Presented By:Anneline Venter CA(SA)

Transfer PricingYear Course

Lecture 5

Arm’s length PrincipleAnd Introduction to

Comparability

IntroductionIf prices do not reflect arm’s length prices

tax it will distort:Tax liabilities of associated enterprisesTax revenues of host countries

Other factors than tax considerations may also distort commercial and financial relations between associated enterprises: Customs valuationsExchange or price controlsCash flow requirements of enterprises

Arm’s Length Principle

Introduction (…continued)Adjustment to arm’s length price

sometimes needed irrespective of:Contractual obligation to pay a

particular priceIntention of the parties to minimize tax

Tax authorities should not automatically assume MNEs have sought to manipulate profits.

Arm’s Length Principle

Statement of arm’s length principleArticle 9 OECD Model Tax Convention:“[Where] conditions are made or imposed between thetwo [associated] enterprises in their commercial orfinancial relations which differ from those whichwould be made between independent enterprises, thenany profits which would, but for those conditions,have accrued to one of the enterprises, but, by reasonof those conditions, have not so accrued, may beincluded in the profits of that enterprise and taxedaccordingly.”

Arm’s Length Principle

Justification for use of arm’s length principle Puts associated enterprises and independent

enterprises on a more equal footing for tax purposes, thereby promoting trade.

Adopts as benchmark the normal operations of the market

No realistic or legitimate alternative exists:Global formulary apportionment would not be

acceptable in theory, implementation or practice

Arm’s Length Principle

Application of the arm’s length principle Comparability analysis is at the heart

of the application of the arm’s length principle (par 1.6)

Significance of Comparability analysis and meaning of “comparable’.

Arm’s Length Principle

Internal and External Comparable Transactions

Arm’s Length Principle

Internal Comparable

External Comparable

Co A

ControlledTransactio

n

UncontrolledTransaction

Co A Co B

ControlledTransactio

n

UncontrolledTransaction

Factors affecting ComparablesCharacteristics or Property/Services

Functional Analysis

Contractual Terms

Economic Circumstances

Business Strategies

Tangible Property: physical features; quality and reliability, availability and volume of supply

Services: nature (shareholder or stewardship) and extent

Intangible Property: Form of transaction: licensing or sale Type of property: patent, trademark, know-howDuration and degree of protectionAnticipated benefits

Characteristics of Property or ServicesFactors affecting Comparables

Main category of type of transaction:Distributor, wholesaler, retailerFully fledged or contract manufacturerFully fledged or contract marketingSub-functions:Manufacturing, material purchasing, Packaging, storage of inventory, shippingQuality control, negotiation, admin

Functional ProfileFactors affecting Comparables

FunctionalAnalysis

Contract Manufacturer Full- Fledged Manufacturer

Functions

Research & Development √

Purchasing √ √

Manufacturing √ √

Assembling and Packaging √ √

Warehousing and Logistics √ √

Engineering √ √

Quality Control √ √

Labour Management, Training √ √

Marketing √

Sales & Distributions √

After Sales Services √

Risks

Business risks √

Market risks √(volume) √

Manufacturing risk √ √

Foreign exchange risk ? √

Inventory risk √ √

Credit risk √ √

Research & Development risk √

Warranty risk √

Assets

Product intangibles √

Manufacturing intangible ? ?

27

Full-FledgedManufacturer

Manufacturing+ R&D+ Regional/global marketing+ All risks

Simple(Low)

Integrated(High)

Functions/Risks/Assets Employed

Low_

+High

ExpectedProfit

Profit expectation follows functions, risks and assets

Loss possible

Contract Manufacturer

Define how risks, benefits and responsibilities are divided

Analyse terms whether written or oral, explicit or implied

Independent parties will hold one another to terms and only rarely will modify

Less incentive to do so in controlled transaction: therefore examination necessary

Analysis: whether the actual conduct of the parties is consistent with terms of contract

Contractual TermsFactors affecting Comparables

Prices vary across different markets even for similar products

Essential to identify relevant market(s) related to transaction

Whole variety of factors to take into account: Location, size, competitive position, availability

of substitute goods/services, level of supply and demand, purchasing power, regulation and local costs, level of market (retail or wholesale), date and time of transactions etc.

Economic CircumstancesFactors affecting Comparables

DIFFERENT ECONOMIC CIRCUMSTANCES: GDP PER CAPITA

USA

GER

MAN

Y

FR

AN

CE

RSA

ZAM

BIA

10970

1611

35068

38077

48328

DIFFERENT ECONOMIC CIRCUMSTANCES: INFLATION

USA

GER

MAN

Y

FR

AN

CE

RSA

ZAM

BIA

1,67%

1,38%

1,71%

7,65%

11,45%

DIFFERENT ECONOMIC CIRCUMSTANCES: RISK FREE RATE

USA

MALA

WI

FR

AN

CE

RSA

ZAM

BIA

2,22%

1,28%

3,50%

6,85%

8,30%

Business strategies may include start up (entering a new market)marketing strategy to increase of market share;

Business strategy may sacrifice current for anticipated profits

What happens if anticipated profits are not in fact realized?evaluate position critically to see if strategy is credible:

e.g. look for consistent behaviour and see who bears costs and is intended to reap rewards

would independent enterprise have entered into such a scheme and would it have continued long after anticipated profits have not materialized?

Business StrategiesFactors affecting Comparables

Recognition of actual transactions undertakenBe careful of restructuring of transactionsCircumstances were restructuring will

appropriate:Economic substance differs from the form “…(T)he arrangements made in relation to the

transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner….”

Arm’s Length Principle

LossesSituation: one group entity experience consistent

losses while overall group is profitable. Legitimate business reasons may exist: heavy start-

up costs, unfavourable economic conditions or inefficiencies.

Independent enterprises would not tolerate losses indefinitely.

Loss enterprise may not be receiving adequate compensation.

Example

Arm’s Length Principle

Other issuesThe effect of government policies

Government interventions (interest rate controls, control over royalty payments etc.) should be treated as normal market conditions.

Use of customs valuationsMay not be aligned with OECD TP methodsMay provide valuable contemporaneous information Taxpayers may have competing incentive in setting

prices for customs valuations and tax purposes

Arm’s Length Principle

Source:OECD Guidelines: Chapter 1UN TP Manual for Developing Countries:

Chapter 1 (section 4)ATAF: TP for Policy Makers: Session 1:

“Arm’s length range” by OECD (PDF)

Arm’s Length Principle