer pricing enquiry that depend on
information in respect of the taxpayer, the associated enterprises, the
nature of
the transaction, and the basis on which the transaction is priced. The
following
section outlines the information that could be relevant, depending on
the
individual circumstances. It is intended to demonstrate the kind of
information
that would facilitate the enquiry in the generality of cases, but it
should be
underscored that the information described below should not be viewed as
a
minimum compliance requirement. Similarly, it is not intended to set
forth an
exhaustive list of the information that a tax administration may be
entitled to
request.
5.17 An analysis under the arm's length principle generally requires
information about the associated enterprises involved in the controlled
transactions, the transactions at issue, the functions performed,
information
derived from independent enterprises engaged in similar transactions or
businesses, and other factors discussed elsewhere in this Report, taking
into
account as well the guidance in paragraph 5.4. Some additional
information
about the controlled transaction in question could be relevant. This
could
include the nature and terms of the transaction, economic conditions and
property involved in the transactions, how the product or service that
is the
subject of the controlled transaction in question flows among the
associated
enterprises, and changes in trading conditions or renegotiations of
existing
arrangements. It also could include a description of the circumstances
of any
DOCUMENTATION
July 1995 V-7
©OECD
known transactions between the taxpayer and an unrelated party that are
similar
to the transaction with a foreign associated enterprise and any information
that
might bear upon whether independent enterprises dealing at arm's length
under
comparable circumstances would have entered into a similarly structured
transaction. Other useful information may include a list of any known
comparable companies having transactions similar to the controlled
transactions.
5.18 In particular transfer pricing cases it may be useful to refer to
information relating to each associated enterprise involved in the
controlled
transactions under review, such as:
i) an outline of the business;
ii) the structure of the organization;
iii) ownership linkages within the MNE group;
iv) the amount of sales and operating results
from the last few years
preceding the transaction;
v) the level of the taxpayer's transactions
with foreign associated
enterprises, for example the amount of sales of inventory assets,
the rendering of services, the rent of tangible assets, the use and
transfer of intangible property, and interest on loans;
5.19 Information on pricing, including business strategies and special
circumstances at issue, may also be useful. This could include factors
that
influenced the setting of prices or the establishment of any pricing
policies for
the taxpayer and the whole MNE group. For example, these policies might
be
to add a mark up to manufacturing cost, to deduct related costs from
sales
prices to end users in the market where the foreign related parties are
conducting a wholesale business, or to employ an integrated pricing or
cost
contribution policy on a whole group basis. Information on the factors
that
lead to the development of any such policies may well help an MNE to
convince tax administrations that its transfer pricing policies are
consistent
with the transactional conditions in the open market. It could also be
useful to
have an explanation of the selection, application, and consistency with
the
OECD TRANSFER PRICING GUIDELINES
V-8 July 1995
©OECD
arm's length principle of the transfer pricing method used to establish
the
transfer pricing. It should be noted in this respect that the
information most
useful to establishing arm's length pricing may vary depending upon the
method being used.
5.20 Special circumstances would include details concerning any set-off
transactions that have an effect on determining the arm's length price.
In such a
case, documents are useful to help describe the relevant facts, the
qualitative
connection between the transactions, and the quantification of the
set-off.
Contemporaneous documentation helps minimise the use of hindsight. As
discussed in Chapter I, a set-off transaction may occur, for example,
where the
seller supplies goods at a lower price, because the buyer provides
services to
the seller free of charge; where a higher royalty is established to
compensate
for an intentionally lower price of goods; and where a royalty-free
cross-license
agreement is concluded concerning the use of industrial property or
technical
know-how.
5.21 Other special circumstances could involve management strategy or
the type of business. Examples are circumstances under which the
taxpayer's
business is conducted in order to enter a new market, to increase share
in an
existing market, to introduce new products into a market, or to fend off
increasing competition.
5.22 General commercial and industry conditions affecting the taxpayer
also may be relevant. Relevant information could include information
explaining the current business environment and its forecasted changes;
and
how forecasted incidents influence the taxpayer's industry, market
scale,
competitive conditions, regulatory framework, technological progress,
and
foreign exchange market.
5.23 Information about functions performed (taking into account assets
used and risks assumed) may be useful for the functional analysis that
ordinarily would be undertaken to apply the arm's length principle. The
functions include manufacturing, assemblage, management of purchase and
materials, marketing, wholesale, stock control, warranty administration,
advertising and marketing activities, carriage and warehousing
activities,
lending and payment terms, training, and personnel.
DOCUMENTATION
July 1995 V-9
©OECD
5.24 The possible risks assumed that are taken into account in the
functional analysis may include risks of change in cost, price, or
stock, risks
relating to success or failure of research and development, financial
risks
including change in the foreign exchange and interest rates, risks of
lending and
payment terms, risks for manufacturing liability, business risk related
to
ownership of assets, or facilities.
5.25 Financial information may also be useful if there is a need to
compare
profit and loss between the associated enterprises with which the
taxpayer has
transactions subject to the transfer pricing rules. This information
might
include documents that explain the profit and loss to the extent
necessary to
evaluate the appropriateness of the transfer pricing policy within an
MNE
group. It also could include documents concerning expenses borne by
foreign
related parties, such as sales promotion expenses or advertising
expenses.
5.26 Some relevant financial information might also be in the possession
of the foreign associated enterprise. This information could include
reports on
manufacturing costs, costs of research and development, and/or general
and
administrative expenses.
5.27 Documents also may be helpful for showing the process of
negotiations for determining or revising prices in controlled
transactions.
When taxpayers negotiate to establish or to revise a price with
associated
enterprises, documents may be helpful that forecast profit and
administrative
and selling expenses to be incurred by foreign subsidiaries such as
personnel,
depreciation, marketing, distribution, or transportation expenses, and
that
explain how transfer prices are determined; for example, by deducting
gross
margins for subsidiaries from the estimated sales prices to end-users.
D. Summary of Recommendations on Documentation
5.28 Taxpayers should make reasonable efforts at the time transfer
pricing
is established to determine whether the transfer pricing is appropriate
for tax
purposes in accordance with the arm's length principle. Tax
administrations
should have the right to obtain the documentation prepared or referred
to in this
process as a means of verifying compliance with the arm's length
principle.
However, the extensiveness of this process should be determined in
accordance
with the same prudent business management principles that would govern
the
OECD TRANSFER PRICING GUIDELINES
V-10 July 1995
©OECD
process of evaluating a business decision of a similar level of
complexity and
importance. Moreover, the need for the documents should be balanced by
the
costs and administrative burdens, particularly where this process
suggests the
creation of documents that would not otherwise be prepared or referred
to in
the absence of tax considerations. Documentation requirements should not
impose on taxpayers costs and burdens disproportionate to the
circumstances.
Taxpayers should nonetheless recognize that adequate record-keeping
practices
and voluntary production of documents facilitate examinations and the
resolution of transfer pricing issues that arise.
5.29 Tax administrations and taxpayers alike should commit themselves to
a greater level of cooperation in addressing documentation issues, in
order to
avoid excessive documentation requirements while at the same time
providing
for adequate information to apply the arm's length principle reliably.
Taxpayers should be forthcoming with relevant information in their
possession,
and tax administrations should recognize that they can avail themselves
of
exchange of information articles in certain cases so that less need be
asked of
the taxpayer in the context of an examination. The Committee on Fiscal
Affairs intends to study the issue of documentation further to develop
additional guidance that might be given to assist taxpayers and tax
administrations in this area.
March 1996 VI-1
© OECD
Chapter VI
Special Considerations for Intangible Property
A. Introduction
6.1 This Chapter discusses special considerations that arise in seeking
to
establish whether the conditions made or imposed in transactions between
associated enterprises involving intangible property reflect arm's
length dealings.
Particular attention to intangible property transactions is appropriate
because the
transactions are often difficult to evaluate for tax purposes. The
Chapter
discusses the application of appropriate methods under the arm's length
principle
for establishing transfer pricing for transactions involving intangible
property
used in commercial activities, including marketing activities. It also
discusses
specific difficulties that arise when the enterprises conducting
marketing
activities are not the legal owners of marketing intangibles such as
trademarks
and tradenames. Cost contribution arrangements among associated
enterprises
for research and development expenditures that may result in intangible
property
will be discussed in Chapter VIII.
6.2 For the purposes of this Chapter, the term "intangible
property" includes
rights to use industrial assets such as patents, trademarks, trade
names, designs or
models. It also includes literary and artistic property rights, and
intellectual
property such as know-how and trade secrets. This Chapter concentrates
on
business rights, that is intangible property associated with commercial
activities,
including marketing activities. These intangibles are assets that may
have
considerable value even though they may have no book value in the
company's
balance sheet. There also may be considerable risks associated with them
(e.g., contract or product liability and environmental damages).
B. Commercial intangibles
i) In general
6.3 Commercial intangibles include patents, know-how, designs, and
models
that are used for the production of a good or the provision of a
service, as well as
intangible rights that are themselves business assets transferred to
customers or
OECD TRANSFER PRICING GUIDELINES
VI-2 March 1996
©OECD
used in the operation of business (e.g., computer software). Marketing
intangibles are a special type of commercial intangible with a somewhat
different
nature, as discussed below. For purposes of clarity, commercial
intangibles other
than marketing intangibles are referred to as trade intangibles. Trade
intangibles
often are created through risky and costly research and development
(R&D)
activities, and the developer generally tries to recover the
expenditures on these
activities and obtain a return thereon through product sales, service
contracts, or
licence agreements. The developer may perform the research activity in
its own
name, i.e. with the intention of having legal and economic ownership of
any
resulting trade intangible, on behalf of one or more other group members
under
an arrangement of contract research where the beneficiary or
beneficiaries have
legal and economic ownership of the intangible, or on behalf of itself
and one or
more other group members under an arrangement in which the members
involved
are engaged in a joint activity and have economic ownership of the
intangible
(also discussed in Chapter VIII on cost contribution arrangements).
Reciprocal
licensing (cross-licensing) is not uncommon, and there may be other more
complicated arrangements as well.
6.4 Marketing intangibles include trademarks and tradenames that aid in
the
commercial exploitation of a product or service, customer lists,
distribution
channels, and unique names, symbols, or pictures that have an important
promotional value for the product concerned. Some marketing intangibles
(e.g.,
trademarks) may be protected by the law of the country concerned and
used only
with the owner's permission for the relevant product or services. The
value of
marketing intangibles depends upon many factors, including the
reputation and
credibility of the tradename or the trademark fostered by the quality of
the goods
and services provided under the name or the mark in the past, the degree
of
quality control and ongoing R & D, distribution and availability of
the goods or
services being marketed, the extent and success of the promotional
expenditures
incurred in order to familiarize potential customers with the goods or
services (in
particular advertising and marketing expenditures incurred in order to
develop a
network of supporting relationships with distributors, agents, or other
facilitating
agencies), the value of the market to which the marketing intangibles
will provide
access, and the nature of any right created in the intangible under the
law.
6.5 Intellectual property such as know-how and trade secrets can be
trade
intangibles or marketing intangibles. Know-how and trade secrets are
proprietary
information or knowledge that assists or improves a commercial activity,
but that
SPECIAL CONSIDERATIONS FOR INTANGIBLE PROPERTY
March 1996 VI-3
©OECD
is not registered for protection in the manner of a patent or trademark.
The term
know-how is perhaps a less precise concept. Paragraph 11 of the
Commentary on
Article 12 of the OECD Model Tax Convention gives the following
definition:
"Know-how is all the undivulged technical information, whether
capable of being
patented or not, that is necessary for the industrial reproduction of a
product or
process, directly and under the same conditions; in as much as it is
derived from
experience, know-how represents what a manufacturer cannot know from
mere
examination of the product and mere knowledge of the progress of
technique."
Know-how thus may include secret processes or formulae or other secret
information concerning industrial, commercial or scientific experience
that is not
covered by patent. Any disclosure of know-how or a trade secret could
substantially reduce the value of the property. Know-how and trade
secrets
frequently play a significant role in the commercial activities of MNE
groups.
6.6 Care should be taken in determining whether or when a trade or
marketing
intangible exists. For example, not all research and development
expenditures
produce a valuable trade intangible, and not all marketing activities
result in the
creation of a marketing intangible. It can be difficult to evaluate the
degree to
which any particular expenditure has successfully resulted in a business
asset and
to calculate the economic effect of that asset for a given year.
6.7 For example, marketing activities may encompass a wide range of
business activities, such as market research, designing or planning
products
suitable to market needs, sales strategies, public relations, sales,
service, and
quality control. Some of these activities may not have an impact beyond
the year
in which they are performed, and so would properly be treated as current
expenses rather than as capitalisable expenditures. Other activities may
have
both short-term and long-term effect. The treatment of such activities
is likely
to be important in a functional analysis carried out in order to
establish
comparability for the purposes of transfer pricing. In some cases, the
costs of
marketing activities and, with respect to trade activities, R&D
expenditures, may
be sought to be recovered through the charging for associated goods and
services,
whereas in other cases there may have been created intangible property
on which
a royalty is separately charged, or a combination of the two.
OECD TRANSFER PRICING GUIDELINES
VI-4 March 1996
©OECD
ii) Examples: patents and trademarks
6.8 The differences between trade and marketing intangibles can be seen
in a
comparison of patents and trademarks. Patents are basically concerned
with the
production of goods (which may be sold or used in connection with the
provision
of services) while trademarks are used in promoting the sale of goods or
services.
A patent gives an exclusive right to its owner to use a given invention
for a
limited period of time. A trademark may continue indefinitely; its
protection will
disappear only under special circumstances (voluntary renunciation, no
renewal
in due time, cancellation or annulment following a judicial decision,
etc.).
A trademark is a unique name, symbol or picture that the owner or
licensee may
use to identify special products or services of a particular
manufacturer or dealer
and, as a corollary, to prohibit their use by other parties for similar
purposes
under the protection of domestic and international law. Trademarks may
confer a
valuable market status on the goods or services to which they are
attached,
whether or not those goods or services are otherwise unique. Patents may
create
a monopoly in certain products or services whereas trademarks alone do
not,
because competitors may be able to sell the same or similar products so
long as
they use different distinctive signs.
6.9 Patents are usually the result of risky and costly research and
development
and the developer will try to recover its costs (and earn a return)
through the sale
of products covered by the patent, licensing others to use the invention
(often a
product or process), or through the outright sale of the patent. The
legal creation
of a new trademark (or one newly introduced to a given market) is
usually not an
expensive matter. In contrast, it will very often be an expensive business
to make
it valuable and to ensure that the value is maintained (or increased).
Intensive
and costly advertising campaigns and other marketing activities will
ordinarily be
necessary as will expenditure on the control of the quality of the
trademarked
product. The value and any changes will depend to an extent on how
effectively
the trademark is promoted in the markets in which it is used. Value will
also
depend on the reputation of the owner for quality in production and
rendering of
services and on how well this reputation is maintained. In certain
cases, the value
for the licensor may increase as the result of efforts and expenditure
by the
licensee. In some cases patents, because of their outstanding quality,
may also
have a very strong marketing effect similar to that of a pure trademark
and
payments for the right to use such patents may have to be looked at in
much the
same light as payments for the right to use a trademark.
SPECIAL CONSIDERATIONS FOR INTANGIBLE PROPERTY
March 1996 VI-5
©OECD
6.10 Trademarks may be established for goods, either for specific
products or
for a line of products. They are perhaps most familiar at the consumer
market
level, but they are likely to be encountered at all market levels.
Trademarks may
also be acquired for services. The ownership of a trademark would
normally be
vested in one person, for example, a legally independent company. A
trade name
(often the name of an enterprise) may have the same force of penetration
as a
trademark and may indeed be registered in some specific form as a
trademark.
The names of certain multinational enterprises in pharmaceutical or
electronic
industries, for example, have an excellent sales promotion value, and
they may be
used for the marketing of a variety of goods or services. The names of
wellknown
persons, designers, sports figures, actors, people working in show
business, etc., may also be associated with trade names and trademarks,
and they
have often been very successful marketing instruments.
6.11 A trademark may be sold, licensed, or otherwise transferred by one
person
to another. Various kinds of license contracts are concluded in
practice.
A distributor could be allowed to use a trademark without a licence
agreement in
selling products manufactured by the owner of the trademark, but
trademark
licensing also has become a common practice, particularly in
international trade.
Thus, the owner of a trademark may grant a licence to the trademark to
another
enterprise to use for goods that it produces itself or buys from other
sources (or
from the licensor, e.g., where goods or components are purchased
generically in a
separate transaction without a trademark). The terms and conditions of
license
agreements may vary to a considerable extent.
6.12 It is sometimes difficult to make a clear-cut distinction between
income
from trade and marketing intangibles. For instance, in research-oriented
industries, the trademark and tradename are vital components in securing
sufficient income to reward past research and undertake new projects,
particularly
as patents are time-limited. Building up brand confidence and trademark
recognition is therefore vitally important to ensure that the product
continues to
be commercially viable after the patent expires or even in cases where
no patent
was developed. See Section D describing arm's length arrangements
involving
marketing intangibles.
OECD TRANSFER PRICING GUIDELINES
VI-6 March 1996
©OECD
C. Applying the arm's length principle
i) In general
6.13 The general guidance set out in Chapters I, II, and III for
applying the
arm's length principle pertains equally to the determination of transfer
pricing
between associated enterprises for intangible property. This principle
can,
however, be difficult to apply to controlled transactions involving
intangible
property because such property may have a special character complicating
the
search for comparables and in some cases making value difficult to
determine at
the time of the transaction. Further, for wholly legitimate business
reasons due to
the relationship between them, associated enterprises might sometimes
structure a
transfer in a manner that independent enterprises would not contemplate
(See
Chapter I, paragraphs 1.10 and 1.36).
6.14 Arm's length pricing for intangible property must take into account
for the
purposes of comparability the perspective of both the transferor of the
property
and the transferee. From the perspective of the transferor, the arm's
length
principle would examine the pricing at which a comparable independent
enterprise would be willing to transfer the property. From the
perspective of the
transferee, a comparable independent enterprise may or may not be
prepared to
pay such a price, depending on the value and usefulness of the
intangible property
to the transferee in its business. The transferee will generally be
prepared to pay
this license fee if the benefit it reasonably expects to secure from the
use of the
intangibles is satisfactory having regard to other options realistically
available.
Given that the licensee will have to undertake investments or otherwise
incur
expenditures to use the licence it has to be determined whether an
independent
enterprise would be prepared to pay a licence fee of the given amount
considering
the expected benefits from the additional investments and other
expenditures
likely to be incurred.
6.15 This analysis is important to ensure that an associated enterprise
is not
required to pay an amount for the purchase or use of intangible property
that is
based on the highest or most productive use when the property is of more
limited
usefulness to the associated enterprise given its business operations
and other
relevant circumstances. In such a case, the usefulness of the property
should be
taken into account when determining comparability. This discussion highlights
SPECIAL CONSIDERATIONS FOR INTANGIBLE PROPERTY
March 1996 VI-7
©OECD
the importance of taking all the facts and circumstances into
consideration when
determining comparability of transactions.
ii) Identifying arrangements made for the transfer of intangible
property
6.16 The conditions for transferring intangible property may be those of
an
outright sale of the intangible or, more commonly, a royalty under a
licensing
arrangement for rights in respect of the intangible property. A royalty
would
ordinarily be a recurrent payment based on the user's output, sales, or
in some
rare circumstances, profits. When the royalty is based on the licensee's
output or
sales, the rate may vary according to the turnover of the licensee.
There are also
instances where changed facts and circumstances (e.g., new designs,
increased
advertising of the trademark by the owner) could lead to a revision of
the
conditions of remuneration.
6.17 The compensation for the use of intangible property may be included
in
the price charged for the sale of goods when, for example, one
enterprise sells
unfinished products to another and, at the same time, makes available
its
experience for further processing of these products. Whether it could be
assumed
that the transfer price for the goods includes a licence charge and
that,
consequently, any additional payment for royalties would ordinarily have
to be
disallowed by the country of the buyer, would depend very much upon the
circumstances of each deal and there would appear to be no general
principle
which can be applied except that there should be no double deduction for
the
provision of technology. The transfer price may be a package price,
i.e., for the
goods and for the intangible property, in which case, depending on the
facts and
circumstances, an additional payment for royalties may not need to be
paid by the
purchaser for being supplied with technical expertise. This type of
package
pricing may need to be disaggregated to calculate a separate arm's
length royalty
in countries that impose royalty withholding taxes.
6.18 In some cases, intangible property will be bundled in a package
contract
including rights to patents, trademarks, trade secrets, and know-how.
For
example, an enterprise may grant a licence in respect of all the industrial
and
intellectual properties it owns. The parts of the package may need to be
considered separately to verify the arm's length character of the
transfer (see
paragraph 1.43 of Chapter I). It also is important to take into account
the value of
OECD TRANSFER PRICING GUIDELINES
VI-8 March 1996
©OECD
services such as technical assistance and training of employees that the
developer
may render in connection with the transfer. Similarly, benefits provided
by the
licensee to the licensor by way of improvements to products or processes
may
need to be taken into account. These services should be evaluated by
applying
the arm's length principle, taking into account the special
considerations for
services described in Chapter VII. It may be important in this respect
to
distinguish between the various means of making know-how available.
Guidance
on these issues is provided by paragraph 11 of the Commentary on Article
12 of
the OECD Model Tax Convention.
6.19 A know-how contract and a service contract may be dealt with
differently
in a particular country according to its internal tax legislation or to
the tax treaties
it has concluded with other countries. This issue is one which will be
given
further attention from the Working Party No. 1 on Double Taxation and
Related
Questions. For example, whether or not a withholding tax is levied on
payments
made to non-residents may depend on the way the contract is viewed. If
the
payment is seen as service fees, it is usually not taxed in the country
of origin
unless the receiving enterprise carries on business in that country
through a
permanent establishment situated therein and the fee is attributable to
the
permanent establishment. On the other hand, royalties paid for the use
of
intangible property are subject to a withholding tax in some countries.
iii) Calculation of an arm's length consideration
6.20 In applying the arm's length principle to controlled transactions
involving
intangible property, some special factors relevant to comparability
between the
controlled and uncontrolled transactions should be considered. These
factors
include the expected benefits from the intangible property (possibly
determined
through a net present value calculation). Other factors include: any
limitations on
the geographic area in which rights may be exercised; export
restrictions on
goods produced by virtue of any rights transferred; the exclusive or
non-exclusive
character of any rights transferred; the capital investment (to
construct new plants
or to buy special machines), the start-up expenses and the development
work
required in the market; the possibility of sub-licensing, the licensee's
distribution
network, and whether the licensee has the right to participate in
further
developments of the property by the licensor.
SPECIAL CONSIDERATIONS FOR INTANGIBLE PROPERTY
March 1996 VI-9
©OECD
6.21 When the intangible property involved is a patent, the analysis of
comparability should also take into account the nature of the patent
(e.g. product
or process patent) and the degree and duration of protection afforded
under the
patent laws of the relevant countries, bearing in mind that new patents
may be
developed speedily on the basis of old ones, so that the effective
protection of the
intangible property may be prolonged considerably. Not only the duration
of the
legal protection but also the length of the period during which patents
are likely to
maintain their economic value is important. An entirely new and
distinctive
"breakthrough" patent may make existing patents rapidly
obsolete and will
command a higher price than one either designed to improve a process
already
governed by an existing patent or one for which substitutes are readily
available.
6.22 Other factors for patents include the process of production for
which the
property is used, and the value that the process contributes to the
final product.
For example, where a patented invention covers only one component of a
device,
it could be inappropriate to calculate the royalty for the invention by
reference to
the selling price for the complete product. In such a case, a royalty
based on a
proportion of the selling price would have to take into account the
relative value
of the component to the other components of the product. Also, in
analysing
functions performed (including assets used and risks assumed) for
transactions
involving intangible property, the risks considered should include
product and
environmental liability, which have become increasingly important.
6.23 In establishing arm's length pricing in the case of a sale or
licence of
intangible property, it is possible to use the CUP method where the same
owner
has transferred or licensed comparable intangible property under
comparable
circumstances to independent enterprises. The amount of consideration
charged
in comparable transactions between independent enterprises in the same
industry
can also be a guide, where this information is available, and a range of
pricing
may be appropriate. Offers to unrelated parties or genuine bids of
competing
licensees also may be taken into account. If the associated enterprise
sub-licenses
the property to third parties, it may also be possible to use some form
of the resale
price method to analyse the terms of the controlled transaction.
6.24 In the sale of goods incorporating intangible property, it may also
be
possible to use the CUP or resale price method following the principles
in
Chapter II. When marketing intangibles (e.g. a trademark) are involved,
the
analysis of comparability should consider the value added by the
trademark,
OECD TRANSFER PRICING GUIDELINES
VI-10 March 1996
©OECD
taking into account consumer acceptability, geographical significance,
market
shares, sales volume, and other relevant factors. When trade intangibles
are
involved, the analysis of comparability should moreover consider the
value
attributable to such intangibles (patent protected or otherwise
exclusive
intangibles) and the importance of the ongoing R&D functions.
6.25 For example, it may be the case that a branded athletic shoe
transferred in
a controlled transaction is comparable to an athletic shoe transferred
under a
different brand name in an uncontrolled transaction both in terms of the
quality
and specification of the shoe itself and also in terms of the consumer
acceptability
and other characteristics of the brand name in that market. Where such a
comparison is not possible, some help also may be found, if adequate
evidence is
available, by comparing the volume of sales and the prices chargeable
and profits
realised for trademarked goods with those for similar goods that do not
carry the
trademark. It therefore may be possible to use sales of unbranded
products as
comparable transactions to sales of branded products that are otherwise
comparables, but only to the extent that adjustments can be made to
account for
any value added by the trademark. For example, branded athletic shoe
"A" may
be comparable to an unbranded shoe in all respects (after adjustments)
except for
the brandname itself. In such a case, the premium attributable to the
brand might
be determined by comparing an unbranded shoe with different features,
transferred in an uncontrolled transaction, to its branded equivalent,
also
transferred in an uncontrolled transaction. Then it may be possible to
use this
information as an aid in determining the price of branded shoe
"A", although
adjustments may be necessary for the effect of the difference in
features on the
value of the brand. However, adjustments may be particularly difficult
where a
trademarked product has a dominant market position such that the generic
product is in essence trading in a different market, particularly where
sophisticated products are involved.
6.26 In cases involving highly valuable intangible property, it may be
difficult
to find comparable uncontrolled transactions. It therefore may be
difficult to
apply the traditional transaction methods and the transactional net
margin
method, 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.
SPECIAL CONSIDERATIONS FOR INTANGIBLE PROPERTY
March 1996 VI-11
©OECD
6.27 In assessing whether the conditions of a transaction involving
intangible
property reflect arm's length dealings, the amount, nature, and
incidence of the
costs incurred in developing or maintaining the intangible property
might be
examined as an aid to determining comparability or possibly relative
value of the
contributions of each party, particularly where a profit split method is
used.
However, there is no necessary link between costs and value. In
particular, the
actual fair market value of intangible property is frequently not
measurable in
relation to the costs involved in developing and maintaining the
property. One
reason is that intangible property, such as patents and know-how, may be
the
result of long-lasting and expensive R&D. The actual size of R&D
budgets
depends on a variety of factors, including the policy of competitors or
potential
competitors, the expected profitability of the research activity, and
the trend of
profits; or considerations based on some relation to turnover, or an
assessment of
the yield from R&D activity in the past as a basis for fixing future
expenditure
levels. R&D budgets may be sought to be covered by product sales
even though
the products in question may not be a direct or even perhaps an indirect
result of
the R&D. Another reason is that intangible property may require
ongoing R&D
and quality control that may benefit a range of products.
iv) Arm's length pricing when valuation is highly uncertain at the
time
of the transaction
6.28 As stated at the outset of this section, intangible property may
have a
special character complicating the search for comparables and in some
cases
making value difficult to determine at the time of a controlled
transaction
involving the property. When valuation of intangible property at the
time of the
transaction is highly uncertain, the question is raised how arm's length
pricing
should be determined. The question should be resolved, both by taxpayers
and
tax administrations, by reference to what independent enterprises would
have
done in comparable circumstances to take account of the valuation
uncertainty in
the pricing of the transaction.
6.29 Depending on the facts and circumstances, there are a variety of
steps that
independent enterprises might undertake to deal with high uncertainty in
valuation when pricing a transaction. One possibility is to use
anticipated
benefits (taking into account all relevant economic factors) as a means
for
establishing the pricing at the outset of the transaction. In
determining the
anticipated benefits, independent enterprises would take into account
the extent to
OECD TRANSFER PRICING GUIDELINES
VI-12 March 1996
©OECD
which subsequent developments are foreseeable and predictable. In some
cases,
independent enterprises might find that the projections of anticipated
benefits are
sufficiently reliable to fix the pricing for the transaction at the
outset on the basis
of those projections, without reserving the right to make future
adjustments.
6.30 In other cases, independent enterprises might not find that pricing
based
on anticipated benefits alone provides an adequate protection against
the risks
posed by the high uncertainty in valuing the intangible property. In
such cases,
independent enterprises might adopt shorter-term agreements or include
price
adjustment clauses in the terms of the agreement, to protect against
subsequent
developments that might not be predictable. For example, a royalty rate
could be
set to increase as the sales of the licensee increase.
6.31 Also, independent enterprises may determine to bear the risk of
unpredictable subsequent developments to a certain degree, however with
the
joint understanding that major unforeseen developments changing the
fundamental assumptions upon which the pricing was determined would lead
to
the renegotiation of the pricing arrangements by mutual agreement of the
parties.
For example, such renegotiation might occur at arm's length if a royalty
rate
based on sales for a patented drug turned out to be vastly excessive due
to an
unexpected development of an alternative low-cost treatment. The
excessive
royalty might remove the incentive of the licensee to manufacture the
drug at all,
in which case the agreement might be renegotiated (although whether this
in fact
would happen would depend upon all the facts and circumstances).
6.32 When tax administrations evaluate the pricing of a controlled
transaction
involving intangible property where valuation is highly uncertain at the
outset,
the arrangements that would have been made in comparable circumstances
by
independent enterprises should be followed. Thus, if independent
enterprises
would have fixed the pricing based upon a particular projection, the
same
approach should be used by the tax administration in evaluating the
pricing. In
such a case, the tax administration could, for example, inquire into
whether the
associated enterprises made adequate projections, taking into account
all the
developments that were reasonably foreseeable, without using hindsight.
SPECIAL CONSIDERATIONS FOR INTANGIBLE PROPERTY
March 1996 VI-13
©OECD
6.33 It is recognized that a tax administration may find it difficult,
particularly
in the case of an uncooperative taxpayer, to establish what profits were
reasonably foreseeable at the time that the transaction was entered
into. For
example, such a taxpayer, at an early stage, may transfer intangibles to
an
affiliate, set a royalty that does not reflect the subsequently
demonstrated value of
the intangible for tax or other purposes, and later take the position
that it was not
possible at the time of the transfer to predict the subsequent success
of the
product. In such a case, the subsequent developments might prompt a tax
administration to inquire what independent enterprises would have done
on the
basis of information reasonably available at the time of the
transaction. In
particular, consideration should be paid to whether the associated
enterprises
intended to and did make projections that independent enterprises would
have
considered adequate, taking into account the reasonably foreseeable
developments and in light of the risk of unforeseeable developments, and
whether
independent enterprises would have insisted on some additional
protections
against the risk of high uncertainty in valuation.
6.34 If independent enterprises would have insisted on a price
adjustment
clause in comparable circumstances, the tax administration should be
permitted to
determine the pricing on the basis of such a clause. Similarly, if
independent
enterprises would have considered unforeseeable subsequent developments
so
fundamental that their occurrence would have led to a prospective
renegotiation
of the pricing of a transaction, such developments should also lead to a
modification of the pricing of a comparable controlled transaction
between
associated enterprises.
6.35 It is recognised that tax administrations may not be able to
conduct an
audit of a taxpayer's return until several years after it has been
filed. In such a
case, a tax administration would be entitled to adjust the amount of
consideration
with respect to all open years up to the time when the audit takes
place, on the
basis of the information that independent enterprises would have used in
comparable circumstances to set the pricing.
D. Marketing activities undertaken by enterprises not owning
trademarks or tradenames
6.36 Difficult transfer pricing problems can arise when marketing
activities are
undertaken by enterprises that do not own the trademarks or tradenames
that they
OECD TRANSFER PRICING GUIDELINES
VI-14 March 1996
©OECD
are promoting (such as a distributor of branded goods). In such a case,
it is
necessary to determine how the marketer should be compensated for those
activities. The issue is whether the marketer should be compensated as a
service
provider, i.e., for providing promotional services, or whether there are
any cases
in which the marketer should share in any additional return attributable
to the
marketing intangibles. A related question is how the return attributable
to the
marketing intangibles can be identified.
6.37 As regards the first issue -- whether the marketer is entitled to a
return on
the marketing intangibles above a normal return on marketing activities
-- the
analysis requires an assessment of the obligations and rights implied by
the
agreement between the parties. It will often be the case that the return
on
marketing activities will be sufficient and appropriate. One relatively
clear case
is where a distributor acts merely as an agent, being reimbursed for its
promotional expenditures by the owner of the marketing intangible. In that
case,
the distributor would be entitled to compensation appropriate to its
agency
activities alone and would not be entitled to share in any return
attributable to the
marketing intangible.
6.38 Where the distributor actually bears the cost of its marketing
activities
(i.e., there is no arrangement for the owner to reimburse the
expenditures), the
issue is the extent to which the distributor is able to share in the
potential benefits
from those activities. In general, in arm's length dealings the ability
of a party
that is not the legal owner of a marketing intangible to obtain the
future benefits
of marketing activities that increase the value of that intangible will
depend
principally on the substance of the rights of that party. For example, a
distributor
may have the ability to obtain benefits from its investments in
developing the
value of a trademark from its turnover and market share where it has a
long-term
contract of sole distribution rights for the trademarked product. In
such cases, the
distributor's share of benefits should be determined based on what an
independent
distributor would obtain in comparable circumstances. In some cases, a
distributor may bear extraordinary marketing expenditures beyond what an
independent distributor with similar rights might incur for the benefit
of its own
distribution activities. An independent distributor in such a case might
obtain an
additional return from the owner of the trademark, perhaps through a
decrease in
the purchase price of the product or a reduction in royalty rate.
SPECIAL CONSIDERATIONS FOR INTANGIBLE PROPERTY
March 1996 VI-15
©OECD
6.39 The other question is how the return attributable to marketing
activities
can be identified. A marketing intangible may obtain value as a
consequence of
advertising and other promotional expenditures, which can be important
to
maintain the value of the trademark. However, it can be difficult to
determine
what these expenditures have contributed to the success of a product.
For
instance, it can be difficult to determine what advertising and
marketing
expenditures have contributed to the production or revenue, and to what
degree.
It is also possible that a new trademark or one newly introduced into a
particular
market may have no value or little value in that market and its value
may change
over the years as it makes an impression on the market (or perhaps loses
its
impact). A dominant market share may to some extent be attributable to
marketing efforts of a distributor. The value and any changes will
depend to an
extent on how effectively the trademark is promoted in the particular
market.
More fundamentally, in many cases higher returns derived from the sale
of
trademarked products may be due as much to the unique characteristics of
the
product or its high quality as to the success of advertising and other
promotional
expenditures. The actual conduct of the parties over a period of years
should be
given significant weight in evaluating the return attributable to
marketing
activities. See paragraphs 1.49-1.51 (multiple year data).
March 1996 VII-1
©OECD
Chapter VII
Special Considerations for Intra-Group Services
A. Introduction
7.1 This Chapter discusses issues that arise in determining for transfer
pricing purposes whether services have been provided by one member of an
MNE group to other members of that group and, if so, in establishing
arm's length
pricing for those intra-group services. The Chapter does not address
except
incidentally whether services have been provided in a cost contribution
arrangement, and if so the appropriate arm's length pricing, i.e., where
members
of an MNE group jointly acquire, produce or provide goods, services,
and/or
intangible property, allocating the costs for such activity amongst the
members
participating in the arrangement. Cost contribution arrangements are the
subject
of Chapter VIII.
7.2 Nearly every MNE group must arrange for a wide scope of services to
be available to its members, in particular administrative, technical,
financial and
commercial services. Such services may include management, coordination
and
control functions for the whole group. The cost of providing such
services may
be borne initially by the parent, by a specially designated group member
("a group service centre"), or by another group member. An
independent
enterprise in need of a service may acquire the services from a service
provider
who specialises in that type of service or may perform the service for
itself
(i.e., in house). In a similar way, a member of an MNE group in need of
a service
may acquire it directly or indirectly from independent enterprises, or
from one or
more associated enterprises in the same MNE group (i.e., intra-group),
or may
perform the service for itself. Intra-group services often include those
that are
typically available externally from independent enterprises (such as
legal and
accounting services), in addition to those that are ordinarily performed
internally
(e.g., by an enterprise for itself, such as central auditing, financing
advice, or
training of personnel).
7.3 Intra-group arrangements for rendering services are sometimes linked
to arrangements for transferring goods or intangible property (or the
licensing
thereof). In some cases, such as know-how contracts containing a service
element, it may be very difficult to determine where the exact border
lies between
OECD TRANSFER PRICING GUIDELINES
VII-2 March 1995
©OECD
the transfer or licensing of property and the transfer of services.
Ancillary
services are frequently associated with the transfer of technology. It
may
therefore be necessary to consider the principles for aggregation and
segregation
of transactions in Chapter I where a mixed transfer of services and
property is
involved.
7.4 Intra-group service activities may vary considerably among MNE
groups, as does the extent to which those activities provide a benefit,
or expected
benefit, to one or more group members. Each case is dependent upon its
own
facts and circumstances and the arrangements within the group. For
example, in
a decentralised group, the parent may limit its intra-group activity to
monitoring
its investments in its subsidiaries in its capacity as a shareholder. In
contrast, in a
centralised or integrated group, the Board of Directors and senior
management of
the parent company may make all important decisions concerning the
affairs of
its subsidiaries and the parent company may carry out all marketing,
training and
treasury functions.
B. Main issues
7.5 There are two issues in the analysis of transfer pricing for
intra-group
services. One issue is whether intra-group services have in fact been
provided.
The other issue is what the intra-group charge for such services for tax
purposes
should be in accordance with the arm's length principle. Each of these
issues is
discussed below.
i) Determining whether intra-group services have been rendered
7.6 Under the arm's length principle, the question whether an
intra-group
service has been rendered when an activity is performed for one or more
group
members by another group member should depend on whether the activity
provides a respective group member with economic or commercial value to
enhance its commercial position. This can be determined by considering
whether
an independent enterprise in comparable circumstances would have been
willing
to pay for the activity if performed for it by an independent enterprise
or would
have performed the activity in-house for itself. If the activity is not
one for which
the independent enterprise would have been willing to pay or perform for
itself,
the activity ordinarily should not be considered as an intra-group
service under
the arm's length principle.
SPECIAL CONSIDERATIONS FOR INTRA-GROUP SERVICES
March 1995 VII-3
©OECD
7.7 The analysis described above quite clearly depends on the actual
facts
and circumstances, and it is not possible in the abstract to set forth
categorically
the activities that do or do not constitute the rendering of intra-group
services.
However, some guidance may be given to elucidate how the analysis would
be
applied for some common types of activities undertaken in MNE groups.
7.8 Some intra-group services are performed by one member of an MNE
group to meet an identified need of one or more specific members of the
group.
In such a case, it is relatively straightforward to determine whether a
service has
been provided. Ordinarily an independent enterprise in comparable
circumstances would have satisfied the identified need either by
performing the
activity in-house or by having the activity performed by a third party.
Thus, in
such a case, an intra-group service ordinarily would be found to exist.
For
example, an intra-group service would normally be found where an
associated
enterprise repairs equipment used in manufacturing by another member of
the
MNE group.
7.9 A more complex analysis is necessary where an associated enterprise
undertakes activities that relate to more than one member of the group
or to the
group as a whole. In a narrow range of such cases, an intra-group
activity may be
performed relating to group members even though those group members do
not
need the activity (and would not be willing to pay for it were they
independent
enterprises). Such an activity would be one that a group member (usually
the
parent company or a regional holding company) performs solely because of
its
ownership interest in one or more other group members, i.e. in its
capacity as
shareholder. This type of activity would not justify a charge to the
recipient
companies. It may be referred to as a "shareholder activity",
distinguishable from
the broader term "stewardship activity" used in the 1979
Report. Stewardship
activities covered a range of activities by a shareholder that may
include the
provision of services to other group members, for example services that
would be
provided by a coordinating centre. These latter types of non-shareholder
activities could include detailed planning services for particular
operations,
emergency management or technical advice (trouble shooting), or in some
cases
assistance in day-to-day management.
OECD TRANSFER PRICING GUIDELINES
VII-4 March 1995
©OECD
7.10 The following examples (which were described in the 1984 Report)
will
constitute shareholder activities, under the standard set forth in
paragraph 7.6:
a) Costs of activities relating to the
juridical structure of the parent
company itself, such as meetings of shareholders of the parent,
issuing of shares in the parent company and costs of the supervisory
board;
b) Costs relating to reporting requirements
of the parent company
including the consolidation of reports;
c) Costs of raising funds for the acquisition
of its participations.
In contrast, if for example a parent company raises funds on behalf of
another
group member which uses them to acquire a new company, the parent
company
would generally be regarded as providing a service to the group member.
The
1984 Report also mentioned "costs of managerial and control
(monitoring)
activities related to the management and protection of the investment as
such in
participations". Whether these activities fall within the
definition of shareholder
activities as defined in these Guidelines would be determined according
to
whether under comparable facts and circumstances the activity is one
that an
independent enterprise would have been willing to pay for or to perform
for itself.
7.11 In general, no intra-group service should be found for activities
undertaken by one group member that merely duplicate a service that
another
group member is performing for itself, or that is being performed for
such other
group member by a third party. An exception may be where the duplication
of
services is only temporary, for example, where an MNE group is
reorganizing to
centralize its management functions. Another exception would be where
the
duplication is undertaken to reduce the risk of a wrong business decision
(e.g., by getting a second legal opinion on a subject).
7.12 There are some cases where an intra-group service performed by a
group member such as a shareholder or coordinating centre relates only
to some
group members but incidentally provides benefits to other group members.
Examples could be analysing the question whether to reorganise the
group, to
acquire new members, or to terminate a division. These activities could
constitute intra-group services to the particular group members
involved, for
SPECIAL CONSIDERATIONS FOR INTRA-GROUP SERVICES
March 1995 VII-5
©OECD
example those members who will make the acquisition or terminate one of
their
divisions, but they may also produce economic benefits for other group
members
not involved in the object of the decision by increasing efficiencies,
economies of
scale, or other synergies. The incidental benefits ordinarily would not
cause these
other group members to be treated as receiving an intra-group service
because the
activities producing the benefits would not be ones for which an
independent
enterprise ordinarily would be willing to pay.
7.13 Similarly, an associated enterprise should not be considered to
receive
an intra-group service when it obtains incidental benefits attributable
solely to its
being part of a larger concern, and not to any specific activity being
performed.
For example, no service would be received where an associated enterprise
by
reason of its affiliation alone has a credit-rating higher than it would
if it were
unaffiliated, but an intra-group service would usually exist where the
higher
credit rating were due to a guarantee by another group member, or where
the
enterprise benefitted from the group's reputation deriving from global
marketing
and public relations campaigns. In this respect, passive association
should be
distinguished from active promotion of the MNE group's attributes that
positively
enhances the profit-making potential of particular members of the group.
Each
case must be determined according to its own facts and circumstances.
7.14 Other activities that may relate to the group as a whole are those
centralised in the parent company or a group service centre (such as a
regional
headquarters company) and made available to the group (or multiple
members
thereof). The activities that are centralised depend on the kind of
business and on
the organisational structure of the group, but in general they may
include
administrative services such as planning, coordination, budgetary
control,
financial advice, accounting, auditing, legal, factoring, computer
services;
financial services such as supervision of cash flows and solvency,
capital
increases, loan contracts, management of interest and exchange rate
risks, and
refinancing; assistance in the fields of production, buying, distribution
and
marketing; and services in staff matters such as recruitment and
training. Group
service centres also often carry out research and development or
administer and
protect intangible property for all or part of the MNE group. These type
of
activities ordinarily will be considered intra-group services because
they are the
type of activities that independent enterprises would have been willing
to pay for
or to perform for themselves.
OECD TRANSFER PRICING GUIDELINES
VII-6 March 1995
©OECD
7.15 In considering whether a charge for the provision of services would
be
made between independent enterprises, it would also be relevant to
consider the
form that an arm's length consideration would take had the transaction
occurred
between independent enterprises dealing at arm's length. For example, in
respect
of financial services such as loans, foreign exchange and hedging,
remuneration
would generally be built into the spread and it would not be appropriate
to expect
a further service fee to be charged if such were the case.
7.16 Another issue arises with respect to services provided "on
call". The
question is whether the availability of such services is itself a
separate service for
which an arm's length charge (in addition to any charge for services
actually
rendered) should be determined. A parent company or a group service
centre
may be on hand to provide services such as financial, managerial,
technical, legal
or tax advice and assistance to members of the group at any time. In
that case, a
service may be rendered to associated enterprises by having staff,
equipment, etc.,
available. An intra-group service would exist to the extent that it
would be
reasonable to expect an independent enterprise in comparable
circumstances to
incur "standby" charges to ensure the availability of the
services when the need
for them arises. It is not unknown, for example, for an independent
enterprise to
pay an annual "retainer" fee to a firm of lawyers to ensure
entitlement to legal
advice and representation if litigation is brought. Another example is a
service
contract for priority computer network repair in the event of a
breakdown.
7.17 These services may be available on call and they may vary in amount
and importance from year to year. It is unlikely that an independent enterprise
would incur stand-by charges where the potential need for the service
was
remote, where the advantage of having services on-call was negligible,
or where
the on-call services could be obtained promptly and readily from other
sources
without the need for stand-by arrangements. Thus, the benefit conferred
on a
group company by the on-call arrangements should be considered, perhaps
by
looking at the extent to which the services have been used over a period
of
several years rather than solely for the year in which a charge is to be
made,
before determining that an intra-group service is being provided.
7.18 The fact that a payment was made to an associated enterprise for
purported services can be useful in determining whether services were in
fact
provided, but the mere description of a payment as, for example,
"management
fees" should not be expected to be treated as prima facie evidence
that such
SPECIAL CONSIDERATIONS FOR INTRA-GROUP SERVICES
March 1995 VII-7
©OECD
services have been rendered. At the same time, the absence of payments
or
contractual agreements does not automatically lead to the conclusion
that no
intra-group services have been rendered.
ii) Determining an arm's length charge
a) In general
7.19 Once it is determined that an intra-group service has been
rendered, it is
necessary, as for other types of intra-group transfers, to determine
whether the
amount of the charge, if any, is in accordance with the arm's length
principle.
This means that the charge for intra-group services should be that which
would
have been made and accepted between independent enterprises in
comparable
circumstances. Consequently, such transactions should not be treated
differently
for tax purposes from comparable transactions between independent
enterprises,
simply because the transactions are between enterprises that happen to
be
associated.
b) Identifying actual arrangements for charging for intra-group
services
7.20 To identify the amount, if any, that has actually been charged for
services, a tax administration will need to identify what arrangements,
if any,
have actually been put in place between the associated enterprises to
facilitate
charges being made for the provision of services between them. In
certain cases,
the arrangements made for charging for intra-group services can be
readily
identified. These cases are where the MNE group uses a direct-charge
method,
i.e., where the associated enterprises are charged for specific
services. In general,
the direct-charge method is of great practical convenience to tax
administrations
because it allows the service performed and the basis for the payment to
be
clearly identified. Thus, the direct-charge method facilitates the
determination of
whether the charge is consistent with the arm's length principle.
7.21 An MNE group should often be able to adopt direct charging
arrangements, particularly where services similar to those rendered to
associated
enterprises are also rendered to independent parties. If specific
services are
provided not only to associated enterprises but also to independent
enterprises in
a comparable manner and as a significant part of its business, it could
be
OECD TRANSFER PRICING GUIDELINES
VII-8 March 1995
©OECD
presumed that the MNE has the ability to demonstrate a separate basis
for the
charge (e.g., by recording the work done and costs expended in
fulfilling its third
party contracts). As a result, MNEs in such a case are encouraged to
adopt the
direct-charge method in relation to their transactions with associated
enterprises.
It is accepted, however, that this approach may not always be
appropriate if, for
example, the services to third parties are merely occasional or
marginal.
7.22 A direct-charge method for charging for intra-group services is so
difficult to apply in practice in many cases for MNE groups that such
groups have
developed other methods for charging for services provided by parent
companies
or group service centres. In these cases, the practice of MNE groups for
charging
for intra-group services is often to make arrangements that are either a)
readily
identifiable but not based on a direct-charge method; or b) not readily identifiable
and either incorporated into the charge for other transfers, allocated
amongst
group members on some basis, or in some cases not allocated amongst
group
members at all.
7.23 In such cases, MNE groups may find they have few alternatives but
to
use cost allocation and apportionment methods which often necessitate
some
degree of estimation or approximation, as a basis for calculating an
arm's length
charge following the principles in part c) of this subsection. Such methods are
generally referred to as indirect-charge methods and should be allowable
provided sufficient regard has been given to the value of the services
to recipients
and the extent to which comparable services are provided between
independent
enterprises. These methods of calculating charges would generally not be
acceptable where specific services that form a main business activity of
the
enterprise are provided not only to associated enterprises but also to
third parties.
While every attempt should be made to charge fairly for the service
provided, any
charging has to be supported by an identifiable and reasonably
foreseeable
benefit. Any indirect-charge method should be sensitive to the
commercial
features of the individual case (e.g., the allocation key makes sense
under the
circumstances), contain safeguards against manipulation and follow sound
accounting principles, and be capable of producing charges or
allocations of costs
that are commensurate with the actual or reasonably expected benefits to
the
recipient of the service.
7.24 In some cases, an indirect charge method may be necessary due to
the
nature of the service being provided. One example is where the
proportion of the
SPECIAL CONSIDERATIONS FOR INTRA-GROUP SERVICES
March 1995 VII-9
©OECD
value of the services rendered to the various relevant entities cannot
be quantified
except on an approximate or estimated basis. This problem may occur, for
example, where sales promotion activities carried on centrally (e.g. at
international fairs, in the international press, or through other
centralised
advertising campaigns) may affect the quantity of goods manufactured or
sold by
a number of affiliates. Another case is where a separate recording and
analysis of
the relevant service activities for each beneficiary would involve a
burden of
administrative work that would be disproportionately heavy in relation
to the
activities themselves. In such cases, the charge could be determined by reference
to an allocation among all potential beneficiaries of the costs that
cannot be
allocated directly, i.e., costs that cannot be specifically assigned to
the actual
beneficiaries of the various services. To satisfy the arm's length
principle, the
allocation method chosen must lead to a result that is consistent with
what
comparable independent enterprises would have been prepared to accept.
See
part c) of this subsection.
7.25 The allocation might be based on turnover, or staff employed, or
some
other basis. Whether the allocation method is appropriate may depend on
the
nature and usage of the service. For example, the usage or provision of
payroll
services may be more related to the number of staff than to turnover,
while the
allocation of the stand-by costs of priority computer back-up could be
allocated in
proportion to relative expenditure on computer equipment by the group
members.
7.26 The compensation for services rendered to an associated enterprise
may
be included in the price for other transfers. For instance, the price
for licensing a
patent or know-how may include a payment for technical assistance
services or
centralised services performed for the licensee or for managerial advice
on the
marketing of the goods produced under the licence. In such cases, the
tax
administration and the taxpayers would have to check that there is no
additional
service fee charged and that there is no double deduction.
7.27 When an indirect charge method is used, the relationship between
the
charge and the services provided may be obscured and it may become
difficult to
evaluate the benefit provided. Indeed, it may mean that the enterprise
being
charged for a service itself has not related the charge to the service.
Consequently, there is an increased risk of double taxation because it
may be
more difficult to determine a deduction for costs incurred on behalf of
group
members if compensation cannot be readily identified, or for the
recipient of the
OECD TRANSFER PRICING GUIDELINES
VII-10 March 1995
©OECD
service to establish a deduction for any amount paid if it is unable to
demonstrate
that services have been provided.
7.28 In identifying arrangements for charging any retainer for the
provision
of "on call" services (as discussed in paragraphs 7.16 and
7.17), it may be
necessary to examine the terms for the actual use of the services since
these may
include provisions that no charge is made for actual use until the level
of usage
exceeds a predetermined level.
c) Calculating the arm's length consideration
7.29 In trying to determine the arm's length price in relation to
intra-group
services, the matter should be considered both from the perspective of
the service
provider and from the perspective of the recipient of the service. In
this respect,
relevant considerations include the value of the service to the
recipient and how
much a comparable independent enterprise would be prepared to pay for
that
service in comparable circumstances, as well as the costs to the service
provider.
7.30 For example, from the perspective of an independent enterprise
seeking
a service, the service providers in that market may or may not be
willing or able
to supply the service at a price that the independent enterprise is
prepared to pay.
If the service providers can supply the wanted service within a range of
prices
that the independent enterprise would be prepared to pay, then a deal
will be
struck. From the point of view of the service provider, a price below
which it
would not supply the service and the cost to it are relevant considerations
to
address, but they are not necessarily determinative of the outcome in
every case.
7.31 The method to be used to determine arm's length transfer pricing
for
intra-group services should be determined according to the guidelines in
Chapters I, II, and III. Often, the application of these guidelines will
lead to use
of the CUP or cost plus method for pricing intra-group services. A CUP
method
is likely to be used where there is a comparable service provided
between
independent enterprises in the recipient's market, or by the associated
enterprise
providing the services to an independent enterprise in comparable
circumstances.
For example, this might be the case where accounting, auditing, legal,
or
computer services are being provided. A cost plus method would likely be
appropriate in the absence of a CUP where the nature of the activities
involved,
assets used, and risks assumed are comparable to those undertaken by
SPECIAL CONSIDERATIONS FOR INTRA-GROUP SERVICES
March 1995 VII-11
©OECD
independent enterprises. As indicated in Chapter II, in applying the
cost plus
method, there should be a consistency between the controlled and
uncontrolled
transactions in the categories of cost that are included. In exceptional
cases, for
example where it may be dificult to apply the CUP method or the
cost-plus
method, it may be helpful to take account of more than one method
(see paragraph 1.69) in reaching a satisfactory determination of arm's
length
pricing, and transactional profit methods may have to be used as a last
resort
(see paragraph 2.49).
7.32 It may be helpful to perform a functional analysis of the various
members of the group to establish the relationship between the relevant
services
and the members' activities and performance. In addition, it may be necessary
to
consider not only the immediate impact of a service, but also its
long-term effect,
bearing in mind that some costs will never actually produce the benefits
that were
reasonably expected when they were incurred. For example, expenditure on
preparations for a marketing operation might prima facie be too heavy to
be
borne by a member in the light of its current resources; the
determination whether
the charge in such a case is arm's length should consider expected
benefits from
the operation and the possibility that the amount and timing of the
charge in some
arm's length arrangements might depend on the results of the operation.
The
taxpayer should be prepared to demonstrate the reasonableness of its
charges to
associates in such cases.
7.33 Depending on the method being used to establish an arm's length
charge for intra-group services, the issue may arise whether it is
necessary that
the charge be such that it results in a profit for the service provider.
In an arm's
length transaction, an independent enterprise normally would seek to
charge for
services in such a way as to generate profit, rather than providing the
services
merely at cost. The economic alternatives available to the recipient of
the service
also need to be taken into account in determining the arm's length
charge.
However, there are circumstances (e.g., as outlined in the discussion on
business
strategies in Chapter I) in which an independent enterprise may not
realize a
profit from the performance of service activities alone, for example
where a
supplier's costs (anticipated or actual) exceed market price but the
supplier agrees
to provide the service to increase its profitability, perhaps by
complementing its
range of activities. Therefore, it need not always be the case that an
arm's length
price will result in a profit for an associated enterprise that is
performing an intragroup
service.
OECD TRANSFER PRICING GUIDELINES
VII-12 March 1995
©OECD
7.34 For example, it may be the case that the market value of
intra-group
services is not greater than the costs incurred by the service provider.
This could
occur where, for example, the service is not an ordinary or recurrent
activity of
the service provider but is offered incidentally as a convenience to the
MNE
group. In determining whether the intra-group services represent the
same value
for money as could be obtained from an independent enterprise, a
comparison of
functions and expected benefits would be relevant to assessing
comparability of
the transactions. An MNE group may still determine to provide the
service intragroup
rather than using a third party for a variety of reasons, perhaps
because of
other intra-group benefits (for which arm's length compensation may be
appropriate). It would not be appropriate in such a case to increase the
price for
the service above what would be established by the CUP method just to
make
sure the associated enterprise makes a profit. Such a result would be
contrary to
the arm's length principle. However, it is important to ensure that all
benefits to
the recipient are properly taken into account.
7.35 Where the cost plus method is available (and no CUP exists), the
analysis would require examining whether the costs incurred by the group
service
provider need some adjustment to make the comparison of transactions
valid.
For example, if the controlled transaction has a higher proportion of
overhead
costs to direct costs than the otherwise comparable transaction, it may
be
inappropriate to apply the mark-up achieved in that transaction without
adjusting
the cost base of the associated enterprise to make a valid comparison.
In some
cases, the costs that would be incurred by the recipient were it to
perform the
service for itself may be instructive of the type of arrangement an
recipient would
be prepared to accept for the service in dealing at arm's length.
7.36 When an associated enterprise is acting only as an agent or
intermediary in the provision of services, it is important in applying
the cost-plus
method that the return or mark-up is appropriate for the performance of
an
agency function rather than for the performance of the services
themselves. In
such a case, it may not be appropriate to determine arm's length pricing
as a
mark-up on the cost of the services but rather on the costs of the
agency function
itself, or alternatively, depending on the type of comparable data being
used, the
mark-up on the cost of services should be lower than would be
appropriate for the
performance of the services themselves. For example, an associated
enterprise
may incur the costs of renting advertising space on behalf of group
members,
SPECIAL CONSIDERATIONS FOR INTRA-GROUP SERVICES
March 1995 VII-13
©OECD
costs that the group members would have incurred directly had they been
independent. In such a case, it may well be appropriate to pass on these
costs to
the group recipients without a mark-up, and to apply a mark-up only to
the costs
incurred by the intermediary in performing its agency function.
7.37 While as a matter of principle tax administrations and taxpayers
should try to establish the proper arm's length pricing, it should not
be
overlooked that there may be practical reasons why a tax administration
in its
discretion exceptionally might be willing to forgo computing and taxing
an
arm's length price from the performance of services in some cases, as
distinct
from allowing a taxpayer in appropriate circumstances to merely allocate
the
costs of providing those services. For instance, a cost-benefit analysis
might
indicate the additional tax revenue that would be collected does not
justify the
costs and administrative burdens of determining what an appropriate
arm's
length price might be in some cases. In such cases, charging all
relevant costs
rather than an arm's length price may provide a satisfactory result for
MNEs
and tax administrations. This concession is unlikely to be made by tax
administrations where the provision of a service is a principal activity
of the
associated enterprise, where the profit element is relatively
significant, or
where direct charging is possible as a basis from which to determine the
arm's
length price.
C. Some examples of intra-group services
7.38 This section sets forth several examples of transfer pricing issues
in
the provision of intra-group services. The examples are provided for
illustrative purposes only. When dealing with individual cases, it is
necessary
to explore the actual facts and circumstances to judge the applicability
of any
transfer pricing method.
7.39 One example involves debt-factoring activities, where an MNE group
decides to centralize the activities for economic reasons. For example,
it may be
prudent to centralize the debt-factoring activities to limit currency
and debt risks
and to minimize administrative burdens. A debt-factoring centre that
takes on
this responsibility is performing intra-group services for which an
arm's length
charge should be made. A CUP method could be appropriate in such a case.
OECD TRANSFER PRICING GUIDELINES
VII-14 March 1995
©OECD
7.40 Contract manufacturing is another example of an activity that may
involve intra-group services. In such cases the producer may get
extensive
instruction about what to produce, in what quantity and of what quality.
The
production company bears low risks and may be assured that its entire
output will
be purchased, assuming quality requirements are met. In such a case the
production company could be considered as performing a service, and the
cost
plus method could be appropriate, subject to the principles in Chapter
II.
7.41 Contract research is an example of an intra-group service involving
highly skilled personnel that is often crucial to the success of the
group. The
actual arrangements can take a variety of forms from the undertaking of
detailed
programmes laid down by the principal party, extending to agreements
where the
research company has discretion to work within broadly defined
categories. In
the latter instance, generally involving frontier research, the
additional functions
of identifying commercially valuable areas and assessing the risk of
unsuccessful
research can be a critical factor in the performance of the group as a
whole.
However, the research company itself is often insulated from financial
risk since
it is normally arranged that all expenses will be reimbursed whether the
research
was successful or not. In addition, intangible property deriving from
research
activities is generally owned by the principal company and so risks
relating to the
commercial exploitation of that property are not assumed by the research
company itself. In such a case a cost plus method may be appropriate,
subject to
the principles in Chapter II.
7.42 Another example of intra-group services is the administration of
licences. The administration and enforcement of intangible property
rights
should be distinguished from the exploitation of those rights for this
purpose.
The control of a licence might be handled by a group service centre
responsible
for monitoring possible license infringements and for enforcing license
rights.
August 1997 VIII-1
©OECD
Chapter VIII
Cost contribution arrangements
A. Introduction
8.1 This Chapter discusses cost contribution arrangements (CCAs)
between two or more associated enterprises (possibly along with
independent
enterprises). There are many types of CCAs and this Chapter does not intend
to discuss or describe the tax consequences of every variation. Rather,
the
purpose of the Chapter is to provide some general guidance for
determining
whether the conditions established by associated enterprises for a CCA
are
consistent with the arm's length principle. The tax consequences of a
CCA will
depend upon whether the arrangement is structured in accordance with the
armÕs length principle according to the provisions of this Chapter and
is
adequately documented. This Chapter
does not resolve all significant issues
regarding the administration and tax consequences of CCAs. For example,
further guidance may be needed on measuring the value of contributions
to
CCAs, in particular regarding when cost or market prices are
appropriate, and
the effect of government subsidies or tax incentives (see paragraphs
8.15
and 8.17). Further development might also be useful regarding the tax
characterisation of contributions, balancing payments and buy-in/buy-out
payments (see paragraphs 8.23, 8.25, 8.33 and 8.35). Additional work
will be
undertaken as necessary to update and elaborate this Chapter as more
experience is gained in the actual operation of CCAs.
8.2 Section B provides a general definition and overview of the concept
of CCAs. Section C describes the standard for determining whether a CCA
satisfies the armÕs length principle. The discussion includes guidance
on how to
measure contributions for this purpose, guidance on whether balancing
payments are needed (i.e. payments
between participants to adjust their
proportionate shares of contributions), and guidance on how
contributions and
balancing payments should be treated for tax purposes. Section C also
addresses the determining of participants and the treatment of special
purpose
companies. Section D discusses the adjustments to be made in the event
that
the conditions of a CCA are found to be inconsistent with the armÕs
length
principle, including adjustments of the proportionate shares of
contributions
under the arrangement. Section E addresses issues relating to entry into
or
OECD TRANSFER PRICING GUIDELINES
VIII-2 August 1997
©OECD
withdrawal from a CCA after the arrangement has already commenced.
Section F discusses suggestions for structuring and documenting CCAs.
B. Concept of a CCA
i) In general
8.3 A CCA is a framework agreed among business enterprises to share
the costs and risks of developing, producing or obtaining assets,
services, or
rights, and to determine the nature and extent of the interests of each
participant
in those assets, services, or rights. A CCA is a contractual arrangement
rather
than necessarily a distinct juridical entity or permanent establishment
of all the
participants. In a CCA, each participantÕs proportionate share of the
overall
contributions to the arrangement will be consistent with the
participantÕs
proportionate share of the overall expected benefits to be received
under the
arrangement, bearing in mind that transfer pricing is not an exact
science.
Further, each participant in a CCA would be entitled to exploit its interest
in
the CCA separately as an effective owner thereof and not as a licensee,
and so
without paying a royalty or other consideration to any party for that
interest.
Conversely, any other party would be required to provide a participant
proper
consideration (e.g. a royalty),
for exploiting some or all of that participantÕs
interest.
8.4 Some benefits of the CCA activity will be known in advance, whereas
other benefits, for example, the outcome of research and development
activities, will be uncertain. Some types of CCA activities will produce
benefits in the short term, while others have a longer time frame or may
not be
successful. Nevertheless, in a CCA there is always an expected benefit
that
each participant seeks from its contribution, including the attendant
rights to
have the CCA properly administered. Each participantÕs interest in the
results
of the CCA activity should be established from the outset, even where
the
interest is inter-linked with that of other participants, e.g. because legal
ownership of developed intangible property is vested in only one of them
but
all of them have effective ownership interests.
COST CONTRIBUTION ARRANGEMENTS
August 1997 VIII-3
©OECD
ii) Relationship to other chapters
8.5 Chapter VI and Chapter VII provide guidance on how to determine an
armÕs length consideration for an intra-group transfer of, respectively,
intangible property and services. This ChapterÕs goal is to provide
supplementary guidance where resources and skills are pooled and the
consideration received is, in part or whole, the reasonable expectation
of
mutual benefits. Thus, the provisions of Chapter VI and VII, and indeed
all the
other chapters of these Guidelines, will continue to apply to the extent
relevant,
for instance in measuring the amount of a contribution to a CCA as part
of the
process of determining the proportionate shares of contributions. MNEs
are
encouraged to observe the guidance of this Chapter in order to ensure
that their
CCAs are in accordance with the armÕs length principle.
iii) Types of CCAs
8.6 Perhaps the most frequently encountered type of CCA is an
arrangement for the joint development of intangible property, where each
participant receives a share of rights in the developed property. In
such a CCA,
each participant is accorded separate rights to exploit the intangible
property,
for example in specific geographic areas or applications. Stated more
generally, a participant uses the intangible property for its own
purposes rather
than in a joint activity with other participants. The separate rights
obtained
may constitute actual legal ownership; alternatively, it may be that
only one of
the participants is the legal owner of the property, but economically
all the
participants are co-owners. In cases where a participant has an effective
ownership interest in any property developed by the CCA and the
contributions
are in the appropriate proportions, there is no need for a royalty
payment or
other consideration for use of the developed property consistent with
the
interest that the participant has acquired.
8.7 While CCAs for research and development of intangible property are
perhaps most common, CCAs need not be limited to this activity. CCAs
could
exist for any joint funding or sharing of costs and risks, for
developing or
acquiring property or for obtaining services. For example, business
enterprises
may decide to pool resources for acquiring centralised management
services, or
for the development of advertising campaigns common to the participantsÕ
markets.
OECD TRANSFER PRICING GUIDELINES
VIII-4 August 1997
©OECD
C. Applying the arm's length principle
i) In general
8.8 For the conditions of a CCA to satisfy the armÕs length principle, a
participantÕs contributions must be consistent with what an independent
enterprise would have agreed to contribute under comparable
circumstances
given the benefits it reasonably expects to derive from the arrangement.
What
distinguishes contributions to a CCA from an ordinary intra-group
transfer of
property or services is that part or all of the compensation intended by
the
participants is the expected benefits to each from the pooling of
resources and
skills. Independent enterprises do enter into arrangements to share
costs and
risks when there is a common need from which the enterprises can mutually
benefit. For instance, independent parties at armÕs length might want to
share
risks (e.g. of high technology
research) to minimise the loss potential from an
activity, or they might engage in a sharing of costs or in joint
development in
order to achieve savings, perhaps from economies of scale, or to improve
efficiency and productivity, perhaps from the combination of different
individual strengths and spheres of expertise. More generally, such
arrangements are found when a group of companies with a common need for
particular activities decides to centralise or undertake jointly the
activities in a
way that minimises costs and risks to the benefit of each participant.
8.9 The expectation of mutual benefit is fundamental to the acceptance
by
independent enterprises of an arrangement for pooling resources and
skills
without separate compensation. Independent enterprises would require
that
each participantÕs proportionate share of the actual overall
contributions to the
arrangement is consistent with the participantÕs proportionate share of
the
overall expected benefits to be received under the arrangement. To apply
the
armÕs length principle to a CCA, it is therefore necessary to determine
that all
the parties to the arrangement have the expectation of benefits, then to
calculate
each participantÕs relative contribution to the joint activity (whether
in cash or
in kind), and finally to determine whether the allocation of CCA
contributions
(as adjusted for any balancing payments made among participants) is proper.
It
should be recognised that these determinations may bear a degree of
uncertainty. The potential exists for contributions to be allocated
among CCA
participants so as to result in an overstatement of taxable profits in
some
countries and the understatement of taxable profits in others, measured
against
COST CONTRIBUTION ARRANGEMENTS
August 1997 VIII-5
©OECD
the armÕs length principle. For that reason, taxpayers should be
prepared to
substantiate the basis of their claim with respect to the CCA (see
Section F).
ii) Determining participants
8.10 Because the concept of mutual benefit is fundamental to a CCA, it
follows that a party may not be considered a participant if the party
does not
have a reasonable expectation that it will benefit from the CCA activity
itself
(and not just from performing part or all of that activity). A
participant
therefore must be assigned a beneficial interest in the property or
services that
are the subject of the CCA, and have a reasonable expectation of being
able
directly or indirectly (e.g. through
licensing arrangements or sales, whether to
associated or independent enterprises) to exploit or use the interest
that has
been assigned.
8.11 The requirement of an expected benefit does not impose a condition
that the subject activity in fact be successful. For example, research
and
development may fail to produce commercially valuable intangible
property.
However, if the activity continues to fail to produce any actual benefit
over a
period in which the activity would normally be expected to produce
benefits,
tax administrations may question whether the parties would continue
their
participation had they been independent enterprises (see the sections in
Chapter
I on business strategies (particularly 1.35), and losses (1.52-1.54)).
8.12 In some cases, the participants in a CCA may decide that all or
part of
the subject activity will be carried out by a separate company that is
not a
participant under the standard of paragraph 8.10 above. In such a case
of
contract research and/or manufacturing, an armÕs length charge would be
appropriate to compensate the company for services being rendered to the
CCA
participants. This would be the case even where, for example, the
company is
an affiliate of one or more of the CCA participants and has been
incorporated
in order to secure limited liability exposure in case of a high-risk
research and
development CCA activity. The armÕs length charge for the company would
be
determined under the general principles of Chapter I, including inter
alia
consideration of functions performed, assets used, and risks assumed, as
well as
the special considerations affecting an armÕs length charge for services
as
described in Chapter VII, particularly paragraphs 7.29 - 7.37.
OECD TRANSFER PRICING GUIDELINES
VIII-6 August 1997
©OECD
iii) The amount of each participantÕs contribution
8.13 For the purpose of determining whether a CCA satisfies the armÕs
length principle -- i.e. whether each
participantÕs proportionate share of the
overall contributions to the CCA is consistent with the participantÕs
proportionate share of the overall expected benefits -- it is necessary
to measure
the value or amount of each participantÕs contributions to the
arrangement.
8.14 Under the armÕs length principle, the value of each participantÕs
contribution should be consistent with the value that independent
enterprises
would have assigned to that contribution in comparable circumstances.
Therefore, in determining the value of contributions to a CCA the
guidance in
Chapters I through VII of these Guidelines should be followed. For
example, as
indicated in Chapter I of these Guidelines, the application of the armÕs
length
principle would take into account, inter alia, the contractual terms and
economic circumstances particular to the CCA, e.g. the sharing of risks and
costs.
8.15 No specific result can be provided for all situations, but rather
the
questions must be resolved on a case-by-case basis, consistent with the
general
operation of the armÕs length principle. Countries have experience both
with
the use of costs and with the use of market prices for the purposes of
measuring
the value of contributions to armÕs length CCAs. It is unlikely to be a
straightforward matter to determine the relative value of each
participantÕs
contribution except where all contributions are made wholly in cash, for
example, where the activity is being carried on by an external service
provider
and the costs are jointly funded by all participants.
8.16 It is important that the evaluation process recognises all
contributions
made by participants to the arrangement, including property or services
that are
used partly in the CCA activity and also partly in the participantÕs
separate
business activities. It can be difficult to measure contributions that
involve
shared property or services, for example where a participant contributes
the
partial use of capital assets such as buildings and machines or performs
supervisory, clerical, and administrative functions for the CCA and for
its own
business. It will be necessary to determine the proportion of the assets
used or
services that relate to the CCA activity in a commercially justifiable
way with
regard to recognised accounting principles and the actual facts, and
adjustments, if material, may be necessary to achieve consistency when
COST CONTRIBUTION ARRANGEMENTS
August 1997 VIII-7
©OECD
different jurisdictions are involved. Once the proportion is determined,
the
contribution can be measured in accordance with the principles in the
rest of
the Chapter.
8.17 In measuring a participantÕs contribution, there is an issue
regarding
any savings arising from subsidies or tax incentives (including credits
on
investments) that may be granted by a government. Whether and if so to
what
extent these savings should be taken into account in measuring the value
of a
participantÕs contribution depends upon whether independent enterprises
would
have done so in comparable circumstances.
8.18 Balancing payments may be required to adjust participantsÕ
proportionate shares of contributions. A balancing payment increases the
value of the contributions of the payer
and decreases the value of the
contributions of the payee by the amount of the payment. Balancing
payments
should maintain the armÕs length condition that each participantÕs proportionate
share of the overall contributions be consistent with its proportionate
share of
the overall expected benefits to be received under the arrangement. For
the tax
treatment of balancing payments, see paragraph 8.25 below.
iv) Determining whether the allocation is appropriate
8.19 There is no rule that could be universally applied to determine
whether each participantÕs proportionate share of the overall
contributions to a
CCA activity is consistent with the participantÕs proportionate share of
the
overall benefits expected to be received under the arrangement. The goal
is to
estimate the shares of benefits expected to be obtained by each
participant and
to allocate contributions in the same proportions. The shares of
expected
benefits might be estimated based on the anticipated additional income
generated or costs saved by each participant as a result of the
arrangement.
Other techniques to estimate expected benefits (e.g. using the price charged in
sales of comparable assets and services) may be helpful in some cases.
Another
approach that is frequently used in practice would be to reflect the
participantsÕ
proportionate shares of expected benefits by using an allocation key.
The
possibilities for allocation keys include sales, units used, produced, or
sold,
gross or operating profit, the number of employees, capital invested,
and so
forth. Whether any particular allocation key is appropriate depends on
the
OECD TRANSFER PRICING GUIDELINES
VIII-8 August 1997
©OECD
nature of the CCA activity and the relationship between the allocation
key and
the expected benefits.
8.20 To the extent that a material part or all of the benefits of a CCA
activity are expected to be realised in the future and not currently,
the
allocation of contributions will take account of projections about the
participantsÕ shares of those benefits. Use of projections may raise
problems for
tax administrations in verifying that such projections have been made in
good
faith and in dealing with cases where the projections vary markedly from
the
actual results. The problems may be exacerbated where the CCA activity
ends
several years before expected benefits actually materialise. It may be
appropriate, particularly where benefits are expected to be realised in
the
future, for a CCA to provide for possible adjustments of proportionate
shares of
contributions over the term of the CCA on a prospective basis to reflect
changes in relevant circumstances resulting in changes in shares of
benefits. In
situations where actual results differ markedly from projections, tax
administrations might be prompted to inquire whether the projections
made
would have been considered acceptable by independent enterprises in
comparable circumstances, taking into account all the developments that
were
reasonably foreseeable by the participants, without using hindsight.
8.21 In estimating the relative expected benefits accruing from R&D
directed towards the development of a new product line or process, one
measure sometimes used by businesses is the projected sales of the new
product line or projected stream of royalties to be received from
licensing the
new process. This example is for illustration only and it is not
intended to
suggest a preference for the use of sales data for any particular case.
Whatever
the indicator, if benefits are expected to be realised in the future,
care must be
taken to ensure that any current data used are a reliable indicator of
the future
pattern of shares of benefits.
8.22 Whatever the allocation method, adjustments to the measure used
may be necessary to account for differences in the expected benefits to
be
received by the participants, e.g. in
the timing of their expected benefits,
whether their rights are exclusive, the different risks associated with
their
receipt of benefits, etc. The allocation key most relevant to any
particular CCA
may change over time. If an arrangement covers multiple activities, it
will be
important to take this into account in choosing an allocation method, so
that the
contributions being allocated are properly related to the benefits
expected by
COST CONTRIBUTION ARRANGEMENTS
August 1997 VIII-9
©OECD
the participants. One approach (though not the only one) is to use more
than
one allocation key. For example, if there are five participants in a
CCA, one of
which cannot benefit from certain research activities undertaken within
the
CCA, then in the absence of some form of set-off or reduction in
contribution
the costs associated with those activities might be allocated only to
the other
four participants. In this case, two allocation keys might be used to
allocate the
costs. Also, exchange of information between treaty partners, the mutual
agreement procedure, and bilateral or multilateral advance pricing
arrangements may help establish the acceptability of the method of
allocation.
v) The tax treatment of contributions and balancing payments
8.23 Contributions by a participant to a CCA should be treated for tax
purposes in the same manner as would apply under the general rules of
the tax
system(s) applicable to that participant if the
contributions were made outside a
CCA to carry on the activity that is the subject of the CCA (e.g. to perform
research and development, to obtain a beneficial interest in property
needed to
carry out the CCA activity). The character of the contribution, e.g. as a research
and development expense, will depend on the nature of the activity being
undertaken by the CCA and will determine how it is recognised for tax
purposes. Frequently, the contributions would be treated as deductible
expenses
by reference to these criteria. No part of a contribution in respect of
a CCA
would constitute a royalty for the use of intangible property, except to
the
extent that the contribution entitles the contributor to obtain only a
right to use
intangible property belonging to a participant (or a third party) and
the
contributor does not also obtain a beneficial interest in the intangible
property
itself.
8.24 Because a participantÕs proper contribution to a CCA is to be
rewarded by the expected benefits to be derived from the arrangement and
these expected benefits may not accrue until a later period, there is
generally no
immediate recognition of income to the contributor at the time the
contribution
is made. The return to the contributor on its contribution will be
recognised
either in the form of cost savings (in which case there may not be any
income
generated directly by the CCA activity), or obtained as the results of
the
activity generate income (or loss) for the participant, for instance, in
the case of
R&D. Of course, in some cases such as the provision of services the
benefits
OECD TRANSFER PRICING GUIDELINES
VIII-10 August 1997
©OECD
arising from the arrangement may flow in the same period in which the
contribution is made and would therefore be recognised in that period.
8.25 A balancing payment should be treated as an addition to the costs
of
the payer and as a reimbursement (and therefore a reduction) of costs to
the
recipient. A balancing payment would not constitute a royalty for the
use of
intangible property, except to the extent that the payment entitles the
payer to
obtain only a right to use intangible property belonging to a
participant (or a
third party) and the payer does not also obtain a beneficial interest in
the
intangible property itself. In some cases a balancing payment might
exceed the
recipientÕs allowable expenditures or costs for tax purposes determined
under
the domestic tax system, in which case the excess could be treated as
taxable
profit.
D. Tax consequences if a CCA is not armÕs length
8.26 A CCA will be considered consistent with the arm's length principle
where each participantÕs proportionate share of the overall
contributions to the
arrangement, adjusted for any balancing payments, is consistent with the
participantÕs proportionate share of the overall expected benefits to be
received
under the arrangement. Where this is not the case, the consideration
received
by at least one of the participants for its contributions will be
inadequate, and
the consideration received by at least one other participant for its
contribution
will be excessive, relative to what independent enterprises would have
received. In such a case, the arm's length principle would require that
an
adjustment be made. The nature of the adjustment will depend upon the
facts
and circumstances, but most often will be an adjustment of the net
contribution
through making or imputing a balancing payment. Where the commercial
reality of an arrangement differs from the terms purportedly agreed by
the
participants, it may be appropriate to disregard part or all of the
terms of the
CCA. These situations are discussed below.
i) Adjustment of contributions
8.27 Where a participantÕs proportionate share of the overall
contributions
to a CCA, adjusted for any balancing payments, is not consistent with
the
participantÕs proportionate share of the overall expected benefits to be
received
COST CONTRIBUTION ARRANGEMENTS
August 1997 VIII-11
©OECD
under the arrangement, a tax administration is entitled to adjust the
participantÕs contribution (although bearing in mind that tax
administrations
should hesitate from making minor or marginal adjustments). See
paragraph 1.68. Such a situation may arise where the measurement of a
participantÕs proportionate contributions of property or services has
been
incorrectly determined, or where the participantsÕ proportionate
expected
benefits have been incorrectly assessed, e.g. where the allocation key when
fixed or adjusted for changed circumstances was not adequately
reflective of
proportionate expected benefits. See paragraph 8.19. Normally the
adjustment
would be made by a balancing payment from one or more participants to
another being made or imputed.
8.28 If a CCA is otherwise acceptable and carried out faithfully, having
regard to the recommendations of Section F, tax administrations should
generally refrain from making an adjustment based on a single fiscal
year.
Consideration should be given to whether each participantÕs
proportionate
share of the overall contributions is consistent with the participantÕs
proportionate share of the overall expected benefits from the
arrangement over
a period of years (see paragraphs 1.49-1.51)
ii) Disregarding part or all of the terms of a CCA
8.29 In some cases, the facts and circumstances may indicate that the
reality of an arrangement differs from the terms purportedly agreed by
the
participants. For example, one or more of the claimed participants may
not
have any reasonable expectation of benefit from the CCA activity.
Although in
principle the smallness of a participant's share of expected benefits is
no bar to
eligibility, if a participant that is performing all of the subject
activity is
expected to have only a small fraction of the overall expected benefits,
it may
be questioned whether the reality of the arrangements for that party is
to share
in mutual benefits or whether the appearance of sharing in mutual
benefits has
been constructed to obtain more favourable tax results. In such cases,
the tax
administration may determine the tax consequences as if the terms of the
arrangements had been consistent with those that might reasonably have
been
expected had the arrangements involved independent enterprises, in
accordance
with the guidance in paragraphs 1.36-1.41.
OECD TRANSFER PRICING GUIDELINES
VIII-12 August 1997
©OECD
8.30 A tax administration may also disregard part or all of the
purported
terms of a CCA where over time there has been a substantial discrepancy
between a participantÕs proportionate share of contributions (adjusted
for any
balancing payments) and its proportionate share of expected benefits,
and the
commercial reality is that the participant bearing a disproportionately
high
share of the contributions should be entitled to a greater beneficial
interest in
the subject of the CCA. In such a case, that participant might be
entitled to an
armÕs length compensation for the use of that interest by the other
participants.
In circumstances that indicate an attempt to abuse the rules governing
CCAs, it
may be appropriate for a tax administration to disregard the CCA in its
entirety.
E. CCA entry, withdrawal, or termination
8.31 An entity that becomes a participant in an already active CCA might
obtain an interest in any results of prior CCA activity, such as
intangible
property developed through the CCA, work in-progress and the knowledge
obtained from past CCA activities. In such a case, the previous
participants
effectively transfer part of their respective interests in the results
of prior CCA
activity. Under the arm's length principle, any transfer of pre-existing
rights
from participants to a new entrant must be compensated based upon an
armÕs
length value for the transferred interest. This compensation is called a
"buy-in"
payment. The relevant terminology varies across jurisdictions, and so
sometimes any contribution (or balancing payment) made in recognition of
the
transfer of pre-existing property or rights is called a buy-in payment,
whether
or not it is made by a new entrant to the CCA. For purposes of this
Chapter,
however, the term "buy-in payment" is limited to payments made
by new
entrants to an already active CCA for obtaining an interest in any
results of
prior CCA activity. Other contributions, including balancing payments,
are
addressed separately in this Chapter.
8.32 The amount of a buy-in payment should be determined based upon
the arm's length value of the rights the new entrant is obtaining,
taking into
account the entrantÕs proportionate share of overall expected benefits
to be
received under the CCA. It is possible that the results of prior CCA
activity
may have no value, in which case there would be no buy-in payment. There
may also be cases where a new participant brings already existing
intangible
property to the CCA, and that balancing payments would be appropriate
from
the other participants in recognition of this contribution. In such
cases, the
COST CONTRIBUTION ARRANGEMENTS
August 1997 VIII-13
©OECD
balancing payments and the buy-in payment could be netted, although
appropriate records must be kept of the full amounts of the separate
payments
for tax administration purposes.
8.33 A buy-in payment should be treated for tax purposes in the same
manner as would apply under the general rules of the tax system(s)
(including
conventions for the avoidance of double taxation) applicable to the
respective
participants as if the payment were made outside a CCA for acquiring the
interest being obtained, e.g. an interest
in intangible property already developed
by the CCA, work in progress and the knowledge obtained from past CCA
activities. No part of a buy-in payment in respect of a CCA would
constitute a
royalty for the use of intangible property, except to the extent that
the payment
entitles the payer to obtain only a right to use intangible property
belonging to a
participant (or a third party) and the payer does not also obtain a
beneficial
interest in such intangible property itself.
8.34 Issues similar to those relating to a buy-in could arise when a
participant leaves a CCA. In particular, a participant who leaves a CCA
may
dispose of its interest in the results of past CCA activity (including
work in
progress) to the other participants. If there is an effective transfer
of property
rights at the time of a participant's withdrawal, the transfer should be
compensated according to the arm's length principle. This compensation
is
called a "buy-out" payment.
8.35 In some cases, the results of prior CCA activity may have no value,
in
which case there would be no buy-out payment. In addition, the amount of
the
buy-out payment under the arm's length principle should consider the
perspective of the remaining participants. For example, in some cases a
participant's withdrawal results in an identifiable and quantifiable
reduction in
the value of the continuing CCA activity. Where, however, the value of a
remaining participantÕs interest in the results of past CCA activity has
not
increased as a result of the withdrawal, a buy-out payment from that
participant
would not be appropriate. A buy-out payment should be treated for tax
purposes in the same manner as would apply under the general rules of
the tax
system(s) (including conventions for the avoidance of double taxation)
applicable to the respective participants as if the payment were made
outside a
CCA as consideration for the disposal of the pre-existing rights (e.g.
an interest
in intangible property already developed by the CCA, work-in-progress
and the
knowledge obtained from past activities undertaken within the CCA). No
part
OECD TRANSFER PRICING GUIDELINES
VIII-14 August 1997
©OECD
of a buy-out payment in respect of a CCA would constitute a royalty for
the use
of intangible property, except to the extent that the payment entitles
the payer
to obtain only a right to use intangible property belonging to the
departing
participant and the payer does not also obtain a beneficial interest in
the
intangible property itself.
8.36 There may be instances in which the absence of buy-in and buy-out
payments is not a problem. For example, such provisions would not be
required where the arrangement is solely for the provision of services
that
participants jointly acquire and pay for on a current basis and the
services do
not result in the creation of any property or right.
8.37 When a member enters or withdraws from a CCA, it may also be
necessary to adjust the proportionate shares of contributions (based on
changes
in proportionate shares of expected benefits) for the increased or
reduced
number of participants who remain after the entry or withdrawal.
8.38 There may be cases where, even though the CCA does not contain
terms addressing the consequences of participants entering or
withdrawing, the
participants make appropriate buy-in and buy-out payments and adjust
proportionate shares of contributions (reflecting changes in
proportionate
shares of expected benefits) when changes in membership have occurred.
The
absence of express terms should not prevent a conclusion that a CCA
exists in
respect of past activities, provided the intention and conduct of the
parties
involved is otherwise consistent with the guidelines contained in this
Chapter.
However, ideally such arrangements should be amended to address future
changes in membership expressly.
8.39 When a CCA terminates, the armÕs length principle would require
that each participant receive a beneficial interest in the results of
the CCA
activity consistent with the participantÕs proportionate share of
contributions to
the CCA throughout its term (adjusted by balancing payments actually
made
including those made incident to the termination). Alternatively, a
participant
could be properly compensated according to the armÕs length principle by
one
or more other participants for surrendering its interest in the results
of the CCA
activity.
COST CONTRIBUTION ARRANGEMENTS
August 1997 VIII-15
©OECD
F. Recommendations for structuring and documenting CCAs
8.40 A CCA should be structured in a manner that conforms to the armÕs
length principle. A CCA at armÕs length normally would meet the
following
conditions:
a) The participants would include only enterprises
expected to derive
mutual benefits from the CCA activity itself, either directly or
indirectly (and not just from performing part or all of that
activity). See paragraph 8.10;
b) The arrangement would specify the nature
and extent of each
participant's beneficial interest in the results of the CCA activity;
c) No payment other than the CCA
contributions, appropriate
balancing payments and buy-in payments would be made for the
beneficial interest in property, services, or rights obtained through
the CCA;
d) The proportionate shares of contributions
would be determined in
a proper manner using an allocation method reflecting the sharing
of expected benefits from the arrangement;
e) The arrangement would allow for balancing
payments or for the
allocation of contributions to be changed prospectively after a
reasonable period of time to reflect changes in proportionate
shares of expected benefits among the participants; and
f) Adjustments would be made as necessary
(including the
possibility of buy-in and buy-out payments) upon the entrance or
withdrawal of a participant and upon termination of the CCA.
8.41 As indicated in Chapter V on Documentation, it would be expected
that application of prudent business management principles would lead
the
participants to a CCA to prepare or to obtain materials about the nature
of the
subject activity, the terms of the arrangement, and its consistency with
the
armÕs length principle. Implicit in this is that each participant should
have full
access to the details of the activities to be conducted under the CCA,
projections on which the contributions are to be made and expected
benefits
OECD TRANSFER PRICING GUIDELINES
VIII-16 August 1997
©OECD
determined, and budgeted and actual expenditures for the CCA activity.
All
this information could be relevant and useful to tax administrations in
the
context of a CCA and taxpayers should be prepared to provide it upon
request.
The information relevant to any particular CCA will depend on the facts
and
circumstances. It should be emphasised that the information described in
this
list is neither a minimum compliance standard nor an exhaustive list of
the
information that a tax administration may be entitled to request.
8.42 The following information would be relevant and useful concerning
the initial terms of the CCA:
a) a list of participants;
b) a list of any other associated enterprises
that will be involved with
the CCA activity or that are expected to exploit or use the results
of the subject activity;
c) the scope of the activities and specific
projects covered by the
CCA;
d) the duration of the arrangement;
e) the manner in which participantsÕ
proportionate shares of expected
benefits are measured, and any projections used in this
determination;
f) the form and value of each participantÕs
initial contributions, and a
detailed description of how the value of initial and ongoing
contributions is determined and how accounting principles are
applied consistently to all participants in determining expenditures
and the value of contributions;
g) the anticipated allocation of
responsibilities and tasks associated
with the CCA activity between participants and other enterprises;
h) the procedures for and consequences of a
participant entering or
withdrawing from the CCA and the termination of the CCA; and
COST CONTRIBUTION ARRANGEMENTS
August 1997 VIII-17
©OECD
i) any provisions for balancing payments or
for adjusting the terms
of the arrangement to reflect changes in economic circumstances.
8.43 Over the duration of the CCA term, the following information could
be useful:
a) any change to the arrangement (e.g. in terms, participants, subject
activity), and the consequences of such change;
b) a comparison between projections used to
determine expected
benefits from the CCA activity with the actual results (however,
regard should be had to paragraph 1.51); and
c) the annual expenditure incurred in
conducting the CCA activity,
the form and value of each participantÕs contributions made during
the CCAÕs term, and a detailed description of how the value of
contributions is determined and how accounting principles are
applied consistently to all participants in determining expenditures
and the value of contributions.
October 1999 A-1
© OECD
Appendix
RECOMMENDATION OF THE COUNCIL ON THE
DETERMINATION OF TRANSFER PRICING BETWEEN
ASSOCIATED ENTERPRISES [C(95)126/Final] as amended
The COUNCIL,
Having regard to Article 5(b) of the Convention on the Organisation for
Economic Co-operation and Development of 14th December, 1960;
Having regard to the Declaration of 21st June, 1976 adopted by the
Governments of OECD Member Countries on International Investment and
Multinational Enterprises and the Guidelines annexed thereto
[C(76)99(Final)];
Having regard to the Report on the Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administrations, hereafter referred to
as "the
1995 Report" [DAFFE/CFA(95)19 and Corrigendum I] adopted on 27 June
1995
by the Committee on Fiscal Affairs, as supplemented by the report on
intangible
property and services adopted on 23 January 1996 by the Committee on
Fiscal
Affairs [DAFFE/CFA(96)2], by the report on cost contribution
arrangements
adopted on 25 June 1997 by the Committee on Fiscal Affairs
[DAFFE/CFA(97)27] and by the report on the guidelines for conducting APAs
under the mutual agreement procedure adopted on 30 June 1999 by the
Committee on Fiscal Affairs [DAFFE/CFA(99)31];
Having regard to the fundamental need for co-operation among tax
administrations in order to remove the obstacles that international double
taxation
presents to the free movement of goods, services and capital between
Member
countries;
OECD TRANSFER PRICING GUIDELINES
A-2 October 1999
© OECD
Considering that transactions between associated enterprises may take
place under conditions differing from those taking place between
independent
enterprises;
Considering that the prices of such transactions between associated
enterprises (usually referred to as transfer pricing) should,
nevertheless, for tax
purposes be in conformity with those which would be charged between
independent enterprises (usually referred to as armÕs length pricing) as
provided
in Article 9 (paragraph 1) of the OECD Model Tax Convention on Income
and on
Capital;
Considering that problems with regard to transfer pricing in
international transactions assume special importance in view of the
substantial
volume of such transactions;
Considering the need to achieve consistency in the approaches of tax
administrations, on the one hand, and of associated enterprises, on the
other hand,
in the determination of the income and expenses of a company that is
part of a
Multinational Enterprise Group that should be taken in to account within
a
jurisdiction.
I. RECOMMENDS to the Governments of Member countries:
I.1. that their tax administrations follow, when reviewing, and if
necessary,
adjusting transfer pricing between associated enterprises for the
purposes of
determining taxable income, the guidance in the 1995 Report, as amended
--
considering the integrity of the Report and the interaction of the
different
chapters -- for arriving at armÕs length pricing for transactions
between associated
enterprises;
I.2. that tax administrations should encourage taxpayers to follow the
guidance in the 1995 Report, as amended and to that end that they give
the 1995
Report as amended publicity in their country and have it translated,
where
necessary, into their national language(s);
I.3. that they develop further co-operation between their tax
administrations, on a bilateral or multilateral basis, in matters
pertaining to
transfer pricing.
RECOMMENDATION
October 1999 A-3
© OECD
II. INVITES the Governments of Member countries:
II.1. to notify the Committee on Fiscal Affairs of any modifications to
the
text of any laws or regulations that are relevant to the determination
of transfer
pricing or of the introduction of new laws or regulations.
III. INSTRUCTS the Committee on Fiscal Affairs:
III.1. to pursue its work on issues pertinent to transfer pricing and to
issue the
additions to the guidelines referred to in the 1995 Report as amended;
III.2. to monitor the implementation of the 1995 Report as amended, in
cooperation
with the tax authorities of Member countries and with the participation
of the business community and to recommend to the Council to amend and
update, if necessary, the 1995 Report as amended, in the light of this
monitoring;
III.3. to report periodically to the Council on the results of its work
in these
matters together with any relevant proposals for improved international
cooperation;
III.4. to develop its dialogue with non-Member countries, consistently
with
the policy of the Organisation, with the aim of assisting them to become
familiar
with the 1995 Report as amended, and where appropriate encourage them to
associate themselves with the 1995 Report as amended.
February 1998 AN-1
©OECD
Annex
GUIDELINES FOR MONITORING PROCEDURES ON THE OECD
TRANSFER PRICING GUIDELINES AND THE INVOLVEMENT OF
THE BUSINESS COMMUNITY
A. Background
1. In July 1995, the OECD Council approved for publication "Transfer
Pricing Guidelines for Multinational Enterprises and Tax
Administrations"
("the Guidelines"), submitted by the Committee on Fiscal
Affairs ("the
Committee"). At the same time, the OECD Council endorsed the
CommitteeÕs
recommendation that the Guidelines be reviewed and up-dated periodically
as
appropriate based upon the experience of Member countries and the
business
community with the application of the principles and methods set forth
in the
Guidelines. For this purpose, and to facilitate on-going clarifications
and
improvements, the OECD Council instructed the Committee to undertake a
period of monitoring international transfer pricing experience. The
monitoring
role is seen as an integrated part of the agreement reached in July 1995
and its
successful implementation is a key feature to getting a consistent
application of
the Guidelines. The Council Recommendation "instructs the Committee
on
Fiscal Affairs:---to monitor the implementation of the 1995 Report in
cooperation
with the tax authorities of Member countries and with the
participation of the business community and to recommend to the Council
to
amend and update, if necessary, the 1995 Report in the light of this
monitoring".
2. To summarise, the main purpose of the monitoring is to examine how
far Member countries' legislation, regulations and administrative
practices are
consistent with the Guidelines and to identify areas where the
Guidelines may
require amendments or additions. The monitoring should not only lead to
identification of problematic issues, but also to the identification of
practices
OECD TRANSFER PRICING GUIDELINES
AN-2 February 1998
©OECD
followed by one or more Member countries in applying the Guidelines
which
could be usefully extended to other countries. The monitoring is not intended
to arbitrate on particular cases.
3. The monitoring is expected to be an on-going process and to cover all
aspects of the Guidelines but with particular emphasis on the use of
transactional profit methods. The purpose of this note is to set forth
some
procedures for carrying out the monitoring, thereby implementing the
instruction of the OECD Council. These procedures will be implemented
gradually. Further revisions may be necessary once the procedures have
been
put into practice.
4. In line with the Council's Recommendation, there will be a role for
the business community in the monitoring and this role is set out in
Section C.
B. Process
5. The monitoring process will be carried out through four related
projects: (1) peer reviews of Member country practices; (2)
identification and
analysis of difficult case paradigms; (3) review of changes in
legislation,
regulations, and administrative practices; and (4) development of
examples.
Each of these is discussed below.
i) Peer reviews
6. The Working Party No. 6 on Taxation of Multinational Enterprises
(Òthe Working PartyÓ) has been undertaking peer reviews of the transfer
pricing practices of Member countries over the course of the last few
years.
The peer reviews aim to gain detailed information on legislation,
practices and
experiences of transfer pricing in Member countries. The Delegates of
the
Working Party jointly decide which country should be reviewed and which
countries would conduct the review. The reviews follow guidelines
approved
by the Committee.
7. The peer review guidelines call for a report to be submitted to the
Working Party for each reviewed country. The report covers the legal
basis for
dealing with transfer pricing issues, any country guidelines to direct
MONITORING PROCEDURES
February 1998 AN-3
©OECD
enforcement practices, approaches commonly used to address a complex
transfer pricing problem, administrative arrangements for handling
transfer
pricing cases, case law principles, and experience with data gathering
and
taxpayer documentation. The report also is to describe experiences with
administrative approaches to avoiding and resolving transfer pricing
disputes
(e.g. mutual agreement procedure, advance pricing arrangements and safe
harbours).
8. Peer reviews will continue to be carried out but at three different
levels:
i) The first level would be an Òissue
reviewÓ, which would
look at the approach taken by all Member countries to a
particular issue of widespread significance. Ideally, the
review should link up with other aspects of the
monitoring process. For example, the best way to solve
any problems emerging from such a review may be to
analyse the issue in more detail by developing difficult
case paradigms (see Part B (ii) below) or to develop
practical examples for insertion in the Guidelines (see
Part B (iv) below).
ii) The second level would be a Òlimited
reviewÓ in that it
would only look at the approach of a particular country
or countries in relation to a specific and relatively narrow
issue. The review would be carried out by two reviewers
for each country and the level of input necessary would
depend on the nature of the issue
iii) The third level would be a Òfull
reviewÓ of a particular
country which would be carried out according to the
existing peer review guidelines referred to in paragraph 7
above. A Òfull reviewÓ would therefore address directly
the interpretation and application of the Guidelines in the
particular Member country.
OECD TRANSFER PRICING GUIDELINES
AN-4 February 1998
©OECD
Selection Criteria
9. To improve the effectiveness of the peer review process it is
essential
that the reviews are undertaken selectively and concentrate on the areas
of
greatest difficulty in applying the Guidelines. The final decision to
undertake
any of the three types of review will be made by the full Working Party
having
regard both to the overall usefulness of any review to the work of the
Working
Party in monitoring the application of the Guidelines and to whether
there are
sufficient resources available to undertake the proposed review. It is
important
that any review, once undertaken, is completed to a high standard so
that
worthwhile conclusions can be drawn from it.
ii) Identification and analysis of difficult case paradigms
10. A key aspect of monitoring will be to identify and then to analyse
difficult fact patterns and problem areas which may be illustrated by
practical
examples and which present obstacles to an internationally consistent
application of the transfer pricing methods set out in the Guidelines.
Monitoring will also include areas where the Guidelines appear to offer
no or
inadequate guidance to tax authorities or taxpayers. All Member
countries will
be actively involved in this process and recognise that resources will
be
required to ensure its success. The business community will also be
involved
in the monitoring (see Section C).
11. The first issue is the procedure to be used and the responsibility
assigned for identifying the difficult case paradigms, focusing on
issues and
situations where the Guidelines may provide no or inadequate guidance or
where Member countries might be interpreting the Guidelines differently
and
therefore presenting obstacles to an internationally consistent
application of the
Guidelines. Member countries can identify areas where, in their view,
the
Guidelines might not address or adequately address a particular issue .
12. In the context of the regular meetings of Tax Inspectors organised
by
the Committee on Fiscal Affairs, the Working Party will arrange biennial
meetings of tax examiners to discuss difficult case paradigms and to
provide an
input to any appropriate updates to the Guidelines. OECD will consider
the
difficult case paradigms only from the perspective of monitoring the
application of the Guidelines.
MONITORING PROCEDURES
February 1998 AN-5
©OECD
13. Individual countries would take responsibility at meetings of
Working
Party No. 6 for leading discussions of the difficult case paradigms and
of
problematic areas that can be illustrated with practical examples.
14. The outcomes envisaged by the Working Party from the identification
and analysis of difficult case paradigms could include the development
of
examples illustrating the application of the Guidelines in cases
(identified for
discussion) where the principles already contained within the Guidelines
can be
applied. It could also include identification of areas where the
Guidelines
could be amended to provide clearer guidance or where new material could
be
inserted into the Guidelines.
iii) Updates of legislation and practice
15. The Secretariat will solicit from Member countries reports on
developments in their domestic transfer pricing legislation,
regulations, and
administrative practices, consistent with the invitation of the Council.
iv) Development of examples
16. The foregoing monitoring procedures will parallel the development of
additional hypothetical examples to be added to the Guidelines. The
examples
are not intended to develop new principles or to cover new issues but
rather to
assist in interpreting principles and in addressing difficult issues
already
discussed in the Guidelines. To ensure that they are of practical value
and avoid
being overly prescriptive the examples will be short, based on stated
facts and
relatively straightforward so that their scope is not so confined that
the
guidance they provide is of narrow and limited application. The examples
will
fall into two broad categories. The first will consist of illustrations
of the
application of the methods and approaches described in the Guidelines.
The
second set of examples will be designed to aid in the selection of a
suitable
transfer pricing method or methods. Although hypothetical, the examples
will
draw on the practical experiences of tax administrations and taxpayers
in
applying the arm's length principle under the Guidelines, and will
contribute to
the establishing of good practices.
OECD TRANSFER PRICING GUIDELINES
AN-6 February 1998
©OECD
C. Involvement of the business community
17. It is not intended that the OECD should intervene in the resolution
of
transfer pricing disputes between a taxpayer and a tax administration.
The
monitoring process is not intended to be a form of arbitration and so
taxpayers
will not be able to present individual cases for resolution by the
Working Party.
Nevertheless, as foreseen in the Guidelines and the Council
Recommendation,
the business community will be encouraged to identify problematic issues
(preferably illustrated with practical but hypothetical examples) which
raise
questions about the internationally consistent application of the
Guidelines.
18. The Business Industry Advisory Committee (BIAC) will be invited to
present practical difficulties in monitoring the application of the
Guidelines to
the Working Party for its consideration of the adequacy of the guidance
provided in the Guidelines in relation to such areas, respecting
confidentiality
of the information.
19. In contributing to the OECD role of monitoring the implementation of
the Guidelines, the business community would be encouraged to take
particular
note of the guidance given at paragraph 17 above. It should therefore
focus on
issues that give rise to either theoretical or
practical difficulties and not on
specific and unresolved transfer pricing cases. However, it may be
useful to
illustrate a particular issue by reference to a hypothetical example. In
constructing such an example, which could draw upon features taken from
a
number of real cases, care should be taken to ensure it remains
hypothetical and
does not resemble a current case, and that the features described should
be
restricted to the problematic issues concerned in order to avoid an
impression
of setting any general precedent for the resolution of an individual
case.
Peer reviews
20. It is felt that one of the strengths of the peer review process is
that the
review is conducted solely by peers i.e. in this case the other Member
countries. That way the process is conducted in a positive and
constructive
manner so that best practice can be passed on and worse practice
improved.
However, the general guidance to the business community encourages them
to
identify problematic issues which may be suitable for further analysis
and the
MONITORING PROCEDURES
February 1998 AN-7
©OECD
Working Party will be able to take account of this input when making its
final
selection of issues for the revised peer review.
21. It is also envisaged that once an issue or a country has been
selected
by the Working Party for further review, the BIAC will be notified of
the
decision so that they have the opportunity to comment. If the issue is
one
originally identified by the BIAC - particularly in the context of issue
reviews -
they would be kept informed of the Working PartyÕs discussion on these
issues
and asked, if necessary, to provide additional clarification. However, a
further
role for the BIAC in the peer review process beyond that already
described is
not contemplated at the moment.
Identification and analysis of difficult case paradigms and the
development
of examples
22. The difficult case paradigms are intended to illustrate issues and
situations where the Guidelines provide no or inadequate guidance.
Practical
examples when complete will be inserted into the Guidelines to provide
illustrations of particular principles. There is a clear role for the
business
community in assisting in the development of paradigms or examples by
contributing the practical experience of their members. The Working
Party will
ask for comments on both the difficult case paradigms and the practical
examples at regular stages in their development. BIAC may also initiate
paradigms or examples, provided the caveats in paragraph 17 are followed
so
that there can be no question of the process being used to resolve a
particular
transfer pricing case.
Updates of legislation and practice
23. The aim of this element in the monitoring process is to keep the
Member countries informed about developments in each othersÕ countries.
There are usually well established ways at the national level by which
the
business community can make an input into any developments in the
transfer
pricing legislation, regulations and administrative practices of a
Member
country. At the level of the OECD, the BIAC will
have an opportunity to bring
to the attention of the Working Party changes in legislation or
practices in both
Member and non-Member countries, which it considered were inconsistent
OECD TRANSFER PRICING GUIDELINES
AN-8 February 1998
©OECD
with the Guidelines or which it felt could give rise to practical
problems in
terms of implementation without, of course, referring to individual
cases.
24. The input from the BIAC will be discussed at the regular joint
meetings between the BIAC and the Working Party.
February 1998 AN-9
©OECD
Annex
ANNEX OF EXAMPLES TO ILLUSTRATE
THE TRANSFER PRICING GUIDELINES
The adjustments and assumptions about armÕs length arrangements in the
examples that follow are intended for illustrative purposes only and
should not
be taken as prescribing adjustments and armÕs length arrangements in
actual
cases or particular industries. While they seek to demonstrate the
principles of
the Sections of the Guidelines to which they refer, those principles
must be
applied in each case according to the specific facts and circumstances
of that
case.
February 1998 AN-11
©OECD
APPLICATION OF THE RESIDUAL PROFIT SPLIT METHOD
1. The success of an electronics product is linked to the innovative
technological design both of its electronic processes and of its major
component. That component is designed and manufactured by associated
company A, is transferred to associated company B which designs and
manufactures the rest of the product, and is distributed by associated
company
C. Information exists to verify by means of a resale price method that
the
distribution functions and risks of Company C are being appropriately
rewarded by the transfer price of the finished product from B to C.
2. The most reliable method to price the component transferred from A
to B would be a CUP, if a sufficiently similar comparable could be
found. See
Paragraph 2.7 of the Guidelines. However, since the component
transferred
from A to B reflects the innovative technological advance enjoyed by
company
A in this market, in this example it proves impossible (after the
appropriate
functional and comparability analyses have been carried out) to find a
reliable
CUP to estimate the correct price that A could command at armÕs length
for its
product. Calculating a return on AÕs manufacturing costs could however
provide an estimate of the profit element which would reward AÕs
manufacturing functions, ignoring the profit element attributable to the
intangible used therein. A similar calculation could be performed on
company
BÕs manufacturing costs, to give an estimate of BÕs profit derived from
its
manufacturing functions, ignoring the profit element attributable to its
intangible. Since BÕs selling price to C is known and is accepted as an
armÕs
length price, the amount of the residual profit accrued by A and B
together
from the exploitation of their respective intangible property can be
determined.
See Paragraphs 3.5, 3.19 of the Guidelines. At this stage the proportion
of this
residual profit properly attributable to each enterprise remains
undetermined.
3. The residual profit may be split based on an analysis of the facts
and
circumstances that might indicate how the additional reward would have
been
OECD TRANSFER PRICING GUIDELINES
AN-12 February 1998
©OECD
allocated at armÕs length. Paragraph 3.19 of the Guidelines. The R&D
activity
of each company is directed towards technological design relating to the
same
class of item, and it is established for the purposes of this example
that the
relative amounts of R&D expenditure reliably measure the relative
value of the
companiesÕ contributions. See Paragraph 3.18 of the Guidelines. This
means
that each companyÕs contribution to the productÕs technological
innovation
may reliably be measured by their relative expenditure on research and
development, so that, if AÕs R&D expenditure is 15 and BÕs 10, the
residual
could be split 3.2.
4. Some figures may assist in following the example:
a) Profit & Loss of A and B
A B
Sales 50 100
Less
Purchases 10 50
Manufacturing costs 15 20
Gross profit 25 30
Less
R&D 15 10
Operating expenses 10 25 10 20
Net profit 0 10
b) Determine routine profit on manufacturing by A and B, and
calculate total residual profit
It is established, for both jurisdictions, that third-party comparable
manufacturers without innovative intangible property earn a return on
manufacturing costs (excluding purchases) of 10% (ratio of net profit to
the
direct and indirect costs of manufacturing).1 See Paragraph 3.19 of the
1 This 10% return does not technically
correspond to a cost plus mark-up in its
strictest sense because it yields net profit rather than gross profit.
But neither
does the 10% return correspond to a TNMM margin in its strictest sense,
INTANGIBLE PROPERTY AND UNCERTAIN VALUATION
February 1998 AN-13
©OECD
Guidelines. AÕs manufacturing costs are 15, and so the return on costs
would
attribute to A a manufacturing profit of 1.5. BÕs equivalent costs are
20, and so
the return on costs would attribute to B a manufacturing profit of 2.0.
The
residual profit is therefore 6.5, arrived at by deducting from the
combined net
profit of 10 the combined manufacturing profit of 3.5.
c) Allocate residual profit
The initial allocation of profit (1.5 to A and 2.0 to B) rewards the
manufacturing functions of A and B, but does not recognise the value of
their
respective R&D that has resulted in a technologically advanced
product. That
residual can, therefore, be split between A and B based on their share
of total
R&D costs, since, for the purposes of this example2, it can reliably be assumed
that the companiesÕ relative expenditure on R&D accurately reflects
their
relative contributions to the value of the productÕs technological
innovation.
AÕs R&D expenditure is 15 and BÕs 10, giving combined R&D
expenditure of
25. The residual is 6.5 which may be allocated 15/25 to A and 10/25 to
B,
resulting in a share of 3.9 and 2.6 respectively, as below:-
AÕs share6.5 x 15/25= 3.9
BÕs share 6.5 x 10/25= 2.6.
d) Recalculate Profits
AÕs net profits would thus become 1.5+ 3.9 = 5.4.
BÕs net profits would thus become 2.0 + 2.6 = 4.6.
since the cost base does not include operating expenses. The net return
on
manufacturing costs is being used as a convenient and practical first
stage of
the profit split method, because it simplifies the determination of the
amount
of residual net profit attributable to intangible property.
2 But see paragraph 6.27 of the Guidelines.
OECD TRANSFER PRICING GUIDELINES
AN-14 February 1998
©OECD
The revised P & L for tax purposes would appear as:
A B
Sales 55.4 100
Less
Purchases 10 55.4
Manufacturing costs 15 20
Gross profit 30.4 24.6
Less
R&D 15 10
Operating expenses 10 25 10 20
Net profit 5.4 4.6
Note
5. The example is intended to exemplify in a simple manner the
mechanisms of a residual profit split and should not be interpreted as
providing
general guidance as to how the armÕs length principle should apply in
identifying armÕs length comparables and determining an appropriate
split. It is
important that the principles that it seeks to illustrate are applied in
each case
taking into account the specific facts and circumstances of the case. In
particular, it should be noted that the allocation of the residual split
may need
considerable refinement in practice in order to identify and quantify
the
appropriate basis for the allocation. Where R&D expenditure is used,
differences in the types of R&D conducted may need to be taken into
account,
e.g. because different types of R&D may have different levels of
risk
associated with them, which would lead to different levels of expected
returns
at armÕs length. Relative levels of current R&D expenditure also may
not
adequately reflect the contribution to the earning of current profits
that is
attributable to intangible property developed or acquired in the past.
February 1998 AN-15
©OECD
INTANGIBLE PROPERTY AND UNCERTAIN VALUATION3
Example 1
1. Manufacturing and distribution rights for an established drug are
licensed between associated enterprises under an agreement that fixes
the rate
of royalty for the three-year term of the agreement. Those terms are
found to
be in accordance with industry practice and equivalent armÕs length
agreements for comparable products, and the rate is accepted as being
equivalent to that agreed in uncontrolled transactions based on the
benefits
reasonably anticipated by both parties at the time the agreement is
executed.
2. In the third year of the agreement, it is discovered that the drug
has
capabilities in another therapeutic category in combination with another
drug,
and the discovery leads to a considerable increase in sales and profits
for the
licensee. Had the agreement been negotiated at armÕs length in year
three
with this knowledge, there is no doubt that a higher royalty rate would
have
been agreed to reflect the increased value of the intangible.
3. There is evidence to support the view (and the evidence is made
available to the tax administration) that the new capabilities of the
drug were
unanticipated at the time the agreement was executed and that the
royalty rate
established in year one was adequately based on the benefits reasonably
anticipated by both parties at that time. The lack of price adjustment
clauses
or other protection against the risk of uncertainty of valuation also is
consistent with the terms of comparable uncontrolled transactions. And,
3. The following three examples illustrate the application of the
principles
concerning armÕs length pricing when valuation of transferred intangible
property is highly uncertain at the time of the transaction. See
paragraphs
6.28-6.35.
OECD TRANSFER PRICING GUIDELINES
AN-16 February 1998
©OECD
based on analysis of the behaviour of independent enterprises in similar
circumstances, there is no reason to believe that the development in
year three
was so fundamental that it would have led at armÕs length to a
renegotiation of
the pricing of the transaction.
4. Taking all these circumstances into account, there is no reason to
adjust the royalty rate in year three. Such an adjustment would be
contrary to
the principles set out in Chapter 6 because it would represent an
inappropriate use of hindsight in this case. See Paragraph 6.29 of the
Guidelines. There is no reason to consider that the valuation was
sufficiently uncertain at the outset that the parties at armÕs length
would have
required a price adjustment clause, or that the change in value was so
fundamental a development that it would have led to a re-negotiation of
the
transaction. See paragraphs 6.30-6.31.
Example 2
5. The facts are the same as in the previous example. Assume that at the
end of the three- year period the agreement was re-negotiated between
the
parties. At this stage it is known that the rights to the drug are
considerably
more valuable than they had at first appeared. However, the unexpected
development of the previous year is still recent, and it cannot reliably
be
predicted whether sales will continue to rise, whether further
beneficial effects
will be discovered, and what developments in the market may affect sales
as
competitors piggyback on the discovery. All these considerations make
the
re-evaluation of the intangible rights a highly uncertain process.
Nevertheless, the associated enterprises enter into a new licensing
agreement
for a term of ten years that significantly increases the fixed royalty
rate based
on speculative expectations of continuing and increasing demand.