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'Sixth method' raises transfer pricing concerns in developing countries

January 29, 2013

In brief

Application of a so-called 'sixth method' for determining transfer prices of commodities presents

practical concerns because the method does not consider critical drivers in the determination of an arm's

length price or reference. The method first was implemented in Argentina and now has been adopted by

a number of developing countries — primarily in Latin America but extending beyond to India — with

expansion of the method expected to continue. Companies should consider whether they might be

required to adopt the sixth method in countries in which they operate and how such a requirement could

affect their worldwide tax liability.

In detail

OECD transfer pricing

methods

The OECD Transfer Pricing Guidelines describe five transfer pricing methods that may be applied to establish whether the conditions of controlled transactions are consistent with the arm's length principle: three 'traditional transaction methods' (the comparable uncontrolled price (CUP) method, the resale price method, and the cost plus method) and two 'transactional profit methods' (the transactional net margin method and the transactional profit split method).

The OECD states that the 'most appropriate method' should be selected for a particular case, taking into account (1) the respective strengths and

weakness of the recognized methods; (2) the appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis; (3) the availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method and/or other methods; and (4) the degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them. In applying these criteria, the OECD regards the traditional transaction methods (particularly the CUP method) as more direct and therefore preferable to transactional profit methods where the

methods can be applied in an equally reliable manner.

Other methods

In addition to the five transfer pricing methods specified by the OECD, 'other methods' may be used in certain circumstances. A transfer pricing method other than the specified methods may be applied where it can be demonstrated that (1) none of the approved methods can be reasonably applied to determine arm's length conditions for the controlled transaction and (2) such other method yields a result consistent with that which would be achieved by independent enterprises engaging in comparable uncontrolled transactions under comparable circumstances. Therefore, while other methods may be applied to establish

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prices if the result satisfies the arm's length principle, such methods should not be used in place of the five specified methods if the recognized methods are more appropriate to the facts and circumstances. A 'sixth method' required in some countries may be viewed as an 'other method' under the OECD Guidelines or as a specific application of the CUP method.

In addition to the OECD Guidelines, the United Nations has published its Practical Manual on Transfer Pricing for Developing Countries to offer practical guidance to policy makers and administrators in developing countries on the application of the arm's length principle. The UN Manual generally shows a preference for the CUP method and does not explicitly address a sixth method.

Why a 'sixth method'?

The sixth method originated in Argentina, where the government sought to address raw materials transactions that utilized an agent located in a country where significantly less tax was paid than in the exporting country. For many developing countries, exports of commodities are such a significant part of the economy that it is important to the governments to avoid price manipulations that lower transfer prices and taxes collected. For developing countries with economies heavily dependent upon commodities exports, changes to transfer pricing rules may be viewed as a source for raising taxable income. This strategy appears to be supported by international development organizations. Mandating use of the sixth method has been an effective way for governments to increase the tax assessed on companies exporting commodities.

Applying the sixth method

The sixth method applies to certain commodities that usually are specified in the local regulations and vary among jurisdictions. For example, transfer pricing legislation in Argentina, Uruguay, and Ecuador and amendments to the legislation in Brazil and Peru stipulate certain restrictions and guidelines to test the transfer pricing of commodities. Although in countries such as Argentina the sixth method is explicitly described in legislation, in countries like Uruguay and Peru the sixth method is referred to only as a variation of the CUP method. In addition, amendments to the Brazilian legislation introduced new transfer pricing methods for commodities. The concept of how to test the nature of the arm's length price for commodities is similar in these cases.

The sixth method generally may apply in the following circumstances:

Export/import transactions of

tangible goods (classified as

commodities) between related

parties.

The price of the tangible goods are

publicly quoted in the transparent

market (known public price).

In certain cases, when there is a

foreign intermediary in the inter-

company transaction such that

goods do not reach the final

consumer directly (triangular

transactions).

The sixth method attempts to avoid transfer of passive income to jurisdictions with low or no taxation. The application of this method considers quoted prices of export/import goods at the time of shipment, regardless of volume,

geography, and other key factor that influence the price. Importantly, the sixth method does not take into account transportation costs, agreement covenant, or the agreed price between the taxpayer and the intermediary.

Under the sixth method the only reference point to evaluate an inter-company transaction is the quoted price at the time of shipment, which may not be comparable to the economic conditions of the transaction under review. An exception may be applicable when the agreed price is greater than the most recent quoted price available, in which case the greater of the two is taken as the most appropriate transfer price for local transfer pricing purposes.

Use of the sixth method typically is mandatory unless an exception applies. For example, Argentina effectively requires use of the sixth method in certain situations by stating in its legislation that the best method to assess Argentine-source income is the trading value of the good in the market on the date in which the goods are shipped — regardless of the means of transport — without considering the price that would have been agreed upon with an international broker unless the agreed price is higher than the publicly traded price. The transfer pricing methodology included in Argentine income tax law establishes no order of precedence for the use of the methods, except where the sixth method is applicable. In addition, the taxpayer must indicate the reasons why a given method has been chosen and prove that the mechanism chosen is the most appropriate for the transaction made.

Mandatory use of a trading price for transfer pricing may raise serious concerns for taxpayers because this

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method does not take into consideration the circumstances of the transaction. Requiring companies to use the sixth method may contradict the OECD standard for selecting the most appropriate method based on the specified criteria.

The sixth method may not be applicable when the intermediary in the transaction operates under the following conditions:

Has real presence in the place of

residence and its functions, risks,

and assets are consistent with the

transaction volume it conducts.

The principal activity may not

constitute passive business

(income) or exclusive intermediary

agent of goods between the related

parties of a group.

The inter-company transactions

with foreign related parties may

not exceed 30 percent of the total

activity performed by the

intermediary.

Some jurisdictions may require a formal certification regarding the items listed above from a public accountant from the country of residence where the intermediary operates.

Practical concerns

The circumstances in which products are sold are particularly important and mandatory use of the sixth method does not allow the evaluation of those circumstances. For example, consider a farmer who makes an investment by planting and harvesting grain. At market, the farmer can expect to obtain the publicly traded price for grain. A very different scenario occurs if a farmer receives up front a guaranteed price for the output of his crop, regardless of factors such as grain quality or the market price at the time the crop reaches the market.

It is clear that in this case the farmer may accept a different price. Under the best method or most appropriate method analysis, it is possible that in this situation a different method would be preferable over the publicly traded price. Mandated use of the sixth method, however, could result in imposition of the market price. As a result, taxpayers operating in jurisdictions that have introduced the sixth method may want to consider avoiding target return arrangements, which may not conform to application of the sixth method.

Which countries have adopted the

sixth method?

Argentina in 2003 was the first country to implement the sixth method, with countries such as Ecuador and Uruguay soon following. Latin American countries have been active in adopting the sixth method in the last two years. Of the new jurisdictions in Latin America introducing transfer pricing legislation (e.g., Dominican Republic, El Salvador, Guatemala, and Chile) all but Chile introduced the sixth method and of those amending their current regulations (e.g., Brazil, Panama, Peru, and Colombia), Brazil and Peru adopted the sixth method. India also has introduced a sixth method that appears to expand the CUP method. As a result of these changes, multinational companies increasingly are becoming subject to the sixth method. As tax authorities in Latin America and other developing countries increase their focus on transfer pricing, companies will need to consider their global transfer pricing positions as well as compliance with local transfer pricing requirements.

Preference for other methods

There currently is a similar issue in the United States regarding the use of the Income Method in evaluating

platform contribution transactions. The Income Method is not a method under the OECD Guidelines, UN Manual, or Section 482 regulations for evaluating transactions for the use of intangibles. Nevertheless, since its introduction in an IRS Coordinated Issue Paper (CIP) published in 2007, the Income Method has become the de facto method of choice for the IRS in evaluating transfers or contributions of intangible property (while the CIP was later withdrawn, the Income Method was still the preferred method in the proposed and then final cost sharing regulations).

The takeaway

Adoption of the sixth method is expanding in Latin America and in other developing countries. Applying the sixth method raises a number of transfer pricing issues because the method does not consider critical drivers in the determination of an arm's length price or reference. Practical concerns include:

The quoted price does not consider

geography, which has a direct

impact in the transportation,

logistics, and insurance costs.

The volume and agreement terms

are not considered and directly

impact in the price.

The sixth method imposes

limitation to future transactions

and planning.

In many cases, the tax authorities

fail to provide a clear

determination of what would be

considered publicly or known

prices as well as what is considered

a commodity.

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Let’s talk

For a deeper discussion of how this issue might affect your business, please contact:

Transfer Pricing

Amparo Mercader, Washington Metro +1 703 918 3043 amparo.mercader@us.pwc.com

Horacio Peña, New York +1 646 471 1957 horacio.pena@us.pwc.com

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© 2013 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers (a Delaware limited liability partnership), which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.