UEPLAC Presentation on Transfer Pricing_Part_I

7/31/2019 UEPLAC Presentation on Transfer Pricing_Part_I

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Workshop Practice of implementation of

the EU Member States national tax legislation

in the sphere of transfer pricing

Analysis of the EU transfer pricing

documentation approach

Konstantinos Makris, UEPLAC expert

UPMF

PAI, FIIAPP, Louis

Berger SAS, KLC HRTA

- , V

EuropeAid/127777/C/SER/UA

Kyiv, 6 March 2012


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Scope of transfer pricing legislation

Scope of the transfer pricing relevant legislation is compliance with

the arms length principle for intragroup transactions.

Historically it has been initiated with an OECD report in 1979 underthe title Transfer Pricing and Multinational Enterprises. This

guideline has been supplemented with : The report on intangible property and services, adopted on

23/1/1996and noted by the council on 11/4/1996.

The report on cost contribution arrangements, adopted on25/6/1997 and noted by the council on 24/7/1997

The report on the guidelines for monitoring procedures and theinvolvement of the business community, adopted on 24/6/1997

and noted by the council on 23/10/1997

The report on the guidelines for conducting advance pricingarrangements under the mutual agreement procedure, adoptedon 30/6/1999and noted by the council on 28/10/1999.


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Transfer pricing in EU The Commission study Company taxation in the internal market SEC (01)

1681 of 23 October 2001 identified high compliance costs and potentialdouble taxation for intra-group transactions as a major tax obstacle tocross-border economic activities in the internal market.

Conversely, Member States are concerned about the risk of a loss of taxthrough the artificial setting of transfer prices so that profits arise in othercountries than they would under arms length conditions.

Some EU Member States, wanted to ensure effective application of

transfer pricing rules, through the introduction of new or additional transferpricing documentation requirements.

The existence of different sets of documentation requirements in theInternal Market represents a burden for a company in one Member Statethat wants to set-up and/or conduct business with an affiliated company inanother Member State. The preparation of separate and uniquedocumentation packages in different Member States was uneconomic.Small and medium-sized enterprises especially can be hit by theseproblems.

The Commissions company tax study concludes that the compliance costs

and the uncertainty could be reduced by better co-ordination betweenMember States of documentation requirements and developing bestpractices. A more uniform approach by EU Member States, within theframework of the OECD Guidelines, would also contribute to a strongerposition in relation to countries outside the EU.


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The EU Code of ConductOn 27th June 2006, the Council adopted a Code of Conduct on transfer pricing documentationfor associated enterprises in the European Union (EUTPD).

The Code of Conduct encourages member states to implement the EU Transfer PricingDocumentation (EU TPD) approach, allowing taxpayers to avoid transfer pricing penalties if theymaintain:

Master filedocumentation

Country specificdocumentation

The EU TPD approach means, that a multinational group of companies has a standardized andconsistent set of documentation


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Advantages of the EUTPD approachFor both taxpayers and tax

administrations

From a taxpayer perspective From a tax administration

perspective

Consistency in the comparabilityanalyses (including functionalanalyses)

less probability of being audited more information about intra-group transactions that arerelevant for theMember States concerned

Consistency in the application oftransfer pricing methods

reduced risk of double taxation more effectively perform theirrisk assessment

Enhanced transparency of thetransfer pricing process

shorter tax audits reduce administrative costs

Centralisation of the review ofany material prepared at locallevel to avoidmisunderstandings

assess the transfer prices of theinter-company transactions

Reduction, facilitation andexpedition of mutual agreementprocedures


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Contents of the EU TPDThe masterfile:

The masterfile should contain the following items:a) a general description of the business and business strategy including changes in the business strategycompared to the previous tax year;b) a general description of the groups organisational, legal and operational structure (including an

organisation chart, a list of group members and a description of the participation of the parent company inthe subsidiaries);c) the general identification of the associated enterprises engaged in controlled transactions involvingenterprises in the EU;

d) a general description of the controlled transactions involving enterprises in the EU, i.e. a generaldescription of

i) flows of transactions (tangible and intangible assets, services, financial);ii) invoice flows; andiii) amounts of transaction flows;

e) a general description of functions performed and risks assumed and a description of changes in respectof functions and risks compared to the previous tax year, e.g. the change from a full fledged distributor to a

commissionaire;f) the ownership of intangibles (patents, trademarks, brand names, know how etc.) and royalties paid orreceived; g) the group's inter-company transfer pricing policy or a description of the groups transfer pricingsystem that explains the arm's length nature of the companys transfer prices;h) a list of Cost Contribution Agreements, APAs and Rulings covering transfer pricing aspects as far asgroup members in the EU are affected; andi) an undertaking by the taxpayer to provide supplementary information upon request and within areasonable time frame according to national rules .


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EXAMPLE:

Member state B Member state C Member state DNon Member

state E

Parent Company

Subsidiary B Subsidiary D Subsidiary ESubsidiary C

Product delivery

Controlled transaction 7

Memberstate A

Product delivery

Product delivery Controlled transaction 6

Controlled transaction 5


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Contents of the EU TPDCountry specific file:

a country specific documentation should contain, in addition to the content of the masterfile, the followingitems:a) a detailed description of the taxpayer's business and business strategy including changes in the businessstrategy compared to the previous tax year;b) information, i.e. description and explanation, on country specific controlled transactions; including

i) flows of transactions (tangible and intangible assets, services, financial);ii) invoice flows; andiii) amounts of transaction flows;

c) a comparability analysis, i.e.i) characteristics of property and services;ii) functional analysis (functions performed, assets used, risks assumed);iii) contractual terms;iv) economic circumstances; andv) specific business strategies;

d) an explanation about the selection and application of the transfer pricing method[s], i.e. why a specific

transfer pricing method was selected and how it was applied;e) relevant information on internal and/or external comparables, if available; andf) a description of the implementation and application of the group's intercompany transfer pricing policy.


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Preparation, storage and

submission of the documentationThe taxpayer should have to submit its EU TPD, i.e. the masterfile and the country specific documentation,to the tax administration only at the beginning of a tax audit or upon specific request. Where a MemberState requires a taxpayer to submit information about transfer pricing with its tax return, that informationshould be no more than a short questionnaire or an appropriate risk assessment form. Where a MemberState requires a taxpayer to make in its tax return an adjustment to its taxable profit resulting from theapplication of the arm's length principle, documentation demonstrating such an adjustment should be

available.A multinational enterprise should undertake to prepare the masterfile in time to comply with any legitimaterequest originating from one of the tax administrations involved.The taxpayer in a given Member State should make its EU TPD available upon request of a taxadministration, within a reasonable time dependant on the complexity of the transactions.The business responsible for making documentation available to the tax administration would be thebusiness that was requested to make the tax return and this Business would be liable to a penalty ifadequate documentation was not made available. This would be the case even if the documentation was

prepared and stored by one company within a group on behalf of another.


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Methods used to establish pricesTransfer pricing is governed by the OECD principle that transactions must be at arm's length.

Traditional Transaction Methods

i) Comparable uncontrolled price method (CUP) - preferable over all other methods

An uncontrolled transaction is comparable to a controlled transaction for purposes of the CUP method ifone of two conditions is met:

1. none of the differences (if any) between the transactions being compared or between the enterprisesundertaking those transactions could materially affect the price in the open market; or2. 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 andreliable way to apply the arm's length principle.

The CUP method is a particularly reliable method where an independent enterprise sells the sameproduct as is sold between two associated enterprises.

One illustrative case where adjustments may be required is where the circumstances surrounding controlledand uncontrolled sales are identical, except for the fact that the controlled sales price is assuming 30 daysof credit and the uncontrolled sales are made with a 60 days of credit. The differences in terms of credithave a reasonably ascertainable effect on price. Therefore, to determine the uncontrolled sales price,adjustment should be made to the price for the difference in credit terms.


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Methods used to establish pricesTraditional Transaction Methods

ii) Resale price methodThe resale price method begins with the price at which a product that has been purchased from an associatedenterprise is resold to an independent enterprise. This price (the resale price) is then reduced by an appropriategross margin (the "resale price margin") representing the amount out of which the reseller would seek to coverits selling and other operating expenses and, in the light of the functions performed (taking into account assetsused and risks assumed), make an appropriate profit. What is left after subtracting the gross margin can beregarded, after adjustment for other costs associated with the purchase of the product (e.g. customs duties), as

anarm's length price for the original transfer of property between the associated enterprises.This method is more appropriate for the purchase and resale of products on which the seller does notadd significant value.

An appropriate resale price margin is easiest todetermine where the reseller does not addsubstantially to the value of the product. Incontrast, it may be more difficult to use the resaleprice method to arrive at an arm's length pricewhere, before resale, the goods are furtherprocessed or incorporated into a more complicatedproduct so that their identity is lost or transformed.So, in order for tax administration to evaluate theappropriateness of the resale method, individualcompanys value chain should be well described:


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Methods used to establish pricesiii) Cost plus method

The cost plus method begins with the costs incurred by the supplier of property (or services) in a controlledtransaction for property transferred or services provided to a related purchaser. An appropriate cost plusmark up is then added to this cost, to make an appropriate profit in light of the functions performed and themarket conditions. What is arrived at after adding the cost plus mark up to the above costs may beregarded as an arm's length price of the original controlled transaction. This method probably is mostuseful where semi finished goods are sold between related parties, where related parties have

concluded joint facility agreements or long-term buy-and-supply arrangements, or where thecontrolled transaction is the provision of services that do not involve the provision of non highvalued intangible assets.

When applying the cost plus method one should pay attention: to apply a comparable mark up to a comparable cost basis.to consider differences in the level and types of expenses -- operating expenses and non operatingexpenses including financing expenditures -- associated with functions performed and risks assumed

by the parties or transactions being compared. to ensure accounting consistency.


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Methods used to establish pricesTransactional profit methodsA transactional profit method examines the profits that arise from particular controlled transactions. Thetransactional profit methods for purposes of OECD Guidelines are the profit split method and thetransactional net margin method.

i) Profit split methodWhere 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 andagree 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 by determining the division of profits thatindependent enterprises would have expected to realize from engaging in the transaction or transactions.The profit split method first identifies the profit to be split for the associated enterprises from the controlledtransactions in which the associated enterprises are engaged. It then splits those profits between theassociated enterprises on an economically valid basis that approximates the division of profits that wouldhave been anticipated and reflected in an agreement made at arm's length.

Strengths Weaknesses

Does not rely directly on closely comparabletransactions

External market data considered in valuing thecontribution each associated enterprise makesto the controlled transactions will be lessclosely connected

It is less likely that either party to the controlledtransaction will be left with an extreme andimprobable profit result, since both parties to

the transaction are evaluated.

Difficult to measure combined revenue andcosts for all the associated enterprises


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Methods used to establish pricesApplication of the method

If the profit split method were to be used by associated enterprises to establish transfer pricing in controlledtransactions, then :-each associated enterprise would seek to achieve the division of profits that independent enterprises wouldhave expected to realize in a joint venture relationship.- conditions would have to be based upon projected profits rather than actual profits-Tax administration should acknowledge that the taxpayer could not have known what the actual profitexperience of the business activity would be.Approaches for estimating the division of profits:

-Contribution analysis, and- Residual analysisUnder a contribution analysis, the combined profits would be divided between the associated enterprisesbased upon the relative value of the functions performed by each of the associated enterprises participatingin the controlled transactions, supplemented as much as possible by external market data that indicate howindependent enterprises would have divided profits in similar circumstances. In cases where the relativevalue of the contributions can be measured directly, it may not be necessary to estimate the actual market

value of each participant's contributions.A residual analysis divides the combined profit in two stages. In the first stage, each participant is allocatedsufficient profit to provide it with a basic return appropriate for the type of transactions in which it isengaged. Ordinarily this basic return would be determined by reference to the market returns achieved forsimilar types of transactions by independent enterprises. 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 thefacts and circumstances that might indicate how this residual would have been divided betweenindependent enterprises. Indicators of the parties contributions of intangible property and relative

bargaining positions could be particularly useful in this context.


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Methods used to establish pricesii) Transactional net margin method

The transactional net margin evaluates the arms length nature ofthe net profit margin relative to anappropriate base (e.g. costs, sales, assets) of a controlled transaction, by comparing it to the net marginearned on comparable uncontrolled transactions. Where possible, the net margin earned by the relatedparty on the controlled transaction should be compared to the net margin earned by the same related partyon comparable uncontrolled transactions. However, where this is not possible, the net margin earned byindependent enterprises engaged in comparable business activities may serve as a guide.

Strengths Weaknesses

Net margins may be more tolerant to some

functional differences between the controlled and

uncontrolled transactions than gross profit margins

Taxpayers may not have access to enough specific

information on the profits attributable to

uncontrolled transactions to make a valid

application of the method.

Not necessary to determine

the functions performed and responsibilities

assumed by more than one of

the associated enterprises

Application of any arm's length method requires

information on uncontrolled transactions that may

not be available at the time of the controlled

transactions

The TNMM requires the least comparability between the controlled and uncontrolledtransactions of all the arms length methods.


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Methods used to establish pricesApplication of the method

Step 1: Determine whether a benefit provided by the transactionStep 2: Determine whether the offered activities should be charged.Step 3: Determining the cost base of the relevant services.Step 4: Determining the appropriate mark-up for implementation in cost base.

Choice of profit level indicatorsThree commonly used PLIs are the operating margin (OM: operating profit turnover),

the net cost plus margin (NCP:operating profit cost of sales),and the return on operating assets (ROA: operating profit operating assets )

Usage of multiple year data

Usage of a range of results


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Analysis of the EU transfer pricing

documentation approach

END OF PART I

THANK YOU !!!

UEPLAC Presentation on Transfer Pricing_Part_I

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