178 00 ADIT Paper-IIIF-Transfer-Pricing-Manual Combined PDF

Tolley Exam Training
ADIT
PAPER IIIF
Principles of Corporate and International Taxation
TRANSFER PRICING OPTION

Study Manual
2014 EXAMINATIONS
178
Tolley® Exam Training INTRODUCTION
INTRODUCTION
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YOUR STUDIES
ADIT Paper IIIF TP examines Principles of Corporate and International Taxation –

Secondary Jurisdiction – Transfer Pricing option.
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Your study pack contains the ADIT Paper IIF TP study manual and question bank.
After this introduction you will find:
• a contents listing
• the study manual chapters.
Behind the study manual is your question bank which has one chapter of questions
for each chapter of your study manual. The final section of the question bank
contains case studies together with instructions as to when they should be
attempted.
Kees Van Raad
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Tax Cases
The facts of a case will often be discussed in the manual. Questions are set from
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© Reed Elsevier UK Ltd 2013 I 2014 Sittings

Tolley® Exam Training INTRODUCTION
This material contains general information only. Whilst every care has been taken
to ensure the accuracy of the contents of this work, no responsibility for loss
occasioned to any person acting or refraining from action as a result of any
statement in it can be accepted by the author or the publishers.
1 September 2013.
Parts of this manual have been prepared from original material supplied by
authors for the production of the Tolley publication: UK Transfer Pricing 2012/13.
Additional material was provided by:
David Abrehart (Chapter 24)

Gareth Green (Chapters 12,13)
Paul Griffiths (Chapters 3,15,23)
Philip Howell (Chapters 2,16)
BDO (Chapters 5,7)
© Reed Elsevier UK Ltd 2013 II 2014 Sittings

Tolley® Exam Training CONTENTS
CONTENTS
1 Fundamental Sources
2 Associated Enterprises
3 The Arm’s Length Principle & Comparability
4 Transfer Pricing Methods
5 Functional Analysis
6 Analysis of Functions, Assets & Risk
7 Relating Functional Analysis to Selection of TP Method
8 Entity Characterisation
9 Comparability Analysis: OECD Proposed Process
10 Comparability Analysis: Aggregation and Use of Third Party non-

transactional Data
11 Comparability Adjustment including Practical Issues
12 Specific Transactions: Intra Group Services
13 Specific Transactions: Loans and Other Financial Transactions
14 Specific Transactions: Intangible Property
15 Specific Transactions: Business Restructuring
16 Recharacterisation Issues
17 Permanent Establishments
18 Attribution of Profits to PEs
19 PE: Attribution of Profits to Financial Institutions & Financial Instruments
20 Compliance Issues
21 Avoiding Double Taxation and Dispute Resolution I
22 Avoiding Double Taxation and Dispute Resolution II
23 Role of Strategic & Managerial Transfer Pricing
24 Latest developments in Transfer Pricing
© Reed Elsevier UK Ltd 2013 III 2014 Sittings

Tolley® Exam Training CONTENTS
Appendices
Appendix 1 Case Law
Appendix 2 EU Arbitration Convention © European Union, http://eur-lex.europa.eu/
EUJTP Revised Code of Conduct for the effective implementation of the Arbitration
Convention © European Union, http://eur-lex.europa.eu/
EUJTP Code of Conduct on transfer pricing documentation for associated

enterprises in the European Union (EU TPD) © European Union, http://eur-
lex.europa.eu/
© Reed Elsevier UK Ltd 2013 IV 2014 Sittings

Tolley® Exam Training ADIT PAPER IIIF CHAPTER 1
CHAPTER 1
FUNDAMENTAL SOURCES
In this chapter we will look at:

– origins of Transfer Pricing;
– the origin of the Arm’s Length Principle (ALP);
– the ALP in the OECD Guidelines;
– the ALP in the OECD Model Tax Convention;
– application of the OECD Guidelines by states;
– alternatives to the ALP.
1.1 Management accounting origins
To a management accountant, transfer pricing is a fundamental process required

in order to draw up accounts for any organisation which operates through more
than one segment (ie, company, division, profit centre). In this context, a transfer
price can be defined as “the amount charged by one segment of an organisation
for a product or service that it supplies to another segment of the same
organisation”. (Charles T Horngren and Gary L Sundem “Introduction to
Management Accounting”, page 336, ninth edition. Prentice-Hall International
Inc.)
The economic reason for charging transfer prices is to be able to evaluate the
performance of the relevant segments of the organisation. By charging
appropriate prices for goods and services transferred within a group, managers of
group entities are able to make the best possible decision as to whether to buy or
sell goods or services inside or outside the group and they are able to make a
realistic judgement about the relative contribution being made by each entity to
the overall profits from a particular product or service.
 Illustration 1
Entity 1
← Production cost
(Loss)
Product
↓
Entity 2
Profit
↑
Sale
Revenue
To take a simple scenario where entity 1 produces a product and it is sold to an

external customer by entity 2, if there were no transfer price for the product, all of
the sales revenue would be in entity 2 and all of the production cost would be in
entity 1, so entity 1 would show a loss and entity 2 would show a profit margin of
100% (or perhaps a little lower if it has sales and marketing costs). Clearly, a transfer
price is needed, so that the accounts of both entities better reflect the economic
contribution that they have made.
© Reed Elsevier UK Ltd 2013 1 2014 Sittings

The above might seem obvious, but it bears repeating, because there has been a
tendency, particularly in recent years, for the term “transfer pricing” to be used (by
certain politicians, journalists and campaigners) in a pejorative sense, as if the term
has inherent connotations of deliberately charging inappropriate prices in order to
shift taxable income artificially from a company in a high tax country to a related
company in a country with a lower tax rate.
This is a misuse of the term. Transfer pricing is a process which every multinational
enterprise must necessarily carry out and it is inherently neither good nor bad. This
was a point made by the United Nations Secretariat in 2001. (“Transfer Pricing
History-State of the Art-Perspectives”, a paper by the United Nations Secretariat
dated 26 June 2001) It is certainly possible to set transfer prices that are blatantly
inappropriate, in an attempt to avoid tax, and no doubt there are some
organisations that do so. This is, however, certainly far less common than some
campaigners would claim, and highly unlikely to be successful.
We will look at the role transfer pricing has in respect of the internal operation of
multinational groups in a later chapter dealing with the strategic and managerial
aspects of transfer pricing.
1.2 Taxation context
As the taxable profits of the entities will normally be based upon the accounting
profits, which will necessarily reflect the transfer prices that have been used, the
transfer prices will affect the taxable profits in both countries. For this reason,
transfer pricing usually has important tax consequences, which has, over the last
century, given rise to specific tax legislation in relation to transfer pricing. This
manual relates to transfer pricing in its tax context, rather than the wider
management accounting sense.
 Illustration 2
Entity 1
Country 1
Production cost Transfer price

amount will affect
profit split
Product
↓
↓ 3rd Party Customer
Entity 2 ←
Country 2
↑
↑ Sales Product →
Revenue
To be specific, the main tax impact of transfer pricing is that although it would not
normally change the combined profit before tax made by the entities between
which the transfer price applies, transfer pricing does affect how that combined
profit is split between the entities. If those entities are taxpayers in different
countries, transfer pricing therefore affects the share of that combined profit that is

taxable by each country. There is therefore potential scope for the two taxpayers
to conspire to set the transfer price in order to influence how the profits are split
between them or for other factors to lead the taxpayers to adopt transfer pricing
that differs from what they would have adopted if they were unrelated.
Accordingly, transfer pricing rules seek to ensure that transfer prices are set so that
each country gets to tax its fair share of the profit.
In this taxation context, the term transfer pricing is inseparable from the concept of
the arm's length principle. Tax rules on transfer pricing generally authorise a tax
authority to increase the taxable profits of the taxpayer entity if the transfer pricing
between it and another related party is higher than or lower than the arm's length
price, and, as a result, the taxable profits of the taxpayer entity have been
understated. The arm's length price is the price that is paid in a comparable
transaction between unrelated parties. The process of comparing the actual
transfer price with the arm's length price is referred to as the arm's length test. The
arm's length principle is the principle that transfer prices between related parties
should meet the arm's length test.
In some countries, the arm's length principle is used in a slightly different way, as
the standard by which it is determined whether a company has given a
constructive dividend or hidden profit distribution to its parent. The result is that the
company is denied a deduction for the relevant expenses and may sometimes
also suffer withholding tax on the deemed dividend.
Although the arm's length principle has been adopted extremely widely as the
appropriate standard by which it should be judged if a transfer price is
acceptable, there are some countries which refuse to accept the arm's length
principle. In recent years, countries such as India and China have adopted the
arm's length principle. Perhaps the most notable country which rejects the arm's
length principle is Brazil, which sets its own rules about acceptable levels of profits
from intercompany transactions.
1.3 Origin of the arm's length principle
The arm's length principle appears in two main settings. First, it appears in domestic
tax transfer pricing legislation of many countries, including the UK. Second, it
appears in double taxation treaties (also known as double tax agreements or
conventions) and related guidance.
Based on an OECD survey published in 2012, the arm's length principle was first
introduced in domestic legislation in 1911, by Norway. (“Multi-Country Analysis of
Existing Transfer Pricing Simplification Measures – 2012 Update”,
www.oecd.org/dataoecd/42/33/50517144.pdf). It was followed by the UK in 1915.
The USA, which is often seen as the birthplace of transfer pricing, did not introduce
this obligation until 1935, although this would still make it one of the earliest
adopters.
The aforementioned OECD survey provides the following chart showing the dates
reported by the 41 countries which provided information for the survey. (We note
however that some countries, such as France, interpreted the question as relating
to the introduction of the arm's length principle in its current legislative form.) As
can be seen, there has been a surge of countries introducing the arm's length
principle in their domestic tax legislation over the last two decades.

The chart only shows the OECD member countries, but the trend to introduce
transfer pricing rules has recently spread to many other countries and it is now
relatively rare for any countries not to have transfer pricing rules (which are
generally based around the arm's length principle). For instance, the 2012 edition
of the book International Transfer Pricing, published and written by
PricewaterhouseCoopers, contains reports on transfer pricing rules in 67 different
countries, plus a chapter covering Africa, in which the transfer pricing rules in a
further five countries are described at length and other countries, such as Malawi
and Zimbabwe, are reported to be considering introducing transfer pricing rules.
The main exceptions are tax havens, countries cut-off from international trade,
such as North Korea, and some of the least developed countries in the world.
The arm's length principle was included in tax treaties concluded by France, the
UK and the USA as early as the 1920s. This led to the principle being incorporated in
Article 6 of the League of Nations draft Convention on the Allocation of Profits and
Property of International Enterprises in 1936. It was incorporated as Article VII in the
Mexico Draft of 1943 and in the London Draft of 1946. These articles are
substantially similar to Article 9 of the 1963 OECD Draft Convention and Article 9,
paragraph 1 of the present OECD and UN Model tax treaties. (“Transfer Pricing
History-State of the Art-Perspectives”.) Article 9 is described further on in this
chapter. These days, the arm's length principle is a ubiquitous feature of virtually
every fully fledged tax treaty.
1.4 The OECD Guidelines
In the early 1990s, the OECD recognised the need to update, consolidate and
expand its 1979 and 1984 reports in response to huge growth in international trade
and the spread of multinational enterprises. Further impetus was given by the fact
that the US was pushing ahead with its own, wide-ranging, unilateral views on how
the arm's length principle should be applied and these views were not always
congruent with the views of other countries. The OECD took the view that it was
important to bridge the differences that were developing, as one of its main
missions is to avoid double taxation.
The result was a report entitled “Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrations”, which is almost universally referred to within
transfer pricing circles as the “OECD Guidelines”. As described below, the
Guidelines have evolved since they were created in 1995.
1.5 Fundamental source: OECD Guidelines
The original OECD Guidelines were issued in 1995. In fact, they were released in
instalments, starting with Chapters I to V in 1995, covering the Arm's Length
Principle (Chapter I), Traditional Transaction Methods (Chapter II), Other Methods
(Chapter III), Administrative Approaches to Avoiding and Resolving Transfer Pricing
Disputes (Chapter IV), and Documentation (Chapter V). These were
supplemented by Chapter VI, Special Considerations for Intellectual Property, and

Chapter VII, Special Considerations for Intra-Group Services, in 1996. A year later,
Chapter VIII, on Cost Contribution Arrangements, was published.
After a relatively quiet period in terms of new guidelines from the OECD, 2010 saw
the culmination of several years work on two projects. The first project led to
revisions of the first three chapters of the OECD Guidelines. (Discussed further in
later chapters.) Symbolic of the removal of the preference for the traditional
transaction-based methods, all methods are now dealt with in a single chapter,
Chapter II. Additional guidance has been provided in relation to comparability
analysis and this has now been split out from the old Chapter I and is dealt with in
the new Chapter III. Arguably, the new discussion of the Transactional Net Margin
Method is more accepting of the fact that often this method can only be applied
using the overall profitability of comparable companies, and therefore moves
closer to the US Comparable Profits Method.
The second project related to the Transfer Pricing Aspects of Business Restructurings
and this gave rise to Chapter IX, the first chapter to be added to the Guidelines
since 1997. (Discussed further in a later chapter).
It is therefore important to be clear which version of the OECD Guidelines is

relevant for any particular analysis. The situation is not entirely clear. It could be
argued that the new Guidelines should be ignored except in cases where the year
under examination is later than 2010 and the new Guidelines have clearly been
adopted, for instance by specific reference in legislation or by renewing a double
taxation agreement without expressing any opt out from the new Guidelines.
However, the counter position would be that the 2010 Guidelines are simply a
more detailed elaboration on the original Guidelines, in which case the 2010
Guidelines are relevant even for years before 2010.
The OECD is currently working on a major new project aiming to resolve some of
the most controversial issues in transfer pricing, in relation to intangible assets. A
discussion draft of a proposed revised Chapter VI was issued in June 2012. This was
discussed by transfer pricing experts from Governments and private
representatives in November 2012. This is considered in more detail in a later
chapter.
In April 2013 a revised section on safe harbours in Chapter V was approved by the
committee on fiscal affairs. We will also look at this in a later chapter.
1.6 Fundamental source: OECD Model Tax Convention
As already mentioned, the arm's length principle has been incorporated in double
taxation agreements since as early as the 1920s. This led to it becoming Article 9 of
the Model Tax Convention originally issued by the OECD in 1963, based on earlier
model tax treaty wording created by the League of Nations. Article 9 of the United
Nations model treaty has similar wording. The arm's length principle also plays a
role in several other articles of the OECD Model Tax Convention, including Article
11, Interest, Article 12, Royalties, and Article 7, Business Profits. These are discussed
below.
Article 9 Associated Enterprises
Article 9 is the article which permits countries that have signed a double tax treaty
(with wording based on the Model Tax Convention) to adjust inappropriate
transfer pricing. If it were not for this Article, it could be protested that making a

transfer pricing adjustment should not be allowed, because the treaty generally
sets out to eliminate double taxation.
The article reads as follows:
Article 9
ASSOCIATED ENTERPRISES
1. Where
a. an enterprise of a Contracting State participates directly or indirectly in the

management, control or capital of an enterprise of the other Contracting
State, or
b. the same persons participate directly or indirectly in the management, control

or capital of an enterprise of the Contracting State and an enterprise of the
other Contracting State,
and in either case 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. Where a Contracting State includes in the profits of an enterprise of that State –

and taxes accordingly – profits on which an enterprise of the other Contracting
State has been charged to tax in that other State and the profits so included are
profits which would have accrued to the enterprise of the first-mentioned State if
the conditions made between the two enterprises had been those which would
have been made between independent enterprises, then that other State shall
make an appropriate adjustment to the amount of the tax charged therein on
those profits. In determining such adjustment, due regard shall be had to the other
provisions of this Convention and the competent authorities of the Contracting
States shall if necessary consult each other.
The wording is somewhat tortuous, but if it is read slowly the meaning is clear.
Broadly speaking, paragraph 1 authorises a country that is a signatory to the tax

treaty to increase the taxable profits of an enterprise. The conditions for it to do so
are that those profits have been understated as a result of making or imposing
non-arm's length conditions (which usually means prices that do not meet the
arm's length test) in its commercial or financial relations (which usually means
transactions) with another enterprise which is associated with the first enterprise.
It should be noted that it is generally accepted that Article 9 is intended to be

permissive; it allows Contracting States to apply the transfer pricing rules that form
part of their tax legislation. It is generally considered that, although not explicitly
stated in either the Model Tax Convention or the Commentary thereon, Article 9
does not create a stand-alone right for countries to make transfer pricing
adjustments that go beyond what is authorised by their own domestic rules. This is
because the basic purpose of a double taxation agreement is to relieve double
taxation; it would go way beyond this purpose if a double taxation agreement
imposed harsher tax treatment on a particular transaction between country A and
country B than would have applied if the same transaction had taken place
between country A and another country, with which country A has not concluded
a double taxation agreement.

Paragraph 2 relates to what are known as corresponding adjustments, although

this term is not specifically used in paragraph 2. (The term is used in the glossary to
the OECD Guidelines.) It requires that where a transfer pricing adjustment is made
by country A to increase the profits of the enterprise which is a taxpayer in that
country, country B must give consideration to reducing the profits of the other
enterprise (a corresponding adjustment) so that no profits are taxed in both
countries.
Country B is not automatically obliged to give a downward adjustment merely

because country A has made an upward adjustment. But it is obliged to give an
adjustment if it agrees that the profits of the enterprise in country B would have
been lower if its profits had been calculated based on prices which met the arm's
length test.
The Commentary makes it clear that if the two countries disagree about the
appropriate adjustment, the mutual agreement procedure provided for under
Article 25 should be implemented. This obliges the two parties to endeavour to
agree the appropriate transfer price, but, as will be discussed in a later chapter of
this manual, they are not obliged to come to an agreement.
Article 9 does not contain any time limits. The Commentary makes it clear that this
is not because it necessarily feels there must be an open-ended commitment to
give a corresponding adjustment. The question of time limits is left for individual
countries to negotiate in their individual bilateral double taxation agreements,
based on the OECD Model Tax Convention. If the relevant double taxation
agreement is silent on this matter, time limits will presumably follow domestic law.
The United Nations Model Double Taxation Convention contains wording which
mirrors Article 9 of the OECD Model Tax Convention, but in 2001 a third paragraph
was inserted, as follows:
3. The provisions of paragraph 2 shall not apply where judicial, administrative or

other legal proceedings have resulted in a final ruling that by actions giving rise to
an adjustment of profits under paragraph 1, one of the enterprises concerned is
liable to penalty with respect to fraud, gross negligence or willful default.
In other words, where a transfer pricing adjustment arises because of a failed

attempt at tax avoidance or tax evasion by a multinational group, the penalties
directly incurred as a result of that attempt will be compounded by subjecting the
multinational group to double taxation. The underlying philosophy seems to be
that relief from double taxation in relation to a transfer pricing adjustment is a
privilege which should only be extended in cases where the transfer pricing
misstatement arose despite good-faith efforts to comply with the arm's length
principle.
Article 7 Business Profits
The other main part of the OECD Model Tax Convention in which the arm's length
principle plays a core role is Article 7.
Article 9 deals with transactions between separate enterprises, one of which is

resident in one Contracting State and the other is resident in the other Contracting
State. Article 7 deals with a single enterprise resident in one Contracting State
which also operates in the other Contracting State through a permanent
establishment. A typical example would be a company operating through an
overseas branch.

Article 7 effectively follows on from Article 5, which sets out the conditions under
which an enterprise of one Contracting State is deemed to have sufficient nexus
with the other Contracting State that it is taxable therein. Article 5 does this by
defining what constitutes a permanent establishment.
Article 7 sets out the consequences of having a permanent establishment and

defines the extent to which the business profits of an enterprise are taxable in a
Contracting State within which it has a permanent establishment. The wording is as
follows:
Article 7
BUSINESS PROFITS
1. Profits of an enterprise of a Contracting State shall be taxable only in that State

unless the enterprise carries on business in the other Contracting State through a
permanent establishment situated therein. If the enterprise carries on business as
aforesaid, the profits that are attributable to the permanent establishment in
accordance with the provisions of paragraph 2 may be taxed in that other State.
2. For the purposes of this Article and Article [23A] [23B], the profits that are
attributable in each Contracting State to the permanent establishment referred to
in paragraph 1 are the profits it might be expected to make, in particular in its
dealings with other parts of the enterprise, if it were a separate and independent
enterprise engaged in the same or similar activities under the same or similar
conditions, taking into account the functions performed, assets used and risks
assumed by the enterprise through the permanent establishment and through the
other parts of the enterprise.
3. Where, in accordance with paragraph 2, a Contracting State adjusts the profits

that are attributable to a permanent establishment of an enterprise of one of the
Contracting States and taxes accordingly profits of the enterprise that have been
charged to tax in the other State, the other State shall, to the extent necessary to
eliminate double taxation on these profits, make an appropriate adjustment to the
amount of the tax charged on those profits. In determining such adjustment, the
competent authorities of the Contracting States shall if necessary consult each
other.
4. Where profits include items of income which are dealt with separately in other
Articles of this Convention, then the provisions of those Articles shall not be
affected by the provisions of this Article.
This wording is taken from the 2010 update to the OECD Model Tax Convention,
which was the culmination of a project that has, over several years, reviewed and
revised OECD policy in relation to the attribution of profits to permanent
establishments. This is explained in greater depth in a later chapter.
Paragraph 1 sets out the basic rule, which is that an enterprise of a Contracting
State is only taxable in the other Contracting State on the profits that are
attributable to its permanent establishment in that other State.
The arm's length principle is brought into play by paragraph 2 of the Article,
specifically the requirement that the profits that are attributable to the permanent
establishment should be the profits that the permanent establishment might be
expected to make if it were a separate and independent enterprise engaged in
the same or similar activities under the same or similar conditions. In other words,
we are required to hypothesise that the permanent establishment is an enterprise
separate and independent from the enterprise of which it is in fact a part. We then

apply the arm's length principle in order to determine the appropriate transfer
pricing of any hypothetical transactions between the two hypothetical entities.
As will be explained in greater detail in a later chapter, the 2010 update of Article
7, together with the revised Commentary thereon, removes the previous
perceived ambiguity about whether the separate enterprise hypothesis should
override the fact that the permanent establishment is in fact just a part of a wider
enterprise. Therefore an arm's length amount of interest can, for instance, be
allocated to the permanent establishment to reflect an appropriate amount of
capital to reflect the functions of the permanent establishment.
Article 11 Interest
Article 11 of the OECD Model Tax Convention relates to interest arising in one
Contracting State and paid to a resident of the other Contracting State. The first
five paragraphs of the article apply regardless of whether the borrower and lender
are associated. However, paragraph 6 introduces a special rule which denies the
protection of the article to interest that does not meet the arm's length test.
Paragraph 6 reads as follows:
6. Where, by reason of a special relationship between the payer and the

beneficial owner or between both of them and some other person, the amount of
the interest, having regard to the debt-claim for which it is paid, exceeds the
amount which would have been agreed upon by the payer and the beneficial
owner in the absence of such relationship, the provisions of this Article shall apply
only to the last-mentioned amount. In such case, the excess part of the payments
shall remain taxable according to the laws of each Contracting State, due regard
being had to the other provisions of this Convention.
It can be seen that the concept of the amount of interest that would have been
agreed upon between the borrower and lender in the absence of the special
relationship between them amounts to the arm's length test.
The general effect of Article 11 is to limit the amount of tax that can be applied by
the country where the interest is sourced. The Model Tax Convention limits the tax
to 10% of the interest, although many double taxation agreements that are based
on the Convention adopt different limits and in many cases source taxation is
prohibited altogether. This protection is removed for interest in excess of an arm's
length amount.
The effect is that a multinational enterprise can potentially be doubly penalised if it

is shown to have charged interest which exceeds an arm's length amount. First, it
can be denied a deduction for the excess interest, by virtue of Article 9; second, it
can suffer greater tax at source on the excess interest.
It will be noted that whereas Article 9 defines association in terms of direct or

indirect participation in management, control or capital of an enterprise, this
wording is not mirrored in Article 11, which uses the simple term “special
relationship”. This is because Article 11(6) is intended to apply more widely than
Article 9, for instance where the special relationship arises by way of family or
marriage ties between individuals or where there is “any community of interests” –
see paragraph 34 of the Commentary to Article 11 – between the lender and
borrower other than the loan relationship itself.

Article 12 Royalties
Article 12, the royalties article of the OECD Model Tax Convention, includes a
special relationships paragraph (in this case paragraph 4) which has a similar
effect to paragraph 6 of Article 11. That is, there is no protection from source
taxation of a royalty that exceeds an arm's length royalty.
Paragraph 4 reads as follows:
4. Where, by reason of a special relationship between the payer and the

beneficial owner or between both of them and some other person, the amount of
the royalties, having regard to the use, right or information for which they are paid,
exceeds the amount which would have been agreed upon by the payer and the
beneficial owner in the absence of such relationship, the provisions of this Article
shall apply only to the last-mentioned amount. In such case, the excess part of the
payments shall remain taxable according to the laws of each Contracting State,
due regard being had to the other provisions of this Convention.
1.7 Fundamental source: Application of the OECD Guidelines by states
The OECD has no authority to bind member countries to its guidelines. Few of them
have, like the UK, incorporated the Guidelines within their domestic legislation.
However, all member countries accept that the Guidelines are intended to
represent the international consensus and that if there is a divergence of practice,
this heightens the risk of double taxation, which could discourage international
trade. In practice, they are highly influential amongst all OECD member countries
and increasingly amongst countries that are not OECD members. They have
become the international norm for how transfer pricing analysis is conducted,
except in the relatively rare cases where governments explicitly reject the arm's
length principle, the most prominent example being Brazil.
Brazil has detailed rules on related entities and classes all entities in low tax
jurisdictions as related. The acceptable methodologies do not follow the OECD
Guidelines.
It has an approach that sets out a maximum ceiling on the expenses that may be
deducted for tax purposes in respect of imports and lays down a minimum level for
the gross income in relation to exports, effectively using a set formula to allocate
income to Brazil. Taxpayers are allowed to use the method that gives the lowest
taxable income.
Kazakhstan is another example. In 2009 Kazakhstan adopted a law including the

arm's length principle however there are significant departures from the OECD
Guidelines. One important feature is the scope of the transfer pricing legislation. It
covers transactions between related and unrelated parties for the following
international business transactions:
• Between related parties;
• Barter transactions;
• Involving counter-claims and reducing claims;
• With parties registered in tax havens;
• With legal entities that have taxation privileges; and

• With legal entities that have reported losses in their tax returns for the two tax
years preceding the transaction.
The acceptable methodologies that can be used are comparable uncontrolled

price, cost plus, resale price, profit split and net profit in that order.
Part of the reason why most countries endeavour to abide by the OECD
Guidelines is that they can effectively be seen as forming part of the OECD
Commentary on how Article 9 of its Model Tax Convention should be applied. The
actual Commentary on Article 9 cross-refers to the OECD Guidelines. The
Guidelines would therefore be a major determinant of how any dispute between
treaty partners is resolved under Mutual Agreement Procedures (that is,
negotiations to try to reach a common position about the arm's length transfer
price for the purposes of Article 9, so that any transfer pricing adjustment made by
one country is balanced by a corresponding opposite adjustment in the other
country, without which double taxation would arise).
If a country adopts a transfer pricing position that is contrary to the OECD

Guidelines, it knows that it is likely to find itself trying to defend this position in
Mutual Agreement Procedures and few countries are willing to allow Mutual
Agreement Procedures to fail by insisting on an interpretation of the arm's length
principle that is inconsistent with the OECD Guidelines. This tends to encourage
countries to abide by the Guidelines at all stages of applying their transfer pricing
rules.
It should also be noted that the OECD Guidelines are just that: guidelines. They are
not worded in the same way as legislation, in a completely definitive, prescriptive
fashion. Rather, they make observations about what would generally be
preferable and they frequently leave room for alternative interpretations. They are
the result of discussions amongst many people representing many countries and
other organisations and it is not always possible to reach full consensus. As a result,
the OECD Guidelines sometimes deliberately do not address certain contentious
issues (or they explicitly state that no consensus has yet been reached). An
example would be the recent discussions about business restructuring, which
frequently became bogged down by disagreements about the treatment of
intangible assets. In order not to hold up the Business Restructuring chapter of the
OECD Guidelines any longer, intangibles were taken out of the scope of the
business restructuring work. They were carved out into a separate project, which is
currently underway.
The current OECD member countries are: Australia, Austria, Belgium, Canada,
Chile, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece,
Hungary, Iceland, Ireland, Israel, Italy, Japan, Luxembourg, Mexico, Netherlands,
New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, South Korea,
Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.
Generally speaking, these are highly developed countries, although some of the
more recent joiners, such as Turkey and Mexico would generally be considered to
be developing countries, albeit at the richer end of the spectrum of development.
The OECD is accordingly seen by some as being a club that represents the
interests of rich countries.
The United Nations Model Tax Treaty is generally seen as being an alternative to
the OECD Model Tax Convention which contains wording that is intended to be
more favourable to less developed countries. (However, the differences tend not
to relate to transfer pricing.) The United Nations Model Tax Treaty Article 9
(Associated Enterprises) refers to the arm's length principle in a similar manner to

the OECD Model Tax Convention. The United Nations has not put forward any
alternative to the OECD Guidelines.
Membership is gradually expanding and Russia is currently engaged in discussions

to join the OECD. In addition, the OECD has enhanced agreements with Brazil,
China, India, Indonesia and South Africa. Representatives from those countries
participate in the OECD's deliberations about transfer pricing as observers.
As mentioned above the Guidelines are a guide to the member countries. A

survey by the OECD published in May 2012 looked at simplifications that countries
had added to the Guidelines in their domestic rules. The survey covered 41
countries and so included some non OECD members. Of the 41 countries surveyed
only 8 had not put in place some kind of simplification measure. Many of the
simplifications related to simplifications for small and medium sized enterprises
(SMEs) (some 21 countries including the UK, Ireland, Argentina, Mexico and China)
or small value transactions (some 15 countries including Germany, France, India
and the United States). Another common area for simplification was
documentation (some 37 countries including Australia, Germany, Turkey and
India). Almost half of those with simplification measures had safe harbours (16 out
of 33).
1.8 Alternatives to the arm's length principle
The arm's length principle has always had its detractors. The original report by the
OECD in 1979, “Transfer Pricing and Multinational Enterprises”, devoted space to
discussing the alternatives to the arm's length principle as a way to allocate taxing
rights in relation to the profits made by multinational enterprises.
The main alternative is global formulary apportionment, under which the total
consolidated worldwide profits of a group are allocated between the various
jurisdictions where the group carries out business activities. The allocation is based
on a formula, usually consisting of certain allocation keys, such as turnover, payroll
and the value of assets in each country. Variations on this approach are used
within federal states, such as the USA and Switzerland, in order to determine what
portion of the profits of individual entities in those countries are taxable in each
State/Canton.
The OECD came to the firm conclusion that such methods should not be
endorsed, on the grounds that they are arbitrary, disregard market conditions,
ignore management's own allocation of resources, do not bear a sound
relationship to the economic facts, and carry significant risk of double taxation.
This conclusion was reiterated in the 1995 OECD Transfer Pricing Guidelines.
The tide has long been in favour of the arm's length principle and it has been
adopted by almost all major economies, whether or not OECD members, with a
particular surge of adoption since 1995. Even Brazil, which rejects the arm's length
principle, does not use formulary apportionment. It uses instead a modified version
under which it insists on the right to specify acceptable profit margins for Brazilian
entities in relation to transactions with non-Brazilian related parties.
In recent years, particularly since the global financial crash that began in 2007,
voices opposing the arm's length principle and championing formulary
apportionment have grown louder, fuelled by a growing perception (correct or
not) that transfer pricing is being widely abused by multinational companies to
avoid paying their fair share of taxes in the countries where they have significant
operations. A form of formulary apportionment is being considered by the

European Union if it moves to a common tax base for member countries (or a
subset thereof).
1.9 Countries that do not follow the OECD Transfer Pricing Guidelines
As already noted, not all countries follow the OECD Transfer Pricing Guidelines.
Here we will look at a few examples – this is not an exhaustive list of the countries
that don't follow the OECD Guidelines.
As stated above Brazil rejects the arm's length principle. Instead the government
sets different margins depending on the sector that the business is in. The rules
define maximum prices on costs for intragroup imports and minimum profit levels
on intragroup exports. The transfer pricing rules also cover intragroup financing
arrangements that are not registered with the national bank. Low tax territories are
defined in the Brazilian legislation and all import and export transactions by
Brazilian residents with low tax territories that have secrecy legislation regarding
ownership of corporate bodies are subject to transfer pricing rules. Brazil has
contemporaneous documentation requirements. The fixed profit margin approach
should not be mistaken as easier to comply with than the arm's length approach
as the legislation contains many complexities.
India has not adopted the OECD Guidelines. They do broadly follow the OECD
Guidelines and have stated that they are happy to follow them in audits so long as
they don't conflict with Indian transfer pricing rules. Indian legislation mainly applies
to cross border situations. Indian legislation contains the same methodologies as
the OECD however where there is more than one arm's length price they require
that the mean average is used so that a single arm's length price can be
identified. The rules also state that a transfer pricing adjustment is not required
where the arm's length price revises downwards the profits taxable in India.
Kazakhstan has adopted separate transfer pricing law recognising the arm's
length principle however it does differ from the OECD Guidelines. The legislation
gives a clear preference to the Comparable Uncontrolled Price (CUP) method.
One of the other methods should only be used only if it is impossible to use CUP.
The transfer pricing rules are very broad in scope and can cover transactions not
involving related parties.
1.10 Pacific Association of Tax Administrations (PATA)
The PATA members include Australia, Canada, Japan and the United States. One
of the aims of the organisation is to provide principles under which taxpayers can
create uniform transfer pricing documentation (‘PATA Documentation Package’)
so that one set of documentation can meet their respective transfer pricing
documentation provisions. Use of this PATA Documentation Package by taxpayers
is voluntary and does not impose any legal requirements greater than those
imposed under the local laws of a PATA member.
The members of PATA believe that its documentation package is consistent with
the general principles outlined in Chapter V of the OECD 2010 Transfer Pricing
Guidelines.
PATA has produced guidance on the Mutual Agreement Procedure (MAP) to

facilitate cooperation amongst members and bilateral Advanced Pricing
Agreements (APAs) to try to standardise procedures.

1.11 African Tax Administrators Forum (ATAF)
The ATAF is a forum to promote and facilitate cooperation between African tax
administrators and other interested parties. The ATAF has been working with the
OECD to promote awareness of the need for transfer pricing rules in Africa. A
working group has been set up to look at transfer pricing issues including review of
the OECD 2010 Transfer Pricing Guidelines.

CHAPTER 2
ASSOCIATED ENTERPRISES
In this chapter we are going to look at Associated Enterprises, an important but somewhat
ill-defined concept, in particular looking at:
– The OECD and UN Model Tax Conventions and the definition of Associated Enterprises;
– SME practices and the Associated Enterprise definition
2.1 Introduction
As we saw in the previous chapter, Article 9 of the OECD Model Treaty permits
Contracting States to apply domestic law transfer pricing legislation only in respect
of transactions between “associated enterprises”. As such, defining the scope of
what is, and is not, an associated enterprise is of considerable practical
importance. There are definitional difficulties with this term as it appears in the
OECD and UN Model Treaties. Moreover, there is very extensive variation between
the scope of different countries’ domestic associated enterprises rules which may
give rise to the possibility of double taxation even in cases where tax treaties
apply.
2.2 The OECD and UN Model Tax Conventions and the definition of
Associated Enterprises
The Glossary to the OECD Guidelines define associated enterprises as follows:
“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”.
However, the above “definition” is not illuminating. Article 9 of the 2010 OECD
Model Tax Convention is titled Associated Enterprises, but the text of the article
does not explicitly use the word associated. You will recall that Article 9(1) reads
as follows:
Where
a. an enterprise of a Contracting State participates directly or indirectly in the

management, control or capital of an enterprise of the other Contracting
State, or
b. the same persons participate directly or indirectly in the management, control

or capital of an enterprise of a Contracting State and an enterprise of the
other Contracting State,
and in either case 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.
Article 9(1) of the 2011 UN Model Tax Convention is worded identically.

There are many circumstances where there will be no doubt that two enterprises
are associated with each other. The two most obvious cases are two companies
in a parent/100% subsidiary relationship or two companies under 100% control by a
third common parent company.
 Illustration 1
A Inc is a body corporate resident in State A; B Limited is a body corporate

resident in State B. A Inc holds 100% of the voting shares in B Limited and no
person other than A Inc has an interest in the management, control or capital of B
Limited,
A Inc
State A
B Limited
State B
 Illustration 2
As Illustration 1, except A Inc also holds 100% of the voting shares of C SA resident
in State C and no person other than A Inc has an interest in the management,
control or capital of C SA.
A Inc
State A
B Limited C SA
State B State C
All states which have domestic transfer pricing legislation include such blatant
control relationships within the scope of that legislation, so that if conditions are
made or imposed between the above which deviate from arm’s length terms,
then such domestic legislation that may exist in States A, B or C would be
supported by a double tax convention which included wording based on Article
9(1) of the OECD Model.
Enterprises
The Commentary on Article 9 does start with the following statement:
“This Article deals with adjustments to profits that may be made for tax purposes
where transactions have been entered into between associated enterprises
(parent and subsidiary companies and companies under common control) on
other than arm's length terms”.
Article 9 is phrased to apply to “enterprises”. This is in contrast to most of the rest of

the Model Tax Convention, which generally applies to residents. The phrase
“enterprise” is also used for Article 5, which deals with Permanent Establishments,
and Article 7, which deals with the Business Profits of Permanent Establishments.
The phrase “enterprise” is not defined in the body of the Model Tax Convention,
but is commonly thought of as analogous to “business”.

It might be thought that the word “enterprise” was deliberately used instead of the
word “company” in order to ensure that the article was not restricted to
companies, despite the suggestion quoted in the Commentary above. It is clearly
possible that taxable entities other than companies (such as partnerships and
individuals) could be sufficiently associated with other taxable entities that they
might not be dealing on an arm’s length basis.
In practice, the distinction is of limited importance because it is relatively rare for

there to be a transfer pricing issue on transactions between persons at least one of
which is not a company. Many countries explicitly limit their domestic transfer
pricing legislation to transactions between companies, although this is not the
case in the UK, which phrases its transfer pricing legislation in terms of provisions
between persons.
2.3 State Practice and the Associated Enterprises definition
Overview
It is not clear from the Model Tax Conventions or their commentaries what
constitutes participation in management, control or capital. It is left to individual
states to define (usually in their domestic legislation) exactly how much
participation in “the management, control or capital of an enterprise” is sufficient
to bring transfer pricing rules into effect.
There is an enormous variation in state practice. At one extreme are countries

such as Denmark which apply a relatively narrow de jure requirement of at least
50% of share capital or voting rights. As an example of the other extreme,
Australia’s legislation is engaged in a wide variety of de facto circumstances
including both parties having common directors or being members of a cartel.
It is instructive to examine the required relationship threshold for two countries, the
UK and India, in a little more depth.
United Kingdom
TIOPA 2010 s157 to s163 defines participation in the management, control or

capital of a person for the purposes of this legislation and sets out rules that
attribute rights and powers to a person when considering whether that person
controls a company or partnership.
The term “person” includes a body of persons. So, for example, a partnership can
control a company even if, individually, none of the partners control the
partnership or company.
In the first instance, TIOPA 2010 s217 determines that control is defined by
reference to CTA 2010 s1124 which considers matters such as voting power, power
given by the Articles of Association and the actual ability of a person to direct the
affairs of the company in the absence of the visible signs of such rights.
We can see from the above that it is very important to underline that control does
not only manifest itself where one enterprise is the majority shareholder in the
other. Control exists whenever one enterprise has the power to ensure that the
business of another enterprise is managed to achieve the other enterprise's goals.
There are detailed rules setting down when voting rights and control should be
attributed to a person. However, the attribution rules need to be considered in
relatively few cases.

While the legislation prevents abuse where trusts are interposed in a control chain,
it does not reproduce ITA 2007 s993(4), with the result that persons are not
connected simply by virtue of being members of the same partnership.
The control rules in TIOPA 2010 s160 contain an important feature. This is the
inclusion of a provision deeming a 40% participant in a joint venture to control that
joint venture where there is one other participant who owns at least 40% of the
venture. Hence, the transfer pricing rules also apply to joint ventures; however, the
rules only apply to transactions between at least one of the joint venture parties
and the joint venture itself, not between the two joint venture parties themselves.
Nevertheless, if the transaction meets the conditions of TIOPA 2010 s157 transfer
pricing rules still apply.
UK transfer pricing rules, in relation to financing transactions only, also apply where
persons have “acted together” in relation to the financing arrangements of a
company or partnership. This concept of “acting together” is much more widely
drawn than the above condition; it connotes a “community of interests”.
 Illustration 3
The ordinary shares in D Limited are owned respectively 45% by A Inc, 38% by B
GmbH and 17% by C SA in a contractual joint venture. D Limited is a UK resident
company. D’s shareholders are otherwise unconnected by virtue of legal control.
D Limited enters into the following separate transactions with its shareholders:
i. A Inc sells trading stock to D Limited in the normal course of its trade.
ii. B GmbH and C SA jointly provide trade finance to D Limited.
The sale of trading stock to D Limited is unlikely to be within the scope of the UK
participation condition. Although A Inc owns more than 40% of D Ltd, there is no
other participant that also owns at least 40% of D Limited.
However, the provision of financing facilities will fall within the extended “acting
together” definition and the tax return of D Limited must reflect arm’s length terms
in relation to that transaction.
There are a number of cases where associated enterprises are exempt from the
transfer pricing rules, including certain small- and medium-sized enterprises (SMEs)
transacting with states that have a comprehensive double tax convention with the
UK.
India
In India the transfer pricing law is found in Income Taxes Act 1961 s.92 onwards. An
associated enterprise is “defined” analogously to Article 9(1) of the OECD Model
Tax Convention. However, an extensive list is then provided of situations in which
two enterprises shall be regarded as associated. These include:
• Direct or indirect holding of at least 26% voting power.
• A loan advanced from one enterprise constituting at least 51% of the book
value of the assets of the borrower.
• One enterprise guarantees at least 10% of the total borrowings of the other
enterprise.

• Appointment by an enterprise of more than half of the board or the

appointment of executive directors.
• Complete dependence of an enterprise on intellectual property licenced to it

by the other enterprise.
• Substantial purchases or sales of raw materials or manufactured goods at

prices and conditions influenced by the other enterprise.
• The existence of prescribed mutual interest relationships.
Thus a very broad view of direct or indirect control is taken by the Indian
legislation.
Indian tax law does not have exceptions for SMEs as in the UK rules outlined above.
There are certain simplifications for small transactions where the aggregate value
of the international transaction does not exceed 10 million INR - the simplification
relates to documentation requirements.
The consequences of variation in state practice: corresponding adjustment
An important practical implication of the differences in state practices described

above is the possibility that a corresponding adjustment under the applicable
treaty equivalent of Article 9(2) of the Model Tax Convention might be denied if
the Contracting State that would otherwise be obliged to grant the adjustment
does not regard the two enterprises as associated but the other Contracting State
does.
 Illustration 4
Fledgling Enterprises Pvt Limited, an Indian company, is owned 30% by Big Farm
Danmark A/S a Danish manufacturer of specialised agricultural machinery. The
other 70% of the Indian company is owned by a number of individual members of
a wealthy family. The Indian company is in the business of importing and
distributing agricultural machinery into India. Over 90% of its stock is procured from
Big Farm Danmark A/S which has a dominant market position and superior
bargaining power to the Indian company. The Indian tax authorities succeed in
asserting that the prices paid for inventory by Fledgling Enterprises are in excess of
an arm’s length amount and an increase in Indian tax is imposed accordingly.
The two companies are associated enterprises within the meaning of the Indian
transfer pricing rules because there is greater than 26% voting power and the
Indian company is dependent on the Danish company for nearly all its inventory.
However, the two companies are not associated within the meaning of the Danish
rules because there is less than 50% control by share capital or voting rights.
The India/Denmark double tax convention includes an Article based on Article

9(2) of the OECD Model.
“Where a Contracting State includes in the profits of an enterprise of that State

and taxes accordingly profits on which an enterprise of the other Contracting
State has been charged to tax in that other State and the profits so included are
profits which would have accrued to the enterprise of the first-mentioned State if
the conditions made between the two enterprises had been those which would
have been made between independent enterprises, then that other State shall
make an appropriate adjustment to the amount of the tax charged therein on
those profits. In determining such adjustment due regard shall be had to the other

provisions of this Convention and the competent authorities of the Contracting

State shall, if necessary, consult each other.”
It is far from clear that Denmark is obliged to make a corresponding adjustment to

Danish tax on the sale of inventory from Big Farm Danmark A/S to Fledgling
Enterprises Pvt Limited under these circumstances. The Danish Tax Authority might
be expected to argue that “participation in control” is to be construed by
reference to Danish legislation and that the relationship falls short of the requisite
degree of control.
2.4 Conclusion
The concept of Associated Enterprises is important because it concerns the control

thresholds which bring into play domestic transfer pricing rules which often include
onerous documentation requirements and the risk of penalties for non-
compliance. Whether or not two enterprises are associated with each other will , in
many cases, be uncontroversial in both contracting states. However, the lack of a
clear definition in the OECD Model and Commentaries has permitted a wide
variation in state practice which could give rise to double taxation in practice.

CHAPTER 3
THE ARM'S LENGTH PRINCIPLE AND COMPARABILITY
In this chapter we are going to look at:

– why the arm’s length principle is needed;
– the OECD Guidelines and comparability;
– the five comparability factors;
– application of comparability analysis.
3.1 Introduction
The purpose of this chapter is to explore the arm’s length principle, and to
understand how it should be applied by taxpayers and tax authorities (namely,
through comparability analysis). The arm’s length principle itself is very simple:
pricing between related parties for any transaction should reflect pricing that
would be agreed between independent parties (ie. parties operating at “arm’s
length” from each other). However, the complexity of applying this in practice is at
the heart of all uncertainty and controversy within transfer pricing.
Therefore, this chapter will provide:
• An explanation of why the arm’s length principle is needed;
• How the arm’s length principle should be defined and interpreted;
• An overview of how comparability analysis should be used to apply the arm’s

length principle
3.2 Why is the arm’s length principle needed?
Although this is seemingly a fairly basic question, it is worth considering as it informs

us as to why there are so few alternatives and why authorities persist with the arm’s
length principle as the foundation for transfer pricing on a global basis.
Consider a UK company manufacturing and selling products in its local market. If

that company becomes successful, it will likely seek to grow its market, and at
some point that will involve seeking to sell its products overseas. To achieve this,
the company would have the choice of either using third party distribution
channels in other countries, or selling directly to customers itself. Using third parties
may have the short-term advantage of selling to companies with an existing
customer basis and local market knowledge, however it would require sharing
some of the value chain profit with another party. Therefore, the manufacturer
may choose to sell directly. With small scale sales, this may be achievable whilst
maintaining only a UK sales force. Nevertheless, at some point it would most likely
seek to establish a sales force overseas.
Once this happens, for a raft of administrative reasons, the UK company is likely to
seek to establish a subsidiary overseas to employ the sales force (the same effect
could be achieved through establishing a branch, but this would basically have
the same outcome for transfer pricing purposes). When this company begins to
purchase products from the UK manufacturer to sell to its local customers, we have
created the need for a transfer price – a price that is reflected in the sales ledger

of the UK manufacturer and in the cost base of the accounts for the overseas sales
company. Thus, the transfer price exists for accounting purposes rather than
explicitly for tax purposes.
In the absence of any tax constraints, the company is in theory free to choose any
price for the products. If the sales company were located in the United States,
where the corporate tax rate is currently 40%, the company would incentivised to
set a relatively high transfer price. For a given cost of production and end sales
price, this would allow the bulk of the profit to be earned in the UK, where a
corporate tax rate of 23% would be applied. With a high transfer price, little profit
would be earned in the United States and thus little tax would be paid at the
higher rate, minimising the group’s overall tax liability.
Conversely, if the sales company were located in Ireland, with a corporate tax
rate of 12.5%, the company would be incentivised to set a low transfer price. This
would allow more of the profits to be earned and taxed in Ireland, and less in the
UK, reducing the overall tax liability.
 Illustration 1
Final sales price £500.
Cost of production £200
Transfer Price UK Profit USA Profit Ireland Profit Total Profit

23% 40% 12.5%
400 200 100 300
300 100 200 300
In each case the total profit is £300. However where the UK has the lower tax rate,
more of the profit has been left there to be taxed at 23%. Where the tax rate is
lower in Ireland most of the profits have been moved there.
Let us focus on sales in the USA. With a transfer price of £400 to the USA the total
tax payable by the group is 46+40 = 86 leaving after tax profits of £214.
If we amend the transfer price from £400 to £300 as used for Ireland the total tax
bill would become 23+80 = 105 giving after tax profits of £197. We can see how the
lower transfer price has resulted in a larger tax bill overall on the sales in the USA.
This setting of the transfer price based on tax rates is sometimes referred to as tax
arbitrage.
This inherent ability of multinationals to set transfer prices based on tax rate
arbitrage is what drives the need for transfer pricing rules. In the example above,
a UK manufacturer selling to third party distributors in the United States and Ireland
would not have flexibility to choose any price, but rather would have to negotiate.
Furthermore, it would not care about the tax liability of the counterparties, and
instead would only be interested in setting a price that maximised its long term
profits.
To protect against this, tax authorities need a basis for determining an appropriate
transfer price that is independent of the tax rate of counter parties. From a short-
term tax yield perspective, tax authorities may be inclined to use an approach
that maximises the taxable profit in their territory, irrespective of the fact pattern.
The problem with this approach is that it would be highly unlikely to be accepted
by the tax authority in the territory of the counterparty. This would lead to two

different transfer prices used in the calculation of taxable profits in each country
and the double taxation of group profits.
Such an outcome would undesirable on many levels. Ultimately it would lead to a

significant reduction in cross-border trade, impacting jobs and economic
prosperity. Such an outcome would be unpalatable for most governments. The
result is that compromise is required, and this comes in the form of the arm’s length
principle. Under this principle, prices are to be set on an objective basis to reflect
the price that would have been agreed if the two parties couldn’t collude to
produce a better post tax outcome. In short, it says the price should be fair to
both parties, and by inference, to both tax authorities.
The OECD Guidelines recognise the limitations of the arm's length principle as “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.” (See OECD 2010
Transfer Pricing Guidelines Chapter I, B, 1.10).
However imperfect, the arm's length principle has been adopted by most tax
jurisdictions and no other alternative has yet been recognised; hence, the
comparability analysis is key in ensuring that the transfer pricing can be supported
in case of a tax audit.
“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.” (See OECD 2010 Transfer Pricing Guidelines
Chapter I, B, 1.15).
As no alternative has yet been acknowledged, comparability analysis is in all

effects the only available test for determining whether two related parties are
transacting at arm's length.
Notwithstanding the opportunity for associated enterprises to manipulate prices, it

should not be assumed that prices will not be arm’s length. The OECD Guidelines
observe that, “Associated enterprises in MNEs sometimes have a considerable
amount of autonomy and can 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.” (See OECD 2010 Transfer Pricing Guidelines Chapter I, A, 1.5).
Although taxpayers cannot rely upon the defence that prices have been
negotiated for compliance purposes, it may still very well be the case that such
prices are in fact arm’s length. Prices within a business are often set by
commercial rather than tax departments, with performance incentives for both
counterparties meaning that there will be a natural tension tending towards an
arm’s length outcome (we will look at this in a later chapter). Furthermore,

commercial teams will generally have a good understanding of their own industry
and a reasonable idea of what constitutes arm’s length arrangements.
A further complication is that taxpayers will often enter into transactions and
arrangements that simply do not exist between unrelated parties.
“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.
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. The mere fact that a transaction
may not be found between independent parties does not of itself mean that it is
not arm’s length.” (See OECD 2010 Transfer Pricing Guidelines Chapter I, A, 1.11).
It has long been established by economists that large firms tend to exist to take
advantage of economies of scale and scope not available to smaller firms. The
concept of comparability analysis can sometimes be difficult to apply as
businesses part of a larger multinational enterprise (MNE) often exchange services
and products, which are often not the “finished article”.
For example, multinational groups may centralise certain ancillary activities to be

more efficient. These activities may include human resources, IT support and
finance. Although it is possible to find independent companies providing these
services, it is important to note that for the independent companies, these services
are core activities. As such, they will also need to perform their own sales activity
and commercial management and generally act in an entrepreneurial manner.
Where these activities are performed in the context of a related party service,
there is generally no such entrepreneurial element.
A further example is found in the context of business restructuring (discussed in

more detail in a later chapter). Companies may choose to centralise many of the
key economic activities and business risks, such that operations in local markets
may have a very limited role. For example, distributors may have only a very
specific role in sales management, and manage few risks. Such distributors are
unlikely to be found operating independently. Nevertheless, provided the structure
is not purely for the purpose of tax avoidance, the transaction should be
respected and the arm’s length principle should still apply. In such cases, more
thorough analysis would be required to evaluate the arm’s length price.
The natural corollary to this is to note that the arm’s length principle does not
require taxpayers to behave in arm’s length manner. It is simply the case that
pricing for transactions should be consistent with an arm’s length consideration.
For example, companies are not required to negotiate as independent parties
would, or limit access to commercial information.
3.3 The OECD Guidelines and Comparability
In order to apply the arm’s length principle, it is necessary to undertake

comparability analysis (a subject that we will be looking at in detail later in this
manual). Determining or proving the arm’s length nature of a price can only be
undertaken with reference to objective data from a comparable independent
source. The OECD Guidelines describe this as follows:
“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 independent
enterprises evaluate potential transactions is required.” (See OECD 2010 Transfer
Pricing Guidelines Chapter I, D, 1.33).
The statement above recognises that for two transactions to be deemed as

comparable a number of variables and conditions should be tested; hence, it
acknowledges the difficulty in comparing transactions foreign to the tested
enterprise even though they operate in the same industry/field.
3.4 The Five Comparability Factors
This is the first time we are going to look at the five comparability factors, we will
look at them again in more detail in a later chapter.
The OECD makes reference to consideration of economically relevant

characteristics when undertaking comparability analysis, and specifically identifies
five comparability factors. These factors should all be taken into account when
undertaking comparability analysis:
• Characteristics of property or services;
• Functional analysis;
• Contractual terms;
• Economic circumstances; and
• Business strategies.
These factors are fundamental to choosing the right comparables, however their
relative importance varies depending on the transfer pricing method chosen to
price the transaction under review.
To best understand the role of these factors, and the reason they impact on the
arm’s length price, it is helpful to consider them in the context of a simple example.
Consider a Japanese-owned multinational company, manufacturing televisions in
Japan and selling them into the UK market through a related party distributor.
MNE based in Japan
Connected Distributor
UK sales
The sole transaction under review is the sale of televisions, and the transfer price
that we therefore need to establish is the price per unit of the televisions. The five

comparability factors will tell us what we need to consider when evaluating

objective data that may be available.
Characteristics of property or services
Here we are going to mention some of the approved methodologies such as

Comparable Uncontrolled Price (CUP) and Transactional Net Margin Method
(TNMM). We will explain each of the approved methodologies in detail in a later
chapter.
Considersation of characteristics of property and services relates to the underlying

nature of the product or services that are the subject of the transaction. In the
case of our transaction, the products in question are televisions. However,
depending on the method we select, it may be the case that either more or less
information is required. If we are able to identify market data for the wholesale
price of televisions, we may be able to use a CUP method. In this case the
specification of the products in question would be very important. Factors such as
screen size, HD and 3D capability, internet access and others would all impact the
price. In order to use the third party data to set or test the transfer price, the third
party products would need to be almost identical. If the third party data in
question related to televisions that had 3D capability and the tested party
products did not, one would expect the third party products to be materially more
expensive. As such they could not be used as comparable data to apply the
CUP.
Conversely, if the method being applied is the TNMM, considering companies also
engaged in distribution activities in the UK, the degree of comparablility required
would be much less. The TNMM considers the net margin earned by parties for
their activities undertaken. Unless there is robust evidence to the contrary, there
is would be no reason to believe that a distributor of televisions would earn a
different operating margin on one type of television compared to another.
Indeed, it is likely that the margins earned on distribution of all types of durable
consumer electronics would be similar. Therefore, comparability requirements are
much less onerous in applying a TNMM approach.
Functional Analysis
Functional analysis is going to be looked at several times in this manual as it is a key

part of transfer pricing.
Functional analysis is the area of most significant focus in undertaking

comparability analysis. It involves consideration of the key economic activities of
the parties, not only in terms of their functions, but also how risks are managed and
how assets are developed and owned. Each of these should be considered in
turn.
Functions are the most easily identifiable of the three areas, and requires an
assessment of the relative activities of both counter parties, specifically in relation
to the transaction under review. In the case of our example, there may be a
range of activities undertaken by the UK entity. At one end of the spectrum, it
may have very limited functions. There may be only a handful of employees
engaged in account relationship management. Orders by those customers may
be shipped directly to them by the manufacturer with the distributor taking legal
title for only a split second.
At the other end of the spectrum, the distributor may have a full range of activities.
It may operate a warehouse and engage in a full suite of logistics services, or it
may have an extensive marketing team developing advertising and marketing

materials to promote the products directly to customers. Other things being equal,
it would be expected that a distributor undertaking more of the value chain
activities would purchase goods at a lower price in order to be able to fund those
activities, and would typically expect to earn more profits. Comparability analysis
needs to consider whether the counterparts in the third party data have a similar
functional profile.
You will see more detail on what a functional analysis looks like in a later chapter.
In relation to risks, it is noted that a party bearing more risk would typically expect
to earn more profit (albeit that the actual level of profit earned may fluctuate
depending on whether those risks are realised). In the case of our distributor, it
would be expected that the distributor would earn a higher margin if it bore
inventory risk, warranty risk and customer credit risk, than if those risks were passed
on to the manufacturer. It should be noted that consideration needs to be given
to the behaviour of the parties and not just the contractual relationships. Under
OECD principles, risk (and the reward associated with it) should be attributed to
the party that manages that risk, not just the party that contractually bears it.
Assets are important too, and in particular, intangible assets can be a critical
determinant of transfer prices. If the Japanese manufacturer owns a globally
recognised brand, and attaches that brand to the televisions, that will result in a
very different transfer price to the case where the manufacturer simply produces
unbranded products. In the latter case, the UK distributor may have developed its
own brand through marketing activities, and therefore would expect to pay less
for the products, even if the technical capabilities were the same.
In undertaking comparability analysis, third party data involving companies with

similar functional, risk and asset profiles to the tested party is required. In practice,
it is impossible to find companies with identical profiles. Therefore, broader analysis
of the industry and the company are required to determine which are the
significant determinants of profit for the company, and which are routine.
Contractual terms
Contractual terms and conditions should always be reviewed when using the CUP
method as differences between the third party and the related party contracts
could result in different pricing (e.g. transfer of stock and forex risk from one
distributor to another). At one level, the contractual terms may simply consider
the size of and nature of the transaction. A transaction where the distributor is
seeking to import 50,000 units of a product will likely attract a very different price to
a contract for 500 units, even if the products are identical.
At a deeper level, the contractual arrangements may confer rights and

obligations on the parties that need to be reflected in the transfer pricing. For
example, the distributor may have exclusive rights to distribute the televisions within
the UK market and would therefore expect to pay a premium for such right. It may
also be obligated to undertake a certain level of advertising and promotion
activity that would need to be factored into the price. It may also contractually
bear or pass on some of the risks identified in the functional analysis. An
understanding of the contractual relationship between the parties is therefore
necessary to enable the identification of sufficiently comparable third party
relationships.
Economic circumstances
Economic circumstances relate to the broader context in which the transaction

takes place. There are many factors that are beyond the control of the related

parties that would influence the arm’s length price for any given transaction. The
most obvious example is the state of the economy. If we consider the UK
distributor purchasing televisions against a backdrop of very low economic growth
and poor consumer confidence, this will have a significant impact on the demand
for televisions and other consumer products. This will impact the overall profitability
for the group, and level of profitability that the distributor might expect to make.
Another factor may be the degree of competition amongst customers. For the UK
distributor, there may be a large number of significant customers and a high
degree of competition at the retail level. This would enable the distributor to earn
a higher margin. In other territories, there may be much less competition, with one
or two retailers accounting for the vast majority of sales. Those customers would
have much more buying power, driving down the profit potential for the
distributor.
In undertaking comparability analysis, it is therefore necessary to consider whether

the third parties face the same economic circumstances as the tested party, and
if so, whether those differences are material. Comparable data from different
markets, geographic or otherwise, should not automatically be excluded but do
require careful evaluation.
Business Strategies
The OECD Guidelines acknowledge that business strategies will play an important
role in determining the arm’s length price. In practice, this is most commonly
considered in the context of market penetration. In the case of our example, the
Japanese group and its products may be new to the UK. It may therefore be the
case that it incurs abnormally high set-up costs and additional marketing and
promotional costs to make consumers aware of the new product, whilst at the
same time being unable to command the same market premium as more
established market participants. Under such circumstances, it may therefore be
acceptable for the UK distributor to earn lower profits (or even losses) than
comparable companies whilst still paying an arm’s length price.
However, it should be cautioned that there should be consistency between the

business strategy and the functional analysis. If in the long term the UK distributor is
to be considered a low-risk distributor, with very little responsibility for managing
market risks in the UK, then it would not be expected to incur the costs of starting
up the UK business and establishing the brand. Under those circumstances, the
transfer price would need to be lowered to allow the UK distributor to earn
sufficient profit from a very early stage.
3.5 Application of Comparability Analysis
Comparability analysis will be examined in more detail in a later chapter. We need

to mention it here as to apply the principles above, it is typically necessary to
undertake a comparable search. This may be a search for comparable
transactional data, but more typically this involves searching for companies
involved in comparable activities to the related party chosen to be the tested
party.
Even though there are a number of criteria for choosing comparables that are
easy to follow (e.g. industry, location, time, etc.), the decision whether to accept
or reject a potential comparable bears a certain level of subjectivity which is often
at the centre of challenges by the tax authorities (e.g. does the business
description give enough details to decide if the company should be added to the
set of accepted comparables? And even if the business operates in the same

industry, market and location how can we establish differences in strategy,

commercial goals, etc.?).
“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 transactions. Attributes or comparability factors”
that may be important when determining comparability 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.” (See OECD 2010 Transfer Pricing Guidelines Chapter I, D,
1.36).
In theory, the larger the sample of comparables, the greater the likelihood of
identifying a tighter and more defensible range, since the impact of outliers will be
reduced. However the availability of comparables that can be used for transfer
pricing studies has become more of a concern in recent years.
A third party business can only be used as a potential comparable if it meets strict
independent criteria. The lack of independent comparables has made the
comparability analysis process even more difficult. One reason for this is that
globalisation and the most recent financial crisis have led to increased
competition and smaller players being taken over by the larger groups; hence, the
number of independent parties in all industries has decreased.
A further complication is the increase in information available through the internet.

Whereas ten years ago, comparability would have predominantly been
determined through a short business description on publicly available databases,
and through financial statements, a larger number of companies now have their
own websites providing much more information about activities undertaken.
Ironically, this additional information usually serves to highlight the lack of
comparability between the tested party and the potential comparables.
Regardless of the guidance provided by the OECD Guidelines to enhance

comparability, the element of subjectivity remains. Running sensitivity analysis on
the comparable set (e.g. varying the acceptance criteria to either include or
exclude comparable enterprises) can be very valuable.
For example, if the tax authorities are challenging the comparability of some of the
businesses in the final set of comparables (i.e. the set used to build the arm’s
length range), having run sensitivity analysis and choosing a profit margin (or other
profit indicator depending on the transfer pricing method being chosen) that is
within the range for different sets of comparables could lower the risk of the tax
authorities demanding an adjustment.
When using transfer pricing methods (e.g. TNMM) where third party comparables
are used to generate the arm’s length range for the comparison with the tested
party, it can be often difficult to identify comparables, which deal with
comparable services or products and operate in the same industry. Running two
analyses based on functional and industry comparability then comparing the
results can help make the analysis more robust and support the pricing with the tax
authorities.

CHAPTER 4
TRANSFER PRICING METHODS
In this chapter we are going to look at the methodologies set down by the OECD
Guidelines, in particular:
– Comparable Uncontrolled Price Method (CUP)
– Resale Price Method (RPM)
– Cost Plus
– Transactional Profit Methods
4.1 Introduction
Selecting the appropriate transfer pricing method is key both during planning for a
new transaction/product/service and when putting in place documentation to
support the current transfer pricing.
It is preferable to look at transfer pricing methods prior to setting up intragroup

transactions as it limits the risk of exposure in case of an audit.
Testing an existing pricing policy by choosing one of the transfer pricing methods
does not always guarantee that the current pricing will be supportable (i.e. at
arm's length).
The OECD Guidelines deal with transfer pricing methods in Chapter II and provide
a description of all the acceptable methods and when they should or could be
applied. The methods are broken down into two types; traditional transaction
methods (CUP, RPM, Cost Plus) and transactional profit methods (TNMM,
transactional profit split method).
It is important to understand all the methods; however, it is even more important to

understand how to apply them and when they should be chosen.
4.2 The OECD Guidelines
Up until the 2010 edition, the OECD Guidelines presented a hierarchy of methods;
therefore, the choice was dictated mainly by the availability of data and the tax
payer had to start with the preferred method and work his way down if the higher
ranking method could not be applied.
In 2010 the OECD Guidelines introduced a change in the way the method should
be chosen. The hierarchy no longer exists and the choice of method is based on
the optimal method and best fit method. In other words, the tax payer should
choose the method that best describes the transaction under test and that also
reflects the functional and risk profile for the transaction.
We will look first at each method and how they should be applied and then
understand how the appropriate method should be chosen and go through a few
examples.

4.3 Comparable Uncontrolled Price (“CUP”) Method
“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”. (OECD 2010 Transfer Pricing Guidelines Chapter II,
2.13.)
We can subdivide CUPs into two types – internal CUPs and external CUPs. An
internal CUP is available when an enterprise sells the same product or service to a
third party as it does to an associated enterprise. An external CUP is a transaction
between two unconnected parties. As a general rule internal CUP will give rise to
more reliable data.
The CUP method makes reference to the basic arm's length principle under which
related parties should interact as if they were not related. Therefore, if an
enterprise sells a particular product to a third party for a certain price, the same
price can be used to sell the same product to a related party.
However, as the OECD text highlights, there might be differences between the
third party transaction and the related transaction. For example, a manufacturer
might sell a product to third party distributors for a certain price, which also
includes the sales and marketing efforts of the manufacturer to become the
product supplier of the distributor. However, when the same manufacturer sells to
a related party, the sales and marketing efforts are almost non-existent (as the
related party distributor is more likely to buy and distribute a product
manufactured by the group it belongs to). Therefore, using the third party price
might result in overcharging the related party (in this example).
Some adjustments might be required to ensure the CUP can be used to price the
intragroup transaction. The main comparability criteria to take into account when
deciding if a CUP is applicable or can be applied (after being adjusted) are as
follows:
• Functional profile (i.e. does the related party carry out the same functions to
deliver the service or product to the third party as to the related party?);
• Risk profile (i.e. does the enterprise bear the same risk when dealing with both
the third and the related party?);
• Cost base (i.e. does the enterprise bear more or less cost when interacting with
a related party?); and
• Contractual terms (i.e. are there any differences between the third party and
related party contract? For example, payment terms, return policy,
cancellation terms, etc.).
Depending on the number of transactions and products/services to be tested the

use of CUPs can become very onerous for the taxpayer. Furthermore, differences
in contractual arrangements can make the use of CUPs difficult.
As explained before, CUPs can be adjusted; however, implementing several

adjustments can result in making this method too artificial.

Product comparability should be closely examined in applying the CUP method. A

price may be materially influenced by differences between the goods transferred
in the controlled and uncontrolled transactions, although the functions performed
and risks assumed (e.g. marketing and selling function) are similar so as to result in
similar profit margins. The CUP method is appropriate especially in cases where an
independent enterprise sells products similar to those sold in the controlled
transaction.
Although product comparability is important in applying the CUP method, the

other comparability factors should not be disregarded. Contractual terms and
economic conditions are also important comparability factors.
When looking at CUPs (whether internal or external), in the absence of a perfect

CUP, we can identify close CUPs and inexact CUPs. These are the result of
(unrelated party) transactions that are adjusted to take account of material
difference. Reliable adjustments may be possible for difference regarding the
source of the products, difference in delivery terms, volume discounts, product
modifications and risk incurred.
Reliable adjustment may not be possible for trademarks. Adjustments also cannot
be made to account for material product differences – the CUP method may not
be the appropriate method in such a case.
Difficulties resulting from performing reasonably accurate adjustments to remove

the effect of material differences on prices should not automatically prevent the
use of the CUP method. One should try hard to perform reasonable adjustments.
If reasonable adjustments cannot be performed, the reliability of the CUP method

is decreased. Another transfer pricing method may then be used in combination
with the CUP method or considered instead of the CUP method.
The CUP method used to be the number one method in the hierarchy. Although,
the hierarchy no longer exists, some tax authorities and tax inspectors in general
tend to always look for the existence of CUPs. Therefore, it is good practice to
always consider the CUP method and either provide an explanation why it cannot
be used for a specific transaction or to use this method (even when it is not the
most appropriate) as a complementary method.
Note RPM is sometimes referred to as resale minus method.
4.4 Resale Price Method (“RPM”)
“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 on this price (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”. (OECD 2010 Transfer Pricing Guidelines Chapter II, 2.21.)
£
Selling price Known
Transport costs (X)
Advertising (X)
Other costs (X)
Resale price margin* (X)
Arm's length price X
*This is a known.
The RPM is as the OECD Guidelines describe it the most appropriate method when
testing sales and marketing activities. This method is similar to the way a wholesaler
calculates the price to a distributor (i.e. by taking out its cost plus a margin and
arriving at a discount on the resale price for the distributor).
However, the latest business trends are showing an increasing number of large
MNEs setting up principal structures, where the sales entities act mainly as agents
to facilitate the sale or as limited risk distributors.
In cases where the sales entity does not take legal title to the goods or has a
reduced risk profile and is acting on behalf of a principal distributor the RPM model
is not the appropriate model and it is worth looking at other methods such as the
Transactional Net Margin Method (“TNMM”) instead.
Another consideration that should be made on the RPM, which transpires from the
OECD Guideline's description of the method, is that the gross margin applicable to
the distributor or wholesalers should include an arm's length return.
What happens if there are no internal comparables (i.e. the wholesaler does not
sell products the same way to third parties as it does to related parties) and
looking for external comparables does not return significant results?
How can the tax payer estimate the level of discount to the distributor ensuring the
overall gross margin retained by the wholesaler is at arm's length?
If we look at the overall supply chain for the product we can identify the following
steps:
• Procure;
• Research and develop
• Make;
• Market and advertise;
• Sell; and
• Support and customer relationship.
If a manufacturer sells directly to customers it is likely to own (or outsource at a

cost) each step of the supply chain. In the case where a manufacturer sells to a
related party distributor the last three steps in the supply chain are owned by the

distributor. Therefore, there is a split of functions and risks between the

manufacturer/wholesaler and the related party distributor.
The end price to the customer (i.e. the resale price) can be adjusted (i.e.
discounted) to the distributor by adjusting the price based on the functional and
risk allocation. Cost can be a useful allocation key to calculate the discount in
combination with the risk profile for each of the functions no longer carried out by
the manufacturer.
For example, if a manufacturer sells directly to customer a product for 100 and its
cost base (covering the entire supply chain) is 80 it makes a 20 profit.
However, when it sells via a related party distributor all the marketing, advertising,
selling and customer service efforts fall on the distributor. Therefore, if the cost of
these functions to the manufacturer when selling directly to customer is 16 and we
use cost as the main indicator or allocation key, 20% (i.e. 16/80) discount should be
applied to the resale price when selling to the related party distributor.
It is important to ensure that the cost base is homogenous (e.g. comparing cost of
labour for each of the supply chain steps and including where necessary
amortisation of assets when the assets add considerable value to the process) and
that the risk associated with each function is also taken into account.
For example, the cost of R&D might not be as high as the manufacturing cost, but
if the R&D process generates a very valuable intangible (e.g. a design that makes
the product much more sellable) the cost of R&D should be adjusted to reflect its
true value in the supply chain.
Note RPM is sometimes referred to as resale minus method.
4.5 Cost Plus Method (“C+”)
“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 an associated purchaser. An appropriate cost plus
markup 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 semi finished goods are sold between associated parties,
where associated parties have concluded joint facility agreements or long-
term buy-and-supply arrangements, or where the controlled transaction is the
provision of services”. (OECD 2010 Transfer Pricing Guidelines Chapter II, 2.39).
The cost plus method uses cost as the main driver to arrive at an arm's length
margin. The mark-up applicable to the cost reflects the return the enterprise aims
to achieve and should reflect the value added by the enterprise bearing the cost.
Per OECD Guidelines, this method is particularly useful when looking at semi-
finished products or when looking at services, which do not constitute or are only
part of the finished product or service.
However, although cost can provide a good basis for valuing the input of an
enterprise delivering a service or a product, the mark-up associated with the cost
can exhibit great variance depending on the value added by the enterprise.

To use a similar example to the OECD Guidelines, if the cost is used as a basis to
calculate an arm's length return for manufacturing a product, depending on the
value added at the manufacturing stage the return should be different. It might
help to use premium luxury goods as an example. Goods might be manufactured
in country A, but designed in country B where the brand is owned.
In the case of luxury goods, the brand allows the distributor to sell the product at a
much higher price than non-branded good; therefore, even though the
manufacturing cost might exceed the cost of designing and branding the
product, it adds far less value to the finished product. That is the cost basis cannot
always be used as a proxy for determining the value and margin to be retained.
Another important factor to consider when applying the cost plus method is
determining the cost base for the mark-up. Also, should all cost be marked up?
In general terms and for the purposes of transfer pricing, third party cost can be
recharged without a mark-up as the mark-up should indicate that the enterprise
charging the related party has added some value. The concept of adding value is
very important as when subject to a tax audit and in particular in some jurisdictions
(e.g. Belgium) cost plus recharges can be challenged by tax authorities if there is
no clear value added.
Furthermore, applying the cost plus method presents a number of difficulties in

relation to how cost is managed and what strategy drives spending and
investment patterns in a business as the OECD Guidelines highlight in the extract
below.
“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)”. (OECD 2010 Transfer Pricing Guidelines
Chapter II, 2.43)
This issue ties back to the cost versus value argument, where R&D cost might be
much smaller than manufacturing cost, but it is the R&D that makes the product
more sellable and allows the enterprise to charge a premium price.
However, making adjustments to the cost base can make applying an

appropriate mark-up difficult as when looking for comparable transactions it might
not be as easy to identify the cost base in the comparable (especially if this is a
third party comparable). This issue is also encountered when applying the cost plus
method under a Transactional Net Margin Method (TNMM).
4.6 Transactional Profit Methods
“A transactional profit method examines the profits that arise from particular
controlled transactions. The transactional profit methods for purposes of these
Guidelines are the transactional profit split method and the transactional net
margin method. 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”. (OCED 2010 Transfer Pricing

Guidelines Chapter II, 2.57)
Transactional profit methods used to be regarded as a “last resort” approach in

the previous versions of the OECD Guidelines, when the hierarchy of methods was
in place.
Transactional profit methods essentially test the arm's length nature of a

transaction based on the overall profitability (using a number of profit indicators)
of a related party when compared to a third party.
Finding detailed comparable transactions for each product or service to enable

the tax payer to use the standard methods previously described can be very
difficult especially when looking at services which are not linked to the main line of
business (e.g. an electronic component manufacturer is provided management
services by a related entity).
The two transactional profit methods are probably the most commonly used
methods in transfer pricing as apart from transactions which occur with both third
parties and related parties, the majority of large MNEs exchange a number of
services and products for which it is not possible to identify specific CUPs.
The following extract from the OECD Guidelines details when it is appropriate to
apply each of the two methods.
“A transactional net margin method is unlikely to be reliable if each party to a

transaction makes valuable, unique contributions, … In such a case, a
transactional profit split method will generally be the most appropriate
method, … However, a one-sided method (traditional transaction method or
transactional net margin method) may be applicable in cases where one of
the parties makes all the unique contributions involved in the controlled
transaction, while the other party does not make any unique contribution. In
such a case, the tested party should be the less complex one”. (OECD 2010
Transfer Pricing Guidelines Chapter II, 2.59).
The extract above highlights the concept of “complexity” and makes reference
once again to “value.”
Transactional Net Margin Method (TNMM)
The transactional net margin method looks at third party comparables that carry
out similar activities to the tested party and measures their profitability. Therefore, if
the transaction to be tested is complex and involves several parties contributing to
the overall value being created, the TNMM cannot be easily applied.
The independence criteria together with the overall globalisation trends (i.e. fewer
totally independent third party comparables are available for comparison), make
it more difficult to find a potential comparable third party company that fits the
specific functional and risk allocation of a tested party entering into a complex
transaction.
In cases where the TNMM can be applied it is very important to choose the right
profit indicator to test. It is possible to convert from one profit indicator to another;
however, each profit indicator is subject to a number of sensitivities, which might
lower the comparability and generate non arm's length results as detailed in the
extract below:

“In applying the transactional net margin method, the selection of the most
appropriate net profit indicator should follow the guidance.. in relation to the
selection of the most appropriate method to the circumstances of the case. It
should take account of the respective strengths and weaknesses of the
various possible indicators; the appropriateness of the indicator considered in
view of the nature of the controlled transaction, determined in particular
through a functional analysis; the availability of reliable information (in
particular on uncontrolled comparables) needed to apply the transactional
net margin method based on that indicator; and the degree of comparability
between controlled and uncontrolled transactions, including the reliability of
comparability adjustments that may be needed to eliminate differences
between them, when applying the transactional net margin method based
on that indicator.” (OECD 2010 Transfer Pricing Guidelines Chapter II, 2.76).
The TNMM compares the net profit margin (relative to an appropriate base) that
the tested party earns in the controlled transactions to the same net profit margins
earned by the tested party in comparable uncontrolled transactions or
alternatively, by independent comparable. For example, return on total costs,
return on assets, and operating profit to net sales ratio.
As such, the TNMM is a more indirect method than the cost plus / resale price
method that compares gross margins. It is also a much more indirect method than
the CUP method that compares prices, because it uses net profit margins to
determine arm's length prices.
One should bear in mind that many factors may affect net profit margins, but may
have nothing to do with transfer pricing.
The TNMM is used to analyse transfer pricing issues involving tangible property,
intangible property or services. However, it is more typically applied when one of
the associated enterprises employs intangible assets, the appropriate return to
which cannot be determined directly.
In such a case, the arm's length compensation of the associated enterprise not
employing the intangible asset is determined by determining the margin realised
by enterprises engaged in a like function with unrelated parties.
The remaining return is consequently left to the associated enterprise controlling

the intangible asset; the return to the intangible asset is, in practice, a “residual
category” being the return left over after other functions have been appropriately
compensated at arm's length.
This implies that the TNMM is applied to the least complex of the related parties
involved in the controlled transaction. The tested party should not own valuable
intangible property. As stated above the application of the TNMM is similar to the
application of the cost plus method or the resale price method, but the TNMM
involves comparison of net profit margins.
For example, in the case of a related party distributor applying the resale price
method to establish an arm's length transfer price, the market price of products
resold by the related party distributor to unrelated customers (i.e. sales price) is
known, while the arm's length gross profit margin is determined based on a
benchmarking analysis. The transfer price or cost of goods sold of the related party
distributor is the unknown variable.
The determination of an arm's length transfer price based on the TNMM is similar.
The main difference with a gross margin analysis is that operating expenses are
considered in calculating back to a transfer price. In applying the TNMM on the

tested party distributor, the resale price and the operating expenses of the related
party distributor are known, while the arm's length net profit margin (i.e. net profit
to sales ratio) is found on the basis of a benchmarking analysis. The cost of goods
sold and the gross profit are the unknown variables.
In the case of a manufacturer, applying the cost plus method to establish an arm's
length transfer price, the cost of goods sold of the related party manufacturer is
known. The arm's length gross profit mark-up is based on a benchmarking analysis.
The transfer price or sales revenue of the related party manufacturer is the
unknown variable.
In applying the TNMM to the tested party manufacturer instead of the cost plus
method, the cost of goods sold and the operating expenses of the related party
manufacturer are known. A benchmarking analysis will determine the arm's length
net profit of the related party manufacturer using a profit level indicator such as
the ratio of net profit to total cost. The sales price and the gross profit are the
unknown variables.
Transactional Profit Split Method
“The transactional 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 that independent enterprises would have
expected to realise from engaging in the transaction or transactions. The
transactional profit split method first identifies the profits to be split for the
associated enterprises from the controlled transactions in which the
associated enterprises are engaged (the “combined profits”). References to
“profits” should be taken as applying equally to losses… It then splits those
combined profits between the associated enterprises on 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.” (OECD
2010 Transfer Pricing Guidelines Chapter II, 2.108)
The wording in the OECD Guidelines introducing the Profit Split Method (“PSM”)
immediately touches on the main application for the PSM, which is dealing with
complex transactions where several parties contribute to generate overall value
(i.e. a product or a service). All previous methods we have discussed deal
specifically with one transaction and require a specific functional and risk profile.
That is the other methods necessitate a specific transaction, which can be
identified, compared and weighed (i.e. identify the risk profile to assess whether it
should generate a routine or a non-routine return).
The PSM looks at the overall value generated by the efforts of all the transacting
related parties and provides an arm's length apportionment of the profit based on
the value each party contributes to the business on the basis of its functional and
risk profile.
“The main strength of the transactional profit split method is that it can offer a
solution for highly integrated operations for which a one-sided method would
not be appropriate. A transactional profit split method may also be found to
be the most appropriate method in cases where both parties to a transaction
make unique and valuable contributions (e.g. contribute unique intangibles)
to the transaction, because in such a case independent parties might wish to
share the profits of the transaction in proportion to their respective
contributions and a two-sided method might be more appropriate in these
circumstances than a one-sided method. In addition, in the presence of
unique and valuable contributions, reliable comparables information might
be insufficient to apply another method. On the other hand, a transactional

profit split method would ordinarily not be used in cases where one party to
the transaction performs only simple functions and does not make any
significant unique contribution (e.g. contract manufacturing or contract
service activities in relevant circumstances), as in such cases a transactional
profit split method typically would not be appropriate in view of the functional
analysis of that party.” (OECD 2010 Transfer Pricing Guidelines Chapter II,
2.109)
The extract above further highlights the strengths of the PSM. The presence of high
value intangibles is rapidly increasing in the context of large multinational groups.
The globalisation trends and increasing competition require businesses to come up

with unique ways to sell their products and services and gain (plus keep) the
interest of new and existing customers.
Technical intellectual property, business and industry know-how and brands are
often becoming the main driving force for large businesses. With brands valued in
excess of tens of billions, ensuring that intellectual property is properly accounted
for when allocating profit is key.
One of the inherent properties of intangible is its uniqueness as businesses gain by

differentiating themselves from the competition. However, the unique nature of
intangible translates in more difficulties in finding comparable transactions when
pricing the intangible contribution for transfer pricing purposes.
The PSM provides a solution to the comparability problem. The PSM based on
contribution analysis and the Residual PSM based on residual analysis (“RPSM”) are
often used to price both value and the profit portion contributed by intangibles.
Before elucidating how the PSM and RPSM work with intangibles, it is important to
understand how the PSM and RPSM work in practice.
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
that independent enterprises would have expected to earn from engaging in a
transaction or a series of transactions.
The profit split starts with identifying the profits to be divided between the
associated parties from the controlled transactions. Subsequently, these profits are
divided between the associated enterprises based on the relative value of each
enterprise's contribution, which should reflect the functions performed, risks
incurred and assets used by each enterprise in the controlled transactions. External
market data (e.g., profit split percentages among independent enterprises
performing comparable functions) should be used to value each enterprise's
contribution when possible, so that the split of combined profits between the
associated enterprises is in accordance with that of third party enterprises
performing functions comparable to the functions carried out by the related party.
However, not all functions can be priced using comparables as we already briefly
discussed for intangibles.
Two main methods to split the profits amongst the associated enterprises can be
used:
• Contribution analysis; and
• Residual analysis.

With contribution analysis (or simply PSM), the aggregated profits from the related
party transactions are allocated amongst the associated parties on the basis of
the relative value of functions performed and risk borne by the associated
enterprises engaged in the controlled transactions.
Comparable market data should (when possible) be used to calculate the portion
of the profit due to each of the related parties based on their functional and risk
profile and as detailed in the functional analysis conducted for the purposes of
putting in place transfer pricing documentation.
If the relative value of the contributions can be calculated directly, then

determining the actual value of the contribution of each enterprise may not be
required. The combined profits from the controlled transactions should normally be
determined on the basis of operating profits. However, in some cases it might be
proper to divide gross profits first and subsequently subtract the expenses
attributable to each enterprise. Furthermore, when services are exchanged which
contribute to the overall value proposition, other methods can be used to
apportion the overall profit, such as the cost plus method.
If we compare contribution analysis to TNMM we see that TNMM depends on the

availability of external market data comparables to measure efficiently the value
of contribution of each of the related parties, while the contribution analysis can
still be carried out even when it is not possible to measure directly each party's
contribution to the overall profit base of the multinational group.
The contribution analysis and TNMM are difficult to apply in practice and therefore
not often used, because reliable external market data necessary to split the
combined profits between the associated enterprises are often not available.
How does the Residual PSM (“RPSM”) differ from the simpler PSM, which we have
just analysed? The RPSM model differs from a standard PSM as it involves a two-
step approach. We have already mentioned how certain value contributions
cannot be easily priced by means of comparable benchmarking (e.g.
intangibles). The RPSM first allocates comparable functions' profits, which then
leaves a residual profit to be split amongst the more difficult to price functions such
as intangibles.
In the first step an allocation of arm's length profit to each related party is
implemented to provide a basic compensation for routine contributions (i.e.
functions where the risk profile can be regarded as low – e.g. support services,
limited risk distribution, toll manufacturing, etc.).
The routine profit allocation does not account for any possible valuable intangible
assets owned by the associated party. The routine compensation is determined
based on the returns earned by comparable third party enterprises, which (ideally)
work in a similar industry or that (at least) carry out comparable functions and
exhibit a similar low risk profile. The TNMM is usually employed to determine the
appropriate routine returns for the first step in the RPSM.
Once all routine functions have been remunerated, the residual profit is then split
to account for non-routine activities, which are usually associated with a higher risk
profile. It is interesting to note that as risk bearing functions, the residual does not
necessarily translate in profit allocation; as the routine functions take priority in
allocating the profit, it might be that the residual profit is negative.
Hence, the non-routine functions might end up being allocated a portion of the
loss. However, it is also true that when large profits are collected within a
multinational group, the RPSM is more likely to allocate the majority of the profits to

the risk taking functions within the group. These trends follow the standard
economic trends for risk and reward (i.e. the higher the risk, the higher the
potential for profit, but also losses).
The residual analysis is usually applied in cases where both sides of the controlled
transaction own valuable intangible properties.
The OECD Guidelines do not refer to specific allocation keys to be used when
allocating the residual profit, but it is good practice to investigate a number of
allocation keys and run sensitivity analysis to ensure that the split returns arm's
length results.
Below are a number of examples to illustrate how the residual can be split
depending on the availability of data, comparables and allocation keys.
Third party market benchmarks can be used to assess the fair market value of the
intangible property or other non-routine function to be allocated as part of the
residual profit.
The capitalised cost of developing the intangibles and all related improvements
and updates adjusted to account for the useful life of the asset and its future
potential in providing the added value (i.e. advantage) can be used. However,
using cost as the base to allocate the residual profit might not provide the correct
allocation as some non-routine functions might incur lower cost, but generate high
value.
Another way to allocate the residual profit is to look at the development

expenditures in recent years and identify a trend (i.e. if these costs have been
constant over time).
The RPSM is becoming more popular following the recent restructuring trends of
large multinational groups, which are centralising some of the non-routine
functions and creating structures, which present a complex setup and would not
lend themselves to the standard transfer pricing methods. The RPSM provides a
good alternative in such cases, as the residual approach splits up a complex
transfer pricing problem into two more manageable steps and allows the use of a
number of allocation methods to benchmark, value and weigh the non-routine
component to be transfer priced. Secondly, potential conflict with the tax
authorities is reduced by using the two step residual approach since it reduces the
amount of profit split in the potentially more controversial second step.
The list below highlights some of the strengths and weaknesses of the PSM and the
RPSM.
Both the PSM and RPSM are suitable for highly integrated operations for which a
one sided method may not be appropriate.
The PSM and RPSM are also useful when third party benchmarks cannot be
identified.
The PSM and in particular the RPSM are most useful when looking at non-routine
functions and intangible property, which cannot be easily defined using the
standard transfer pricing methods due to their uniqueness (i.e. lack of
comparables in the market that match the functional and risk profile).
However, both the PSM and in particular the RPSM require a higher level of
reviewing, testing and sensitivity checking when using allocation keys, which do
not necessarily generate arm's length results.

Both the PSM and the RPSM are highly dependent on having access to quality
information and data from group affiliates. The information and data have to be
reviewed and compared to ensure consistency, which is sometimes lacking in
large multinational groups, which have just gone or are undergoing restructuring or
acquisitions.
The PSM can be used in cases involving highly interrelated transactions that
cannot be analysed on a separate basis. This means that the PSM can be applied
in cases where the associated entities engage in several transactions that are
interdependent in such a way that they cannot be priced on a separate basis
using any of the traditional transaction methods. The transactions are thus so
interrelated that it is impossible to identify distinct comparable transactions. Due to
this particular strength, the PSM and the RPSM are suitable for use in complex
industries such as financial services.
The RPSM (in particular) is often used in complex cases where both sides to the
intragroup transaction own valuable intangible properties (e.g. technical IP,
patents, trademarks, and tradenames). If only one of the associated enterprises
own valuable intangible property, the other associated enterprise would have
been the tested party in the analysis using the cost plus, resale price or TNMM.
However, if both sides own valuable intangible properties for which it is impossible
to find comparables, then the PSM is more likely to be the most reliable method.

CHAPTER 5
FUNCTIONAL ANALYSIS
In this chapter we look at:

– The goal of functional analysis;
– An introduction to the analysis of functions, assets and risk;
– Summarising the functional analysis;
– Functional analysis and entity characterisation.
5.1 Introduction
Functional analysis plays a critical part in establishing arm's length transfer pricing.
It involves gathering information and analysing the businesses engaged in the
controlled transaction to ensure that the parties to the transaction and the
transaction itself are understood. This enables an understanding of the
economically significant factors on which the pricing and its analysis will be based.
The 2010 OECD Transfer Pricing Guidelines place great stock on functional analysis
as a pre-requisite for an appropriate assessment of the comparability of a
controlled transaction (of the ‘tested’ party – we will look at this in more detail in a
later chapter), the selection of a transfer pricing method and for establishing the
appropriate pricing by reference to comparability, including where necessary, any
adjustments.
It is the normal starting point for any examination of an enterprise's transfer pricing
and also the means by which businesses and tax authorities can form a high level
view of value chains and the role and reward of transfer priced entities within
them.
This chapter sets out an overview of functional analysis with later chapters focusing
on practical guidance in carrying out a functional analysis and how that feeds
into the selection of a method, and its role in entity characterisation.
5.2 Goal of functional analysis
The goal of functional analysis can be summarised as the identification of the

economically relevant function, asset and risk characteristics of a party to a
transaction to enable the accurate assessment of comparability with an
uncontrolled transaction in the setting of a transfer price.
In order to fully understand importance of functional analysis, we must look at the

role it plays in determining comparability between the controlled transaction
under review and uncontrolled transactions. Paragraph 1.33 of the OECD
Guidelines sets out the essence of comparability in transfer pricing:
1.33 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 help establish this there is guidance from the OECD in paragraph 1.38 on five
important comparability factors that should be considered:
‘Paragraph 1.36 refers to five factors that may be important when determining
comparability. As part of a comparison exercise, the examination of the five
comparability factors is by nature two-fold, i.e. it includes an examination of the
factors affecting the taxpayer's controlled transactions and an examination of the
factors affecting uncontrolled transactions.’
We looked at these comparability factors in an earlier chapter. You will recall that
they may be summarised as:
• Characteristics of property or services
• Functional analysis
• Contractual terms
• Economic circumstances
• Business strategies
The function (taking into account also the assets used and risks assumed)
performed by an enterprise which is a party to a controlled transaction is one of
the key comparability factors to be understood. This is established by way of a
functional analysis.
Paragraph 1.42 of the OECD Guidelines summarises the importance of the

functional analysis and its impact on arm's length pricing:
1.42 In transactions 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, a functional analysis is
necessary. This functional analysis seeks to identify and compare the economically
significant activities and responsibilities undertaken, assets used and risks assumed
by the parties to the transactions. For this purpose, it may be helpful to understand
the structure and organisation of the group and how they influence the context in
which the taxpayer operates. It will also be relevant to determine the legal rights
and obligations of the taxpayer in performing its functions.
An important aspect to this guidance is contained in the word ‘each’. Whilst the
eventual transfer pricing method selected may be essentially ‘one sided’ (i.e. it
tests and supports a price or targeted margin for one of the parties to the
transaction), a functional analysis should consider factors relevant to both parties
engaged in the transaction (for instance, those relevant to establishing their
relative bargaining power) as otherwise there might be a limited basis for
comparability which may in turn raise doubts about the appropriateness of the
selected method and the robustness of the support for the pricing of the
controlled transaction.
Increasingly tax authorities are taking such a ‘two sided’ view on examination of
pricing with their starting point being to corroborate the results of the application
of the selected transfer pricing methodology of the tested party with the results of
the counterparty to the transaction.
Whichever view is taken, the analysis of the economically significant functions,

assets and risks remains key.

5.3 Analysis of functions, assets and risks
The functional analysis is the factual basis of any transfer pricing and the right effort
and focus should be placed on capturing accurate and relevant information
concerning functions, assets and risks, which will be critical in determining the
economically relevant characteristics for comparison with an independent party
situation and therefore minimising adjustments to transfer pricing policies that have
been implemented. Many transfer pricing issues arise due to a lack of clarity on
the factual position.
The OECD Guidelines, in paragraph 1.42, as set out above, reinforce the need for
the functions, assets and risks to be identified and the Guidelines further expand
on functions, assets and risk in paragraphs 1.43 to 1.45.
Para 1.43 ‘…The principal functions performed by the party under examination
should be identified…’
Para 1.44 ‘The functional analysis should consider the type of assets used, such as
plant and equipment, the use of valuable intangibles, financial assets, etc., and
the nature of the assets used, such as the age, market value, location, property
right protections available, etc.’
Para 1.45 ‘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…’
As part of their guidance to UK taxpayers, HMRC also provide a valuable insight

into what a tax authority would look for in a functional analysis when examining
transfer pricing documentation:
‘A functional analysis should …. describe what activities the company performs,

where those activities take place, who bears what risk and who gets what reward.
It should assist with considering the relative weight and importance of those
activities in earning profits for the company and the group. For example, for a
generic, non-branded product which is not the result of complex R & D, the selling
activity may be more important in creating profits than the simple manufacturing
activity. An effective functional analysis will be a valuable source of evidence.
Its credibility may depend on several factors, including the extent of work
conducted by the authors of the report; how detailed an examination of functions
and risk in the business has been performed; the quality of evidence obtained
from interviews with key personnel and so on.
Identification of the location and nature of risk is an important aspect of functional

analysis. Before risk can be considered case teams need to understand fully where
the functions of the trade are located and carried out…’ (INTM484040 – Examining
transfer pricing reports: Information in a report – functional analysis).
A successful functional analysis will draw out the functions, assets and risks in a
manner that will enable comparison to uncontrolled transactions. It is inevitably a
simplification of the complexity of the value drivers in a business and will rarely be
capable of being exhaustive.

As such, a successful functional analysis will identify and draw attention to the most
important and relevant factors. It should allow a reader unfamiliar with the
specifics of the industry to understand the functions, assets and risks of the
enterprise in sufficient detail for them to understand the key relevant economic
characteristics. It will also typically bring to light aspects of the other comparability
factors, for example characteristics of the service.
A functional analysis will often be performed by way of an interview with key

stakeholders in an enterprise. As a tool, the functional analysis interview is an
effective way to explore the full range of comparability factors.
The representation of the functional analysis in documentation is important. It

typically forms a core part of a transfer pricing report and can be the subject of
scrutiny by a tax authority or other interested party (for instance a minority
shareholder) many years after writing. As such, it needs to be a full explanation
that stands alone in a fashion that is not reliant on reference back to source or
detailed supplementary materials.
5.4 Summarising the functional analysis
While a full text explanation of the functional analysis is critical to robust and
effective transfer pricing documentation, a summary showing the key functions,
assets and risks and their location in the group is often useful. This will be a benefit
to the reader, who will be required to take in a lot of information, and for when the
preparer comes to characterise each of the entities involved.
This summary should work through the supply chain in a logical order. Any lack of
clarity in its preparation will identify insufficient understanding in the functional
analysis review.
 Illustration 1
Here we have a functional analysis for the H Group which consists of HO Ltd (the
parent company), MO Ltd and distribution companies.
Activity HO Ltd MO Ltd DO Ltd

Parent Co Manufacturer Distributors
Functions
R&D – management, review, X
budget
R&D – performance X
Procurement X
Production X
Logistics and shipping X
Marketing & business X
development
Sales (inc customer contract) X
After sales service X
Insurance X
Strategic management X
Day-to-day management X X
Back office support X

Assets
Raw materials stock X
Design intellectual property X
Production equipment X
Manufacturing know-how X
Stock of finished goods X
Trade mark and brand IP X
Customer lists X
IT support systems X
Website X
Risks
New product development X
Warranty X
Market X X
Foreign exchange X
Stock X
Regulatory X
Here we can see that the H group is what we would describe as a group with
devolved activities. The parent company just carries out head office activities with
the result that all the manufacturing functions, assets and risk are within MO Ltd
and the functions, assets and risks relating to distribution are in each of the DO Ltd
companies.
We can contrast this to the following illustration.
 Illustration 2
Here we have a functional analysis for the C Group.
Activity CP Ltd CM Ltd CD Ltd

Parent Co Manufacturer Distributors
Functions
R&D – management, review, X
budget
R&D – performance X
Procurement X
Production X
Logistics and shipping X
Marketing & business X X
development
Sales (inc customer contract) X
After sales service X
Insurance X
Strategic management X
Day-to-day management X X X
Back office support X

Assets
Raw materials stock X
Design intellectual property X
Production equipment X
Manufacturing know-how X
Stock of finished goods X
Trade mark and brand IP X
Customer lists X
IT support systems X
Website X
Risks
New product development X
Warranty X
Market X
Foreign exchange X
Stock X
Regulatory X
The C group would be described as a group with centralised activities. We can

see from the table that the parent company CP Ltd is responsible for many group
functions. As a result it also holds a lot of the groups assets and carries a lot of the
risk.
If we compare the functions of the parent company in the C group to the parent
in the H group we can see that functions such as procurement are undertaken by
CP Ltd rather than by the manufacturing company. As a result it holds stock as an
asset and has the risk associated with holding stock.
5.5 Functional analysis and entity characterisation
Characterisation of a controlled party is an important part of the transfer pricing

analysis. It allows other entities with the same characteristics to be identified as
part of the comparability analysis.
The functional analysis along with information from the industry can be used to
characterise the entities. If we take a manufacturing company for example,
common characterisations include full blown manufacturer, contract
manufacturer or toll manufacturer.
Entity characterisation can be a helpful high level tool to assist in examining often
complex value chains (that is, how a business derives value from the various
activities involved in the production of a product or service) and the manner in
which component parts of the value chain relate to each other from a transfer
pricing perspective.
This allows both an initial determination of transfer pricing interactions in existing

value chains, as well as providing a valuable basis of examination of the transfer
pricing consequences for those value chains which are being transformed.
We will look at entity characterisation in more detail in a later chapter.

CHAPTER 6
ANALYSIS OF FUNCTIONS, ASSETS AND RISK
In this chapter we are going to look at the practical aspects of preparing a functional
analysis, including:
– the audience and purpose;
– the sponsor;
– the interviews;
– the functional analysis.
6.1 Introduction
This chapter focuses on the practical aspects of preparing a functional analysis,

from considering the audience for the functional analysis through to conducting
interviews and preparing and updating its documentation.
When preparing a functional analysis, the aim is to document the key functions,
assets and risks of the business. In many respects a functional analysis is the most
interesting aspect of a transfer pricing project. It involves meetings with employees
at all levels of the business, from the people at the coal face, the operational
team that support them through to the executives that develop, drive and
implement its long term vision and strategy.
This chapter has been prepared on the basis that a third party is preparing the
functional analysis, however the guidance can be equally applied by a company
preparing its own functional analysis.
6.2 Preparing for the Functional Analysis
Audience and purpose
Before beginning, consider the audience for the functional analysis. Is it a basic
document to support an uncontroversial tax filing position? Is there a dispute with
a tax authority and is it therefore a defence document setting out the company's
position on the issues? Is it to support a proposed transaction; maybe the
company is proposing to close manufacturing facilities in higher cost countries (in,
for example western Europe or North America) and move them to a lower cost
country in Asia? Such a restructure would need to be supported from a transfer
pricing perspective, clearly documenting the change in functions, assets and risks.
Whatever the purpose of the document, the effort required will depend on the
nature, size and complexity of the parties and transactions involved. The OECD
Guidelines state at paragraph 5.7 (last sentence):
“…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.”
The length and style of the functional analysis will need to reflect the complexity
and materiality of the arrangements it will support. For a basic, uncontroversial
cross border arrangement, a simple tabular functional analysis like the example
that we will look at later in this chapter would be appropriate. In contrast, a tax-

advantaged principal/sales agent arrangement may require a detailed functional

analysis to demonstrate the limited role played by the sales agent.
Tax authorities also have different approaches to functional analysis. For example,
some tax authorities will regularly conduct their own functional analysis where
there appears to be inconsistencies between the taxpayer's own functional
characterisation of the business and the returns achieved.
The importance of a sponsor
To prepare a functional analysis a number of interviews with employees of the

business will need to be conducted. In order to do this, suitable people must be
identified, and time found in their schedules for the interviews. An internal sponsor
within the business is invaluable for facilitating completion of the transfer pricing
project (and not just for organising functional analysis interviews).
A good sponsor will help to arrange interviews, understand the internal politics of
the business, and provide guidance on how to best introduce the project to the
interviewees. Ideally they should be at every interview. A sponsor may also help to
keep interviews focused and on track, and assist in building a rapport with the
interviewee.
Importantly, a sponsor can clear interviewees to discuss problems and past

business failures which may provide invaluable examples to demonstrate the
functions, risks, and assets of the business. No one likes to talk about their business's
failures to strangers but often these are the best source of information about which
party bears the risks of the business.
There are several attributes of a good sponsor:
• They will have a good understanding of the business;
• They will be well connected in the organisation;
• Well respected in the organisation;
• Engaged in the process;
• Able to convey the importance of the project to a variety of interests and

people in the business; and,
• Able to provide insights on contradictory facts that crop-up in the interviews,

and/or identify the right people to get to the bottom of the issue.
Preparation for the interviews
It is important to consider in what order to interview people for the functional

analysis. It is helpful to have the sponsor to identify a “soft” opening interview:
someone who can provide a good overview of the business, ideally someone who
is open and friendly.
In reality the order of interviews is likely to be determined by people's availability.

However, the ideal option would be to start with someone that is likely to
understand transfer pricing and how it relates to the business, for example the
Finance Director or Chief Financial Officer, or Head of Tax. Next, consider an
operational head, then drill down into greater operational detail if required, and
finally meet with senior members of staff, such as the CEO, for the strategic
overview. While it is good to get a senior view of where the business is going, keep

in mind that it may be more difficult to schedule interviews with senior people, and
they are likely to be available for a shorter length of time.
If the functional analysis involves interviewing many people, think carefully about
how to do this. It is not uncommon to go for a “big bang” approach, with a whole
day of back-to-back interviews. This has lots of advantages: it is efficient, quickly
giving an understanding of the company, and if any issues arise or there are
conflicting facts, it may be possible to clarify these in the next interview. However
this approach also comes at a cost: the interview team will get tired, and material
covered in the interviews will start to blend together. The big bang is particularly
hard on the note taker and even harder on them when they have to type up the
meeting notes. If the functional analysis interviews have to be back-to-back, try to
organise a 10-15 minute break between each interview to reflect on what has
been said and how this will impact the following interviews.
If possible, try to meet at least the first few interviewees in person even if time,
geography, schedules and budget constraints may mean that some or all of the
functional analysis interviews have to be conducted by telephone.
The functional analysis interview team
For each functional analysis interview, it is advisable to have one person

responsible for conducting the interview and another person whose sole task is to
take notes of what the interviewee has said. It is very difficult to conduct an
interview and take adequate notes at the same time.
Ideally, in addition to the interviewee, it is helpful to have three participants:
• the functional analysis interview leader;
• the sponsor; and,
• the note taker.
Each has their own role to play.
The functional analysis interview leader
• Completes the introductions (if there is no sponsor or the sponsor chooses not
to do this), and provides context for the interviewee (for example, what
transactions and issues they anticipate examining, the nature of the
questionnaire, etc.).
• Leads the interviewee through the functional analysis questions, identifies any
interesting areas to explore, and moves the conversation in these directions.
• Considers what the interviewee is saying in the context of the project, the
business, and what the team understands from other information sources or
interviewees.
• Needs to be flexible in their questioning style, and recognise when a

conversation tangent is helpful and when the conversation needs to get back
on track.
• Spots issues and is responsible for ensuring the interview covers all the areas
required in the time scheduled.

The sponsor
• Introduces the interview participants and provides context for the interviewee
(for example, the framework for the exercise it proposes and its importance to
the business).
• Is helpful in clarifying issues/solutions.
• Helps the functional analysis interview leader to conduct the interview.
• Can act as a “tie breaker” when contradictory facts are raised at the
interview.
The note taker
• Is the busiest person in the room: if people are talking they probably should be
writing.
• Captures the detail (names, dates, terms of contracts, product names,

company names…) so the functional interview leader can concentrate on
what they hear, and how this fits into the bigger picture.
• Keeps track of actions, “to-do” lists, and follow up points.
• Prepares the meeting notes/draft functional analysis.
6.3 The interview
Conducting the interview
There is undoubtedly an art to conducting a good functional analysis interview but

as a rule, as indeed with most things, the more preparation that is done ahead of
the meeting the better the interview is likely to go.
The interviewee has made the time to talk to the team, so it is important to respect
that time and make the most of it. An agenda and a list of questions will give
structure to the meeting and will help with this. As a functional analysis interviewer's
experience increases, they will be able to prepare for interviews more efficiently,
but even the most experienced functional analysis interview leader can forget
critical questions to ask, so a list of key questions is a must.
It is good practice to begin by explaining to the interviewee the purpose of the

interview, what types of transactions/issues are the highest priority and how the
information will be used. It is surprising how much more relaxed interviewees are
when they find out that the information will only be used in a document for tax
purposes. Keep in mind that the interviewee may be defensive: the questions they
are being asked are trying to get to the core of the business. They are in essence
being asked what they do, why it is important and how they add value. As such, it
never hurts to tell the interviewee that in the majority of cases the document that is
being prepared is unlikely to ever be read by anyone outside of the business's tax
department. Transfer pricing documentation, like insurance, is best when you
never have to use it.
It is good practice to start the functional analysis interview by asking the

interviewee to describe their current role, the team they work in, and their history
with the company. Open questions are key to getting the information needed,
such as “can you please explain how…” or “describe the process involved in…”.

Be prepared to deviate from the planned agenda and absorb answers to

questions that may not be in the planned order.
In general it is fine, in fact helpful, to profess ignorance of the business, particularly

with the operational side. This will encourage the interviewee to explain the
business in layperson's terms. Ultimately, the functional analysis is going to have to
explain the business in a simple and understandable way. Most businesses have
three letter acronyms, technical phrases and other abbreviations; don't be afraid
to ask the interviewee to explain these.
While it is important to strike a balance and make efficient use of the interviewees'
time, if they offer a tour of their operations, warehouse, or factory, it is an
opportunity that should not be refused. The more real the business is to the
interviewer the easier it will be to write about it.
When trying to understand the unique attributes of the company it can be useful
to ask why would a customer use this company instead of a competitor, or when
trying to understand risks, ask what would happen if there was a catastrophic
incident; a key factory burning down for instance, or the product causing the
hospitalisation of a number of customers.
Active, critical listening in conjunction with open questions is crucial to conducting

a good functional analysis interview. While staff members may have a detailed, in-
depth understanding of the functions of their own department, a functional
analysis needs to take a balanced wider view. It is important to listen to
interviewees critically, and consider how their job, business unit or division
contributes to the functions, risks and assets of the broader issue being
documented.
When the interview has finished, take some time to summarise the key points and
issues. It is surprising how often members of the interview team understand critical
facts mentioned in the interview differently.
It is helpful to confirm with the interviewee if they are happy to be contacted

directly to clarify any issues that arise.
6.4 The Functional Analysis
A functional analysis is the fact finding process of researching and documenting

the relevant functions performed, assets owned and risks borne by the business. All
companies will have a slightly different mix of functions, assets and risks, and so the
following sections are intended as a guide only. In some instances, a functional
analysis is prepared to support a single transaction; in other cases it will support
multiple transactions, in multiple jurisdictions. Accordingly, the time it takes to
gather the facts and conduct interviews, and the length and detail included in a
functional analysis will vary greatly.
From a practical perspective, it is necessary to consider how much information to

include about each function, risk and asset, and how to present the information.
Usually, a functional analysis will include the functions of a number of entities in the
document. When preparing a summary functional analysis table, such as the one
included in this chapter, this is relatively straight forward. However, a functional
analysis often involves a longer narrative, addressing each key function, risk and
asset in turn. There are a number of ways to do this. One approach is to do it on an
entity-by-entity basis, which sets out the functions, risks and assets of each entity
separately. An alternative would be to lay it out on a functional basis, which

introduces each function, risk and asset and then describe the entities to which
these apply under each relevant heading.
Throughout this chapter there are examples to help describe key concepts and
issues when preparing a functional analysis. There will be a variety of examples
throughout the chapter, however the following is a Core Example to which we will
often refer.
Core Example: Otaki Group
 Illustration 1
OTAKI CENTRAL
(New York) 3rd PARTY
Pricing, Logistics, Marketing Contract
Design selection, Stores Manufacturers
Trade marks
(Asia)
OTAKI OTAKI
Design Manufacturing
(Milan) (Philippines)
Develops designs 20% of products
Otaki Group is a leading clothing retailer designing, manufacturing and retailing

clothes throughout the world. Otaki Group is headquartered in New York (“Otaki
Central”) and Otaki Central is responsible for selecting designs, determining pricing
strategy, store layout and location, organising logistics, and developing marketing
campaigns, and it owns all Group trademarks.
To ensure that its products are leading the market, Otaki Central has set up a
dedicated design house in Milan (“Otaki Design”) with 100 top designers. Otaki
Design puts on four fashion shows a year, one for each season, and Otaki Central
buyers select garments they like for manufacture. Otaki Design is free to develop
any garment designs it likes, and typically, only 1 in 5 garments are selected.
Otaki Group operates on a high volume, low margin model for 80% of its sales, and
to keep costs down utilises third party contract manufacturers to produce its
garments.
Otaki Central selects its designs, colours, materials, and manufacturing quantities
12 months in advance and invites bids from third-party Asian manufacturing
plants.
Recently the Otaki Group established its own factory (“Otaki Manufacturing”) in
the Philippines to produce limited volume (20% of total sales), higher margin “fast-
fashion” garments, with a short delivery timeframe (6 weeks). These garments have
been very successful, and sell out in hours.
If Otaki Central selects the wrong garments from Otaki Design, or orders the wrong
volumes of garments from the manufacturers, it bears the costs of these failures.

The finished garments are sold in stores (“Otaki Retail”) designed by Otaki Central,
using store layout, staff training systems, and staff scheduling systems also
developed by Otaki Central.
6.5 Functions
When conducting a functional analysis the aim is to distil what are the most
important activities undertaken by the business, and also to convey an
understanding of the relative importance of each function as compared to the
other functions performed within the group.
The various functions should be addressed in an appropriate order: the list below
includes some common functions along with some further thoughts for
consideration, but please note that this is not an exhaustive list and that any
functional analysis will need to be tailored to the specific project to which it
relates.
Research and development (R&D)
R&D can cover a wide spectrum of activity, and depending on the industry can
be a core value driver in a business. For example, in computer processor chip
manufacturing R&D is key to developing smaller, more efficient and faster chips
and this area would likely be a significant area of focus in the functional analysis.
But in other industries, for instance making Champagne, a long established

process must be followed, and the importance of R&D is likely to be less than other
factors such as owning land in the right appellation (an asset).
R&D can lead to valuable intangible property, which is discussed further below. In
general, if a business is undertaking R&D it is important to determine what is the
R&D being performed, which party directs the R&D at a strategic level and on a
day-to-day basis, who determines the budgets, who pays for the R&D, what party
owns the R&D, and what happens if the R&D goes wrong. Are multiple entities
within the group undertaking the R&D function? For example, does the R&D team
work on a technology platform that has been created, owned and maintained by
another entity within the group? Answering these questions will assist in preparing
the functional analysis and categorising the business or transaction.
In the Otaki Group's context, an R&D function is being performed by Otaki Design
which designs garments for Otaki Central. This is undoubtedly a valuable function,
but it needs to be viewed in conjunction with the functions performed and risks
born by Otaki Central. Otaki Central chooses which garments will be produced,
how many will be produced, organises manufacturing and logistics, prepares
marketing materials, and determines how the garments will be displayed in-store.
In this regard, Otaki Design could be viewed as a contract R&D house with Otaki
Central ensuring the benefit of the R&D and being entitled to any valuable
intangible property deriving from it.
Procurement
Procurement is the acquisition of goods or services. Within a global group, this

function might be performed separately by many entities or, in some cases, by a
dedicated business whose sole function is to arrange procurement for members of
a group. By centralising procurement in this way a group may hope to produce
efficiencies and potentially economies of scale.

An entity performing a procurement function may be expected to have expertise

in sourcing products and services, negotiating prices with suppliers and
contracting. If procurement is an important function in the group, consider what
exactly the procurement group is contributing. For example, if a multinational
coffee retailer set up a dedicated procurement centre in Singapore to source all
its coffee bean purchases from one coffee wholesaler, would the resulting
discount in bean prices be due to the negotiation skills of the procurement team
or the volume discount of the business (or perhaps a combination of the two?).
In our example, Otaki Central is responsible for organising the manufacturing of the
garments and the delivery of the final items to Otaki Retail. However, it would not
be unreasonable for this activity to be undertaken by a separate entity in the
group. In the garment industry, it is not uncommon to use purchasing agents which
will identify factories to produce garments and ensure that these are delivered on
time to the agreed destination, in exchange for a percentage of the purchase
price of the goods.
But it should be noted that these agents are bearing substantial risks relating to the
delivery of the garments.
Services
Many of the functions set out in this chapter relate to products in one way or
another, but many successful companies do not sell products; they sell services,
and some companies that once could have been described as selling products
are re-creating themselves as service companies (for example “Software as a
Service”).
Service transactions incorporate many of the functions described in this chapter,

including sales, and they are subject to many of the same risks. When undertaking
a functional analysis for a service company, consider which party is performing the
service, who won the work, and what would happen if the services are not
delivered as contracted.
Manufacturing
Manufacturing can range from low value, low skill functions like manufacturing
toys for a Christmas cracker, through to manufacturing a one-off, extremely high-
value item like a communications satellite. It should be noted that the value of the
item produced does not always relate to the value of the manufacturing function.
For example, having machinery and processes that can produce extremely high
volumes of plastic trinkets for Christmas crackers may be a highly valuable, critical
function for a company.
The functions, risks and assets of a manufacturer will also vary considerably. When
considering a manufacturer, it is important to understand exactly what functions
are performed by the manufacturer. Helpful questions to ask, and factors to
consider when categorising the manufacturer, are provided in a later chapter.
The Otaki Group relies mostly on third-party manufacturers for its sales, but its own
factory produces high margin “fast-fashion” garments which have been very
successful. Part of this success is the flexibility to identify a trend and exploit it
quickly. Once again, this is down to Otaki Central's ability to pick the right
garments. If there was something unique about the manufacturing know-how, or
technology developed by Otaki Manufacturing, then this would require further
consideration in the functional analysis.

Warehousing and logistics
A warehouse may be used to store inventory that has not yet been sold. The
company may use its own facilities or a third party's warehouse. It may also be
storing goods for other group members. Potential issues to consider include: which
party has title to the goods, when is title passed, and which party is responsible for
logistics. What happens when products are damaged in transit or at the
warehouse?
Sales and distribution
The importance of sales and distribution to the success of the business varies from
industry to industry. This is related to the type of products/services being sold, for
instance whether they are generic or highly technical, requiring sales people with
specialist skills. For example, a distributor of medical devices used in surgery may
require sales people with a different or higher skill set than a distributor of stationery
products. The former may involve a more in depth sales process involving specialist
medical or technical knowledge and include meetings with medical specialists
and doctors.
The functions, risks and assets of a distribution entity vary considerably, as

considered in more detail in a later chapter.
Marketing
Marketing, particularly localised marketing performed by a local sales company

may result in the creation of intangibles, and some tax authorities have taken a
firm stance that this activity is not routine and requires additional reward. If
marketing is important to a company, for example it is in the fast moving consumer
goods market, it is advisable to pay particular attention to this area of the
functional analysis.
In classifying marketing activity, it is important to consider what value is likely to

flow to the local company and possibly the wider group. For example, is the
company merely taking global marketing materials (pamphlets, brochures etc)
and translating these into the local language, or are they engaging in bespoke
advertising for the local market? If so, is this marketing above and beyond the
level of marketing undertaken by its competitors and is it likely to create an
intangible for the Group? For example, if a local territory was to sponsor a team in
a globally televised event, such as Formula 1 motor racing, should this cost be
shared with other group members?
After-sale customer support services
The level and importance of after-sale customer support services varies from
industry to industry. For example, a company providing foreign exchange trading
software to a multinational bank may require substantial, experienced technical
support to be available to the customer 24 hours a day, 365 days a year. This
service may be critical to completing a sale, and an important function to
document. In contrast, a fast food restaurant would typically not require these
services. It is important to also consider who bears the cost of warranties, whether
the products require repair or replacement, when, how and by whom.
Strategic management
Strategic management services can be centralised to create efficiencies in

controlling entities that may be spread across broad geographic areas. Examples

may include setting the global marketing plan which subsidiaries can then adapt
to their own local market.
Intragroup services
Many multinational groups have services provided by one or more member to

others, often centralised and/or combined with head office roles. These services
may include back-office support such as human resources, recruitment, IT, and
financial reporting. It is important to consider how beneficial these are, and
whether they are unique or could be sourced from a third-party. This is especially
important for high value services such as marketing.
Financing
Some multinational companies may centralise expertise within an entity to provide

a financing or treasury management function for the group. Examples of this may
include providing capital to subsidiaries in the form of intercompany loans,
providing hedging of foreign exchange exposures, cash pooling, and sweep
accounts. It is important to identify whether the role of a finance entity is to
provide intragroup services, such as advice in respect of hedging, or whether it
enters into transactions and if so to what extent it is exposed to risk.
Flows of debt around the group and how they vary can have an impact on
characterisations, such as whether a lender to a cash pooling arrangement is
effectively making a short term deposit or a long term loan. Depending on the role
of the individual(s) you speak to, you may be able to gain an insight into the
character of loans and the relative lending risk of various group members more
easily than through examining spreadsheets.
6.6 Assets
The type of assets to be included in a functional analysis is broad. As noted in

paragraph 1.44, the OECD Guidelines highlight the importance of considering
assets as part of the functional analysis:
“The functional analysis should consider the type of assets used, such as plant
and equipment, the use of valuable intangibles, financial assets etc., and the
nature of the assets used, such as the age, market value, location, property
right protections available, etc.”
As with the functions listed in the earlier section, the following list of assets should
not be considered exhaustive. It is important to keep an open mind when
considering a company's assets. Often, the most important asset is not initially
obvious. For example, some people may consider the trademark of their mobile
telecommunications supplier to be one of the company's most important assets,
but in order to provide the service the company first had to acquire a licence. For
instance, British Telecom spent just over £4bn to acquire its licence.
Both tangible and intangible assets should be considered. It is important to identify

assets at both ends of the transaction, making it clear which party owns the assets
(legally and economically) and which party uses the assets and how the owner is
compensated.

Tangible assets
When considering tangible assets focus should be on the significant items: there is
no need to cover the routine items like office fittings. Some tangible assets which
may be relevant are described below.
Cash
Does the company have a large amount of cash? Perhaps this cash is on deposit
in a related party interest bearing account. Some groups may pool cash in a
central treasury account. If this is the case, consideration will need to be given to
whether the interest rate applied to the deposits can be supported from a transfer
pricing perspective.
Trade and receivables
Does the company have a large amount of receivables when compared to

payables? If so what are the payment terms offered to related parties and third
parties? Is there a significant difference, and does this impact on the working
capital of the company under review? For example, if a distribution company
receives payment from third party customers after 60 days, but must pay for stock
purchased from related parties within 7 days, this may result in a cash flow issue.
Inventory
Inventory can be in the form of raw materials or finished goods that a company
has not yet sold. It is important to understand whether the company is responsible
for managing its level of inventory and how much risk is associated with this. For
example, if a company is acting as a distributor of products for a related party and
is selling the products to a third party, it may be required to carry a certain level of
inventory to meet the customers' demands. In contrast, a distributor selling
exclusively to related parties may not have to maintain a large inventory as orders
are more certain and predictable, which means purchasing can be clearly
planned.
Property
Does the company own significant amounts of property or have leases, and is this
normal for the industry? In the UK, particularly in the retail sector, holding a large
number of leases may be problematic, particularly if there have been significant
changes in where people shop. For example, a fast food restaurant may have
signed up for a 20 year lease, only to find that a new shopping mall has opened
nearby and footfall has significantly reduced. The fast food restaurant may then
have to open a new site in the mall, and bear the costs of the old premises unless
they can be sub tenanted.
Referring back to our Otaki Group example, what would happen if Otaki Central
made a decision to open a store three times the normal store size in an expensive
high-end mall as a flagship store? Should Otaki Retail have to bear the higher cost
of the store?
Intangible assets
There is increasing emphasis in transfer pricing on determining which party is

responsible for the development, enhancement, maintenance and protection of
intangibles. The functional analysis should clearly state which party is responsible
for these activities and which party is entitled to the rewards arising from the
intangibles.

Legally protectable intangibles
Legally protectable intangibles include trade names, trademarks, patents, and

copyrights. Often these are very valuable to the company, as the company has
gone through the effort and expense to seek legal protection. However, focus on
intangibles should not be limited to just legally protectable intangibles: many
companies choose not to apply for patents as they do not want to share their
intangibles with competitors or the intangibles concerned (often hugely valuable)
may not be eligible for legal protection in the form of a trade name or mark, a
patent or copyright, knowhow, for example.
Manufacturing intangibles
In some industries, manufacturing intangibles are an important factor in a

company's success. In computer chip production, the complexity and cost of
building a manufacturing plant to produce the next generation of microprocessors
has been a key factor in consolidation in the industry. It should be noted that even
when a company uses third-party manufacturers to produce its products and does
not have any production facilities of its own, it may still possess and have
developed manufacturing intangibles.
Marketing intangibles
The OECD Guidelines cast the net on marketing intangibles beyond trademarks
and trade names to include:
“…customer lists, distribution channels, and unique names, symbols or pictures

that have an important promotional value for the product concerned.”
Paragraph 6.4
As noted elsewhere in this Chapter, marketing intangibles can be a contentious

area, with some tax authorities asserting that these are more valuable than
taxpayers may consider reasonable. Caution should be exercised when
documenting these intangibles in the functional analysis. The OECD is currently
redrafting Chapter VI of the Guidelines, so this is an area to closely monitor. This is
looked at in more detail in a later chapter.
6.7 Risks
Risk has often been the most neglected area in a functional analysis, and in many
ways it is the most important area to focus on. The OECD and tax authorities are
placing increased attention on risk as demonstrated in the revised OECD Chapter
IX guidance on business restructurings. The list of risks set out below includes the
common risks that people consider, but it is critical to investigate what other risks
are unique to the business during the functional analysis.
When conducting functional analysis interviews, it can be helpful to ask what

would happen should a catastrophic disaster occur. In the Otaki Group example,
what would happen if it turned out that a third party contract manufacturer used
toxic chemicals in dying a batch of t-shirts that resulted in 50 customers being
hospitalised? How would this be different if it was Otaki Manufacturing that used
the toxic chemicals?
It is important to review any contracts that underpin the intercompany

transactions under review. It is surprising how often a company is not following the
terms of a contract, and may have unnecessarily borne costs or become liable for
risks that another group member is responsible for.

As noted earlier, while companies do not like to discuss failures or significant issues
that they have experienced in the past, it is often these examples that are the
most illuminating when trying to determine which party bears risk in the wider
group when issues arise.
Market risk
Market risk is the risk that a downturn in overall market trading conditions affects
either the turnover or profitability of a company operating in that industry. Using
Otaki Group as an example, assume that the company expanded rapidly in
China, positioning itself as a desirable new western brand in expensive upmarket
retail malls in major Chinese cities. If China was then to experience a down turn,
and sales dropped to a point that the Chinese shops could not cover rent or
wages, which party would pick up these costs? If a number of Chinese stores
closed, which entity would bear the costs of the closures?
Regulatory risk
Regulatory risk arises when an industry is particularly subject to compliance with

government regulations. While this is a barrier to entry that can protect businesses
meeting the requirements, changes to these requirements creates risk that either
additional cost will be incurred or that new competition will be allowed into the
market. For example, assume that an energy sector construction company
entered into a contract to build a new refinery in an emerging market. The
contract is signed, and contains a clause that states that the refinery will meet
local emission laws. Half way through construction the developing nation reacts to
non-government pressure to improve its poor environmental record, and halves
the allowable emissions from all commercial sites including refineries.
As a consequence, the construction company will incur an addition £50m in

construction costs to install new scrubbers and other equipment to meet the
standards.
Contractual risk (or warranty/performance risk)
Contractual risk is the risk which an enterprise exposes itself to under contractual
arrangement with its customers, for example for the proper performance or
function of contracted services or products. Where remedy is required, enterprises
risk additional costs from fulfilling warranties, providing replacements and potential
compensation. The ability to secure future contracts within the industry can also be
at stake.
The refinery example above is also an example of contractual risk, as the energy
company failed to include protective language in the contract stipulating either
what the eventual emissions would be, or stating that it would comply with
emission standards at the date the contract was signed.
Procurement risk
Procurement risk arises where an enterprise is responsible for securing its source of
goods or raw materials for processing and/or sale. During a recent construction
boom, a construction company failed to meet its delivery deadlines as it required
a very large crane to assemble a number of modules that had been constructed
off-site. The company had failed to procure the right tools at the right time to meet
its obligations.

Inventory risk
Where an enterprise holds stock, inventory risk manifests around the maintenance
of required stock levels, and the cost this entails, together with the potential sunk
cost from unsold (or unsellable) stock retained in the inventory.
In the Otaki Group example, if the company had predicted that florescent
coloured wetsuits would be the next high street fashion trend and had
commissioned large volumes of stock from its third party manufacturers, it may
have to substantially discount the garments to move them out of inventory should
this trend not occur.
New product development risk
In many industries, continued success relies on the ongoing development of new

or improved products. Some examples of this may be the development of new
technology, improving an existing technology or a new design for an existing
product. New product development risk arises where the enterprise is primarily
responsible for successfully maintaining this development cycle. For instance,
Apple has been very successful in developing new products in recent years.
Products such as the iPad and iPhone have captured significant amounts of
market share at the expense of other companies, and in the case of the iPad
created a new market.
However, none of Apples competitors have developed a tablet computer to date

which has exceeded the sales volumes of the iPad. Developing new products can
be very risky, and many companies, such as Polaroid and Kodak, have failed
when their products have failed to keep pace with changes in the market when
consumers moved to digital, and mobile phone cameras.
Employment risk
Staff risk is the risk of employing, retaining and replacing sufficient numbers of
employees who are experienced or qualified enough to perform the tasks of the
business. This includes meeting the costs of retention or replacement payments
which may be required when this risk is realised. Staff may develop specialist
technical knowledge and it is important the company is able to transfer this
knowledge through the organisation so if the staff member is lost, the knowledge
remains and is able to be effectively utilised by the business.
Credit risk
Where an enterprise is responsible for credit control and cash collection from its
customers, this risk manifests where there is non- or late-payment and steps both to
recover amounts due and maintain cash flow are required.
This will differ by the customer base, which should have been addressed in the
industry analysis and the specifics of the group's customers. For example, are there
many small customers or a few large ones, and is the industry as a whole in
difficulty?
Foreign exchange risk
Foreign exchange risk arises where an enterprise is exposed to currency

fluctuations on contracts. The risk arises when expenses and revenue are
denominated in different currencies.

Exchange rates can be quiet volatile and generally, unless the subject is a
financial company, the company's core competence will not be in financial
markets.
6.8 Output from functional analysis: meeting notes
There are varying opinions on what materials should be prepared at the

conclusion of the functional analysis interviews: whether it is best to prepare
detailed meeting notes, or focus solely on the functional analysis document.
Detailed meeting notes can be helpful, as a week or two after the interview it can
be difficult to remember the detail of discussions and these will be the key record
of the meetings. However, meeting notes are not a substitute for a functional
analysis, which will still need to be prepared. Ultimately, the decision to prepare
meeting notes will be a function of time, availability of resources, and budget. If it
is considered necessary to prepare meeting notes, it is helpful to structure the
meeting note in the same way as a functional analysis, where the meeting is
condensed under the relevant function, risk and asset headings.
Keep in mind that the purpose of the meeting notes is not to provide a
stenographer's record of what was said, but rather to be shaped for its specific
purpose.
6.9 Presenting the functional analysis
The form and content of the final functional analysis will be determined by the
underlying transaction/business that is being documented. The more complex and
contentious a tax authority is likely to find the arrangement(s), the more substantial
the effort that is likely to be required.
A simple table summarising the key functions, risks and assets is useful as it provides
a snap-shot of the business under review. This is helpful when characterising the
respective entities (see later chapter) and when identifying comparables to
benchmark the arm's length nature of the business. However, for more complex or
contentious arrangements, it is common to include a narrative description for
each significant function, risk and asset. When writing a narrative for the functional
analysis, it is important to strike a balance between being too brief to convey the
detail required and providing too much information. All in all, it is beneficial to be
succinct, including the most economical amount of information required in order
to demonstrate the point that needs to be conveyed.

Table 1: Functional analysis summary: Otaki Group
Company Otaki Otaki Otaki Otaki Retail

Central Design Manufacturing
Functions
Manufacturing X
Design XX
Product selection XXX
Sales & Distribution X
Warehousing X
Strategic XX
Management
Financing X
Tangible Assets
Trade receivables X
Inventory X X X
Property X X XX
Plant / equipment X X
Intangible Assets
Trademark XXX
Manufacturing X
Intangibles
Marketing XXX
Risks
Market XX X
Credit X
Inventory XX
Product selection XXX
Contract XX
Staff X X X X
Key: XXX Key

XX Important
X Routine
If the functional analysis is incorporating a table, it is beneficial to include some

form of weighting so that the reader can quickly determine which functions, risks
and assets are important to the business. If the weighting for a function, risk or asset
is not immediately apparent then additional information should be given, this can
be particularly relevant for intangibles. For example, if Otaki Central outsourced
management and protection of its trade marks to another group member then
value and importance would need to be attributed between value building
activities by Otaki Central and management activities undertaken elsewhere.
When preparing the functional analysis, always keep in mind that it will need to be
updated in the future. In the case of factual information, such as the number of
employees in each division, consider that it will be necessary to locate this
information every time the functional analysis is updated. Consider how easy it will
be to get the information next time and whether it is necessary to include this
detail at all. Where information is presented in a reduced or summarised form,
such as in a table as above, it may be helpful to hold more detailed records
separately so the conclusions can be understood later for updating or in the event
of an enquiry.

It is best to avoid including names of individuals responsible for division/business

units in the documentation. If it is necessary to make reference to an individual, it is
preferable to refer only to their title. In rare circumstances, it may be necessary to
mention an exceptional individual by name: for example, Jonathan Ive, the lead
designer behind many of Apple's most successful products, but this should be by
exception. Providing a list of names will increase the time that it takes to update
the functional analysis in the future as there are likely to be changes in personnel in
the intervening time.
6.10 Maintaining the functional analysis
Businesses never sleep, and the functional analysis will need to be reviewed
periodically when the transfer pricing documentation is being updated. An
efficient way to do this is to send the relevant sections to the respective
interviewees (or their successors) and have them review it ahead of the update
meeting. It is also not uncommon to have them just update the word document
using track changes. If the business undergoes a significant restructure it will be
critical to document how the functions of each entity have changed post-
restructure, and support the transfer pricing policy with robust benchmarking
analysis.
The functional analysis needs to be aligned to how the company portrays itself. If,
for example, the company is categorised as a low risk distributor, this will be
challenged by the local tax authority if the marketing spokesperson or CEO is
interviewed and claims the success of the group is down to the unique skills and
contributions of the local company. This is a difficult area to manage, but media-
facing company staff need to understand that their message must be aligned to
the functions, risks and assets of the company. Many audits have been started or
unnecessarily prolonged by a five minute interview in the media making grand
statements that are inconsistent with how the company actually operates.
Also, make sure that the categorisation of the company is consistent with its
website. Keep in mind that websites, press releases and other publically available
information will be reviewed by tax inspectors. This publically available information
should be in alignment with the functions, risks and assets of the company.
6.11 Conclusion
A good functional analysis will provide a succinct summary of the business'

functions, risks and assets, and the relative importance of these elements to the
business. Once the functional analysis has been established, the next step is to use
this information to characterise the business, which is considered in detail in a later
chapter.

CHAPTER 7
RELATING FUNCTIONAL ANALYSIS TO SELECTION OF TP METHOD
In this chapter we are going to look briefly at how the functional analysis is used when
selecting the transfer pricing method, in particular looking at:.
– An overview of the methodologies
– Most appropriate transfer pricing method
– Comparable Uncontrolled Price Method
– Cost Plus
– Resale Price Method
– Profit split
– Transactional net margin method
– Choice of tested party
– Some examples of profiles and links to transfer pricing methodologies
– The financial indicator where a transactional profit split method is selected
– Availability of comparables
– The identification of the significant comparability factors to be taken into account.
7.1 Introduction
The identification of the functions, assets and risks performed and controlled by the
enterprises which are parties to the transaction being tested is the precursor to
assessing and establishing the comparability of the transaction under review to an
uncontrolled transaction.
The functional analysis has the following aims:
• To identify and understand the intra group transactions;
• To enable a choice of tested party (where needed);
• To form the basis for comparability;
• To determine any necessary adjustments to the comparables;
• To select the most appropriate transfer pricing method;
• To determine the correct profit level indicator;
• To ensure that the functional and risk profile of the tested party is reflected in
the chosen comparable.
Chapter III of the OECD Guidelines sets out a 9 step process to a comparability
assessment in paragraph 3.4. Step 3 of the OECD process describes the relevance
of factual and functional analysis to establishing comparability.
‘3. Understanding the controlled transaction(s) under examination, based in

particular on a functional analysis, in order to choose the tested party (where
needed), the most appropriate transfer pricing method to the circumstances
of the case, the financial indicator that will be tested (in the case of a
transactional profit method), and to identify the significant comparability
factors that should be taken into account.’

An understanding of the relevant functions, assets and risks is therefore critical.

However experience has shown that certain transfer pricing methods present
strengths and weaknesses that lend themselves better to certain transaction types.
For example, a cost based method is usually more useful for determining an arm’s
length price for services and manufacturing, and a resale price based method is
usually more useful for determining an arm’s length price for distribution/selling
functions. These are discussed in Chapter 4, which should be studied alongside this
chapter.
7.2 An overview of the methodologies
As stated in an earlier chapter, the OECD sets out five methods, together with a
provision for ‘other’ methods where none of those listed are appropriate.
• Comparable uncontrolled price (‘CUP’)
• Cost plus
• Resale price
• Profit split
• Transactional net margin method (‘TNMM’)
The guidelines no longer contain a hierarchy for selection of the transfer pricing
method, however some countries continue to do so.
7.3 Most appropriate transfer pricing method
You will recall that the overarching guidance is that the aim should be to find the
most appropriate method for the particular case and that the selection of the
method be considered in the context of the nature of the controlled transaction
determined, in particular through a functional analysis. It can often be the case
that a decision is made as to the type of entity which is the party to a transaction
(‘entity characterisation’) that will influence the selection of method and, where a
transactional profit method is selected, the financial indicator to be used.
Para 2.2. ‘The selection of a transfer pricing method always aims at finding the
most appropriate method for a particular case. For this purpose, the selection
process should take account of the respective strengths and weaknesses of
the OECD recognised methods; the appropriateness of the method
considered in view of the nature of the controlled transaction, determined in
particular through a functional analysis…;’
It is important to stress again how the selection of transfer pricing method is

dependent on the functional analysis – the facts and circumstances of the
transaction. Case law provides examples of where this has not been adhered to.
Dixons (DSG Retail Ltd and Others v HMRC [2009])
The retail group, Dixons, sold additional after-sale insurance to customers.

Following a change to the UK insurance taxation rules the group restructured to
reinsure these sales through a subsidiary in the Isle of Man. The majority of the
related income was attributed to the Isle of Man entity, supported by
comparables.

HMRC challenged this on the basis that the substance of the Isle of Man entity –
the seniority and expertise of its personnel, its capital and risk, and its bargaining
power - were insufficient to support this arrangement. This led to selected
comparables being set aside and the initially selected method replaced with a
profit split that increased the share of income and profit to the UK.
Baird Textile Holdings Limited v Marks & Spencer plc (2001)
While not a transfer pricing case, this is highly informative. Baird had supplied
Marks & Spencer for many years when Marks & Spencer terminated supply
arrangements between them. Baird sought damages for lost profits but failed as
there was no contract and none could be inferred. Where independent parties
would not expect remuneration, this will only be supportable between related
parties where it is possible to differentiate the third party position from a group’s
facts and circumstances.
Maruti Suzuki India Limited v ACIT (2010)
Suzuki Motor Corporation owned over half of Maruti Suzuki India Ltd and provided
the Suzuki name for the company to co-brand cars (alongside the Maruti name)
for the Indian market. A royalty was paid to Suzuki for use of the name. The Indian
tax authorities successfully challenged the value of the Suzuki name in the Indian
market, looking closely at local marketing spending to conclude that Suzuki had,
in their view, ‘piggy-backed’ a better known local brand. This shows the
requirement to understand the functional analysis from both sides and
perspectives, as value may be perceived differently in different territories.
It is worth noting that the challenge in these cases has been to the nature of the
underlying transaction rather than to the method itself. However in almost every
instance where a transaction is not appropriately identified, the resulting TP
method will likewise be inappropriate.
7.4 Comparable Uncontrolled Price (CUP)
The CUP method is often referred to as the most objective method. If we look to
the glossary in the OECD 2010 Transfer Pricing Guidelines we see that it is defined
as a 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.
In cases where comparable uncontrolled transactions can be found, the CUP

method is a direct and sound method to determine whether the conditions of
commercial and financial relations between associated enterprises are at arm's
length. It is often useful to consider the CUP method first when looking at possible
internal comparables and external comparables.
The CUP method is often chosen when:
• One of the associated enterprises involved is engaged in comparable

uncontrolled transactions with an independent enterprise (i.e. an internal
comparable is available). In such a case, all relevant information on the
uncontrolled transactions is available and it is therefore probable that all
material differences between controlled and uncontrolled transactions will be
identified;

• The transactions involve commodity type products, but only those in which
product differences are adjustable; and
• We are looking at the interest rate charged for an intercompany loan.
If the CUP method cannot be applied another transaction or transactional

method can be chosen. In these cases it is good practice to specifically exclude
the CUP as an appropriate method in the transfer pricing documentation’s
‘selection of method’ section.
7.5 Cost Plus
This method takes the direct and indirect costs of the controlled transaction and
adds the appropriate mark up so that a profit is made on the controlled
transaction.
The cost plus method is often most appropriate where the cost of the product or
services provision, rather than sale price, is the key value driver. This will be
determined through the functional analysis.
For example, the cost plus method is typically applied in cases involving the
intercompany sale of tangible property where the related party manufacturer
performs limited manufacturing functions and incurs low risks, because the level of
the costs will then better reflect the value being added and the market price.
The cost plus method is often used in transactions involving a contract

manufacturer, a toll manufacturer or a low risk assembler which does not own
product intangibles and incurs little risk. The cost plus method is usually not a
suitable method to use in transactions involving a fully fledged manufacturer,
which owns valuable product intangibles as it is difficult to locate independent
manufacturers owning comparable product intangibles.
The cost plus method can also be used to price charging for services (e.g. legal,
accounting, information technology, marketing, tax, etc.) if the services can be
considered to provide a benefit to the service recipient. However for services,
often in practice TNMM is most commonly chosen with a cost based profit level
indicator (i.e. cost plus based on transactional rather than transaction. See section
7.11 later in this chapter).
It is important to have good quality data and ensuring that the comparable
transactions are indeed comparable and a close match to the controlled
transaction.
7.6 Resale Price
This methodology is often described as going backwards from the sale price to
find the transfer price. The final selling price is reduced by the cost of getting the
product to market, e.g. transport costs and an appropriate profit margin.
The Resale Price Method is normally used in cases which involve the purchase and
resale of tangible property in which the reseller does not add substantial value to
the tangible goods by way of physically modifying the products before resale or in
which the reseller contributes substantially to the creation or maintenance of
intangible property, for example a local marketing intangible.
In a typical intercompany transaction involving a fully–fledged manufacturer

owning valuable patents or other intangible properties and affiliated sales

companies which purchase and resell the products to unrelated customers, the
resale price method is a method to use in respect of the sales company if the CUP
method is not applicable and those sales companies do not own valuable
intangible properties.
In the case of distribution activities, where the distributor takes ownership of the
goods being sold, the Resale Price Method lends itself best to test the arm's length
nature of the transaction (again, in the absence of a CUP).
7.7 Profit Split
The transactional profit split method and the transactional net margin method are
known as the transaction profit methods, as they focus on the outturn of the
transaction rather than the price of the sale of goods or services themselves.
The profit split method takes the total profit for all the associated enterprises and
splits it amongst them in a way that reflects how it would have been split between
unconnected parties.
In general the profit split method should be applied when transactions cannot be
benchmarked using internal or external comparables or when the transaction to
be benchmarked involves the input of several parties, which might also be
contributing intangible assets to generate the overall value for the business.
The section on the profit split method in an earlier chapter includes considerable
detail on when the method would be used. You should refer to that chapter as
necessary.
7.8 Transactional net margin method
The TNMM compares the net profit margin (relative to an appropriate base) that
the tested party earns in the controlled transactions to the same net profit margins
earned by the tested party in comparable uncontrolled transactions or
alternatively, the net profit margins earned by independent comparable parties.
For example, return on total costs, return on assets, and operating profit to net
sales ratio.
In all cases where individual products or services cannot be priced separately the
use of TNMM provides the optimal solution as it compares the profitability of a third
party with the related party entity. However, when using the TNMM it is very
important to choose the right profit indicator (i.e. cost plus for services, resale price
minus discount for distributors, etc.).
Another key issue when applying the TNMM is ensuring that the functional and risk
profiles match those of the selected third party comparables. However, when
running benchmarking studies it is important to understand that tax authorities can
always challenge the choice of comparables; therefore, running sensitivity analysis
on the set of comparables can be valuable as it shows how the arm's length range
vary. If the transfer pricing is chosen in a manner that makes it less sensitive to
changes in the set of comparable third parties the overall risk of adjustments by
the tax authorities can be reduced.
7.9 Choice of tested party
Para 3.18 of the OECD Guidelines indicates that it is usually the least complex party
to the transaction that should be tested, as this will allow for the greatest reliability.

‘...The choice of the tested party should be consistent with the functional analysis
of the transaction. As a general rule, the tested party is the one to which a transfer
pricing method can be applied in the most reliable manner and for which the
most reliable comparables can be found, i.e. it will most often be the one that has
the less complex functional analysis.’
7.10 Examples of functional profiles and links to pricing methodologies
The following table shows some common examples of functional profiles together
with the transfer pricing methods that may be appropriate to a particular profile.
Functional profile Description Pricing method

Group This is the entity containing Residual profit after
entrepreneur/intangible the decision makers, rewarding the other
owner taking the investment risks entities in the supply
(e.g. research, new chain for their functions.
markets and innovation).
The group entrepreneur
can take several forms. For
example it can be a
manufacturer, the group
researcher or the group
product designer.
Contract manufacturer A contract manufacturer CUP/Cost plus method/
produces goods under the Transactional net
direction and using the margin method
technology of the group
principal (usually by
reference to a contract).
Its risks are primarily limited
to its efficiency and ability
to retain the group
manufacturing contract. In
its most limited risk form it
will be a toll manufacturer
with the principal
supplying and retaining
ownership of all materials
Service provider A service provider supplies CUP/Cost plus
services to other group method/Transactional
companies usually by net margin method
reference to a contract. Its
risks are primarily limited to
its efficiency and ability to
provide contracted
services at budgeted costs
Distributor A group distributor CUP/Resale price
distributes goods supplied method/Transactional
by its principal. It risk profile net margin method
can vary dependent on
the structure of the
operation.

7.11 The financial indicator where a transactional profit method is

selected
On working through the selection of a method, it may be decided that a

transactional profit method is the most appropriate to test and support a transfer
price. Whilst there are variations, these methods essentially compare a profit
measure resulting from a transaction between controlled parties to a profit
measure earned on a comparable uncontrolled transaction.
The TNMM (similar to the Comparable Profits Method ‘CPM’ under the US Regs, if
not in concept, in terms of application) is a popular pricing methodology. It relies
on comparing a margin earned from a transaction/function with comparables
that may either be internal or external (which typically rely on proprietary
databases of financial data).
Where this method is selected, and external data used, a decision needs to be
made on the types of company that the tested party will be compared against
(which the functional analysis will inform) and the appropriate profit level indicator
(‘PLI’) to make a comparison against. The selection of the PLI will usually be
determined by reference to the appropriateness as judged against the
transaction and entity, informed by the functional analysis.
For example:
• sales transaction – consider measuring profit against revenues (sales) of sales

entities;
• service provision – consider measuring profit against costs incurred by service

providers providing the comparable services.
Other transactional profit methods i.e. profit split, whilst not necessarily reliant on a
financial indicator, will be reliant on the functional analysis of the parties to the
transaction.
Again, case law can also provide examples of how functional analysis, selection of
method and PLI are considered together.
GAP International Sourcing (India) PvT. Limited v CIT (2012)
GAP International Sourcing provides procurement services for its group in India.
The Indian tax authorities sought to challenge the company’s transfer pricing
policy of a mark up on value added expenses, preferring a commission of 5% of
the Free on Board price. The taypayer’s position was upheld as the Tribunal found
no evidence of local intangibles that would move its transfer pricing method away
from cost plus and that any location savings would be passed on to customers by
a third party.
NB: “Free on Board” is a transportation term that indicates that the price for goods
includes delivery at the Seller’s expense to a specified point and no further.
LG Electronics India Pvt. Limited v ACIT (2013)
LG India manufactures and distributes LG Korea’s products under license, for

which it paid a royalty. The Indian tax authorities successfully deemed LG India’s
marketing expenses to be excessive and something that should be recharged to
LG Korea with a mark up using the cost plus method at arm’s length given the
license arrangement and allocation of risk between the companies. This

effectively imputed another transaction – for brand building – which had not been
captured in the transfer pricing method. It also confirmed the acceptance of the
‘Bright line’ test, as there was no increase to taxpayer income or profits from the
additional marketing spending.
NB: the “Bright line Test” was first put forward in a US case (DHL). The judge in this
case identified that test which notes that, while every license or distributor is
expected to spend a certain amount of cost to exploit the items of intangible
property with which it is provided, it is when the investment crosses the 'bright line'
of routine expenditure into the realm of non routine that economic ownership,
likely in the form of a marketing intangible is created.
7.12 Availability of comparables
For all transfer pricing methods access to information on comparables is necessary

and it may be that due to difficulty in getting access to reliable data on
comparables a different method is then chosen.
Although independent unrelated comparables are usually used for transfer pricing
purposes, in practice it is often observed that for certain countries it is not
possible to identify comparables or reliable company data that meet the
comparability requirements. In such cases, practical solutions must be
sought in good faith by taxpayers and the tax administration. A possible
solution may include searching for comparables in other geographical regions
that share certain key similarities with the country in which a company conducts
its business (e.g. depending on the industry, for manufacturers established in,
for example, Africa, a search for comparables could be carried out in Asia
or Eastern Europe).
Alternatively an industry analysis (publicly available or internally conducted by

the company) could be used to identify profit levels that can reasonably be
expected for various routine functions (e.g. production, services, distribution, etc.).
7.13 The identification of the significant comparability factors to be taken

into account
As we have seen the functional analysis will indicate, out of the functions, assets
and risks identified, which are the significant ones that will be critical in a
comparability exercise.
It is sometimes the case that adjustments will be needed in establishing

comparability of the controlled transaction with uncontrolled transactions. The
functional analysis is the means by which the need for a comparability adjustment
is identified, determining the nature of the adjustment itself and the basis for
determining whether the adjusted data is sufficiently comparable.
We will look at this topic in more detail in a later chapter.

CHAPTER 8
ENTITY CHARACTERISATION
In this chapter we look at how functional analysis is used for entity characterisation and
how classification can affect the chosen tested party, in particular looking at:.
– An overview of entity classification
– Entity classification comparing simpler and complex entities.
– Sales functions
– Manufacturing entities
– Support service activities
– More complex or entrepreneurial entities
– Planning aspects of entity classification.
8.1 Entity characterisation overview
One of the most helpful outcomes from a functional analysis review is to enable
entities in a group to be classified, based on each entity's functions, assets and
risks, from ‘simpler’ entities to the more ‘complex’.
A complex entity might own, manage and develop intellectual property and
make key strategic decisions. A simpler entity would normally undertake more
routine tasks with lower risk such as contract manufacturing or support service
provision. Simpler entities would typically not own valuable intellectual property.
Take the example of the pharmaceutical industry. A complex entity would be that
which manages the development of new drugs, and owns and manages the
intellectual property relating to existing drugs. If this entity sold the drugs to a
related party distributor in another country, the provision from a transfer pricing
perspective would be the price of these drugs as between the two entities.
From a transfer pricing perspective, it is difficult to quantify the arm's length return
to be made by a pharmaceutical company for selling drugs intra group. The value
of drugs will be dependent on a number of factors such as the treated condition,
whether the drug is seen as revolutionary, the number of competitor products and
local market conditions (for example whether the main buyer of drugs is a single
national health service or whether there are multiple private providers).
Given the difficulty of looking at an arm's length provision from the perspective of
a more complex entity, transfer pricing work tends to focus on the simpler entities:
in this case, the local distributor of the drugs. From a transfer pricing perspective,
distributors of drugs should make relatively similar economic returns regardless of
the pharmaceutical company or the type of drug being distributed. This is due to
the fact that a pure sales activity requires essentially the same skill set and
practices for all pharmaceutical products – the functions, assets and risks of a
distributor is likely to be broadly the same.
In order to support the pricing between the parent and the distributor, if no
comparable uncontrolled price (CUP) is available it would be normal to look at
the profit margins earned by the distributor as a result of the purchase of the drugs
and compare these margins with those achieved by independent companies (for
instance, companies acting as distributors for third parties) performing the same
activities in that market. This is normally carried out by a benchmarking study using

an economic database that draws on data from different markets, for example
North America, Europe or Asia.
Some local differences may exist. For example, in markets such as the US it may be
necessary for pharmaceutical distributors to spend significant sums targeting
doctors and patients with promotions and advertising which arguably could
create a local marketing intangible. However, it could still be possible to
benchmark a local distributor's returns, taking into account this marketing
intangible by comparing them against the returns of other independent entities in
the market that bear similar costs. Effective functional analysis will guide these
types of decision.
Generally, the simplest entity becomes the tested party for transfer pricing
purposes. Where two parties are subject to a transaction or provision, the
economic analysis will be usually performed on the simpler entity. This arises from a
practical perspective, as comparable companies (and their financial data) are
easier to identify where there are fewer differentiating functions, assets and risks
involved.
While the transfer pricing analysis will normally be performed on the simpler entity,
there is still work to be carried out using the functional analysis to assess the precise
rewards of the tested party: there is a sliding scale between ‘simple’ and
‘complex’. Some simpler entities will have a much higher level of functionality and
risks assumed than other entities, and this could have a crucial impact on the arm's
length transfer pricing provision. It is also important not to generalise a specific fact
pattern into a generic classification; a service function that includes key business
risks – for example outsourced analysts who perform quality control of deliverables
going direct to a client – might not be appropriately rewarded as a routine, low-
risk function.
The next section looks at entity classification based on the functional analysis and
its impact on the reward achieved by different entities that are party to a
provision.
8.2 Entity classification -comparison of simple and complex entities
Comparing simpler and more complex entities gives an initial understanding of

how to direct the transfer pricing analysis. However, further work is needed to
understand the precise value contributed by each entity in order to measure an
appropriate arm's length reward.
Once a detailed functional analysis is performed, it is possible to obtain an

understanding of the economic purpose of each entity within the group and the
contribution that they make to the overall “value chain” of the group for providing
a particular product or service and the component transactions from which this is
made.
A value chain relates to the steps needed to deliver a product or service and
measures the contribution (in value terms) of each step or process to the overall
value chain. By understanding the value chain and in particular the contribution of
each entity, it is possible to classify each entity for transfer pricing purposes.
Entity classification is perhaps one of the most important and controversial areas of
transfer pricing. It requires groups to take a dispassionate look at the outputs of
their functional analysis and to assess the activities that each entity performs and
the value they add, and then to classify each entity accordingly. The entity

classification will feed directly into the selection of transfer pricing method and
economic analysis.
The diagram below shows how the entity classification, which is derived from the
functional analysis, can affect the transfer pricing policy and, through it, the level
of local profitability.
Fundamentally there is a direct correlation between the profit potential of a

company and the type of activity it conducts, the risks that it assumes and the
assets, especially intellectual property, that it owns. More complex entities possess
a higher degree of functionality, risks and assets, and so have the potential to
generate the greatest profit margins. On the other hand, increased functionality
and risk gives rise to the potential for much greater fluctuations in profitability,
including the possibility of financial losses. These more complex entities are more
“entrepreneurial” where they drive the key strategic and critical decisions for a
group and take on the associated risk. The right or wrong decisions in this regard
will have a direct impact on the financial performance of the group.
In some cases, multinational enterprises may seek to centralise key strategic or

high value functions and risks in a single entity to avoid duplication and simplify
management. Where implemented effectively, this further reduces the functions,
assets and risks of local activities in favour of those in the entrepreneur or
“principal” company.
The key to successful entity classification is to draw evidence directly from the
functional analysis outputs without imposing an oversimplified view which is neater
but which may not reflect the variation of local activities. Where the latter occurs,
tax authorities are increasingly identifying and challenging the position, particularly
when in practice ‘limited risk’ operations are less limited than they are presented.
To achieve this, the table in the functional analysis, like the one we saw for Otaki
Group in an earlier chapter, summarising the location of key functions, assets and
risks is often valuable as this shows each entity's relative complexity.

Simpler or routine entities
Many group entities often carry out more simple or “routine” functions, especially
where key risks are managed centrally. These are normally the focus for the
economic analysis as the “tested party.”
These entities perform functions which, while part of the value chain, do not
contribute materially to the value added functions, assets and risks which
differentiate the business. They will normally undertake activities which can be
easily replicated (i.e. they are not protectable) and as such are neither unique nor
dependent on proprietary intellectual property. This might include distribution
activities, contract manufacturing or contract research and development, or the
provision of services, but as always the classification of these activities will depend
on the fact pattern concerned.
It is important to remember that a classification can extend to the whole activity of

an entity (for example a contract manufacturer), or be limited to activities in
respect of specific transactions, such as the provision of IT services.
The type of entity classification that is applied depends on the nature of the
activity involved.
8.3 Sales functions
Whilst a sales function on its own is normally considered routine, its type of activity
and level of risk can vary widely. At one end of the spectrum is the example of a
full risk sales entity or a licensed distributor, taking stock risk or licensing a brand or
other intangibles. At the other, an entity may provide sales support, researching
the market and facilitating logistics but not entering into customer contracts or
taking title to products. Some of the terms commonly given to the spectrum of
sales function and the potential for profit (and profit volatility) associated with
them are illustrated below.
Taking each in turn:

Sales support entity
The information from the functional analysis may reveal evidence that a local sales
operation is in reality a sales support function. For example, it does not enter into
contacts directly with customers (these may be concluded between customers
and the entrepreneurial entity over the internet), or take product title or stock risk.
It may facilitate distribution logistics and/or local marketing under the close
direction of the entrepreneur in the value chain.
This may suggest that value driver in this sales support entity is primarily cost rather
than sales. This may then support the selection of a transfer pricing method based
on cost, such as cost-plus, as the most appropriate method.
Sales agent or commissionaire
Where an entity acts as a sales agent for a principal, more substance will be
shown through the functional analysis as the entity will negotiate with customers
within outlined parameters set by the principal. The entity will not take legal title,
and so not be exposed to stock, warranty or litigation risks, again leaving local
entity risk at a low level. How this is reflected through intercompany agreements
will be an important point for the functional analysis to confirm a characterisation
of sales agent (under common law) or commissionaire (under civil law).
As the name suggests, a commissionaire will receive a commission for the sales it
secures, suggesting that a transfer pricing method based on sales, such as the
resale price method may be most appropriate.
Limited risk distributor
An entity may be a limited risk distributor (‘LRD’) where it is entering into contracts
on its own behalf, making sales in its own name, and performing local
implementation of a central marketing strategy. A LRD's title to a product may only
be brief, with ‘flash title’ passing at the moment of sale. Local risk will still be limited,
with key risks such as inventory, warranty, currency and bad debt risks borne by
the entrepreneurial entity, which also provides strategic management.
The most appropriate method for rewarding an LRD will depend on the fact
pattern and available data. For example a target operating margin may be
assessed under TNMM which is then implemented through the product price,
supported by periodic adjustments.
Licensed distributor
It is common to see third parties buy in intellectual property through a license or

franchise arrangement. Here, the third party franchisee will not own the intellectual
property but will have a local right to exploit it and maximise their returns.
In these cases, the functional analysis may show a significant level of local decision
making and risk, for example in relation to market strategy, pricing and inventory in
addition to the other risks assumed by an LRD. There will usually be a significant
profit potential from these activities, but also the downside risk of potential losses,
as results can fluctuate with this level of local risk.
The functional analysis becomes even more important in determining the most
appropriate method as, even with these fluctuations, profit or loss will need to be
allocated appropriately in the value chain. It may be that the entity's underlying
distribution functions are essentially routine and may be tested in a similar way to
those of an LRD (although at a higher level in the resulting pricing range), with any

balance of profit attributable to the licensor or franchisor. If the licensor is shown by

its functional analysis to be more passive or the licence of a limited or measurable
value, it may be that the licence transaction becomes tested with the balance of
profit or loss remaining in the distribution entity.
Full risk distributor
If the functional analysis shows a sales activity which begins to take on elements of
a smaller-scale replica of the whole entity, ‘full risk distributor’ may be appropriate.
This may be similar to a licensed or franchised distributor, but either replacing or
enhancing any bought-in intellectual property with local value adding assets. This
could include local marketing intangibles such as sub-brands, as well as greater
levels of local management and risk.
As its characterisation suggests, a full risk distributor may not be a simpler entity in
its relationship with other group entities – as always this will depend on the fact
pattern. The method will need careful consideration as profit split or TNMM may be
most appropriate, or it may be that counterparties such as the group's
manufacturer or brand owner should themselves become the tested party.
For all these arrangements, it is important that the functional analysis review shows
the risk borne by both entities, including the more complex. Key questions to
consider will include:
• Who takes the risk of unsold stock?
• Who bears the cost of a market shortfall when demand is insufficient to cover
a distributor's costs?
• Who is liable for proper performance of customer contacts, for example in the
event of late delivery or warranty issues?
8.4 Manufacturing entities
Many groups outsource their manufacturing operations to third party contract

manufacturers, particularly in low cost territories such as China and Eastern Europe,
to enhance profit margins and to be price competitive. Groups may decide that it
is more effective to set up their own manufacturing subsidiary - for instance, to
have more control over the manufacturing process or to protect their intellectual
property.
A functional analysis can identify different types of manufacturing entity. Again,

some of the terms commonly given to the spectrum of manufacturing function
and the potential for profit (and profit volatility) associated with them are
illustrated below.

Toll manufacturer
The lowest risk entity is a toll manufacturer. Here the complex entity retains title to
both the raw materials and goods throughout the manufacturing process. The
complex entity buys the raw materials or sub-assembled goods, although the
physical flow of goods will be directly to the manufacturer itself. As a result, the
complex entity bears all the inventory and sales risk, while the toll manufacturer (or
‘toller’) is primarily responsible for the management and effective utilisation of its
assets in the production process.
As this fact pattern suggests, an appropriate method to reward a toller will be one
based on cost, such as cost plus or a return on assets employed.
Contract manufacturer
A contract manufacturer is the first step up from a toll manufacturer. In addition to

owning plant and machinery and employing a skilled labour force, it will also own
the raw materials through the production process and have title to the end
product. However it will not own any of the design-related intellectual property
(despite having know-how relating to its production processes) and will usually
manufacture set volumes to order.
Functional analysis will show to what degree this exists: for example, a contract
manufacturer may perform its own procurement and may retain title to the
finished goods, or both of these could be centralised elsewhere in a group. It will
also show which entity has responsibility for increased unit costs from
undercapacity: these might be set out in an intercompany agreement showing
order volumes, or this risk may be assumed entirely by the entrepreneurial entity.
Again, the most appropriate method may be to apply a cost plus on product
pricing, or target a margin under TNMM which is then implemented through the
price of manufactured product sold to group entities.

Licensed manufacturer
As with their equivalent distributors, a manufacturer may license (either explicitly or

in effect) design intellectual property from another group entity. This may be a
long term arrangement. The manufacturer will then have the responsibility to
exploit this effectively, potentially investing in developing intangibles used in the
production process. Again, there is a sliding scale of functionality. It may
undertake its own procurement or draw from a central group function, and it may
hold stocks of both raw materials, semi-finished and finished product. It is also
much more likely to carry local risk for under-utilisation of its production capacity.
Again, careful functional analysis is important to identify all the relevant

transaction types – does it contract out procurement, for example? This will allow
an understanding of whether the licensed manufacturer remains the simpler entity
or whether the other assets and functions on which it relies – including group
distributors – are in fact themselves the simpler parties in respect of the transactions
involved.
Full risk manufacturer
Where a functional analysis shows a manufacturer assuming significant levels of

functions and risks in respect of its processes, similar to or greater than a licensed
distributor, then it should be considered to be ‘full risk’. This will include
management decisions on the use of production capacity and related risks such
as procurement and warranty issues, together with pricing of its output.
As a result, profit levels are expected to be more volatile as aspects such as

capacity and input raw materials cost are taken into account. This will need to be
reflected through the transfer pricing method either for the overall activities of the
manufacturer (if a profit-based method is used) or for component transactions
with other group entities. If the latter is used, consideration should again be given
to whether the full risk manufacturer remains the simpler party and the appropriate
focus of testing. Key questions for the functional analysis may include:
• Who owns design intellectual property and/or how is this accessed?
• Who takes volume/capacity risk?
• Who takes inventory risk for raw materials and finished goods?
• To what extent does the manufacturer carry product warranty risk?
• Who takes procurement risk – i.e. securing appropriate raw materials at the
right price?
8.5 Support service activities
Groups often choose to centralise support services to avoid the cost of

duplication. These often comprise ‘back office’ functions such as human
resources, IT, finance and legal services. The functional analysis will show where
these are performed and their level of associated risk and business value –
frequently these activities are necessary but not a business differentiator. This gives
them the characteristics of a routine service more appropriately rewarded by a
return on their cost than an indicator based on, say, sales value.
These functions may be performed centrally with personnel employed by an

otherwise more complex entity within a group. However the services may

themselves be routine and appropriately charged on this basis, for example at

cost plus.
An effective functional analysis will also provide supporting evidence for the
benefit these activities provide to recipients in the group; this is something the
recipients' local tax authorities increasingly seek in tax audits.
Specialist contract services
Third parties often outsource the performance of services to centres with specific
skill sets while retaining overall direction and control in-house. These could include
engineers, chemists or software developers. Where this fact pattern exists, the
service provision – for example contract research and development – may be
rewarded on a routine basis, usually at cost plus.
For this to be appropriate, the functional analysis would need to show that the
complex entity or entrepreneur is making the key decisions on the scoping and
management of the projects, and that all key risks are borne by the entrepreneur.
It is also important to demonstrate that the activity concerned could potentially
be contracted out to a third party. Where the research and development activity
performed is cutting edge, it may be difficult to find a third party contract
research and development company able to do the work, or in practice much of
the development may be devolved to local specialists. Under those
circumstances, treatment of the activity as a routine service may not be
appropriate. As such, the research and development company may be deemed
to be a more complex entity from a transfer pricing perspective, and share in the
entrepreneurial rewards for its research and development effort.
8.6 More complex or entrepreneurial entities
The functions, assets and risks not found in the simpler entity will sit elsewhere in a
group. In summary, these will be the value added, differentiating elements of a
business such as intangible assets, strategic management, and research and
development. They may also extend to other functions, depending on the industry.
As discussed above, the more complex entity will not be the tested party as its
attributes may well be unique and so not comparable in practice. Typically it will
receive the balance of profit or loss on a transaction or share in the group's system
profit. This reflects its greater profit potential which comes from its greater share of
business risk. In some cases where business risk has been deliberately centralised,
this may be particularly noticeable.
The functional analysis may not provide a clear cut answer, however. Where a
group's functions are dispersed, such as between a manufacturer, distributor and
an intellectual property company, there may be no obviously ‘more complex’
entity at first glance. Here, the functional analysis and evidence such as legal
agreements should show where key business risks fall and the extent of
management in each entity (i.e. where the significant people in the business may
be found). Conversely, in groups which have grown by acquisition, more than one
complex entity may exist. Once identified, careful consideration must be given to
how these are rewarded when the economic analysis is performed.
8.7 Planning aspects of entity classification
From a planning perspective, group companies could have a financial motivation

to locate entrepreneurial activities in low tax jurisdictions and routine activities in
higher tax jurisdictions. There is therefore a risk that groups could let their preferred

choice of entity characterisation bias the way in which the functional analysis
review is undertaken and documented, whereas the functional analysis should
always come first and be used as the tool to drive entity classification.
Tax authorities are aware of the potential motivation for groups to operate through
limited risk entities in higher tax locations. Where an entity is purported to have
limited risk, a tax authority may raise detailed questions about the group functional
analysis or re-perform their own functional analysis during an investigation by
written correspondence, through meetings with management or reviewing
primary documentation such as board minutes, emails or mobile phone records.
Where a tax authority is able to show that the entity classification that has been
chosen is inconsistent with the functional analysis and the value chain of the
group, they may seek to recharacterise the entity or transactions, which could
lead to a transfer pricing adjustment arising. This is one of the major causes of
transfer pricing adjustments in the current environment, which underlines the
importance of a robust functional analysis review.
Both the OECD and tax authorities are focusing more closely on key personnel
who are capable of making key decisions, and where they are located. Whilst an
entity could have its costs reimbursed and indemnified against any economic and
financial risk it still may not be successfully supported as limited risk based on the
functional analysis. A critical issue will be whether the entrepreneurial activity is
capable of directing the activities of the limited risk entity.
 Illustration 1
In order to bring all these concepts together, the following is a practical illustration:
Consider the case of the latest smart phone purchased by a customer.
The three key differentiators of a smart phone to customers typically will be the
brand, the particular operating system (its user interface and availability of apps
etc.) and the hardware (its features and look). This market is highly competitive
and requires a significant investment in research and development and branding
in order to be successful. There are many different ways in which a mobile phone
manufacturer could structure itself. The diagram below shows one potential
approach illustrating the concepts above.
Brand & IP
management company
(complex entity)
Wholesales to Software/hardware/ brand Central services

retail stores development company
In this example, there is a complex entity directing the group (in some groups this
may be located in a lower tax territory). The role of this entity is to own and
manage the group's brand and intellectual property. In order to be able to
operate on a global basis it needs to make use of professionals to assist in
designing the brand message, the software and hardware. These professionals will

typically be located in certain areas in the world such as Silicon Valley, California.
This will be typically achieved by limited risk development entities.
Many groups will outsource their manufacturing operations to third party contract
manufacturers in China, but equally they could use their own contract or toll
manufacturers. Typically the group would also centralise back office functions to
avoid duplication.
In order to facilitate a global distribution network, groups will need a presence in

the major territories around the world where they expect to do business. They will
normally have an entity whose role is to wholesale the smart phones to retail stores
and to market the product in the local marketplace. This could be achieved
through a limited risk structure.
The above is a simple example. When implemented properly, it could result in a

tax efficient supply chain with “supernormal” profits associated with the group's
intellectual property accruing offshore. However, a group's lack of robustness in
the implementation process could undermine the effectiveness of the structure.
Typically this will be due to commercial and personnel issues.
For example, it could be difficult to operate a brand management company

offshore as brand people from a commercial perspective may wish to work in
places such as London, California, etc where there is a pool of talent and key
advertising agencies to develop campaigns. There are also personnel issues in that
many individuals for personal reasons such as family, education and quality of life
would prefer not to work in an offshore location.
A detailed and regular functional analysis needs to be carried out to identify the
location of key personnel within the group and the decisions they make and assess
whether or not this is supportive of the overall structure from a transfer pricing
perspective. This personnel issue is one of the key practical issues that groups will
face and ultimately is the most important factor in a practical functional analysis
review.

CHAPTER 9
COMPARABILITY ANALYSIS: OECD PROPOSED PROCESS
In this chapter we look at the OECD guidance on how to perform a comparability analysis
including:
– the process laid down in the OECD Transfer Pricing Guidelines;
– choice of the tested party;
– external comparables and sources of information;
– selection of comparables;
– comparability adjustments;
– the Arm’s Length range;
– timing issues;
– compliance issues;
9.1 Introduction
This chapter follows closely Chapter III of the OECD 2010 Transfer Pricing
Guidelines. You may find it useful to highlight key parts of your copy of Guidelines
as you work through the chapter.
9.2 Performing a comparability analysis
The OECD's suggested process for the comparability analysis is discussed in

Chapter II of its 2010 Transfer Pricing Guidelines. For ease of reference the present
chapter, which summarises and comments upon the OECD material, uses the
same numbering system and headings as in the Guidelines. These distinguish
between the search for comparables and the comparability analysis itself,
indicating that the two should neither be confused nor separated. The search for
information on potentially comparable uncontrolled transactions and the process
of identifying suitable comparables are dependent on prior analysis of the
taxpayer's controlled transaction and of the relevant comparability factors, which
are identified in D.1.2 of the OECD 2010 Transfer Pricing Guidelines as:
• Characteristics of property or services;
• Functional analysis;
• Contractual terms;
• Economic circumstances; and
• Business strategies.
9.3 Typical process
The 2010 Transfer Pricing Guidelines set out in Chapter III Section 41 a typical
process for the comparability analysis in nine steps. They indicate that this process
is accepted as good practice but is not compulsory; other methods that lead to a
reliable result are equally acceptable. The steps are as follows.
Step 1: Determination of years to be covered.

Step 2: Broad-based analysis of the taxpayer's circumstances.
Step 3: Review of the controlled transaction and choice of the tested party.
Step 4: Review of existing internal comparables, if any.
Step 5: Identifying and assessing available sources of external comparables.
Step 6: Selecting the most appropriate transfer pricing method and (depending on
the method) determining the relevant financial indicator.
Step 7: Identifying potential comparables. This will involve determining the key
characteristics that need to be met by an uncontrolled transaction in order to be
potentially comparable, based on the analysis at step 3 and the five
comparability factors set out above.
Step 8: Making comparability adjustments as appropriate.
Step 9: Interpreting and using the data collected, in order to arrive at the arm's
length price.
The OECD 2010 Transfer Pricing Guidelines note that these steps will not necessarily
be applied by a simple progression from Step 1 to Step 9. In particular, Steps 5 to 7
may need to be repeated a number of times if the sources of information initially
identified at Step 5 do not prove adequate to enable the process to be
completed.
Broad-based analysis of the taxpayer's circumstances
Step 2 of the typical process involves an analysis of the industry, competition,

economic and regulatory factors and other elements that affect the taxpayer and
its environment, in a wider context than that of the specific transactions for which
an arm's length price is sought. The results will aid in the understanding both of the
controlled transactions and of the uncontrolled transactions with which they will
be compared later in the process.
Review of the controlled transaction and choice of the tested party
Step 3 of the typical process is a review of the controlled transaction, in order to

identify the factors that are relevant to the choice of: the tested party (see later
section on this); the most appropriate transfer pricing method; the financial
indicator that will be tested if a transactional profit method is chosen; the selection
of comparables and the determination of comparability adjustments if these are
required.
Evaluation of a taxpayer's separate and combined transactions
Ideally, the arm's length principle should be applied to individual transactions.

Sometimes, however, transactions are so closely linked that they must be
considered together. Examples are the supply of:
a. goods or services under long-term contracts;
b. rights to use intangibles;
c. closely linked products where determining a price for each would be

impractical;

d. manufacturing know-how sold together with vital components
e. goods or services routed through an associated enterprise;
f. supplies under a ‘portfolio’ business strategy that aims to yield an appropriate

return over the portfolio rather than on each product or service, and which
may therefore involve some products or services being supplied at a low level
of profit or even at a loss, in view of the expected ‘aftermarket’ sales. For
example, jet engines may be sold at a low profit margin under contracts that
involve maintenance work and the supply of spare parts over their 25-year life.
Portfolio approaches must be reasonably targeted; they cannot justify applying

the chosen transfer pricing method at a company-wide level to transactions that
have differing economic logic. Neither can such an approach justify a situation
where low profits in one company of an MNE group are balanced by high profits in
another.
The converse situation may also arise, where a contract gives a single price for a
package of supplies, but it is not feasible to apply transfer pricing methodology to
the package as a whole. In this case the elements of the package will initially
need to be considered separately, but it will be appropriate to consider whether
any adjustment is needed when they are ‘rebundled’, in order to arrive at an arm's
length result. For example, a computer may be sold with included items of
software, each of which has an easily identifiable arm's length price. However, in
considering the price of the package as a whole it may be appropriate to adjust
for the fact that the supply of anti-virus software below cost will be a sensible
commercial choice if this will encourage the customer to renew the subscription
automatically at the end of a trial period rather than seeking alternatives.
Where it is appropriate for transfer pricing purposes to determine an arm's length

price on a package basis it may still be necessary to make a split of the price for
other tax purposes; for example, where part of the consideration constitutes a
royalty subject to withholding tax.
Intentional set-offs
Associated enterprises may intentionally incorporate a set-off into the terms of the
transaction under examination, on the basis that the totality of the arrangement
gives an arm's length result. So, for example, two enterprises may each allow the
other to use their intellectual property on the basis that (with a balancing payment
where necessary) this leaves neither side worse off. Such arrangements may vary
in complexity from a simple case where each side makes supplies of the same
value to the other at an equally favourable price, to a situation where all supplies
of goods and services in either direction over a period are aggregated and a
single payment is made by one party to reflect the perceived net benefit it has
received.
It may be necessary to evaluate the transactions separately to see whether the

arm's length principle is met. If they are to be considered together care will be
needed in selecting comparable transactions, and the discussion of package
deals above will be relevant.
The terms of set-offs relating to international transactions may not be fully

consistent with those relating to purely domestic transactions because the set-off
may be treated differently under different national tax systems, or under rules in
bilateral tax treaties.

9.4 Choice of the tested party
This is a subject we have looked at in an earlier chapter but it is worth revisiting it

here.
When the transfer pricing method employed is a cost plus, resale price or
transactional net margin method, it is necessary to select the party to the
transaction for which a financial indicator is tested (the ‘tested party’). That
financial indicator will be, in each of those cases respectively, the mark-up on
costs, the gross margin, or the net profit indicator.
The OECD Guidelines indicate that, as a general rule, the tested party will be the
one for which a transfer pricing method can be applied in the most reliable way
and for which the most reliable comparables can be found, which will usually be
the party for which the functional analysis of the transaction is less complex.
The OECD Guidelines give an example under which company A manufactures

product 1 and product 2, and sells both to overseas associated company B.
PARENT CO
COMPANY A Product 1 → COMPANY B

Manufacturer Intangibles
Simple functions Technical
specifications
↑
Tested Party
Product 1 is manufactured using valuable intangibles owned by company B and

following technical specifications set by B. Company A performs only simple
functions, and does not make any valuable, unique contribution in relation to the
transaction. The tested party would most often be company A.
PARENT CO
COMPANY A Product 2→ COMPANY B

Manufacturer Distributor
Intangibles Simple functions
↑
Tested Party
By contrast, in the case of product 2 company A uses its own valuable and unique
intangibles while company B only acts as a distributor, performing simple functions.
The tested party for this transaction would most often be company B.

Despite this guidance, in practice the choice of tested party will often be driven
by the structure of the relevant legislation in the jurisdiction in question. This may
specifically require consideration of the position of the resident taxpayer, rather
than of any other party. Even where the focus of the legislation is on the terms of
the transaction rather than the position of the taxpayer, so that in theory arm's
length terms could be established by considering either party, in practice there
may be an expectation by the tax authorities that the question should be
approached by reference to the party whose tax liability is at issue. In addition,
that will normally be the party in relation to which most information is available
both to advisers and to the tax authorities; in practice, obtaining sufficient
information from related companies in other jurisdictions may be difficult.
9.5 Information on the controlled transaction
In order to select and apply the most appropriate transfer pricing method,
information is needed in relation to the transaction on the five comparability
factors, and in particular on the functions, assets and risks of all the parties,
including the foreign associated enterprise. While one-sided methods such as cost
plus, resale price or transactional net margin only require a financial indicator or
profit level indicator for the tested party, some information on the comparability
factors of the transaction, and in particular on the functional analysis of the non-
tested party, will still be needed in order to justify the choice of that method.
Where the most appropriate transfer pricing method in a particular case is a

transactional profit split method, detailed financial information will be required on
all the parties to the transaction, and it will be reasonable to expect the domestic
enterprise to provide relevant information as regards the foreign associated
enterprise. Such information will be needed not only to demonstrate that this is the
appropriate method, but also to determine the amount of combined profits to be
split, and what constitutes an appropriate split.
In the case of a one-sided method (for example TNMM), financial information as

regards the tested party will be required in order to apply the method
appropriately (as well as the information needed to justify the choice of method
as above). If the tested party is a foreign entity then this will require information
relating to that entity, but if the tested party is the domestic taxpayer the tax
administration generally has no need to ask for financial data relating to the
foreign associated enterprise.
9.6 Comparable uncontrolled transactions
In general
The identification of comparable uncontrolled transactions forms Steps 4 and 5 of

the typical process. They may be transactions between one party to the
controlled transaction and an independent party (‘internal comparables’) or
between two independent enterprises, neither of which is involved in the
controlled transaction (‘external comparables’). Other controlled transactions
within the same or another MNE group are irrelevant to the application of the
arm's length principle and therefore should not be used by a taxpayer to justify its
transfer pricing policy or by a tax administration to justify an adjustment. The
presence of minority shareholders may be a factor leading to controlled
transactions being closer to arm's length, depending on the level of influence of
the minority shareholders, but this is not determinative in and of itself.

Internal comparables
The review of existing internal comparables is Step 4 of the typical process. Where
such transactions exist information is likely to be more complete and less costly to
assemble, and the financial analysis may be easier and more reliable because it
relies on identical accounting practice. Nevertheless, the comparability factors in
D.1.2 must still be met, and comparability adjustments may still be required as at
A.6. For example, an internal comparable that relates to the same goods as the
controlled transaction but to very different quantities may not give a reliable
comparison unless an appropriate adjustment can be devised.
9.7 External comparables and sources of information
The search for external comparables is Step 5 of the typical process. It may not be
necessary to embark on this step if reliable internal comparables have been
identified.
Databases
Commercial databases of filed company accounts can sometimes provide a

cost-effective way of identifying external comparables, but they have a number
of limitations:
a. They are not available in all countries.
b. Within a country they may include different types of information, because

disclosure and filing requirements vary for different types of company.
c. They are not primarily compiled for transfer-pricing purposes, with the result
that the information may be insufficiently detailed. In particular, it relates to
the results of companies rather than the results of transactions. Accounts are
therefore unlikely to be of any assistance in applying transfer pricing methods
based on comparable prices, as opposed to levels of profit. In addition, in
owner managed businesses (OMBs) margins may be affected by policy
decisions such as to whether to reward owners by means of salary or dividend,
and it may be difficult to identify and separate out these factors.
d. Comparable companies are often identified using Standard Industrial

Classification (SIC) codes. However, whether the SIC code is chosen by the
company or the compilers of the database, it may not always be reliable. This
means that companies identified in initial searches may need to be excluded
because they are not comparable (and also, of course, that companies
which would have provided valid comparables may fail to be identified).
e. Companies identified for comparison may have significant transactions with

related parties, without this being apparent from their accounts.
f. The quality of the accounts may vary considerably, both between jurisdictions
and within any one jurisdiction. However comparable a company's activities, it
may not always be possible to extract reliable information to assist with transfer
pricing calculations.
The results of database searches may therefore need to be refined by reference

to other publicly available information. Some advisory firms maintain their own
databases, but these may be based on a more limited portion of the market than
commercial databases. In the next chapter we will see how databases can be
used in practice.

Foreign source or non-domestic comparables
Non-domestic comparables are not automatically to be rejected, but their

reliability will need to be assessed on a case-by-case basis and by reference to the
normal five comparability factors in D.1.2. It may be appropriate to make one
regional search for comparables for several subsidiaries of an MNE group
operating in different countries of that region, depending on the circumstances,
but it will be necessary to take account of market differences and different
accounting standards.
Information undisclosed to taxpayers
While tax administrations may have relevant information available to them from
dealing with the affairs of other taxpayers it would not be appropriate for them to
use this unless, unusually, they were permitted by their domestic confidentiality
requirements to disclose it to the taxpayer involved in the controlled transaction.
Use of non-transactional third party data
Third party data relating to results at company or segment level may sometimes
provide reliable comparables for controlled transactions, where those results
represent the aggregate of a number of similar transactions. Where the results are
for a segment, this may raise issues as to the way in which expenses have been
allocated.
Limitations in available comparables
As a practical matter, it may not be possible to identify uncontrolled transactions

that are exactly comparable to the controlled transaction. It may therefore be
necessary to select comparables where the business strategy, business model or
economic circumstances are somewhat different; or where the transactions are in
the same industry but a different geographical market; or in the same
geographical market but a different industry.
In some circumstances it may be appropriate to apply a transactional profit split

method without comparables, where the absence of comparable data arises
because each party contributes valuable and unique intangibles to the
transaction. However, even where the comparables are scarce and imperfect this
does not alter the fact that the transfer pricing method selected should be
consistent with the functional analysis of the parties to the controlled transaction.
9.8 Selecting or rejecting potential comparables
Identifying potential comparables, which is one of the most critical aspects of the
comparability analysis, is Step 7 of the typical process. (Step 6, which is the
selection of the most appropriate transfer pricing method, is dealt with in Chapter
II of the OECD 2010 Transfer Pricing Guidelines.) There are two methods, which in
practice may be operated in combination.
The ‘additive’ approach involves drawing up a list of third parties who are
believed to carry out potentially comparable transactions, and then collecting
information on those transactions to see whether they provide acceptable
comparables on the basis of pre-determined comparability criteria. This may be
used as the sole approach where the taxpayer has knowledge of a few
appropriate third parties. It may also be combined with the use of internal
comparables.

The ‘deductive’ approach starts with a wide set of companies (typically obtained
from a database search) that operate in the same sector of activity, perform
similar broad functions and do not have obviously different economic
characteristics. This set is then refined using selection criteria and publicly available
information, informed by the guidance on identifying and assessing comparables.
The choice of selection criteria has a major influence on the outcome of the
comparability analysis and should reflect the most significant economic
characteristics of the transactions compared.
Examples of qualitative criteria are product portfolios and business strategies, and
tests to exclude special situations such as start-up companies or insolvent
companies. The most common quantitative criteria are:
a. figures for sales, assets or number of employees, and the size of the transaction
either in absolute terms or in proportion to the activities of the parties;
b. criteria related to intangibles, such as the ratio of the net value of intangibles
to the total value of net assets, or the ratio of R&D to sales, as compared to
the figures for the tested party. These criteria might, for example, exclude from
the potential comparables companies that had significant intangibles or R&D
expenditure, where those were not features of the tested party's business;
c. the ratio of export sales to total sales; and
d. the absolute or relative value of inventories.
The deductive approach has the advantage of being more reproducible and
transparent than the additive approach, and easier to verify. However, its
outcome depends on the quality of the search tools on which it relies, which may
be a practical limitation in some countries. In practice in most countries there are
likely to be significant difficulties arising both from the fact that accounts often do
not disclose the necessary information and that, even where they do, it may not
be accurately reflected in the databases.
9.9 Comparability adjustments
Because the comparables identified are unlikely to match the controlled

transaction exactly, adjustments may be appropriate, depending upon the costs
and compliance burden that this would involve. This is Step 8 in the typical process.
Different types of comparability adjustments
Adjustments may be made to eliminate differences in accounting treatment

between the controlled and uncontrolled transactions, to exclude significant non-
comparable transactions included within composite data for the uncontrolled
transactions, and to take account of differences between companies in capital,
functions, assets and risks. In practice these factors may also affect decisions as to
where to place a company within the range of arm's length results as discussed
below. For example, a transaction that exposes a company to higher than
average degree of risk may justify placing it in that part of the range which will
produce a higher profit.
Sometimes a working capital adjustment will be appropriate to reflect the fact

that where a company carries high levels of debtors and inventory the cost of
doing so may (theoretically at least) be reflected in the price it charges; similarly,
the benefit of a high level of creditors may be reflected in a reduced price.

Purpose of comparability adjustments
Comparability adjustments are only appropriate where they increase the reliability
of the results, bearing in mind the materiality of the difference for which the
adjustment is intended to compensate, the quality of the data subject to
adjustment, and the purpose and methodology of the adjustment itself. There is no
point in adjusting for small matters if there are major issues where adjustment is not
practical; nor in multiplying adjustments to give a spurious impression of accuracy
that is not justified by the underlying data. The need for numerous adjustments
may, indeed, indicate that the transactions in question are not in fact sufficiently
similar to provide valid comparables.
Reliability of the adjustment performed
The OECD Guidelines warn that ‘it is not appropriate to view some comparability
adjustments, such as those for working capital, as “routine” and uncontroversial,
and to view certain other adjustments, such as those for country risk, as more
subjective and therefore subject to additional requirements of proof and
reliability’. It is not entirely obvious what this means. Clearly, as the paragraph in
question goes on to say, ‘the only adjustments that should be made are those that
are expected to improve comparability’. Nevertheless, it must remain the case
that some adjustments will be more subjective than others, and tax authorities can
hardly be blamed for paying particular attention to these.
Documenting and testing comparability adjustments
Taxpayers will need to be in a position to explain how adjustments were

calculated and why they were considered appropriate, and to supply
appropriate documentation as discussed in Chapter V of the OECD Guidelines.
9.10 Arm's length range
Step 9 of the typical process involves interpreting and using the data collected, in
order to arrive at the arm's length price.
In general
In some cases the process may arrive at a single arm's length figure (whether that
be a price or a margin). In other cases a range of equally reliable figures may
result, either because of approximations employed in the process or because
independent parties would indeed vary in the price they charged for the goods or
services in question. It may then be possible to narrow the range by excluding
some of the uncontrolled transactions that have a lesser degree of comparability.
In practice single figures are perhaps more likely to result from identifying a
comparable uncontrolled price or from using other traditional transaction
methods, where specific comparable data exists; ranges are more likely to result
when dealing with more complex transactions that require the use of transactional
profit methods.
That may leave a range of figures based on comparables that (given the inherent
limitations of the process) are considered to include defects that either cannot be
identified or cannot be quantified. In this case, if the range includes a sufficiently
large number of observations it may be appropriate to apply statistical tools that
narrow the range around the centre; for example, by taking the interquartile
range (a practical illustration of this is given in a later chapter). As indicated above
in the context of comparability adjustments, factors such as different degrees of

risk may also be used to justify placing of the particular company in question at the
higher or lower end of the range.
A range of figures may also result where different methods are used to evaluate a
controlled transaction. In such cases it may be appropriate to locate the arm's
length price where the ranges overlap, or to reconsider the accuracy of the
methods if there is no overlap; all depends on the reliability of the different
methods and the quality of the information they use.
Selecting the most appropriate point in the range
If the relevant condition of the controlled transaction (e.g. the price or margin) is
within the arm's length range determined as above no adjustment should be
made. If it falls outside the range that the tax administration contends is
appropriate, the taxpayer should have the opportunity to present the case for a
different arm's length range. If that cannot be done successfully, it remains for the
tax authorities to determine the point in the range which it will treat as the arm's
length figure.
Where the range is made up of results of equal and high reliability, a case can be
made for any point within it. Where there are remaining comparability defects
within the results as discussed above, it may be appropriate to use measures of
central tendency such as the median, the mean, or weighted averages.
Extreme results: comparability considerations
Extreme results in one of the potential comparables may indicate a defect in

comparability, or exceptional conditions that only apply to an otherwise
comparable third party. While extreme results may be excluded on the ground
that they bring to light previously overlooked defects in comparability, they should
not be excluded merely because they are extreme.
In general, all relevant information should be used. There is no general principle

that loss-making comparables should either be included or excluded, because it is
the circumstances of a company taken as a whole that determine whether it is
comparable, rather than its financial result. The existence of a loss will, however,
normally trigger further investigation of whether the comparable is valid. It should
be excluded where the loss does not reflect normal business conditions, or where it
reflects a level of risk that does not exist in the controlled transaction. Similar factors
apply as regards abnormally large profits.
It will also be helpful to take into account the different ways in which extreme
results may affect different statistical measures. For example, in general they will
have more effect on the arithmetic mean than on the median. Where those
measures diverge significantly it may be helpful to identify the results that account
for this difference and consider how they should be dealt with. Where there are
extreme results it will always be necessary to consider the features of specific
transactions rather than simply applying mathematical formulae to narrow the
range of results.
9.11 Timing issues in comparability
Various issues arise as regards the time of origin, collection and production of
information on comparability factors and on uncontrolled transactions for use in
the comparability analysis.

Timing of origin
Ideally, comparisons would be made with contemporaneous uncontrolled

transactions, which reflect the same economic circumstances. In practice,
however, that may not always be practical.
Databases of company accounts will always be out of date by a minimum period

of about one year, once allowance is made for the time taken to produce
accounts and then to incorporate them into the database. Sometimes it will be
helpful to consider a number of years together in order to detect any underlying
trends.
Timing of collection
Some taxpayers will establish transfer pricing documentation at the time they
undertake their controlled transactions, based on the information available at that
time (which necessarily relates to past transactions) together with information on
subsequent market and economic changes (‘arm's length price setting’).
However, independent parties in similar circumstances would not base their
pricing decisions on historic data alone.
Other taxpayers will test their controlled transactions after the event, typically in
connection with the preparation of their tax return for the period concerned
(‘arm's length outcome testing’), or the two approaches may be combined. This
raises issues concerning the use of hindsight. It is legitimate to use external data
such as other companies' accounts as evidence of what pricing decisions those
companies reached at the same time and in comparable circumstances. It is not,
however, appropriate to suggest that the taxpayer whose affairs are in issue
should have been aware of those decisions, and should have taken them into
consideration in its own pricing decisions, before the accounts or other data were
publicly available.
The purpose for which the transfer price is set may affect the timing of information
gathering. We will look at this and further issues on timing of collection in the next
chapter.
Valuation highly uncertain at the outset and unpredictable events
Where valuation uncertainties existed at the time of the controlled transaction, it is

necessary to ask whether the uncertainty was so great that independent parties
would have incorporated a price adjustment mechanism in their agreement.
Similarly, where unpredictable events affecting the value occurred after the time
of the controlled transaction it is necessary to consider whether these were so
fundamental to the value that independent parties would have renegotiated the
transaction. In such cases an arm's length price should be determined on the basis
of the agreed price-adjustment mechanism or a hypothetical renegotiation, as
the case may be. In other cases it will not be appropriate to make calculations
using the benefit of hindsight that would not have been available to independent
parties.
Data from years following the year of the transaction
While care must be taken to avoid using hindsight, data from years after the year
of the transaction may be relevant in certain circumstances; for example, in
comparing product life cycles of controlled and uncontrolled transactions in order
to determine whether the uncontrolled transaction is an appropriate comparable.
Subsequent conduct of parties to a controlled transaction may also be relevant in
determining the actual terms and conditions operating between them.

Multiple year data
The use of multiple year data may be useful in certain circumstances, but it is not
required as a matter of principle. Information from prior years may disclose facts
that have influenced, or should have influenced, the price in the current year; for
example, it may help to establish whether a loss in the current year is part of a
history of losses, the result of exceptional costs in the previous year, or the result of
a product nearing the end of its life cycle. This may be particularly useful where a
transactional profit method is applied.
Multiple year data may also be useful in providing information about the business
and product life cycles of the comparables, and perhaps identifying significant
variances from the comparability characteristics of the controlled transaction
which make the use of those particular comparables inappropriate. Similarly, if
economic conditions in an earlier year, which did not apply to the controlled
transaction, affected the comparable enterprise's pricing or profit for the current
year, it may not provide a reliable comparison.
The use of multiple year data does not necessarily imply the use of averages, but
this may be appropriate in some circumstances.
In practice the use of multiple year data may be more useful in stable industries,
where it can help to establish trends. Where there is a high level of volatility in the
market or in general economic conditions, the prices or profit of one year will be
much less useful in giving any indication of what the terms of trade are likely to
have been in the very different circumstances of another year. In particular,
figures derived by averaging widely varying results of different years are likely to be
unhelpful or positively misleading.
9.12 Compliance issues
Comparability analysis may impose a significant cost and compliance burden on

taxpayers. It is not necessary to conduct an exhaustive search for all possible
relevant sources of information, but simply to exercise judgement to determine
whether particular comparables are reliable.
It is good practice for taxpayers to set up processes to establish, monitor and

review their transfer prices, taking into account the size of the transactions, their
complexity, the level of risk involved and whether they take place in a stable or a
changing environment. Where transactions are small, simple, relatively risk-free
and conducted in stable circumstances it will be reasonable to devote less effort
to finding information on comparables, and perhaps not to perform a complete
comparability analysis every year. Practical issues with review procedures will be
looked at in a later chapter.

CHAPTER 10
COMPARABILITY ANALYSIS: AGGREGATION AND USE OF THIRD

PARTY NON-TRANSACTIONAL DATA
In this chapter we will look at the practical aspects of implementing Comparability

Analyses including:
– aggregation and unbundling;
– set offs;
– segmentation of comparable data;
– sources of information and timing issues;
– sources of third party non transactional data;
– commercial databases;
– comparability lessons from DSG Retail;
– proprietary databases and “secret comparables”;
– using databases;
– other sources of information;
– timing of information on comparable transactions.
10.1 Introduction
In this and the next chapter we will examine the practical aspects of implementing
the OECD 2010 Transfer Pricing Guidelines on comparability. Some reference will
be made to UK practice together with examples of differing positions adopted by
other jurisdictions to highlight some of the compliance difficulties thereby caused.
We will mention again some of the issues set down in the previous chapter where
we examined the comparability process.
Comparability requires a comparison of the economically relevant conditions in a

controlled transaction with the conditions in an uncontrolled transaction.
“To be comparable means that none of the differences (if any) between the
situations being compared could materially effect 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
difference” (See OECD 2010 Transfer Pricing Guidelines, paragraph 1.33)
The 2010 OECD Guidelines contain considerably more extensive commentary

about comparability than did the 1995 Guidelines. The 2010 Guidelines do strike a
reasonable balance between setting a quality threshold for comparability
analyses and an acknowledgment of the limitations to what can cost-effectively
be achieved in practice. However, a concern is that tax authorities may seize on
the more detailed commentary, for example the nine-step “typical” process that
we looked at in the previous chapter, as a justification to require more extensive
analysis from taxpayers.
10.2 Transactions: Aggregation and Unbundling
Article 9(1) of the OECD Model Treaty permits the profits of an enterprise derived
from a controlled transaction to be adjusted for tax purposes to the level that
would have accrued had the two enterprises been independent and dealing at
arm's length.

In fact, the Article does not specifically refer to “transactions” but the OECD
Transfer Pricing Guidelines assert that “ideally” the arm's length principle should be
applied on a transaction-by-transaction basis.
The CUP method can only be applied by using transactional data, whereas all
other pricing methods rely on non-transactional data.
Examples of transactional and non-transactional data
Transactional data Non-transactional data

Publicly available price information Company-wide profitability data
(commodities exchanges) derived from published financial
statements
Royalty rate for patent licence derived Segmented profitability data derived
from US SEC filings 10K from published financial statements
Interest rate and covenants for a loan Trade association data
agreement derived from commercial
databases
Price lists
As we saw in the last chapter the OECD recognise that, in practice, it may be
unrealistic to evaluate each transaction separately. (See OECD 2010 Transfer
Pricing Guidelines Chapter 3 Section A.3.1 Paragraphs 3.9-3.12) The OECD cites the
following examples where aggregation of separate transactions might be
acceptable:
• Long-term contacts for commodities or services
• Rights to use intangible property
• Pricing of very similar products
• Licensing of know-how and supply of related vital components
• Routing of transactions through another affiliate
• Portfolios of higher and lower margin goods or services with an arm’s length
return overall
In any comparability analysis it is essential to identify all controlled transactions,

whether or not specifically priced or documented, and then assess whether
individual transactions should more properly be evaluated separately or together.
Examples of some less obvious transactions might include:
• Secondment of staff to an affiliate for which no charge is made
• Ownership of a brand name exploited by an affiliate for no charge
• Capital contributions which may amount to hidden marketing support
• Provision of employee share options to or by an affiliate
• Cash pooling
• Debt factoring

A dramatic example of inappropriate aggregation of controlled and uncontrolled

transactions can be found in the United States case of Microsoft Corp. v. Office of
Tax and Revenue (D.C. Office of Admin Hearings, Case No. 2010-OTR-00012 (May
2012)) in which the IRS contract auditor applied a CPM analysis comparing profit-
to-cost ratio of Microsoft with the profit-to-cost ratio of businesses chosen as
comparables. However, the auditor aggregated both controlled and uncontrolled
transactions of Microsoft. Columbia Judge found that there was no justification for
such aggregation which rendered the analysis “arbitrary, capricious and
unreasonable.”
Exceptionally, the Guidelines suggest that “unbundling” of aggregated

transactions priced as a package is appropriate if the separate transactions are
quite different in character, for example the licence of a patent and the rental of
office facilities. (See Paragraph 3.11)
Let us consider the Canadian Case of GlaxoSmithKline (2010 FCA 201 (July 2010)).
Central to this case is a failed attempt by the Canadian tax authority to segregate
two inextricably linked transactions: the purchase of an active pharmaceutical
ingredient and the licence to manufacture and sell the drug.
The appellant, Glaxo Canada, was a member of a UK-parented pharmaceutical

group. Glaxo Canada manufactured and marketed Zantac, a branded drug
developed and patented by the UK parent. Glaxo Canada bought the active
ingredient from a Swiss affiliate. However, unrelated pharmaceutical companies
sold generic versions of the drug in Canada but paid substantially less for the
active ingredient than Glaxo Canada did.
The tax authority disallowed a deduction to Glaxo Canada for the price
differential between the prices paid by Glaxo Canada and the generic
manufacturers, asserting that the latter was a CUP. This was upheld by the Tax
Court. The Federal Court of Appeal rejected this, holding that lower court should
not have disregarded the License Agreement which gave the Canadian
distributor access to Glaxo's trademark which gave the company access to the
premium prices paid for the product over its generic competitors. The lower court
had failed to consider the business reality of the situation: although an arm's length
purchaser could always buy the active ingredient at market prices from a willing
seller. However, the question is whether that arm's length purchaser would be able
to sell this under the valuable trademark. Therefore, Appeal Court remitted the
case to the lower court to determine the arm's length price based on the terms of
the License Agreement.
10.3 Set-offs
A “set-off” occurs if affiliate A provides goods or services to affiliate B and affiliate

B provides different goods or services to affiliate A. The Guidelines address
intentional set offs, where the taxpayer deliberately evaluates the overall
economic effect of both transactions. The Guidelines accept that intentional set
offs may be found at arm's length and hence may be acceptable for similar flows,
although not for overall balancing of different transaction types. (See OECD 2010
Transfer Pricing Guidelines Paragraphs 3.13–3.17)
As part of the comparability analysis, it is clearly desirable for taxpayers making

intentional set offs to gather evidence that similar transactions are found at arm's
length. There is a good deal of material available regarding “package pricing” in
some industries e.g. web hosting/ development, broadband/telephony.

 Illustration 1
In this illustration we will look at the approach of the UK tax authorities to

aggregation. The Berg group of companies manufactures and distributes memory
chips for use in smartphones and tablets. The chips are manufactured by Berg
(Polska) sp. z.o.o in Poland and sold to Berg plc in the UK. Berg plc distributes the
chips to third party business customers in the UK and Europe. Berg S.A provides
consultancy services to computer manufacturers in South America.
BERG PLC
UK PARENT
BERG S.A. BERG (Polska) sp. z o.o

Brazilian subsidiary Polish subsidiary
During the year ended 30 June 2013, Berg plc purchased 53 different chip
configurations from its Polish subsidiary, with volumes in the thousands of units for
each configuration. The 53 different chip configurations have similar attributes,
cost of production, cost of marketing and sale price per unit of memory.
Berg plc also granted a loan at a fixed interest rate of 18% to its Brazilian subsidiary
to support the development of the latter's consultancy business.
Looking at the UK approach to aggregation HMRC are likely to accept that all of
the purchases by Berg plc from its Polish subsidiary may be aggregated. On
enquiry, HMRC produces evidence the price paid in aggregate by Berg plc is
excessive. Berg plc claims that the interest received from its Brazilian subsidiary is
greater than an arm's length rate; with the effect that overall its return from
affiliated transactions approximates an arm's length amount. Berg plc is unable to
demonstrate a linkage between the purchase of inventory and the making of a
loan, and its claim to set off the two transaction types is unlikely to succeed.
10.4 Segmentation of comparable data
The transactional nature of transfer pricing requires that if a taxpayer carries on

diverse activities which cannot legitimately be aggregated, the separate
transactions need to be evaluated separately. For profit methods, this usually
requires “segmentation” of the taxpayer's financial data. The structure of the
taxpayer's accounting system will have a bearing on whether this can be
achieved, but even if segmentation is superficially possible, great care will need to
be taken to ensure that expense, revenue, asset and liability allocations between
segments are reliable.
Obtaining segmented financial data for comparable companies carrying on

diversified functions is even more challenging. Some companies may be required
to disclose segmented financial information – the applicable standards include
SSAP 25 in the UK, SFAS 131 in the United States and IFRS 8 for companies reporting
under International Accounting Standards. However, the following limitations need
to be borne in mind:
• IFRS 8 and SFAS 31 only require disclosure for listed companies which may be
prima facie unsuitable potential comparables for small and medium size
taxpayers

• IFRS 8 and SFAS 31 disclosures include earnings before interest, tax

depreciation and amortisation (EBITDA) and total assets per reported segment
as reported internally to management; such internal reporting need not be
consistent with the basis of consolidated financial reporting
10.5 Sources of information and timing issues
The Guidelines distinguish between internal and external comparables. An internal

comparable is a comparable transaction between one party to the controlled
transaction and a third party; an external comparable is a comparable
transaction between two independent enterprises.
 Illustration 2
Copland Machines, Inc. is a United States manufacturer of advanced construction

machinery. Its UK subsidiary, Copland Machines (UK) Limited, acts as the exclusive
distributor of the parent company's products in the UK. In Canada, Copland
Machines, Inc. distributes its product via an unrelated distributor, Delius Inc. An
unrelated UK company, Hindemith plc, is also identified which distributes similar
machinery manufactured by two other companies, both unaffiliated with
Copland, to third party customers in UK and Europe.
Whether the price paid for the sale of inventory from Copland Machines Inc. to
Delius Inc. passes muster as an internal CUP depends on an analysis of the five
comparability factors discussed in earlier chapters and, if appropriate, whether
sufficiently reliable comparability adjustments may be made (discussed in more
detail in the next chapter).
It is very unlikely that Copland will have access to detailed price data in relation to
the purchase of inventory by Hindemith and, consequently, Hindemith is unlikely to
be suitable for evaluation as a potential external comparable company at an
aggregated level.
Again using the UK as an example, HMRC guidance expresses the importance of

evaluating potential internal comparables. It cautions against the mechanical
dismissal of internal comparables merely because they are not identical to the
controlled transaction. Indeed, HMRC take the position that a taxpayer who
adopts a TNMM analysis but ignores a very clear internal comparable without
justification may be exposed to “deliberate inaccuracy” penalties. Many other tax
authorities also express a preference for internal comparables. To some extent, this
may still be supported by some of the wording from the 1995 Guidelines that has
been retained in the 2010 Guidelines. (See, for example, Paragraph 2.58 in the

context of TNMM) However, it is submitted that internal comparables are not

automatically elevated above external comparables.
10.6 Sources of third party non-transactional data
In the event that sufficiently reliable transactional data cannot be identified, the
practitioner and tax official will need to look to other sources of data and
information. Such sources include:
• Commercial databases
• Proprietary databases
• Industry and trade association publications
• Articles from industry press and specialist financial newspapers/journals
• Court documents (for example, anti-trust cases)
• Investment research
10.7 Commercial databases
Commercial databases, permitting search, filtering and analysis of company

information reported to national company registries and similar institutions, play a
major part of transfer pricing practice. The Guidelines note the practical benefits
that such databases may bring, but urge caution against potential misuse. In
particular, databases should not be the default option if reliable information is
available elsewhere, regard must be had to the extent and quality of the source
data, and the emphasis must be on quality over quantity.
Leading commercial databases include:
Name Type Coverage

Amadeus (Bureau van Dijk) Company financial Europe
statements
Orbis (Bureau van Dijk) Company financial Global
statements
Oriana (Bureau van Dijk) Company financial Asia-Pacific
statements
Thomson Reuters Company financial Global
Fundamentals statements
Thomson Reuters European Company financial Europe
Comparables statements
Compustat (Standard & Company financial North America
Poor's) statements Global
ktMINE Royalty Rate Finder Intangible property SEC Global (with US
filings emphasis)
Thomson Reuters Loan Loan pricing market Global
Connector information

Some of the databases may also be used with a commercially available “front
end” software tool designed to assist the user with efficient evaluation of the vast
amount of information that can be contained in the underlying databases. The
potential user of such databases will wish to make his or her own cost/benefit
assessment of such factors as:
• Number of companies/transactions covered
• Geographical scope: country, regional or global
• Recognition by the national tax authorities concerned
• Scope of the source data and reliability of reporting of that data
• Extent of specialist adviser support
A standard framework for performing database search, which should of course be

properly informed by a prior industry, economic and functional analysis can be
summarised diagrammatically as follows:
Initial search
This will typically include filters for:
• Standard Industry Code/principal activities keywords
• Geographical scope
• (Lack of) independence
• Periods covered
• Persistent loss making companies
• Missing financial information

• Dormant companies
• Start-up companies
Standard Industry Codes (SIC) can certainly be a powerful search tool, but caution
is required. It is essential to understand the structure of the particular classification
system used in the database or software front-end.
There are a number of free lookup and conversion tools online. Companies vary
considerably in the diligence with which they disclose SIC codes; for example
many sophisticated businesses return a “other business activities” SIC code. SIC
codes can present a particular challenge when searching for transactional data
on intangible property.
Similarly, creativity and lateral thinking is sometimes required to make the best use
of keyword searches. Companies often do not classify themselves in the same way
as transfer pricing practitioners and a thorough grasp of industry jargon may assist
with a targeted search. As a simple example “value-added reseller” may yield
better results than “distributor” in the computer software industry.
Independence screening should also be approached with care. For example, one
might reject all companies which are subsidiaries of a parent company. Some
writers take the view that it might be preferable to evaluate whether consolidated
financial statements of the parent (if they exist), which should eliminate intra-group
transactions, could in fact be used to assess an arm's length position.
The initial search may yield very few or very many hits. An iterative process can
then be applied to expand, narrow or vary the initial search criteria.
Bulk and subsequent stage rejections
Second stage quantitative filters are typically applied to further refine the search
strategy. These may typically include number of employees, turnover or assets, or
financial ratios. Maxima, minima or a range can be set to mirror the characteristics
of the tested party.
Among the financial ratios applied are:
Name Formula Use

R&D Intensity R&D expenditure/net A measure of relative importance of
sales R&D
Days sales of (Inventory/cost of A measure of how long it takes to
inventory sales) × 365 convert inventory to sales – suitable
for assessing distribution activities
Profit per Operating A measure of whether profit is
employee profit/number of primarily driven by productivity or by
employees size of workforce
Qualitative evaluation
A detailed evaluation of financial statements, company websites, analysts' reports

and any other available information relating to the remaining comparables is key
to the assessment of their suitability.
For example, the Companies Act 2006 requires financial statements of companies
(other than small companies) to include a business review with a description of the
main risks facing the company. This can be a useful tool for comparing the risk

profile of the comparable with that of the tested party, although the depth and
quality of the analysis varies widely.
Financial statements of listed companies should also address trends and factors
facing future development, performance and position of the business and
information about environmental matters, employees and social and community
issues.
10.8 Comparability: lessons from DSG Retail
Decisions handed down by the courts in a number of countries illustrate the

standard for comparability is unlikely to be attained with mechanistic database
searches.
Of prime relevance in the United Kingdom, the DSG Retail case contains important
lessons on the likely approach of the appellate tribunals to comparables. The
decision is described in detail in the Case Law Appendix, but the key points in
relation to comparables were as follows:
• The DSG group comprised the largest UK consumer electronics retailers.

Extended warranties were offered to customers at the point of sale. DSG sales
staff acted as agent for a third party warranty insurer, Cornhill, which reinsured
95% of risk with a DSG subsidiary, DISL, resident in the Isle of Man.
• The Special Commissioners were troubled by the mismatch between the

profitability of DISL and its limited functions and staff as a consequence of
which it had limited bargaining power in contrast to DSG.
• DSG advanced a number of potential CUPs and a TNMM analysis. All were
rejected; a selection is summarised in the following table:–

Potential Description Reason for rejection

comparable
offered
Orion 1982 extended Too old: market changes and
warranty arrangement better claims experience at the
between a large time of the controlled transactions
electrical retailer and
a third party
National Satellite An insurer acted as an The goods were not comparable:
Services (NSS) agent for NSS in selling in the controlled transaction, a
insurance contracts to large diversified range of goods
customers of NSS who were sold. The contractual terms
purchased or repaired were different
satellite equipment.
The insurance was sold
to customers at the
time of installation or
repair
Office of Fair A competition The anonymous data could not be
Trading (OFT) authority report tested; commission rates were very
Report containing fact-specific
anonymised data on
extended warranty
commission rates
Domestic & A third party provider D&G provided insurance to smaller
General (D&G) of domestic appliance businesses and therefore had an
breakdown insurance. infrastructure far in excess of that of
A TNMM analysis was DISL
advanced by
comparing the return
on capital achieved
by D&G with that
achieved by DISL
10.9 Proprietary databases and “secret comparables”
Some large accountancy and other advisory firms have developed in-house
pricing databases using proprietary data or proprietary data mining techniques.
The OECD Guidelines (Paragraph 3.34) do not proscribe such databases; they
urge caution that the potentially more limited data, compared with commercial
databases, may support the tax administration being granted access to the
private database in the interests of transparency.
The flip side of proprietary data belonging to the taxpayer/adviser is that “private”
data is almost certainly possessed by the tax authority. Publicly unavailable
material collected from tax returns and tax audits of other taxpayers potentially
provides a very powerful platform on which taxpayer transfer pricing may be
challenged. The OECD Guidelines adopt an even-handed approach: such “secret
comparables” are unfair unless disclosed to the taxpayer. (See Paragraph 3.36
OECD 2010 Transfer Pricing Guidelines)
Most OECD member countries also respect the OECD Guidelines with respect to
secret comparables, although the position for non-member countries is variable.
For example, the authorities in China and Japan have sanctioned the use of such
data.

10.10 Using databases
Loss-making companies
National practices vary as to whether loss-making companies are likely to be

acceptable as potential comparables. The OECD Guidelines (Paragraphs 1.70 to
1.72) recognise the legitimacy of losses in controlled transactions in start-ups and
other circumstances but assert that, in the long term, losses would not be
sustainable at arm's length.
A balanced approach is required to the question of loss-making comparables. For

example, when performing a multi-year search, it may be appropriate to exclude
companies reporting three consecutive years of loss, but include those reporting
one or two years subject to scrutiny of financial statements and company websites
for other indicators of particular reasons that are not relevant to the tested party.
Local, regional or global comparables?
Comparable company information is plentiful in some countries and almost non-

existent in others. Geographical scope of databases is key: the greater the
granularity of data local to the tested party, the more likely the database is to
provide a good starting point, but equally obtaining country-specific information in
every tested party location, even if that is possible, may be prohibitively expensive.
A common compromise is to use pan-European, pan-American or pan-Asian
regional data sets.
10.11 Other sources of information
It is misguided to place exclusive focus on database and software solutions. An

ever-growing quantity of information is freely available online, although great
caution has to be exercised as to the authoritativeness and age of such
information.
10.12 Timing of information on comparable transactions
Transfer pricing studies may be prepared either for the purposes of setting the
prices and other conditions of prospective transactions to secure compliance with
the arm's length principle, or for the purposes of testing compliance after the end
of the accounting period. Typically the price setting process may need to be
carried out several months before the start of the accounting period, whereas the
testing process may not need to be completed until the corporate income tax
return is filed, perhaps a year after the end of the accounting period and more
than two years after a price setting process.
It is clear that different data will be available at different times to inform the
comparability analysis. National tax rules have widely varying requirements
regarding the time at which data must be compiled or made available to the tax
authorities. For example, in Vietnam very extensive documentation must be in
existence when the transaction occurs, must be updated during the performance
of the transaction, and must be made available within 30 days of notification by
the tax authority. Many other countries refer to “contemporaneous”
documentation but often this amounts to a requirement to create the
documentation by the filing date for the tax return.
The OECD Guidelines recognise the different timing of data for the setting versus
the testing approach. There is recognition that double taxation may arise in

controlled transactions where two tax authorities take a different view on timing of
comparable data.
At the time of writing, the OECD has issued draft proposed revisions to the
Guidelines in response to recognition that different approaches to timing of
information lead to further difficult issues such as respecting taxpayer initiated
year-end adjustments (“true-ups”) and the admissibility of post transaction date
information in assessing the validity of projections and adjustments. The draft
revisions indicate an increased emphasis that information should be as
contemporaneous with the transaction as possible and that information used in
price testing approaches must be related to the timing of the controlled
transaction, with comparability adjustments for economic changes if appropriate.
OECD Guidelines also recognise that data from years following the year of the
transaction may also be relevant to the analysis of transfer prices, but care must
be taken to avoid the use of hindsight. The most notorious example of the use of
hindsight is the 1986 United States “commensurate with income” regulations for
intangible property transfers which require periodic after the fact revisions.
The draft UN Practical Manual on Transfer Pricing contains much the same wording
on timing issues as the OECD Guidelines. However, there is a greater acceptance
of the price testing approach stating that:
“An ex post analysis is most commonly used method to test arm's length price
of international transactions.”
“Contemporaneous data which may be available to the taxpayer and tax

administration at the time of filing of the tax return or conducting ex post
analysis of transfer pricing studies can not be held as use of hindsight.”

CHAPTER 11
COMPARABILITY ADJUSTMENTS INCLUDING PRACTICAL ISSUES
In this chapter we will look at comparability adjustments, in particular, looking at:

– adjustments for accounting items;
– capital intensity
– other adjustments
– tax authority responses to comparability adjustments
– the arm’s length range
– compliance issues
– safe harbours
– frequency of review
11.1 Introduction
This chapter considers what “reasonably accurate adjustments” (See paragraph

3.47 OECD 2010 Transfer Pricing Guidelines) might be made to reduce the effect of
differences between economically relevant conditions in a controlled transaction
and the conditions in an uncontrolled transaction.
Comparability adjustments may be made to either the tested party or to the

potential comparable transaction/company. They may be made under any
transfer pricing method and may be particularly useful where there is an internal
comparable which can accurately inform the adjustments that need to be made
to the controlled transaction. They are also seen frequently in profit methods,
perhaps most commonly in the form of working capital adjustments.
The Guidelines emphasise that comparability adjustments need to be reliable,

objective, transparent and documented. They should not be applied
mechanically or used to create an impression of precision where they are in fact
unwarranted. (See paragraphs 3.50-3.54 OECD 2010 Transfer Pricing Guidelines)
11.2 Adjustments for accounting items
Adjustments may be made to neutralise the effect of accounting items reflecting

differing functions, assets and risks that are present in the potential comparable
but not in the tested party, or vice-versa. Common examples are exceptional
items and non-operating income.
 Illustration 1
Stockhausen Ltd is a UK contract manufacturer, for its German parent of

communications systems for aeronautical applications. A transfer pricing study
identifies TNMM as the most appropriate pricing method with a Profit Level
Indicator (PLI) of Operating Margin (Operating profit/sales). One of the seven
potential comparables remaining after all bulk and second stage rejections is
Simpson Ltd, a UK manufacturer of communications systems for marine
applications.

The financial results of both companies for the year ended 31 March 2013 is as
follows:
Stockhausen Ltd Potential

comparable
(Tested party) Simpson Ltd
£'000 £'000
Sales (S) 2,750 3,876
Cost of sales (750) (1,121)
2,000 2,755
Distribution costs (776) (855)
Administration costs (1,059) (1,530)
Exceptional costs _______ (311)
Earnings before interest and tax 165 59
= operating profit
Operating margin 165/2,750 = 6% 59/3,876 = 1.5%
Examination of the financial statements of Simpson Ltd reveals that the

exceptional item of £311k relates to closure costs of a fabrication plant. Company
press releases state that this closure is due to consolidation of manufacturing
operations in one plant. This is a one-off circumstance which is not replicated in
Stockhausen Ltd and may therefore be adjusted for:
Operating profit 59
Add: Exceptional costs 311
Revised profit 370
Revised operating margin 370/3,876 = 9.5%
11.3 Capital intensity adjustments
Working capital
Working capital adjustments are perhaps the most common type of adjustment
seen in practice. These are intended to equalise the tested party with the potential
comparable by adjusting for differences in capital actively employed in the
business. Working capital is defined as:
Trade debtors (receivables) + Stock (inventory) − Trade creditors (payables)
The need for adjustment is founded on the concept that, for two otherwise
comparable businesses, the profit will increase in line with working capital
employed: the company with the higher net capital will have higher sales revenue
because prices reflect the facility of extending credit terms to its customers, it will
have more stock and can benefit from volume discounts.
 Illustration 2
This is a simplified illustration of the type of working capital adjustment featured in

the OECD Guidelines. (See Annex to Chapter III.) The Guidelines are at pains to
stress that this form of adjustment is merely illustrative and this type of adjustment is
not binding on taxpayers or tax authorities.
In this illustration, the transfer pricing method is TNMM with a PLI of operating
margin, that is, Earnings before interest and tax/sales.

The process outlined is:
1. Compute the working capital as a proportion of sales for both the tested party
and the comparable company
2. Calculate the difference applied to a notional interest rate to reflect the time
value of money
3. Adjust the result to reflect the working capital difference – here the adjustment
is made to the comparables results, but conceptually it could also be made to
the tested party or to both parties.
Tested party Comparative

£million company £
million
Sales 600 800
Earnings before interest and tax (EBIT) 6 24
EBIT/sales (%) 1.00% 3.00%
Working capital:
Trade debtors (receivables) (D) 40 80
Stock (Inventory) (S) 45 90
Trade creditors (C) 22 27
Working capital: 63 143
Working capital/sales 10.5% 17.8%
Working capital adjustment

Working capital/sales – tested party 10.5%
Working capital/sales – comparable company 17.8%
Difference (D) -7.3%
Interest rate (i) 5%
Adjustment D × i -0.37%
EBIT/sales (%) adjusted 3.00%−0.37% = 2.63%
Fixed assets
Also referred to as “property, plant and equipment” (PP&E) adjustments, these are
used to equalise the PLI between a tested party and a potential comparable with
different levels of productive assets. Again, an imputed interest rate is used. One
example of this is a start-up situation for the tested party which requires a large
initial investment in fixed assets but the comparables have lower fixed assets. The
validity of such adjustments is potentially controversial.
11.4 Other adjustments
Less common forms of comparability adjustment include geographical risk and

economic volatility.
11.5 Tax authority responses to comparability adjustments.
There are widely differing country practices and tax authority responses to the use
of comparability adjustments. In the UK, HMRC guidance is extremely cautious.
(See INTM 485110) Their position is that adjustments can quickly become
meaningless, and the more fearsome the algebra, the more suspect they
become.

Comparability adjustments are much more embedded in US practice. The IRS

report on the US APA program (See announcement and Report Concerning
Advance Pricing Agreements; http://www.irs.gov/pub/irs-apa/
2011apmastatutoryreport.pdf) records that such adjustments are standard
practice.
India has a number of appellate tribunal cases on the admissibility of

comparability adjustments. The March 2012 case of Demag Cranes (Demag
Cranes & Components (India) Pvt. Limited vs DCIT (ITA No.120/PN/2011, 4 January
2012)) followed earlier cases in establishing the admissibility of working capital
adjustments.
11.6 The arm's length range
The Guidelines emphasise that a range of “relatively” equally reliable results may
be a legitimate reflection that independent companies engaged in comparable
transactions to the controlled transaction in reality do impose different prices and
conditions to each other. However, every effort must be made to eliminate results
that have a lesser degree of comparability; excessively wide ranges stemming
from large deviations among data points may indicate inadequate comparability
of some data points.
 Illustration 3
Schoenberg Scooters Limited carries out contract research and development in

the United Kingdom for its Austrian parent company. The group commissions a
transfer pricing study which is intended to corroborate the pricing policy adopted
of an operating margin of 5%.
Eleven companies are evaluated as potential comparables, as follows:
Comparable company Operating margin

1 -17.0%
2 -0.5%
3 2.7%
4 3.9%
5 4.1%
6 4.4%
7 8.8%
8 9.0%
9 9.8%
10 13.4%
11 17.3%
On the basis that the median of the above data points is 4.4%, and the mean is
5.07%, it is asserted that the pricing policy is thus supported. However, this is a very
wide range of results which may call into question the validity of some of the
companies used. It is noteworthy that eliminating companies 1 and 2 increase the
median to 8.8%. Any data set should be evaluated for the effect of eliminating or
including potential data points; volatility may call into question the comparables
or, more fundamentally, the pricing method.
Statistical tools
The 2010 revision to the OECD Transfer Pricing Guidelines contains a statement, not
included in the 1995 version, to the effect statistical tools that take account of
“measures of central tendency” may usefully be applied to larger data sets where

every effort has been made to ensure comparability or adjust for non-
comparability. (See OECD 2010 Transfer Pricing Guidelines Paragraph 3.57) The
example of such tools cited is the interquartile range or other percentiles.
The interquartile range includes the 50% of middle values from a sample and
removes the influence of the top and bottom 25% of values. The interquartile
range has long featured in US regulations and it is very commonly used in other
countries, although it should be noted that even the US regulations stipulate that
the interquartile range is only required where the data points are not sufficiently
equally reliable. (US Treasury Regulation Sec 1.482-1(e)(2)(iii)(B)) In the UK, HMRC
guidance summons little enthusiasm for the use of the interquartile range,
preferring a more qualitative assessment of where the tested party should be
placed in the (entire) arm's length range. A similar stance is taken by the tax
authorities in Canada and New Zealand.
11.7 Compliance issues
This is a subject that we will look at in more detail in a later chapter.
The Guidelines acknowledge the need for a risk-based and pragmatic approach,
particularly for SMEs. It is emphasised that there is no need for an exhaustive
search of all possible information sources. (See paragraphs 3.2, 3.81) It may not be
necessary to perform a detailed comparability analysis each year for simple
transactions.
Although the acknowledgment of potential compliance burden in the Guidelines

is welcome, it must be said that there is no specific guidance on practical
approaches, no doubt as reflection of reality that such “soft law” cannot achieve
consistency of approach among all OECD Member Country tax administrations.
However, the OECD has now placed a renewed emphasis on the need for
simplification measures as part of its review of the administrative aspects of transfer
pricing.
11.8 Safe harbours
The IBFD Online Glossary defines a safe harbour as:
“An objective standard or measure, such as a range, percentage, or absolute

amount, which can be relied on by a taxpayer as an alternative to a rule
based on more subjective or judgmental factors or uncertain facts and
circumstances.”
In the specific context of transfer pricing comparability analysis, a safe harbour

provides simplified compliance obligations, such as an acceptable arm's length
range, for transactions with limited mispricing risk. A consultative document issued
by the OECD in June 2012 (See proposed revision of the section on safe harbours
in Chapter IV of the OECD Transfer Pricing Guidelines, OECD Discussion Draft 6
June 2012) recorded a number of member country examples as at 1 January
2012, most commonly:
• Safe harbour arm's length range for “low value-adding” intragroup services
• Safe harbour interest rate for loans.
Such safe harbours are certainly welcome, but they are all unilateral with widely
varying rules for similar transaction types.

We will look in detail at the OECD approach to safe harbours in a later chapter. It
is sufficient to note here that in May 2013 following the consultation document
mentioned above a revised section E to Chapter IV of the guidelines was issued.
The revised guidelines recognise that bilateral or multilateral safe harbours can
provide certainty and reduce the compliance burden for taxpayers whilst
releasing valuable resources for tax authorities
 Illustration 4
Kodaly Concepts Limited is the UK parent of a group of marketing and

communications consultants. It provides accounting, human resources and IT
support to its operational subsidiaries in Australia, Austria and Japan. The company
qualifies for the SME exemption from UK transfer pricing rules and has brought
forward trading losses. It identifies the direct and indirect costs of providing the
above services and charges them at a 12.5% mark-up.
The safe harbour position in the three subsidiary companies for low value adding
intragroup services is:
Australia Cost plus 7.5% to 10%

Austria Cost plus 5% to 15%
Japan Cost only
The group's policy will not therefore satisfy two countries' requirements and it is
likely that a conventional transfer pricing analysis will have to be carried out.
11.9 Frequency of review
Another common practical issue is how often it is necessary to update the

comparability analysis. The Guidelines accept that it may not be necessary to
perform a detailed comparability analysis each year for simple transactions in a
stable environment. (See paragraph 3.82 of the OECD 2010 Transfer Pricing
Guidelines.) It is sometimes advocated that an annual “sense check” could be
used to ensure that previous comparability analysis has not been invalidated by a
significant change in the industry, market or economic environment, together with
a full review every three years. Again, country expectations differ here. The danger
is that incremental changes to the enterprise and its operating environment may
have a material cumulative effect.

CHAPTER 12
SPECIFIC TRANSACTIONS: INTRA GROUP SERVICES
In this chapter we will look at what the OECD Transfer Pricing Guidelines say in respect to
services, in particular looking at the categorisation of services and charging for services.
12.1 Introduction
Almost all groups will have intra-group services of some kind. Often, the services
arise because it is more efficient and economic to centralise certain activities. For
instance, it is particularly common for various back-office services to be provided,
including IT, legal, finance, human resources and so on. These are typically carried
out by the parent company or by a group service centre or by a regional HQ.
Other types of intra-group services are ones that will be apparent to the customers
of the business, such as one company carrying out warranty repairs of equipment
sold by a related company in another country, or one company carrying out sales
as agent of a related company.
This chapter primarily focuses on the main issues that arise in determining the arm’s
length price for services that have been rendered as part of an intra-group
transaction.
Some countries have specific legislation, regulations or guidelines on this, but in

most cases the only guidance is the OECD Transfer Pricing Guidelines. These
include a specific chapter, Chapter VII, dealing with intra-group services. This was
published in 1995 and has been unchanged since then.
In the analysis of transfer pricing for intra-group services, the OECD Guidelines
mainly concentrate on two issues. First of all, it is important to understand whether
a service has actually been rendered in the context of the intra-group transaction
under analysis.
Secondly, once it has been established that a service has been provided by an
enterprise to one or more related parties, it is then crucial to assess what the
charge should be, in accordance with the arm's length principle.
12.2 Determining whether a service has been rendered
In order to assess whether an intra-group service has been rendered one must
consider whether the activity in question provides a related party with economic
or commercial value that enhances its commercial position.
This can be tested by considering whether a third party enterprise in comparable

circumstances would have been willing to pay for the activity or would have
performed the activity in house for itself.
If the answer is no, the service should not be considered an intra-group service
under the arm’s length principle. Some intra-group services are carried out by one
member of an MNE group to fulfill an identified need and to the benefit of one or
more affiliated members of the group. In such a case, it is clear that a service has
been rendered.

 Illustration 1
Company A operates a call centre to provide support to the customers of its sister
company, B, which is in another country. Clearly this is an activity that company B
would have to perform itself or acquire from a third party if company A was not
performing it, and there is a clear benefit to company B. It almost certainly
qualifies as a service for which a charge should be made under the arm’s length
principle.
 Illustration 2
Company C, is a Singaporean company that has been subcontracted by its

parent company, D, to act as investment subadvisor on an investment fund which
invests in equities from the Pacific region. Company D is the investment manager
which has launched and marketed the fund to UK investors, and if company C
was not making decisions about which equities to buy and sell, company D would
clearly need to do this itself or subcontract the work to a third party. It clearly
receives a benefit from the activities carried out by company C for it, and so they
qualify as a service and a charge is justified (indeed necessary) under the arm's
length principle.
The OECD Guidelines make special mention (at paragraph 7.14) of the type of
services that are commonly referred to as head office services or management
services. These are services that benefit the group as a whole and are often
centralised at the regional headquarters or parent company. Paragraph 7.14 lists
many examples:
• 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;
• Services and staff matters such as recruitment and training;
• Research and development and administering and protecting intangible

property for all or part of the group.
The OECD Guidelines say that these kinds of activities ordinarily will be considered
intra-group services because they are the type of activities that independent
enterprises would normally have been willing to pay for or to perform for
themselves. Most companies do need most or all of the above functions in order
to operate, and so if these functions are performed centrally by another group
company this will normally represent a service for which a charge should be
made.
However, depending on the service, identifying whether there is a service might

not be as simple and requires understanding of how the service benefits the
related parties. The OECD Guidelines highlight several situations that may not be a
service to a group company because there is no benefit to that company:
• Shareholder activities;

• Duplicative activities;
• Incidental benefits.
The Guidelines also discuss whether on-call activities are a service. All of these
situations are discussed below.
The Guidelines also state that evidence that a payment has been made for an
alleged service or the existence of service agreements are not in themselves
sufficient to demonstrate that a service has been rendered and that it created a
tangible benefit (direct or indirect) for the related parties involved in the
transaction. Equally, the absence of payments or contractual arrangements does
not automatically lead to the conclusion that no services have been rendered.
Shareholder Activities
Some types of activity are performed by a company because of its ownership

interest in other companies, i.e. in its capacity as shareholder. Ordinarily such
activities do not provide an economically relevant value to the other group
members. They do not need the activity and would not be willing to pay for it if
they were independent. Such activities are referred to as shareholder activities.
The OECD guidelines provide the following examples of shareholder activities:
1. 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;
2. Costs relating to reporting requirements of the parent company including the

consolidation of reports; and
3. Costs of raising funds for the acquisition of its participations (i.e. its subsidiaries).
The OECD Guidelines mention another type of activity that potentially falls within
the definition of “shareholder activity”, namely the costs of managerial and
control (monitoring) activities related to the management and protection of the
investment in the subsidiaries.
In order to determine whether these activities can be categorised as intra-group

services, we should carefully analyse whether they create any benefit. If the
activities are ones that the subsidiary would be likely to carry out itself if they were
not being done for it by its parent, they should probably be counted as a service,
notwithstanding that the parent is carrying out the activity partly because a
shareholder naturally wishes to manage and protect its investment.
The concept of shareholder activities was introduced in an OECD report published

in 1984, entitled Transfer Pricing and Multinational Enterprises – Three Taxation
Issues. This superseded an earlier term, stewardship activities, which was referred to
in the 1979 OECD report, Transfer Pricing and Multinational Enterprises, which was a
forerunner of the OECD Transfer Pricing Guidelines (the first seven chapters of
which were published in 1995). The term stewardship activity was broader in nature
and included activities such as detailed planning services for particular operations,
emergency management and technical advice (troubleshooting), and in some
cases assistance in day-to-day management. The OECD Guidelines make it clear
that these activities are not within the definition of shareholder activities.

 Illustration 3
Company E is a listed Spanish company with a subsidiary in Argentina, company F.

The head office in Spain carries out a number of services for the benefit of itself
and its subsidiary. A transfer pricing analysis is carried out and the following
services are identified:
• accounting, including management accounts, local statutory accounts of

both companies, and consolidation of the Argentinian results into the
published accounts of company E;
• the head of sales in Argentina reports to the head of sales in Spain, who
monitors the performance of the Argentinian sales team;
• the group CEO splits his time between the two companies and a charge is
made for his time spent regarding Argentina.
The accounting services to company F are generally of a nature that creates a

benefit for company F and should therefore be treated as a chargeable service.
However, preparing the published accounts of the parent company is an activity
that is solely for the benefit of company E, even though some of it may relate to
the results of the subsidiary. The element of the head office accounting work that
relates to the published accounts of the parent should be split from the work on
the Argentinian statutory and management accounts and should not be charged
for.
The group head of sales is carrying out managerial and control activities which, in
part, are intended to ensure that the Argentinian sales operation is effectively
managed. However, detailed interviews identify that the managerial and control
activities are the same as are performed in relation to the sales managers in Spain,
and so the group head of sales is effectively acting as part of the Argentinian
management, albeit that she is normally located in Spain. Without this senior
managerial input, the Argentinian business would have to hire a more senior local
sales executive. Accordingly, this is not a shareholder service and a charge should
be made.
Detailed interviews show that the group CEO splits his time primarily on the basis of
one week per month spent visiting Argentina to manage and coach local senior
managers and review performance and meet key local clients. This is not a
shareholder activity. However, during these visits the group CEO often meets with
an Argentinian company which is a 25% shareholder of company E, to report to
them as shareholders. This is a shareholder activity and so it is not a service and no
charge should be made for the time spent on this activity.
Duplicative activities
The OECD Guidelines also state that there will generally be no intra-group service
arising from activities undertaken by one group member for another group
member that merely duplicate an activity that the other group member is
performing for itself, or that is being performed for such other group member by a
third party. This principle is clearly correct, but in practice it is rare for activities to
be duplicative, because most multinationals go to some effort to ensure that their
activities are planned and controlled in a holistic, coherent manner in order to
achieve maximum efficiency and effectiveness. If the same activity is truly being
duplicated, the multinational is being wasteful, so apparent duplication should be
treated with some scepticism. The mere fact that more than one entity carries out
an activity that is labelled with the same description does not mean that there is

necessarily duplication. Multinationals often split activities between group

companies.
A duplicative activity can sometimes constitute a valid service if it is only

temporary, for instance when the group is reorganising to centralise its
management functions and there is temporary overlap. Another exception would
be where the duplication is deliberate and there is valid business justification, such
as obtaining a second legal opinion on a particular issue.
 Illustration 4
Company G manufactures a certain product and sells it in its home market of the
USA. It is the parent company of companies H and I, which are responsible for
sales and distribution in Hungary and Italy, respectively, of the product
manufactured by company G. Company G carries out certain marketing activities
and makes a charge for marketing assistance to its two subsidiaries. A transfer
pricing analysis is carried out and it is identified that the two subsidiaries each have
their own marketing teams. However, on discussion with the head of marketing it
becomes clear that there is strict delineation of marketing responsibilities between
the local marketing teams and the head office. The local marketing teams report
back to head office on a regular basis, so any wasteful duplication would be
spotted and eliminated. Accordingly, it is confirmed that there is in fact no
duplication and the marketing assistance is a valid service for which a charge
should be made.
 Illustration 5
Company J is a law firm which has recently been acquired by company K, a large
multinational law firm with its head office in France. Company J has developed a
knowledge management system consisting of a searchable database of its know-
how and previous work carried out. Company K has its own knowledge
management system which operates using different, incompatible software. Its
policy is that all group companies must use the group knowledge management
system, in order to maximise the sharing of know-how. However, the head of
knowledge management in company J considers that the group system is inferior
and therefore decides to continue operating the existing system, setting up an
arrangement where the content of the local system is automatically added to the
group system in order to satisfy group policy.
Because of the partnership, decentralised ethos of law firms, he is able to resist

efforts to persuade him to save money by closing down the local system. A charge
is made to company J for its share of the group system, on the grounds that the
group system is certainly being made available to company J and that if no
charge were to be made this would encourage the wastefulness to continue.
Although J does use the group system it duplicates almost all of the capabilities
offered by its own system and therefore use of the group system is not a service for
transfer pricing purposes because this would be duplicative. A charge would not
be appropriate for transfer pricing purposes.
Incidental benefits
There are some cases where an intra-group service performed by a group

member relates only to some of the group members but incidentally provides
benefits to other group members. When a MNE is looking to reorganise the group,
acquire a new company, or to terminate a division, these activities could possibly
constitute an intra-group service to the particular members of the group involved.
For instance, a member of the group might be the appropriate entity to acquire a

new business in the same country and might therefore be charged for the costs of
acquiring the new business.
Members of the MNE group involved in these activities are going to receive a
service from a coordinating related party which, in a comparable non-related
situation and circumstance, an independent party would have been willing to pay
for.
These activities may also produce economic benefits for other group members not
involved as parties in the transactions, by increasing efficiencies, economies of
scale or other synergies. The commercial position of the other group members
could be more valuable after the transaction has been entered into, but the
OECD Guidelines take the view that the incidental benefit would not cause the
other group member to receive an intra-group service, because an independent
enterprise would not be willing to pay for it.
This is a conclusion that is easy to agree with in cases where these benefits are truly
incidental. However, in some cases the primary purpose of the transaction is to
create efficiencies, economies of scale, or other synergies for group members,
even though they may not be directly involved. These situations are one example
of where the arm's length principle can be extremely difficult to apply, because
the transaction is one that would never arise for a company if it were an
independent enterprise, and yet the transaction makes economic sense for the
group and is carried out for the benefit of the company in question.
 Illustration 6
A multinational group has operations around the world and manufactures a

certain product line in three factories in Poland, Slovenia and the UK. The group
has significant overcapacity in Europe in relation to this product line and, after a
review, it is decided that one of the factories should be closed down, because this
will allow the other two factories to operate at full capacity and the group will
boost profits through saving the costs of operating the factory that is closed down
and spreading the fixed costs of the other two factories over a much higher
volume of production. It is decided that as the UK factory has the lowest utilisation
it is the one that should be closed down.
The group companies in Poland and Slovenia are not directly involved in the UK
company or the UK business, but they will clearly benefit from increased
profitability due to having additional volume of production and thus lower unit
costs of manufacturing their own products. On an arm's length basis, they would
be unlikely to be willing to pay a competitor to close down its factory, indeed this
would probably be illegal under competition law. Nor would they be reassured
that they would pick up all of the production previously carried out by that
competitor. Nevertheless, the boost in profitability of the two surviving factories is
the whole purpose of the transaction and so is arguably not an incidental benefit
that should be disregarded. The costs of closing down the UK factory could be
argued to be a valid service to the Polish and Slovenian companies. However, this
approach could be controversial with tax authorities. (Indeed, the approach
could be controversial if it is decided that this is not a service for which a charge
should be made.)
Another type of incidental benefit that may not constitute a service is where a
group company obtains incidental benefits attributable solely to its being part of a
larger concern, and not to any specific activity being performed. The OECD
Guidelines (paragraph 7.13) give, as an example, a situation where, as a result of
being part of a wider group, a company has a credit rating higher than it would

have if it were not part of the group. The Guidelines draw a distinction, however,
between benefits arising from passive association as opposed to active promotion
that positively enhances the profit-making potential of particular members of the
group. Thus, if the higher credit rating is the result of an explicit guarantee given by
another group member, the benefit of the higher credit rating has not arisen from
passive association.
This distinction was recently scrutinised by the Canadian courts in a transfer pricing
case involving GE Capital (we will look at this case in more detail in the chapter on
finance). The case concerned a guarantee provided by GE Capital in the US to its
Canadian subsidiary, which had the result that the Canadian subsidiary was able
to borrow on the market at an interest rate considerably lower than if it had been
a stand-alone company. A guarantee fee was charged, equal to 1% of the
borrowings of the Canadian subsidiary. The Canadian tax authority argued that
although an explicit guarantee had been given, the arm’s length guarantee fee
would have been nil, because the Canadian subsidiary could have derived the
same benefits from mere passive association with its US parent. Independent
lenders would have perceived an implicit guarantee, because the US parent
would not have been willing to allow its Canadian subsidiary to default on its
liabilities. This argument is widely considered to be an attempt to widen the
application of the passive association concept.
GE Capital argued that any implicit guarantee arising from passive association
arises only from the shareholding relationship and the arm’s length test requires us
to disregard anything that arises from the shareholding relationship. This defence
arguably attempted to narrow the application of the passive association concept
or even overturn it.
The Canadian High Court, subsequently supported by the appeal court (case
reference 2010 FCA 344), did not agree with either side. It found that an implicit
guarantee would have existed and that this benefit from passive association
should not be disregarded, so in principle the arm’s length test would not allow a
charge for a benefit that would have arisen from the implicit guarantee. However,
it also found that the benefit of the implicit guarantee should not necessarily be
assumed to be the same as the benefit from the explicit guarantee. Based on the
evidence presented to it, the court decided that if GE Capital Canada had only
benefited from an implicit guarantee, it would have paid interest rates more than
1% higher than the interest rates it paid as a result of the explicit guarantee. The
court concluded that the 1% guarantee fee was therefore justifiable under the
arm's length test.
It should be noted that this decision is controversial and would not necessarily be
respected in other countries.
On Call Services
Another important issue that arises when dealing with intra-group services is in
relation to “on call services.” An “on call service” is a service provided by a parent
company or a group service centre that ensures the complete availability of a
service for members of an MNE group. The question is whether the availability of
the service has to be considered an intra-group service itself (in addition to any
services that are actually performed) and therefore should be charged at arm’s
length.
In the OECD Guidelines it is stated that in order to determine the existence of an

intra-group service we should expect an independent enterprise in comparable
circumstances to incur standby charges to ensure the availability of the service
when the need for them arises. However, it is unlikely that an independent

enterprise would incur standby charges where the potential need for the service
was remote, or 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 standby arrangements.
In such cases, the most reasonable course to take, as the OECD Guidelines
suggest, is looking at the extent to which the service have been used over a
period of several years rather than solely the year in which the charge is to be
made. In other words, in determining whether a service has been rendered, we
should concentrate on the substance of this service and to what extent and
measure it has affected the group companies involved in the transaction.
12.3 Determining an arm’s length charge
Having determined that a service has been rendered and that a charge should
be made, the second step is to determine the appropriate quantum of the
charge, consistent with the arm's length principle. The broad principle is the same
as any other type of transaction: the charge should be that which would have
been made and accepted between independent enterprises in comparable
circumstances.
The main topics discussed by the OECD Guidelines in this respect are:
• direct charging methods versus indirect charging methods
• cost allocations
• CUP method versus cost plus method
• the appropriateness of adding a mark-up on top of costs.
Direct versus indirect charging methods
In general large MNEs use a direct or an indirect method for charging services. The
direct charge method is used when associated enterprises are charged for
specific services and it is the most transparent method for identifying the service
being performed, while the indirect charge method is based upon cost allocation
and other apportionment methods.
Direct charging is most likely to be possible and appropriate in cases where a

company is providing an intra-group service that it also provides to third parties,
which means it will have put in place a mechanism for determining an
appropriate charge, such as a system for tracking work done. (It is also likely to
mean that the CUP method can be applied.)
An indirect charge method may be necessary depending on the nature of the

service being provided. For example, as stated by the OECD Guidelines, indirect
charging may be necessary when the proportion of the value of a service
rendered to various entities is not quantifiable except on an approximate or
estimated basis. Certain centralised activities may be intended and expected to
produce simultaneous benefits for more than one group company, although the
quantum of the relative benefit cannot be measured.
Another instance where applying a non-direct method for recharging intra-group

services is appropriate is when a separate analysis of the relevant service activities
for each beneficiary would generate excessive administrative burden for the MNE

group and result in compliance cost that could be excessive in relation to the
activities themselves.
The OECD Guidelines make it clear that although there is often no alternative than
to use cost allocation and apportionment, which generally necessitate some
degree of estimation or approximation, this should be done in a way that gives
sufficient regard to the value of the services to the recipients. The Guidelines do
not come out with a categorical rule, but they appear to be pushing for direct
charging in cases where the intra-group service is one that is provided to third
parties as well.
In practice, indirect charging methods using cost allocation are far more common
than direct charging methods.
Allocations
The OECD Guidelines state that if an indirect charge method is used, it 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.
The Guidelines go on to specify that the allocation method chosen must lead to a
result that is consistent with what comparable independent enterprises would
have been prepared to accept. This is to be achieved by choosing allocation keys
that are appropriate to the particular service being rendered and the benefits
that it creates. Tax authorities are often sceptical when multinational groups
bundle a whole range of different services together and then split all of them
across the group using a single broadbrush allocation key, such as relative sales.
They often argue that this would not have been acceptable if independent
enterprises were sharing costs in this way. They prefer direct charges, but if this is
truly not possible, they tend to prefer the use of several different allocation keys
chosen to give appropriate allocations of the various services.
 Illustration 7
Company L is the parent of a multinational group. It carries out human resources

and IT services on a centralised basis for the whole group. Interviews with the head
of human resources and with the users of its services indicate that, in the long run,
the amount of time spent by the HR team on each country is roughly proportional
to the headcount of staff in each country, so headcount is used as the allocation
key for the costs of the HR Department.
Interviews with the head of IT and with the users of its services indicate that IT
expenditure falls into two main categories. Firstly, every employee around the
world has a desktop computer and the IT department provides support for this.
Secondly, the IT department operates an extremely sophisticated system for
planning, scheduling, controlling, and costing production, which takes place in
two factories in Canada and Thailand. The costs of these two categories are
therefore determined separately and the costs of desktop support are allocated in
proportion to the number of desktops in each country. The costs of the production
system are allocated only to the Canadian and Thai subsidiaries and are split
between them based on the ratio of production capacity in the two factories.

 Illustration 8
Company M is a Chinese company which manufactures consumer products. It

sells them in China and, through its overseas subsidiaries, in the rest of the world.
Although the subsidiaries carry out some of their own marketing, the head office in
China includes a marketing team which carries out marketing for the benefit of
the group as a whole, including carrying out promotion at international fairs and
arranging global marketing campaigns based around sponsorship of international
sports people and teams. The two main sponsorships are in relation to Manchester
United football team and a world champion (Chinese) table tennis player.
Although Manchester United is a UK football team, it was carefully selected by the
head office marketing team because it is extremely widely known and supported
around the world. The table tennis player is a well respected household name in
China and Korea, where table tennis is extremely popular as a spectator sport, but
in most of the rest of the world table tennis is a sport that is of interest to only a tiny
minority.
The international fairs and the Manchester United sponsorship are of significant
benefit in all major markets, but the benefit cannot be objectively measured.
Direct charging is not possible, so it is necessary to allocate the costs across all of
the sales subsidiaries (and the Chinese parent). An appropriate allocation key
might be to split the costs in proportion to sales in each market. In contrast, it
would probably be inappropriate to use the same allocation key for the table
tennis sponsorship costs, because this would not reflect the proportionately higher
benefit in China and Korea. Perhaps in this case it would be appropriate to weight
the sales revenue in proportion to the popularity of table tennis in the different
markets, assuming that an objective measure of this can be found.
12.4 Transfer pricing method
OECD Chapter VII makes clear that any analysis of intra-group services must
consider the perspective of both the service provider and service recipient.
Therefore, it is necessary to consider the value of the service to the recipient, the
amount that a comparable independent enterprise would have been prepared
to pay for the service in comparable circumstances, as well as the costs incurred
by the service provider. It is implicit in this that a one-sided analysis using just cost
plus or CUP is unlikely to be acceptable. (However, this does not necessarily mean
that both methods must not be used.)
Chapter VII says that the method to be used in determining the arm’s length
transfer price for intra-group services should be determined according to the
guidance in Chapters I, II and III. It should be noted that Chapter VII was written in
1995, but Chapters I, II and III have subsequently been replaced in 2010. In
practice, it seems unlikely that it would be acceptable to continue applying the
old Chapters I, II and III. The 2010 rewrite is considered to be the best current view
of how to choose the most appropriate transfer pricing method, and there is no
obvious reason why this should not apply to intra-group services just as much as
any other kind of transaction.
Chapter VII says that the CUP and cost plus methods are often used for pricing
intra-group services, and this is borne out by practical experience. It would be rare
for any other method to be used (although the cost plus method is often applied
in a manner that could equally be described as being a TNMM using total mark-up
on costs as the profit level indicator).

CUP method
The Guidelines say that the CUP method is likely to be applied when the intra-
group service is either provided to third parties by the same entity or another
related entity or there are third party comparables, which can be used to price
the transaction. There is no explicit statement that CUP is to be preferred, although
arguably the discussions regarding mark-ups (see below) implicitly mean that cost
plus is overridden in cases where it would imply a price higher than the market
value of the services (i.e., a CUP).
Using the CUP method to price intra-group services can be very difficult as unless
the service is in relation to the main line of business for the group there will not be
any third party arrangements that can be used for the analysis. Furthermore,
independent enterprises are not likely to disclose the nature and the main
characteristics of services; therefore, even finding third party CUPs could prove a
very difficult exercise.
 Illustration 9
Refer back to the previous illustration involving company L. Assume that the group
is in the business of manufacturing and selling computer hardware and providing IT
services to customers. In such a case, then it may well be possible and appropriate
to use the CUP method to charge for the intra-group IT services by treating these
as if they were being provided to an external customer and pricing them in a
similar way. It would have to be investigated whether the pricing system would
produce a reliable split between the group companies. It is possible that the CUP
method would only produce a figure for the total charge to be made for this
service and that an allocation key would still be necessary in order to split the costs
between the group companies.
As company L is not in the business of supplying human resources services

externally, it would be unlikely to be possible to use the CUP method to charge for
the HR services.
Cost plus method
The OECD guidelines confirm that the cost plus method is, in the absence of a
CUP, the most appropriate method when the nature of activities involved, assets
used and risks assumed are comparable to those undertaken by independent
enterprises. In practice, the cost plus method is by far the most commonly used for
intra-group services.
Many tax authorities have reservations about the use of cost plus for many
services, in part because services that are being provided between unrelated
parties are rarely priced on the basis of the costs of the service provider plus a
fixed percentage mark-up. Few independent service recipients are willing to
guarantee a profit to an unrelated service provider and few service providers are
willing to restrict their potential profitability to just a (usually small) mark up on costs.
However, the use of a transfer pricing method is not conditional on establishing

that the same method would have been used had the transaction have been
carried out between arm's length parties. Moreover, if there is no reliable CUP
available which reaches an acceptable standard of comparability with the
controlled transaction, cost plus is, like it or not, generally the only other method
that can be used.
Regardless of the method used in determining an arm’s length price for intra-
group services, it is important that the remuneration reflects the nature, functional

and risk profiles of the transaction. Typically, when cost plus is being used to set the
transfer price, this inherently means that the service provider has little or no risk. In
comparison, the pricing methods that are commonly seen between unrelated
parties will often expose the service provider to risks, for instance if they have cost
overruns or if they do not generate enough business to keep their staff fully utilised
and so fixed costs rise as a proportion of sales revenue. This can be a source of
controversy.
Issues related to risk were dealt with in depth in the new OECD Chapter IX,
published in 2010. Although this OECD chapter relates to transfer pricing issues
arising from business restructuring, many of the comments relate equally to transfer
pricing if no business restructuring has taken place. It is beyond the scope of the
current chapter of this manual to examine OECD Chapter IX, but it does confirm
that it should be accepted that using cost plus means that the service provider
has no risk. The risk allocation should normally be respected unless certain narrow
conditions are met.
Mark-ups
A common issue that arises when using the cost plus method is whether a mark-up
should be added for the service provider, so that it makes a profit. A number of
countries tend to object to a profit being made on inbound services that are only
carried out internally within the group. The OECD Guidelines do not explicitly state
a clear, unambiguous position on this, but paragraph 7.33 does observe that "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 merely
providing the services at cost". The paragraph then goes on to discuss
circumstances in which an independent enterprise may not realise a profit from
the performance of a service, so it is arguably implicit that a mark-up should be
added unless there are special circumstances to justify providing the services at
cost or even below cost.
One example of a special circumstance in which it might not be appropriate for

there to be a profit mark-up would be where the supplier of the services wishes to
offer the service so that a customer does not turn to the supplier's competitors to
obtain this particular service. This might give the competitor a chance to win the
contract to supply other services currently being rendered by the supplier to the
customer on a profitable basis. Another example would be to open up a new
relationship with a prospective customer. In practice, however, arguments that
such circumstances apply to intra-group services are often viewed sceptically by
tax authorities, because it is often the case that group companies do not have the
same freedom of choice regarding service providers as would be the case if they
were independent.
 Illustration 10
Company N prints and distributes fashion magazines. It has a subsidiary, SP, which
carries out the service of sourcing and procuring small products/gifts that can be
given as free gifts to customers to boost sales of the magazine or help penetrating
certain markets. It does not take title to the goods; it charges a fee for
procurement services. In this case, SP would not see any financial benefit by
providing these services to the parent company at cost. The financial benefit
manifests itself in larger volume of sales of the magazine, which benefits the parent
company only (or potentially the distributors of the magazine). In this case, the
service should generate a profit for SP.

 Illustration 11
Imagine in the above illustration that SP does not just provide this service to its
parent company. Rather, it provides the service to many unrelated magazine
publishers, but to date these have generally been fairly downmarket publications.
Until recently, it was an independent company and, in an attempt to move
upmarket, it entered into negotiations to supply services to company N, whose
fashion magazines are at the top end of the market and extremely prestigious.
Rather than simply become a customer, company N chose to purchase SP, seeing
a large potential to expand SP's business. In such a circumstance, there might be
an opportunity to argue that the kudos and credibility of being a supplier of these
services to the prestigious magazines published by company N would be so
attractive to SP that it might be willing to provide its services to N at cost or even at
less than cost if this were necessary to win the contract with N.
Another example given by the OECD Guidelines of where it might be

inappropriate to add a profit mark-up is where the market value of the intra-group
services is not greater than the costs incurred by the service provider. This is a good
example of a situation where it is particularly hard to apply the arm's length
principle, because the reality is that when an independent service provider incurs
costs in rendering a service that are equal to or higher than the market value of
those services, its customers will not normally be willing to pay more than the
market value, so the service provider faces the choice of discontinuing the service
or selling at cost (if this is equal to the market value) or even below cost. An
independent service provider is unlikely to be willing to continue selling at no profit
except in unusual circumstances, such as a price war with its competitors, which
the company considers it is in a position to win.
However, there may be a number of good reasons why it makes economic sense
to a multinational group for an intra-group service to continue to be performed
internally despite the fact that it costs more than the market value of the service.
The OECD Guidelines make it clear that if the market value of the service is known
(and so the CUP method is able to be used) it would not be appropriate to charge
a higher price than this, even if this would be necessary to ensure that the service
provider covers its costs and makes a profit.
Very careful analysis would be necessary in order to understand fully why the
group has decided not to obtain the service externally, despite this having a lower
price. Such an analysis might indicate that an ostensible CUP is not in fact properly
comparable, because the external service provider would not provide all of the
same benefits as the internal service.
 Illustration 12
Company Q is the UK parent company of a group that provides international

consultancy services. It acquires company R, a Mexican business providing local
consultancy services on a relatively small scale. Q has, over the last decade,
developed an extremely sophisticated computer system for planning, managing,
and tracking its consultancy projects and its policy is that all group companies
should use this. It charges out the cost of this system to all group companies,
splitting the costs in proportion to relative sales in each country, and adding a 7%
mark-up. The charge to Mexico is £107,000.
However, when a transfer pricing analysis is performed in relation to this

transaction, the Mexican CEO explains that this system is far more sophisticated
than is justified by the needs of the current Mexican business. It is tailored to the
needs of other countries, particularly the US and UK, which often need to manage

complex projects involving multiple inputs from many parts of the group and
involving many stages. Current Mexican projects are much more straightforward
and could be handled using simpler software, which would cost £80,000 for the
Mexican company. The group has decided that it is important that all group
companies use the same software, because this allows the group to market itself
as offering the same sophisticated capabilities in every country, even though it is
accepted that Mexican customers are not at present interested in these
capabilities.
It might be appropriate in this case for the parent company to provide the
software at £80,000, even though this means it makes a loss on the £100,000 cost
attributable to Mexico. (The answer might change in the future, if the Mexican
company starts to take on more complex projects and it makes use of the full
capabilities of the software.)
Ideally, the mark-up percentage should be determined on the basis of the mark-
up made on comparable uncontrolled transactions. If, as is often the case, such
transactions cannot be identified, it is in practice necessary to resort to using the
profitability of independent companies that provide comparable services under
comparable circumstances. This is typically found by way of a search of a
database of the company accounts. As discussed above, it can often be difficult
to ensure full comparability, because independent service providers do not usually
operate on a cost plus basis, so risk levels are often different.
It is often supposed that services that require highly paid employees should earn a
higher mark-up than services that do not. Highly paid employees might be an
indication that the service in question is highly valuable and this may be reflected
in the fee charged by independent companies that provide such services, but it
does not necessarily follow that this will give rise to a higher profit margin. It is
perfectly possible that if the service in question requires skills or experience that are
scarce, competition may drive up remuneration to the point where most of the
benefit of the higher fees has been passed to the employees. The profit potential
of a company should reflect the economic value that it is adding over and above
its inputs.
It is beyond the scope of this chapter to discuss specific rules or practice in relation
to services transfer pricing in particular countries. However, it is perhaps worth
noting that the USA takes a particularly pragmatic approach to the question of
mark-ups on certain services. It publishes a list of services on which it will not require
a mark-up. Its rationale is that if the appropriate mark-up would be low, the
amount of tax revenue at stake is also low, so it is willing to waive any requirement
for a mark-up on such services, in order to make tax compliance easier. In
practice, this is only of relevance to services provided by a US company. If the
services are being provided to a US company, by a company in another country,
that other country is likely to expect a mark up.
Cost base
It is often the case that most attention is given to the question of whether there
should be a mark-up and if so, what the percentage should be. Experience
suggests that frequently there can be much more at stake in relation to the cost
base.
Generally speaking, the cost base should include all relevant costs, not just the
salaries of the staff performing the service. For instance, all staff benefits should be
included, as should all overheads, such as rent, power, telecommunications,
human resources support, IT support, etc. This can often make a much bigger
difference than any error in the mark-up.

 Illustration 13
Company S delivers intra-group services to all of its affiliated entities (let’s assume
we are dealing with a large multinational group) and the total cost for delivering
the services is 100 million. If the mark-up chosen is 5%, Company S will generate a
profit of 5 million.
However, a transfer pricing analysis identifies that only 10% of the costs of the head
office human resources department are being included in the cost base for the
recharge, because they only spend 10% of their time providing human resources
support direct to the rest of the group. 50% of the time at the human resources
department is spent dealing with human resources matters in relation to the other
head office departments that are being charged out to the rest of the group.
Therefore, a further 50% of the costs of the human resources department should
have been loaded into the calculation of the costs of the other departments that
are part of the head office charge. Similarly, the costs of the head office IT
department in supporting the other head office departments have not been
included. It is determined that the cost base for the recharge should have been 10
million higher, so company S is actually making a loss of 5 million. The charge
should be increased by 10 million, plus a 5% mark-up on this.
There are other issues to consider in relation to the cost base. In deciding the
appropriate mark-up using comparables, it is important to consider comparability
of the cost base. If the comparables include in their profit and loss accounts types
of cost not included in the costs of the supplier of the intra-group services, the
mark-up percentage is not being calculated on a like-for-like basis.
A related issue is the question of whether a mark-up should be applied in cases

where the service provider is merely acting as an intermediary. On the face of it,
no mark-up should be applied to costs that are merely being passed on, and a
mark-up should only be made on the costs of performing the intermediary
services. An example would be advertising companies, which often acquire
advertising space on behalf of their clients. Arguably, if such a service is being
provided intra-group, the amounts disbursed to the providers of the media space
should not be marked up and the mark-up should only be applied to the costs of
negotiating and arranging the purchase of such space.
However, if the mark-up percentage is being set by reference to comparable

independent companies and those companies have flow-through costs reflected
in their cost base, then their cost base should be adjusted to strip out the flow-
through costs. This is not always possible, depending on the level of disclosure in
the accounts of the comparable independent companies, and so the only option
might be to include flow-through costs in the cost base of the in-house service
providing company.
12.5 EUJTPF Report on Low Value Adding Intra-group Services
The European Union Joint Transfer Pricing Forum (“ EUJTPF”) published a report on
low value adding services in July 2010. The report looks at a certain type of
services, those that are described as “the glue that holds the corporate structure
together to support its main function” services that are routine in nature and do
not add high value to either the provider or the recipient.
One of the aims of the report is to limit the compliance burden in relation to such
services. The report suggests that this can be achieved by having a “narrative” to
provide sufficient correlative evidence that the service has been rendered and an
ALP charged.

In relation to the form of the narrative the report states that: “a dedicated written
narrative could be provided in some cases. Some of the information, if
appropriate, may be given verbally. It might also be the case that the
examination of written contracts will provide an insight to the wider context and
will provide most of the information in any narrative. Each of the approaches or
some combination of them is valid. The important point is that the outcome is an
understanding of how any service provision system works.”
Once the narrative has been received the tax authorities can decide whether any
further information or explanation is required.
Turning to methodologies, the report acknowledges a cost plus method as the

most commonly used. The report states that for low value services only a moderate
mark up will be required.
The report states that “in cases where it is appropriate to use a mark up, this will
normally be modest and experience shows that typically agreed mark ups fall
within a range of 3-10%, often around 5%. However that statement is subject to the
facts and circumstances that may support a different mark up”.
For such low value adding services it is possible that there will not be written
documentation due to the nature of the service. The lack of such documentation
is (say the EUJTPF) not to be a justification for assuming that the arm's length
principle has not been applied.
The report suggests that a useful and a proportionate documentation pack may
contain:
• A narrative;
• Written agreements;
• Details of the cost pool;
• Justification of OECD methodology applied;
• Verification of arm's length price applied;
• Invoicing system and invoices.

CHAPTER 13
SPECIFIC TRANSACTIONS: LOANS AND OTHER FINANCIAL

TRANSACTIONS
In this chapter we are going to look at transfer pricing for financial transactions, in
particular:
– loans;
– thin capitalisation;
– interest free loans;
– guarantee fees;
– captive insurance;
– financial services businesses.
13.1 Introduction
Intragroup transactions are generally regarded as falling into one of four

categories: sales of tangible goods, provision of services, licences to use intangible
property, and financial transactions. There are specific chapters in the OECD
Transfer Pricing Guidelines relating to services and intangible property, and
although there is no specific chapter on tangible goods, much of the first three
chapters of the Guidelines tends to be written in the context of setting a price for
tangible goods. In contrast, the OECD Guidelines have little specific to say about
loans and other financial transactions.
We will start by considering how to determine the arm’s length interest rate for a
loan and will then consider thin capitalisation, which relates to whether the
quantum of the amount lent meets the arm’s length test. We will then briefly
consider other financial transactions, including guarantees.
This chapter does not primarily focus on transfer pricing within the financial services
industry (banks, insurance companies, and so on); it is instead concerned with
transactions of a financial nature, which can occur within multinational groups in
any kind of industry. There is, however, brief discussion of financial services transfer
pricing at the end of the chapter.
13.2 Loans
Association tests for loans
This chapter will not focus on the question of determining whether a loan is subject
to transfer pricing rules, because each country sets its own rules about determining
exactly how closely connected two enterprises must be before they are required
to meet the arm’s length test in relation to transactions between them. In most
cases, the rules will be the same for loan transactions as for any other kind of
transaction. However, it is worth briefly noting that some countries do have special
rules which apply transfer pricing principles to loans in cases where the level of
connection between the lender and borrower would not be sufficient to apply
transfer pricing principles to other types of transaction between them.
An example would be the UK, which has special rules introduced in 2005 with the
intention of ensuring that transfer pricing principles apply to loans made to finance
private equity type investments. Typically, private equity acquisitions of businesses

are funded by high levels of debt advanced by syndicates of lenders who are also
shareholders of the business that is acquired. It is often the case that each
shareholder has a relatively small interest in the target business and would not
normally be considered to be associated with the borrower under the normal tests
of association (which, in the UK, boil down to 50% control or 40% control in cases
where there is another party with 40% control).
As there is scope for these syndicates of shareholders to "act together" because

they jointly control the target business, these special rules provide that a financing
arrangement (a loan) made by a person, P, to another person, B, will be subject to
the UK transfer pricing rules if certain conditions are met. These conditions are that
P acted together with one or more other persons in relation to the financing
arrangement and P would be taken to control B if it were attributed with the rights
and powers of that other person or persons.
Determining the arm’s length interest rate
A loan transaction involves a lender lending money to a borrower in return for the
borrower paying interest and, at some point, repaying the money lent. The interest
is a percentage of the amount lent (the "loan principal"). The interest is the
consideration paid in return for the use of the money and it is therefore the
relevant transfer price. Therefore, in cases where an intragroup loan is subject to
transfer pricing rules, it is necessary to show that the interest rate meets the arm’s
length test. That is, the interest rate is no higher nor lower than it would have been
if the lender and borrower had not been related to one another.
In order to determine whether the interest rate meets the arm’s length test, it is
necessary to understand how interest rates are determined, commercially. Interest
rates always have two components. First, there should be a component of interest
to reflect the use of money. Even if there is no risk that the borrower might default
on the loan, the lender is still making the money available to the borrower and so
there is a minimum price for the use of the money. This is usually referred to as the
base rate. Second, except in cases where the borrower is risk-free, there would
normally be a margin added on top of the base rate, to reflect the additional
reward required by the lender to compensate for the risk that the borrower might
default.
A commercial lender aims to charge interest rates on their portfolio of loans that
are low enough to be competitive with other lenders, yet high enough that it
receives enough interest income to cover its expenses and makes a profit. The
expenses of a commercial lender will include the interest it pays on its own debt
funding, which would normally be close to a risk-free rate for a healthy bank,
although this has not necessarily been the case since the global financial crash
that began in 2007. The expenses also include the running costs of the bank and
any write-offs of irrecoverable loans. In practice, the most difficult part of setting
the interest rate is judging how much risk premium to add, and historically this has
been a key role of banks: assessing the creditworthiness of individual borrowers
and setting appropriate interest rate margins to reflect this.
Interest rates on loans are therefore normally expressed as a base rate plus a
margin (e.g., three-month LIBOR plus 2%). Sometimes, the rate is a fixed rate (e.g.,
4%). However, even when the interest rate does not mention a base rate, it will
have been determined by reference to the relevant risk-free rate and a margin to
reflect the risk that the lender might default. In practice, applying the arm’s length
test to an intragroup interest rate should therefore be carried out by considering
the two components: the arm’s length base rate and the arm’s length margin.

The arm’s length base rate
The base rate that is appropriate for a particular loan will vary according to a
number of factors, the key ones being:
• The currency in which the loan is made
• The term of the loan
• Whether the loan has a fixed rate or a floating rate
• The date the loan was made
Currency
Base rates vary according to the currency of the loan. This is because there is
normally a central bank which controls the base rate for a particular currency and
each central bank sets the rates according to priorities that are usually set for it by
the government that issues the currency and in reaction to the macroeconomic
circumstances of that particular currency. For instance, interest rates on US dollar
loans are affected by interest rate decisions made by the US Federal Reserve,
interest rates on British Pounds are affected by the lending rate at which the Bank
of England is willing to lend to UK banks and interest rates on euros are effectively
determined by decisions by the European Central Bank about its lending rate to
banks.
If we take the second quarter of 2013 as an illustration, the central bank rates for
Pounds and Euros was 0.5% and for US dollars, 0.25%, because the US, UK and
Eurozone economies were in or close to recession and interest rates were being
held at historic record lows in the hope of stimulating economic growth. In
contrast, many emerging market economies were booming and their central
banks were using higher interest rates to dampen unsustainable growth and
control inflation. For instance, the Indian Central Bank rate for Rupees was 7.25% at
this time.
The country of the borrower or of the lender is not necessarily the same thing as
the currency of the loan. What matters is the currency.
 Illustration 1
If an Argentinian company borrows a loan denominated in US dollars, the relevant

base rate is the base rate for US dollars. If there is a greater risk of default by an
Argentinian borrower than an otherwise equivalent US borrower, this should be
taken into account in the margin.
In practice, there are a number of alternatives that can be used as the base rate
for a currency. One option is the central bank rate, which is the rate at which the
central bank announces it is willing to lend to banks. This is normally what is referred
to as the repo rate.
Another option is the interbank rate, which is the rate at which banks are lending
to one another. This is usually determined using daily surveys of banks, which result
in rates such as LIBOR (the London Inter-Bank Offer Rate) which is the average of
rates reported by a panel of London banks. It should be noted that there are
LIBOR rates for many different currencies, not just British Pounds. For instance, there
is a Euro LIBOR rate, which is normally almost exactly the same as EURIBOR, which is
the equivalent for European banks lending in Euros. Historically, most commercial
loans have used the relevant LIBOR rate as the base rate.

It would normally be expected that the LIBOR rate would be almost exactly the
same as the relevant central bank rate, because the interbank rate would
normally be considered to be a risk-free rate. However, at times when there are
concerns about the financial health of banks, such as we have experienced since
2007, the interbank rate can sometimes be considerably higher than the central
bank rate.
Term of the loan
It is generally the case that base rates vary depending on the term of the loan: the
length of time before the loan is due for repayment. Ordinarily, base rates tend to
be higher the longer the term of the loan, because there is a premium to the
lender for committing to make the money available for a longer period. However,
this general tendency can at times be overridden by other factors, such as
expectations about how short-term interest rates will change in the long term. If
short-term interest rates are currently high, but there is an expectation that they will
fall, then the interest rate for a long-term loan might be lower than for a short-term
loan.
LIBOR rates are available for a variety of loan terms up to 12 months. For loans
longer than this, it is common to use interbank swap rates as the relevant base
rate.
Fixed/floating rate
Commercial loans will either have a floating rate of interest or a fixed rate of
interest. A floating rate usually means that there is a fixed margin, but there will be
a floating base rate which reflects changes in the base rate in question. For
instance, if the base rate is defined as three-month sterling LIBOR, it will fluctuate
accordingly, reflecting changes in LIBOR. This will be to the benefit of the borrower
if the base rate falls over the term of the loan, but if the base rate rises the
borrower will find itself paying more interest.
The alternative is a fixed rate, which means that the interest paid will remain the
same over the course of the loan. Borrowers often have the choice of whether to
borrow at floating or fixed rates, so they decide which they prefer depending on
their views about whether floating rates are likely to rise or fall and depending also
on their willingness to take a risk.
It is therefore important to be absolutely clear whether the intragroup loan has a

fixed or floating rate and this should be matched when selecting the relevant
base rate. For instance, if the intragroup loan is a fixed five-year loan, the relevant
base rate would be the interbank rate for five-year maturity (and, as mentioned
above, this would probably be determined using the rate for a five-year interbank
swap). If the loan is a five-year floating rate loan with the interest rate reset once a
quarter, the relevant base rate would be three-month LIBOR.
The date the loan was made
All three of the factors discussed above (currency, term, and fixed/floating) vary
over time. Therefore, in order to determine the appropriate base rate percentage,
it is necessary to match the currency and term as at the date that the loan was
made. If the loan is floating rate, then it is necessary to continue to do this
matching at each date that the interest rate is reset.
Sources of this information include information providers such as Bloomberg and

the Financial Times and official websites such as the website of the relevant central
bank, finance ministry or tax authority.

The interest rate margin
It is usually relatively straightforward to determine the arm’s length base rate.

Determining the arm’s length interest rate margin is often more challenging,
because it is more subjective.
What is required is to determine the interest rate margin that would have been
agreed between the lender and borrower in an uncontrolled transaction. It will
often be the case that the lender in an intragroup transaction is not a bank and is
not in the business of making loans; it is generally accepted that this should be
disregarded in determining the arm’s length interest rate margin. It is difficult to
justify having a higher interest rate margin on the grounds that the lender is not in
business to make loans and would therefore require an extra reward in order to
make it worthwhile to go to the bother of making a loan to an unrelated party.
The interest rate margin should, in broad terms, reflect two key factors: the
creditworthiness of the borrower and the macroeconomic conditions affecting
credit spreads.
Creditworthiness
For an intragroup loan the creditworthiness of the borrower is of course irrelevant,

because it is unlikely that the borrower would be allowed by the group to default.
However, under the arm’s length test it is necessary to disregard this and consider
how the lender would have viewed the borrower if they were unrelated.
There is a very wide range of factors that potentially affect the creditworthiness of
a borrower, including the following:
• Collateral given by the borrower
• Security given by the borrower
• Asset backing for the loan. Companies with large amounts of assets that could
be sold in order to repay the loan if necessary, such as those with large
property portfolios, will generally be considered more creditworthy than
companies with proportionally fewer such assets, such as most companies in
the business of providing services.
• The level of other loans taken out by the borrower. The higher the total amount
of debt of the borrower, the greater the risk that the borrower might have
insufficient cash flow to service all the debt and, in due course, repay the debt
at maturity.
• The ranking of the debt. "Senior" debt is usually considered to be less risky,
because the loan agreement entitles it to be repaid first, in preference to
other debt, if the borrower is unable to repay all of its debt. Debt that ranks
behind senior debt is referred to as junior debt, or mezzanine debt, or
subordinated debt.
• Gearing/leverage. Gearing (referred to in the US as leverage) is a measure of

the proportionate level of total debt relative to the equity capital of the
business. Equity reduces the risk of the lender, because if the borrower makes
a loss this reduces equity first of all, and there would only be any default on the
debt once the equity had been reduced to zero. Therefore, the higher the
proportion of equity, the lower the lending risk.

• Interest cover. Interest cover is a measure of the size of the interest burden
(and sometimes the repayments) as a proportion of the profits out of which
the interest will be paid. The more that the profits exceed the interest burden,
the lower the risk that if profits decline they will be insufficient to continue
servicing the loan.
• Cashflow. Interest is paid with cash, not with profits, so, strictly speaking, it is
better to measure interest cover using cash flow, but in practice EBIT (earnings
before interest and tax) is often used as a proxy. Sometimes, EBITDA (earnings
before interest, tax, depreciation and amortisation) is used as a halfway house
between profit and cash flow. Cash flow forecasts are sometimes used to test
whether the borrower is likely to be able to service the loan.
• Covenants. Commercial loan agreements often include covenants:

commitments by the borrower which help to protect the lender. For instance,
it is common to have covenants that the borrower will ensure that gearing
does not exceed a certain level or that interest cover will not fall below a
certain level. The loan agreement usually provides remedies for breaching the
covenants. For instance, the lender might have the right to demand early
repayment of the loan or to prevent the borrower from paying dividends or
taking out additional debt or incurring expenditure above certain levels.
• Guarantees. If a loan has been guaranteed by a guarantor, the guarantor is

promising to remedy any default by the borrower. This therefore reduces the
risk for the lender and the degree of reduction depends on the
creditworthiness of the guarantor.
• Business risks and volatility. Some businesses are inherently highly risky and
therefore lending to them is highly risky.
• Track record. Commercial lenders will often take into account whether a
borrower has shown a successful track record of servicing and repaying earlier
loans.
• Purpose of the debt and business plan. Commercial lenders will often want to
assess the chances of success of the purpose for which the debt is being
borrowed.
• Industry prospects. Certain industries will be perceived by commercial lenders

as being highly profitable and/or likely to experience considerable future
growth, whereas other industries might be perceived as being characterised
by thin margins and decline.
Macroeconomic conditions
The macroeconomic conditions that should be considered include the following:
• Market sentiment. As we have just seen over the last decade, commercial
lenders do change their views about the level of interest rate margin that they
expect/require for a given level of creditworthiness. During the credit boom
seen in Western economies in the years 2004-2007, banks were keen to lend
and interest rate margins fell. The subsequent crash saw the "animal spirits"
(Keynes 1936; collective optimism and pessimism) evaporate and banks
became extremely risk averse, so interest rate margins shot up. .
• Supply and demand for credit. This is closely linked with market sentiment,
although there are other factors that affect the supply and demand for credit,

including government intervention, such as the quantitative easing policies

used by many governments over the last few years. If supply rises, interest rates
for a given level of creditworthiness will fall, and vice versa.
• Country/region. The preceding two factors vary from country to country at

any one time. It is therefore important to consider the country in question.
Identifying these factors
It will be apparent that many of the above factors are not the sort of thing that
would normally be considered in a functional analysis or in a transfer pricing
analysis, so it is necessary to adapt the procedures of a normal transfer pricing
study to be appropriate when the study relates to an intragroup loan. In order to
understand the above factors, the study should examine or include some or all of
the following:
• Intragroup loan agreements
• Business plans of the borrower
• Forecast financial statements
• Financial modelling of loan servicing
• External loan agreements (of any group companies)
• Reports to external lenders
• Board papers
• Prospectuses issued by the group
• Interviews with the group Treasurer, CFO, operational managers
It will be apparent from the preceding discussion that carrying out a transfer
pricing study in relation to an intragroup loan requires different knowledge and
expertise than might be relevant for other transfer pricing analyses, and this should
be borne in mind in determining who will carry out the transfer pricing study.
Comparability data
As with any transfer pricing analysis, it will normally be necessary to obtain

comparability data to indicate what the interest rate margin would have been, on
an arm’s length basis, given the above comparability factors.
In some cases, the group might have loans to or from unrelated parties. Whether
or not these loans are comparable with the intragroup loan that is under
examination will depend on comparison of the factors described above.
However, it is relatively rare to be able to use this approach.
Another possible approach is to use commercial databases of loan agreements to

try to find comparable loans between unrelated parties. In some cases, there may
be surveys available which contain information (often anonymised) about interest
rates, for instance within a certain industry.
An approach that is sometimes used is to ask a bank to indicate what interest rate
it would have charged if it had been the lender. However, tax authorities are often
sceptical about this, because the bank may not necessarily have carried out

enough analysis in order to give a reliable indication of the right interest rate and
the bank might also have been influenced by the answer that the multinational
group is hoping to hear. For this reason, this approach is sometimes taken a step
further by asking the bank to carry out a formal loan review and issue a loan offer
approved by the bank's credit committee. Even in this case, it can be difficult to
satisfy a tax authority that the loan offer was genuine and is reliable evidence.
A further possible approach is to express the creditworthiness of the borrower as a

credit rating. It would be extremely expensive to pay one of the credit rating
agencies to carry out a full credit rating, but a more cost-effective approach is to
use proprietary software packages made available by the credit rating agencies
which will provide an estimate of the credit rating. This estimate is based on an
algorithm which reflects the correlation between various financial figures and
ratios and actual credit ratings given by the agency. Various information sources,
such as Bloomberg, can then be used to determine the interest rate margin that
corresponds with a given credit rating.
 Illustration 2
Acme Ship Brokers (ASB) is a company which carries on business as a ship broker,
arranging leases of cargo ships. It acquires a foreign company, Prestige Cargo
Ships (PCS), which owns a fleet of cargo ships and leases them. As part of the
acquisition it acquires the debt issued by PCS to its former owner. In order to fund
the acquisition it increases its own external borrowings and negotiates an interest
rate equal to base rate plus 4% margin. On the portion of this funding which it on-
lends to PCS, it charges a rate of base plus 5%, on the grounds that a profit of 1%
seems reasonable.
However, this approach disregards the creditworthiness of PCS. Let's assume that a
transfer pricing study is carried out and it is determined that the arm’s length
interest rate for PCS would be approximately base plus 2%. What rate should be
used? Should ASB on-lend at 2% lower than its own funding cost, or should PCS pay
more than its own creditworthiness would suggest? The answer would be highly
fact dependent, but let's assume that in this case it is established that the
creditworthiness of PCS is much stronger than that of ASB, because PCS has
significant asset backing in the form of its fleet of cargo ships, whereas ASB is asset-
poor. The arm’s length principle suggests that PCS should pay interest at base plus
2%.
The explanation for why this would be acceptable to ASB is as follows. Before
acquiring PCS, ASB was paying an interest rate margin of 5.5%. Because ASB owns
PCS, the interest rate that it pays on its external borrowings fell, to reflect the
creditworthiness of ASB itself and its investment in PCS, so the 4% margin is
effectively a blended rate which reflects the 2% margin that is appropriate for the
PCS business and the 5.5% rate for the ASB business. Therefore, on the portion of
the external debt which is used by ASB to fund its own business, ASB is benefiting
by paying 1.5% lower than it would be paying without PCS. The "loss" made by ASB
on the on-lending to PCS is therefore offset by the interest rate saving on its own
funding.
In other cases, the explanation might be that the loans are in different currencies
and/or for different terms and/or one is floating rate and one is fixed. For instance,
if the lender is borrowing in Euros and on-lending to its Japanese subsidiary in yen,
it might be expected that the interest rate paid by the Japanese subsidiary is lower
than the euro rate.

Similar principles lay behind a court decision in Finland in 2010. The case was an
appeal to the Finnish Supreme Administrative Court and the decision is known as
KHO:2010:73. A Finnish company replaced its external borrowings, on which it was
paying interest of a little over 3%, with an internal loan from a Swedish member of
the same group, on which the interest rate was 9.5%, reflecting the cost of external
funding of the group. The court confirmed that the price of external financing for
the group was not a relevant basis for determining the interest rate that should be
paid by the Finnish company, when, on a stand-alone basis, the borrower would
have received significantly better terms given its own credit rating and other
circumstances. The borrower's financial position had not deteriorated and the
Swedish lender was not providing any additional services that would have justified
a higher rate.
 Illustration 3
Global Oil is an oil company with many subsidiaries in a range of countries around
the world, some of which carry out oil exploration and extraction and others
operate petrol retailing businesses. The parent company makes loans to these
subsidiaries to fund their activities. It wishes to have a standard interest rate for all
intragroup loans, for the sake of simplicity and to avoid complaints by those group
companies that are paying higher rates than others.
A transfer pricing analysis is carried out and it is identified that there are significant
differences in the creditworthiness of the subsidiaries. The petrol retailing
subsidiaries are in a stable, reliable business and are highly creditworthy. The
exploration and extraction subsidiaries are engaged in highly risky activities. Any
exploration is always risky, because there is no assurance that oil or gas will be
found. Furthermore, the level of risk can be compounded by the country in which
the exploration is taking place, due to risks such as civil war, terrorism,
expropriation, natural disaster, and so on.
Global recognises that a one size fits all solution is not possible, but it is anxious not
to have 50 different interest rates. After further consideration, it realises that the
subsidiaries can be sorted into three categories, each of which will contain
companies that will have creditworthiness similar to one another. The first category
is the petrol retailers. The second category is the explorers in relatively benign
countries, such as the USA, where shale gas exploration is taking place. The third
category is the explorers in riskier countries, such as Libya. Analysis of each
category shows that although the creditworthiness of individual companies in the
category might vary a little, the arm’s length range of interest rate margins for
each of them has a degree of overlap, so a single interest rate margin can be
used for the whole category. Therefore, the group uses three interest rate margins.
13.3 Thin Capitalisation
Thin capitalisation (US spelling, capitalization) is a phrase used to describe a

situation where a borrower has an excessive amount of debt capital relative to its
equity capital.
The phrase is not just used within an international tax context. Any commercial
lender will want to determine whether a prospective borrower is thinly capitalised,
because this might indicate that it would be excessively risky to make further loans
to the prospective borrower.

Thin capitalisation for independent companies
Let's first consider how levels of debt capital and equity capital are determined for
an independent company. Most independent companies will need capital to
finance the net assets of the business and they have two broad options. They can
raise debt capital by borrowing money and paying interest on this. Or, they can
use equity capital, by issuing shares or by retaining profits in reserves.
Most independent companies choose a combination of both types of capital. The

difference is that debt ranks ahead of equity, so the company must give priority to
paying interest on the debt and to making repayments. Dividends on equity can
only be paid out of profits after deducting the interest expense. Equity capital is
not normally repaid, but it cannot be repaid if this would leave the company
unable to repay its debts. Equity therefore acts as a buffer reducing the risk for the
lenders, because any downturn in profitability will simply reduce the return for the
shareholders unless the downturn is so large that the company is unable to pay the
interest.
As a result, providing debt capital is less risky than providing equity capital, so the
rate of return required by a lender is lower than the rate of return required by a
shareholder. A further benefit is that the interest paid on debt capital is generally
tax deductible, whereas dividends paid on share capital are not tax-deductible,
so the net rate of return that the company must pay to the lender (the cost of
debt) is further reduced in comparison with the rate of return that the company
must pay to its shareholders (the cost of equity).
Most independent companies can therefore reduce their overall cost of capital by
including some debt capital. If the company is able to use the debt capital to
generate a return that is higher than the net cost of the debt, it generates an
incremental profit which therefore boosts the return to shareholders, which is the
mission of the company. However, as the proportion of debt capital increases, the
level of risk being taken by the lenders increases, because the buffer provided by
the equity capital is proportionately lower. Therefore, the rate of interest
demanded by the lender increases. In addition, the level of risk being taken by the
shareholders also increases, because any downturn in profit will be spread over a
smaller amount of equity capital and will therefore have a bigger proportionate
effect. Therefore, the rate of return expected by the shareholders increases and so
the share price falls.
Accordingly, for an independent company there are limitations to the proportion

of debt capital that it can sustain. There may be a point where the interest rate
that would have to be paid on an incremental amount of debt would be so high
that it has an adverse effect on the overall cost of capital or it would be
unacceptably risky because a downturn in profitability might mean that the
company is unable to meet the interest burden and therefore might go bust. This
would be a concern to both the potential lender and to the borrower.
Each lender and borrower must make its own subjective decision about whether
the proportion of debt has reached the point of being excessive, in which case
they will consider the borrower to be thinly capitalised. If they are excessively
cautious, they might be giving up profits that they could have made. If they are
excessively incautious, they might suffer losses or even endanger their businesses.
It is important to note that whether an independent borrower is thinly capitalised is

a subjective judgement. One lender might consider a company to be thinly
capitalised and therefore refuse to lend to it, whereas another lender might be
willing to make a loan.

Thin capitalisation on intragroup funding
The reason that many countries have thin capitalisation rules within their tax
legislation is that the same considerations might not apply to intra-group funding. If
a parent company already owns 100% shareholding in a subsidiary and the
subsidiary needs additional capital, the parent company has an incentive to
choose to provide the capital by way of an intragroup loan, because the interest
will be tax deductible for the subsidiary. If the subsidiary suffers a decline in
profitability and it is unable to pay the interest or perhaps even to repay the loan,
the parent company is no worse off than if it had injected the capital as equity.
Either way, the parent will suffer the full loss, so there isn't the same limitation on the
proportion of debt capital that there would be if the lender was not also the
shareholder (or associated with the shareholder).
It is therefore common for countries to have specific rules intended to ensure that
multinationals cannot reduce the profits payable by a group company by having
excessive debt levels in that company. There is a variety of ways in which these
rules might work, but they are, generically, all known as thin capitalisation rules.
Most countries choose to use a clear, fixed debt:equity threshold. Typically, the
threshold is that the ratio of debt:equity should not exceed 3:1 or, sometimes, 2:1.
For instance, Canada has a maximum debt:equity ratio of 2:1. As at the time of
writing, Australia uses 3:1, but is considering reducing this to 2:1.
In some countries, this is a firm limit and no deduction is allowed for interest on any
debt in excess of this ratio. In other countries, it is just a safe harbour, so no interest
deduction will be denied for reasons of thin capitalisation if the company is below
the threshold, but if the company exceeds the threshold it may still obtain a full
interest deduction if it can justify that its debt level is not greater than the arm’s
length amount. An example of the safe harbour approach would be China.
The other main approach is to restrict the amount of tax deductible interest to a
set proportion of the profits of the company, an approach often referred to as
earnings stripping rules. This approach is used, for instance, by Germany and Italy,
which restrict interest deductions to 30% of EBITDA. In some cases, any excess
interest can be carried forward and potentially offset in future years. This is the
approach used by the USA, which restricts interest deductions to 50% of taxable
income, but allows carry forward of the excess.
It is a grey area whether earnings stripping rules and thin capitalisation rules
involving fixed debt:equity ratios are transfer pricing rules at all. Arguably, fixed
limits are not consistent with the arm’s length principle, because the arm’s length
level of debt will vary for different independent borrowers. Therefore, some
countries use a different approach, which is to use the arm’s length principle as an
explicit test. That is, they require the transfer pricing analysis to consider not only
whether the interest rate on intragroup loans meets the arm’s length test, but also
whether the quantum of debt exceeds the arm’s length level of debt. This is the
approach used, for instance, by the UK, which deals with thin capitalisation within
its transfer pricing rules.
The UK has introduced Advance Thin Capitalisation Agreements, which are

unilateral Advance Pricing Agreements specifically to give certainty to tax payers
in relation to thin capitalisation. These are usually expressed by setting out limits on
the level of debt, below which the UK tax authorities accept that the taxpayer is
not thinly capitalised. The limits are usually expressed in terms of a limit on debt as
a proportion of capital and there may also be other limits in relation to interest
cover and sometimes a ratio such as debt/EBITDA.

Consistency with OECD principles
Although few countries apply the arm’s length test to the quantum of the debt,
this is a concept recognised by the OECD Transfer Pricing Guidelines. Paragraph
1.37 of the pre-2010 version of Chapter I of the Guidelines explains that one of the
limited circumstances in which it would be appropriate and legitimate for a tax
authority to consider disregarding the structure adopted by a taxpayer in entering
into a controlled transaction is when the economic substance of a transaction
differs from its form. It says that:
"…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."
Determining an arm’s length debt level
In cases where legislation requires a restriction on interest deductibility for interest

on debt in excess of an arm’s length amount of debt, the common approach is to
use an analysis similar to the one described above for examining the
creditworthiness of the borrower. It is necessary to determine how much the
borrower could have borrowed on a stand-alone basis. The comparability factors
listed in the section on credit worthiness above should be considered in order to
determine how much debt would be appropriate and viable for the borrower if it
were an independent company.
Experience in the UK suggests that there is no such thing as a standard answer.

Some industries tend to have high levels of debt, and some do not. For one
company, a 9:1 debt equity ratio might comply with the arm’s length test, whereas
for another company it might be difficult to justify debt of 1:1. For instance,
property investment companies tend to need high levels of debt to finance their
acquisitions and banks are willing to lend at high levels because the property is
available as security for the loan. In contrast, many businesses that provide
services have few assets that could be sold to repay a loan, so they tend to have
lower levels of debt. However, they may also have high levels of profitability and
so they may have strong cash flow to use to service loan interest and repayments.
Historically, it was known that the UK tax authority had an internal "rule of thumb"
under which it was relatively unlikely that they would challenge the debt levels of
UK subsidiaries if they had lower than 1:1 debt equity ratio, but debt levels above
this were more likely to receive scrutiny. A second indicator was that scrutiny was
more likely if interest cover (profits divided by interest expense) was lower than
three. However, although these figures were never intended to be anything more
than a broad guideline, they were sometimes taken by taxpayers and even some
tax inspectors to be safe harbours, so they have now been fully repudiated.
The UK tax authorities insist that it is necessary to consider not only the question of
how much the company could have borrowed from independent lenders, but
also how much the company would have been likely to wish to borrow (which
might be lower than the amount they could have borrowed).
It should be noted that in some countries thin capitalisation is considered to give

rise to a deemed distribution, on the grounds that the "interest" is in substance a
distribution of profits. The consequence is that the excess interest is not deductible
against profits and/or it may be subject to withholding tax, unless withholding tax

on dividends is restricted by the relevant double tax agreement or restricted for

some other reason such as the European Union Parent Subsidiary Directive.
One potential approach is to use estimated credit ratings to indicate whether a

given level of debt will go beyond acceptable levels. However, this approach
requires making a judgement about what credit rating would be acceptable to
the borrower and its lenders on an arm's-length basis. Many tax authorities might
argue that a B rating would indicate an unacceptably high level of debt, because
it is well into junk bond territory, but the counterargument would be that a large
proportion of bonds issued by companies are rated as B and in many cases the
bonds were issued with this intention. It is therefore necessary to understand why
some companies choose to issue junk bonds whereas others take great care for
their debt to remain investment-grade.
 Illustration 4
K9 is a company in the North American country of Columbiana. It carries on

business manufacturing dog food and dog care products in Columbiana and
selling these products in its home market and through distributors in other countries.
Most distributors are independent, but it distributes in the European country of
Albion through its subsidiary, K9 Albion. One of its competitors, Clean Paws, falls
upon hard times and K9 takes the opportunity to grow its business by acquiring
Clean Paws.
Clean Paws is comprised of two companies, one located in the South Pacific
country of Ockerland and the other located in Albion. Each company
manufactures dog food and dog care products and sells them in its region. Both
companies are directly owned by a private equity fund, but are operated as an
integrated multinational business. K9 negotiates a price of $300 million, split
equally between the two companies. To fund the acquisition it borrows $200
million from a bank, on condition that the loan will be secured by a first charge on
the shares and assets of the acquired business.
In order to acquire Clean Paws Ockerland, K9 incorporates a wholly-owned

subsidiary in Ockerland which makes the acquisition. It lends $100 million to this
subsidiary and injects $50 million of share capital. Ockerland has a thin
capitalisation rule based on a fixed debt:equity threshold of 3:1. As K9 Ockerland
debt is equal to twice its equity, it is below this threshold and so it will not be
denied a deduction for interest on any of the loan. (Assume that the interest rate
meets the arm’s length test.)
The acquisition of Clean Paws Albion is carried out by K9 Albion and again K9
wishes to fund this by providing $100 million of debt capital and $50 million of share
capital. These capital increases will leave K9 Albion with $130 million of debt
capital and $55 million of share capital, which is a debt:equity ratio of 2.36:1.
Albion considers thin capitalisation to be a transfer pricing issue and includes in its
transfer pricing rules provisions that will deny a deduction for any interest on debt
to the extent that it exceeds the debt that would have been borrowed if K9 Albion
had been borrowing on an arm’s length basis.
Albion operates a system whereby it is willing to negotiate in advance of

acquistions APAs in relation to thin capitalisation. K9 wishes to have certainty
about the deductibility of interest on the debt, so a thin capitalisation APA is
applied for. In support of the desired debt level, it submits a transfer pricing analysis
which identifies independent companies that are comparable to K9 Albion (taking
into account its investment in Clean Paws Albion) and demonstrates that they

have debt:equity ratios of between 1.5:1 and 2.5:1. It argues that this demonstrates
that the desired level of debt is not excessive.
However, the Albion tax authority argues that it is also important to consider
interest cover. It calculates that the interest cover (EBITDA divided by interest
expense) of the comparable independent companies ranges between 3.25 and
5.3. In contrast, using the profit and loss account of K9 Albion (including notional
consolidation of the P & L of Clean Paws Albion) it calculates that interest cover
with the new level of debt will be 2.4, so it argues that K9 Albion will be thinly
capitalised and the arm’s length level of debt should be determined on the basis
of the level of debt that will give interest cover of at least 3.25.
Considerable debate ensues, with K9 Albion presenting detailed cash flow

forecasts showing that it will be able to service the full amount of debt quite
comfortably. However, the Albion tax authorities raise concerns that the forecasts
might be overoptimistic and so they insist that they will not approve the full amount
of debt.
Time is running out to agree the APA before the acquisition date, but swings in the
value of the Albion currency versus the Columbiana dollar mean that the $150
million of new capital that is to be provided by K9 will not quite be sufficient to
carry out the acquisition. Another $10 million of capital is needed and there is
insufficient time for K9 to negotiate an additional loan facility from its external
bank. Instead, K9 Albion approaches a local bank, which agrees to lend the
additional money despite the fact that the Columbiana bank will have a first
charge over the shares of Clean Paws Albion.
It is realised that this provides strong evidence that the arm’s length level of debt
for K9 Albion must be at least $110 million, because the top-up loan of $10 million is
an arm’s length loan and is in addition to the intragroup loan. This evidence is
presented to the Albion tax authorities and, after making enquiries to verify that
the top-up loan is not, in any way, guaranteed or otherwise supported by K9, they
agree to give clearance for the full amount of debt.
Interaction with interest rates
It should be noted that thin capitalisation and interest rates interact with each
other. The higher the debt level, the higher the interest rate, so increasing the level
of debt can have a double effect on the amount of interest, because interest is
payable on a larger amount of debt and the interest rate to be paid is also higher.
This interaction gives rise to a strange hybrid approach to thin capitalisation in

Australia. Australia has a fixed debt:equity threshold of 3:1. This necessarily means
that in some cases the debt will be higher than it would have been on an arm’s
length basis and yet because it is lower than 3:1, interest on all of the debt will be
deductible under the thin capitalisation rules. The Australian Tax Office takes the
view, however, that in determining the appropriate interest rate the actual
amount of debt should be disregarded and the interest rate should be determined
on the basis of the rate that would have applied on an arm’s length basis if the
debt had been no higher than the arm’s length amount of debt. Other countries
may raise the same argument, but Australia has issued a formal ruling setting out
this policy.
Thin capitalisation on third-party loans
Different countries take different approaches to whether thin capitalisation rules

should apply in cases where the group company has borrowed from an
independent lender. On the face of it, the debt should, by definition, be arm’s

length. However, there can be situations where the debt exceeds an arm’s length
amount, for instance where another group company has given a guarantee to
the lender, without which the lender would not have been willing to lend as much
as it has lent. A variation on this would be a back-to-back loan, where a group
company has lent money to the bank and then the bank has lent a similar amount
to another group company and this amount is greater than it would have lent to
that other group company on a stand-alone basis.
Such situations may not always be caught by thin capitalisation rules; it depends
on the specific wording of the rules. The UK, for instance, has included specific
wording in its transfer pricing legislation to ensure that thin capitalisation rules apply
to external debt in cases where the amount lent has been increased as a result of
a guarantee or other support from another group company.
See also the further comments in 13.5 regarding guarantee fees.
Definitions of debt, equity and interest cover
Whether applying a fixed threshold or the arm’s length test, it is important to use an
appropriate definition of relevant financial figures, such as debt, equity and
interest cover. Some countries set out specific definitions in their thin capitalisation
legislation or in rulings/guidance, whereas others rely on general principles.
Often, it is obvious what counts as debt and equity, but there are some grey areas,
such as preference shares, which have some characteristics of debt and some
characteristics of equity. Another grey area is debt-like instruments such as finance
leases. And should the debt be net of cash deposits?
Similarly, it is important to be clear about the definition of interest cover. It is usually

based around dividing profits or cash flow by interest, but should the profits be EBIT
or EBITDA? Or should it be free cash flow? And should the interest be the gross
interest expense or should it be net of interest income?
13.4 Interest-free loans
An issue that arises from time to time is that a group wishes to make an interest-free
intragroup loan. For instance, the group might prefer not to label an injection of
capital as being equity, for instance due to regulatory restrictions or exchange
controls.
On the face of it, an interest-free loan would not be acceptable under the arm’s
length principle, because an independent lender would not normally be willing to
lend at an interest rate of 0%. However, in certain limited circumstances it may be
possible to justify an interest-free loan, on the grounds that the loan is in substance
fulfilling an equity function and therefore it is not appropriate to require there to be
interest. This is, in effect, a reverse application of the principle underlying thin
capitalisation rules.
This is, for instance, an argument that, in principle, is accepted by the UK tax
authorities, provided it can be shown that the loan is, in substance, equity. For
instance, it is helpful to be able to show that the borrower could not have
obtained loan finance from independent lenders if it were an independent
company. The UK tax authorities are usually only willing to accept this argument
where there is clear evidence that the loan is intended to remain in place in the
long term, because equity is rarely used for short-term funding.

13.5 Guarantee fees
Another issue that often arises in relation to loans is guarantee fees. If a loan to a
company is guaranteed by another company in the same group, this can reduce
the lending risk for the lender, because the guarantor is agreeing that it will meet
the liabilities of the borrower if the borrower defaults. Therefore, the lender will only
suffer a loss on the loan if the borrower defaults and the guarantor also defaults.
The borrower is effectively "piggybacking" on the credit rating of the guarantor. As
this is a clear benefit for the borrower, it would normally be expected that it should
pay a guarantee fee to the guarantor.
Determining the arm’s length guarantee fee is often not easy, but a key part of the
analysis is determining the benefit gained by the borrower, because clearly the
guarantee fee should not exceed the benefit gained. In practice, the guarantee
fee is normally set to be lower than the benefit, so that both the guarantor and the
borrower benefit from the transaction. It is often difficult to determine exactly how
the benefit should be split, but the decision should be based on the relative
bargaining power of the two parties.
In order to determine the benefit gained by the borrower from the guarantee, it is
first necessary to understand the nature of the benefit. In some cases, the
guarantee simply has the result that the interest rate is lower than it would have
been without the guarantee, because the lender has lower lending risk. If so, then
the benefit is the interest rate differential. A common approach to determining this
is to carry out a transfer pricing analysis to determine the interest rate that would
have been paid by the borrower on a stand-alone basis (using the approach
outlined earlier in this chapter) and compare this with the actual interest rate
being paid. If the guarantee relates to an intragroup loan, it may be necessary to
do another analysis to determine the arm’s length interest rate taking into account
the support from the guarantor.
As discussed in the preceding chapter regarding intragroup services, it may also

be necessary to exclude the portion of the benefit that would have arisen from a
passive guarantee. This is because of a legal decision involving the Canadian
subsidiary of GE Capital. It is clearly stated in the OECD Guidelines that where a
benefit is derived by a group company from mere passive association with the rest
of the group, this does not justify any fee being charged for this benefit. The
Guidelines give an example where it is perceived that there is an implicit
guarantee by the group and therefore a group company is able to borrow at
lower interest rates than it might if it were a stand-alone company. They make
clear, however, that where the benefit is brought about by specific action by
another group company, such as giving an explicit guarantee, this is a service for
which a fee should be expected.
The Canadian judgement takes this principle a step further by saying that even
where an explicit legally-binding guarantee has been given it is still necessary to
determine the benefit gained from this guarantee by comparing the actual
interest rate paid by the borrower with the rate that it would have paid if there
had been no explicit guarantee, but the borrower was still a member of the group
and therefore would potentially still benefit from an implicit guarantee. In other
words, the Canadian judgement says that the benefit of the explicit guarantee
should not be determined by comparing with the interest rate that would have
been paid by the borrower if it was a stand-alone entity. This is a controversial view
and would not necessarily be agreed with in other countries.
However, in some cases, the guarantee might also have induced the lender to
lend a higher amount than it would have lent to the borrower on a stand-alone

basis. Therefore, thin capitalisation issues might also arise, although this will depend
on the wording of the relevant thin capitalisation legislation. In the UK, thin
capitalisation is dealt with under the transfer pricing rules and guaranteed loans
are specifically caught. The UK approach is that the borrower should only be
entitled to an interest deduction for the interest on the portion of the loan that it
could have borrowed on a stand-alone basis. Accordingly, it would only make
sense for the guarantee fee to reflect the benefit from the reduced interest rate.
The guarantor might be entitled to a deduction for the rest of the interest, if it is UK
company, as the UK rules allow for a guarantor to be treated as if were the
borrower in respect of disallowed interest.
However, an alternative approach would be that the borrower should be entitled

to a deduction for the interest on the extra debt that it was only able to borrow
because of the guarantee, provided it can be shown that a similar guarantee
would have been available on an arm’s length basis. If so, then determining the
benefit to the borrower would be more complicated, because part of the benefit
is being able to borrow more than it could otherwise have borrowed.
BEPS action plan and interest deductions
In the BEPS (Base Erosion and Profit Shifting) action plan released in July 2013,
interest deductions and other financial payments are targeted as an area that
needs a coordinated approach (Action 4). The work will look at financial and
performance guarantees, derivatives, captive and other insurance arrangements.
The work is to be coordinated with that on hybrids and CFC rules. The action plan
states that the aim is to develop changes to the transfer pricing guidelines by
December 2015.
13.6 Captive Insurance
A number of multinational groups have implemented self-insurance arrangements

under which the group decides that it will no longer obtain external insurance for
certain risks.
Insurance companies work on the basis that although it is difficult to forecast

whether any individual insured party will suffer a loss, statistical analysis allows the
insurance company to anticipate the average loss of a portfolio of similar risks with
much greater certainty. The insurance company therefore sets an insurance
premium that reflects the average likely loss per insured party, plus running costs,
plus a profit margin for the insurance company. The benefit for the insured party is
that they are exchanging the risk of the full loss for the certainty of paying a much
smaller amount as an insurance premium. However, if a (non-insurance) group has
a wide range of group members which each have the same risks, then the group
can also benefit from this portfolio effect.
For instance, an individual company with a single factory probably could not
afford to take the risk that, say, a fire might damage the factory and prevent
production, because the losses could be proportionately very high. However, if the
group has many such factories around the world, the group as a whole might
have sufficient resources to be able to bear the costs of such a loss, because it
would be low in proportion to the group. So it might make no sense to obtain
external insurance for each factory, because this will mean that on average the
group is paying a profit margin to the insurance companies on top of the statistical
average cost of losses.
In order to prevent the results of any individual group company being distorted by
a loss, it is common to have a group company which will act as the internal insurer

for the group, writing insurance policies for the other group members and
collecting premiums from them. These are known as captive insurance
companies. In some cases, the captive insurer will enter into reinsurance contracts
with other group members, under which the group member self insures, but part of
the risk is re-insured. Having centralised the risk in the captive insurer, the group
may sometimes decide to reinsure some of the risk externally, just as an
independent insurance company might choose to do. The captive insurer will
often be staffed with suitable staff to make these judgements.
Although the specific facts surrounding this intragroup service are different from
other kinds of services, the transfer pricing issues are generically similar to the issues
for other services. One must do the functional analysis, then look for comparability
data.
Tax authorities are sometimes sceptical about a CUP approach under which the
captive insurer charges insurance premiums in the same way that an independent
insurance company might do. They sometimes argue that the captive insurer
should not be viewed as taking the same risks as an independent insurance
company and a small cost plus-type reward on the captive insurer's own running
costs would be more appropriate. The correct position will depend on a very
careful analysis of the facts.
An example of this sort of argument is the 2009 UK case, DSG Retail Ltd & Others v
HMRC. This related to a captive insurer in the Isle of Man which insured (in some
years, reinsured) extended warranties sold to customers in a chain of electrical
retail shops in the UK. DSG based the premiums on what it considered to be
comparable uncontrolled transactions, being the premiums charged by
independent companies that provide extended warranties.
The Special Commissioners (the name then given to the lowest level of court for
tax cases) decided that the premiums charged by independent extended
warranty providers were not comparable, because they found that the bargaining
power was different. They took the view that if the UK retailer had been
negotiating with an independent extended warranty provider the UK retailer
would have had most of the bargaining power because the best opportunity to
sell an extended warranty to someone who has just bought, say, a television is to
sell the warranty whilst the customer is standing at the cash till, paying for the
television. They accepted evidence that the extended warranty providers
generally sold their extended warranties via the product manufacturer and they
considered that the balance of bargaining power would be different in this
circumstance. (This point appears to be crucial in the decision, but the case report
does not explain in any detail whether this distinction was just an assertion that was
accepted or there was hard evidence that there is indeed a difference in
bargaining power.) They also found as a matter of fact that the risks involved in
writing large numbers of extended warranties are low, because the claims cost
does not fluctuate much from year to year.
They concluded that on an arm’s length basis the UK retailer would have
negotiated a deal under which the insurer received just a small return on its capital
and the remainder of any profit from the extended warranties would be made by
the UK retailer. This effectively meant that it was held that the arm’s length level of
premium was far lower than the actual premiums paid.

13.7 Financial services businesses
Up to this point, this chapter has considered transfer pricing issues that apply
regardless of the business carried on by the group. Loans arise within groups that
manufacture automobile parts, or that provide legal services, or that design and
sell software, just as much as they arise within banking groups.
Carrying out transfer pricing analysis for financial services businesses such as banks,
insurance companies and asset management companies can be challenging,
but this is primarily because these businesses can be very complex and difficult to
understand. It is not the purpose of this chapter to attempt to explain the nature of
these businesses. By and large, the transfer pricing issues are not that different from
the issues that arise for other types of business, and so there is no need for special
discussion here.
For instance, within an asset management group it is likely that there will be
companies responsible for selling the product of the group (which in this case
happens to be investment funds), but the transfer pricing issues are much the
same as those which arise with a distributor of goods. Similarly, there will probably
be intragroup loans and there might be royalties for the use of, say, the group
brand name, but again the transfer pricing issues will be generic. Even if the
transaction is unique to asset management, such as subcontracting the
investment advisory function to a subsidiary in another country, the issues are the
same as with services in other industries. A functional analysis should be performed
and it should be determined whether there are comparable uncontrolled
transactions and if not, it may be necessary to use a database search for
comparable companies or a profit split approach.
There is, however, one relatively unusual characteristic of transfer pricing for banks
and insurance companies, which is that these businesses typically operate through
branches rather than subsidiaries. One of the main reasons for this is that these
businesses are heavily regulated in terms of their equity capital, because it is
important that there is sufficient equity capital to absorb potential losses.
Operating through branches means that the branch can use the capital of the
company of which it is part, and this is generally a much more efficient way to use
the capital of the company rather than parcelling it out amongst subsidiaries.
(Following the global financial crash in 2007 and 2008, governments are
considering changing rules so that local banking operations are ring fenced, in
which case the situation regarding capital might change, but branch structures
are currently common.)
As explained in greater detail in a later chapter when we look at permanent

establishments, this means that in determining the profits attributable to a branch it
is necessary to attribute debt and equity to the branch, based on the assets and
risks that it would have if it were a separate enterprise. Detailed commentary on
attribution of profits in the context of banking, global trading and insurance is
available in the OECD Report on the Attribution of Profits to Permanent
Establishments (the final version of which was released in 2010).

CHAPTER 14
SPECIFIC TRANSACTIONS: INTANGIBLE PROPERTY
In this chapter we will look at transfer pricing in relation to Intangible Property (IP), in
particular:
– the life cycle of intangibles;
– development of IP;
– OECD Guidelines and Cost Contribution Agreements (CCA);
– case law and cost sharing arrangements;
– exploiting IP Principal Structure v Licensing Out;
– valuation of IP;
– case law on valuation of IP;
– OECD latest developments.
14.1 Introduction
“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.” (OECD 2010 Transfer Pricing Guidelines Chapter VI, 6.2).
Intangible property (“IP”) has been at the centre of several debates and court
cases in recent years. The increasing attention of tax authorities on IP is mainly due
to IP gaining more and more value as part of large multinationals asset base.
Globalisation and increasing competition have led large MNEs to work harder on
differentiating themselves from the competition and investing more in IP to
achieve the required competitive advantage.
As a result, ensuring that intra-group transactions involving IP are thoroughly

planned and priced is key in minimising the risk of tax adjustments and penalties in
case of non-arm's length results.
Among the transfer pricing transactions of MNE Groups, IP transfer prices are the
most significant and susceptible to manipulation. This is a result of IP's high value
and mobility and the complexity of IP-related issues. IP carries high value because
it often produces or has the potential to boost profitability as it provides the MNE
with a competitive advantage. Given that IP is an intangible asset without physical
presence, it is easily transferable from one country to another. IP-related financial
issues exist in commercial practices, valuation, and accounting as well as in
attribution of income for tax purposes.
For example, MNE Groups often attribute research and development (R&D)
expenses to higher-tax countries which provide immediate expensing of these R&D
costs. However, in reality, the R&D costs of producing IP may be widely dispersed
among related entities. Subsequent transfer prices charged through royalty fees to
affiliate MNEs often fail to adequately adjust for the real risk premium assumed for
the original development of the IP. In other situations, to increase deductions in a
higher-tax country, the MNE Group might impose higher transfer prices on a
related MNE operating in a lower-tax country. This shift is made possible by service
charges, royalties paid to the owner or licensor of the IP, or through cost-sharing
arrangements.

As international business has become more complex and integrated, IP has

become immensely important. MNE Groups are sometimes able to generate
substantial royalties from an external party through a license of IP. The value of
patents and other IP can be as high as 70% of the value of the average MNE
Group. IP subject to transfer pricing is generally more broadly defined than
traditional IP.
Four key areas should be mentioned to understand the transfer pricing implications
for patents and other IP. The first area is the common commercial practice of
selling a patent not individually, but together with a group of patents and
combined with other IP. Secondly, the difficulty in establishing the value of IP. Then
it is the current financial accounting standards and issues in describing the IP
assets. Lastly it is the allocation of all related expenses for the development of IP.
14.2 The Life Cycle of intangibles
When it comes to tangible assets it is easy to see their life cycle for a company.
Normally it begins when they are bought, then they are used, accounted for and
depreciated then normally the final step will be their sale. Intangibles also have a
life cycle. Generally we can identify similar stages for an intangible as a tangible
asset. To begin with they will either be bought or developed, they will then need to
be recorded and a valuation arrived at. The intangible will then be used in the
business and where appropriate amortised. Finally it will expire or be sold.
14.3 Development of IP
As noted above IP is a moveable asset that provides opportunities for tax planning
right from the start. There are two main ways that IP can be developed - via
contract R&D agreements or via cost sharing agreements.

Contract R&D
The typical scenario will be that the MNE will set up a separate entity to provide
the contract R&D services. The MNE will often concentrate R&D into a few
locations as this helps to increase efficiency and keep down cost. However where
the plan is that the benefits of the R&D will remain with the principal (normally
located in a low tax territory) the tax authorities will look carefully at the
arrangement. A third party contract R&D provider would have a contract and
hence it is important that there is a contract to support the in-house contract R&D
arrangement. Ownership of IP is a complex legal subject. In some jurisdictions it will
belong to the person who develops it – so this is a key aspect of the contract with
the contract R&D provider. Control is another area that the tax authorities will look
at closely. Many tax authorities would expect the principal to retain some control
of the development of the R&D for there to be a true R&D contract relationship.
← Payment – royalty
PRINCIPAL
Licence
↑ ↓
Payment for
Contract R&D
contract IP Users
services
R&D
↓
CONTRACT
R&D PROVIDER
Cost Sharing/Cost Contribution Arrangements
Cost sharing arrangements/cost contribution agreements is another way to

centralise development of IP. Again it offers commercial advantages of efficiency
and cost saving equally it can offer tax benefits as well. The participants in a cost
contribution arrangement will agree to share the cost of development and the
costs contributed by each participant are normally proportionate to the benefits
they expect to receive in the future. Problems can arise when participants leave
the arrangement and if new participants join at a later date. Tax authorities will
expect to see buy in and in some cases buy out sums being paid.
R&D
↑ Costs
Benefits ↓
COMPANY A COMPANY B COMPANY C
14.4 OECD Guidelines and Cost Contribution Agreements (CCA)
Chapter VIII of the OECD 2010 Transfer Pricing Guidelines sets down the OECD view
on cost contribution agreements. The OECD recognise that cost contribution
agreements can be used in other contexts not just for IP development. A cost
contribution agreement will meet the arm's length principle if the participants

share of the cost is commensurate with their share of the benefits (see paragraph
8.13 of the OECD 2010 Transfer Pricing Guidelines).
In deciding whether the arrangements are arm's length the earlier chapters of the
OECD 2010 Transfer Pricing Guidelines will be in point – that is to say factors such as
the contractual terms, economic circumstances and how risks are shared.
The OECD provide guidance on determining whether the allocation of costs to

each participant is arm’s length, suggesting that one solution could be allocation
keys (see section C4 of Chapter VIII of the OECD 2010 Transfer Pricing Guidelines).
The OECD guidance also recognises the problem of estimating benefits that will
arise in the future and suggests this might be dealt with via a balancing payment
at a later date (see section C5 of Chapter VIII of the OECD 2010 Transfer Pricing
Guidelines).
Section D2 of Chapter 8 to the OECD 2010 Transfer Pricing Guidelines deals with
the issue of disregarding part or all of the terms of a cost contribution agreement.
This is a subject that we will look at in the chapter on recharacterisation issues but it
should be noted that this issue can also arise in relation to contract R&D services.
Buy in and buy out payments will need to be in line with the arm's length principle.
In broad terms the main areas in Chapter VIII are:
1. Direct (lump sum) sales of intangibles between group companies. In most

cases it simply is not possible to identify a CUP, and valuation is very uncertain.
Hindsight is generally not to be used for valuing arm's length transactions;
contemporaneous circumstances, and what independent parties would have
done in such circumstances, should form the basis of a valuation.
In substantial contrast, the US legislation solves the problem of valuing

intangibles by basically using hindsight in the context of a “commensurate
with income” approach and seeing what the ultimate arm's length royalties
are or should be. The net present value of streams of royalty income may form
the basis of a lump sum valuation within such an approach.
2. Royalty rates charged by one group company to another under a licence

arrangement. The royalty rate should ideally be based on a CUP, but in
practice this is difficult to achieve.
Where a third party licence agreement can be identified which deals with
identical intangible property then this can be used as a basis for determining
an arm's length royalty rate.
Adjustments may need to take account of geographic coverage, the range

of rights, the length of time of the licence and whether there are sub-licensing
rights.
In relation to group owners of highly valuable rights, normal royalty rates might
not apply and allocation of profits to such an owner might involve a profit split
or TNMM methodology (see above).
3. Development of intangibles and cost contribution arrangements. A question

to be asked in relation to global development of intangible property is which
companies have the main economic ownership over the development of the
property. Any future benefits would then be attributable to those companies.

It is possible that a service company is contracted by group companies to

undertake the development, but the main economic benefit would not pass
to the service company itself.
A cost contribution arrangement is accepted by the OECD as being a valid

method for sharing group development costs, where it is known that a number
of companies will economically benefit from such development. In essence
the costs contributed by each party should reflect anticipated benefits, using
appropriate allocation keys that independent parties would use in entering a
similar joint venture arrangement. Valuation issues arise when new parties
enter cost contribution arrangements, or parties drop out of them –
circumstances which are not easy to compare with third party situations.
14.5 Case law on cost sharing arrangements
VERITAS Software Corp., 133 TC No. 14,Dec. 58,016 (Dec. 10, 2009)
This was a US case looking at “buy in” costs for a cost contribution arrangement.
The IRS argued that what had taken place was akin to a sale or spinoff of Veritas
operations hence the sum to be paid should be valued on this basis.
Veritas Software, which is in the business of developing, manufacturing, marketing,

and selling software products, went through several corporate changes a few
years back; mostly notably, it was purchased by Symantec Corp. on July 2, 2005.
Prior to that, on November 3, 1999, Veritas Software assigned all its existing sales
agreements with its European-based sales subsidiaries to a new corporation –
Veritas Ireland. In addition, on the same date, Veritas Software and Veritas Ireland
entered into a research and development agreement, as well as a technology
license agreement.
Based on the licensing agreement, Veritas Software granted Veritas Ireland the
right to use certain “covered intangibles,” as well as the right to use Veritas
Software's trademarks, trade names, and service marks. In exchange for the rights
granted by licensing agreement, Veritas Ireland agreed to pay royalties, as well as
a “prepayment amount.”
In 2000 Veritas Ireland made a $166 million “lump sum buy-in payment” to Veritas
Software. This amount was later adjusted downward to $118 million. At issue, from
a tax perspective, is whether the buy-in payment was “arm's length.”
The court rejected the IRS approach agreeing with Veritas that the amount to be
paid should be based on comparable uncontrolled royalties payable over the life
of the agreement. Further the court said that the IRS determination was arbitrary,
capricious, and altogether unreasonable.
Veritas used agreements between Veritas Software and certain original

equipment manufacturers (OEMs) as comparables. The IRS contended that the
OEM agreements involve substantially different intangibles. But the court
disagreed: it concluded that, collectively, the more than 90 “unbundled” OEM
agreements the parties stipulated were sufficiently comparable to the controlled
transaction.
In noting the comparability, the court also pointed out the following:
(1) Veritas Ireland and the OEMs undertook similar activities and employed similar
resources in conjunction with such activities, (2) there were no significant

differences in contractual terms, (3) the parties to the controlled and uncontrolled
transactions bore similar market risks and other risks, and (4) there were no
significant differences in property or services provided,
therefore, the court was happy that the unbundled OEM agreements were
sufficiently comparable to the transaction they were looking at thus giving the
result that comparable uncontrolled transaction method (CUT) (as set down in the
US regulations) was the best method to determine the appropriate buy-in price.
The buy-in payment charged met the arm's length standard and the IRS's
contention was rejected.
14.6 Exploiting IP Principal Structure V Licensing Out
A typical principal structure will involve setting up a subsidiary in a low tax territory.
The principal will be the company that owns the IP thus the principal will earn the
profits from the IP. In the context of IP the principal company acts like a distributor
as it receives income from the licenses as the other companies in the group
operate as the IP developers. The agreement between the companies and the
allocation of risk will be important for ensuring that the structure is tax efficient with
income allocated to the low tax jurisdiction conforming with the arm's length
principle.
Licensing of IP within a group can lead to questions as to the arm's length principle
for the license to use the IP. If the group company is a fully fledged manufacturer
then a separate license fee would be required as a third party would need to pay
such a fee. Without a central policy on IP it could be that the fee ends up in a high
tax territory. A structure that results in centralisation of assets including IP would
mean that the manufacturer would be set up as a contract manufacturer and a
separate licence fee is not required.
This structure can give more scope for keeping the receipt of licence fees in a low
tax territory. However it may be that the manufacturer is in a high tax territory in
which case a separate license fee may be the preferred option.
14.7 Valuation of IP
The valuation of IP is difficult to carry out without an element of subjectivity and is

often subject to scrutiny by the auditors and tax authorities. The economic value of
IP is primarily determined by the economic and legal environment in which the IP is
created and exploited, the market demand for the IP and the existence or
absence of close substitutes.
Valuation experts usually identify assumptions in establishing value such as

expected future earnings estimates, the rate of the average cost of capital, and
other factors including the discount rate. The valuation of IP is also affected by its
tax treatment.
IP value can often fluctuate in value depending on the market, competitors, etc.
The fluctuation occurs not only over time, but at any one time depending upon
the key assumptions of the inherent risks associated with the IP. These risks can
include liability concerns or the possibility that competitors will create new and
better products.
Thus, the OECD 2010 Transfer Policy Guidelines recognise that it is often difficult to
attribute a distinct value to each piece of IP on an ongoing basis.

The valuation of IP poses difficulties for transfer pricing decision making and
government oversight for three major reasons:
• Comparables for such assets seldom exist. Patents are rarely traded on
external markets. Usually MNEs are unwilling to sell their patents, but might
license out some of the rights to use the intangible asset.
• IP rights are often transferred in combination with tangible assets or services,

known as “embedded intangibles.” Buyers may want to acquire a product
that relies on a combination of IP and other assets.
• Intangibles other than patents are particularly difficult to detect because they
are not reported in financial statements.
There are a number of generally accepted approaches to ascertaining the fair

market value of a business. These approaches are accepted by most tax
administrations and are consistent with generally accepted accounting principles
in most jurisdictions:
• Income based approach;
• Market based approach;
• Asset based approach; and
• Cost based approach.
Income based approach
An income based approach seeks to generate a single present value from the
quantum, duration and risk associated with expected future economic benefits of
the business asset. An appropriate discount rate must be applied reflecting a rate
of return on investments appropriate to the asset being valued and the relevant
market conditions. IFRS 3 does not provide guidance on the appropriate discount
rate to apply – it is generally appropriate to look at the rates an acquirer would
receive on similar investments.
The discounted cash flow (DCF) method in particular involves a rigorous review of
projected performance and is often preferred as a valuation method where
credible financial data is available.
A ‘multiples’ income method is often applied in estimating future sustainable

economic benefits (e.g. a profits multiplier). This method has the advantage of
permitting the asset to be compared to other internal or external valuations or
transactions for consistency. However, in isolation, this valuation method will often
be challenged under tax or audit principles as being rudimentary and subjective.
Market based approach
A market based approach seeks to identify comparable transactions and isolate

common components or measures which drive value. These components can
then be adjusted for any differences in circumstances and can be applied to
arrive at a valuation based on market transactions.
Note that market information will often be critical in informing income based
approaches; by way of example, market information on discount rates, multipliers
and forecasts can help increase the credibility of assumptions applied in income
based methods.

Asset based approach
An Asset-Based method seeks to adjust all assets/liabilities (including off-balance

sheet, intangible, and contingent assets/liabilities) to their fair market, current
values. This method is not normally sufficient in isolation when considering a going-
concern operating company; however, this method can be of use in the following
situations:
• No earnings history for the asset
• No consistent, predictable customer base
• Low barriers to entry in the industry
• Capital intensive industries(e.g. a high degree of real estate)
Cost based approach
Historic cost, in isolation, is less useful as a business valuation tool. It can provide
some background or useful context to value.
Replacement cost is often more relevant; a potential buyer can always consider
the cost of generating a business asset as opposed to purchasing one.
Selection of appropriate methodology
When the MNE management is able provide sufficient financial information to

perform a robust DCF valuation method, this method is more widely accepted by
tax administrations and under generally accepted accounting principles to be an
appropriate valuation methodology for a going-concern operating business.
The DCF method of valuation is based on projecting cash flows into the future,
which are then discounted to a present value. The formula for calculating a value
using the discounted cash flow basis is as follows:
DCFV = C1/(1 + r) + C2/(1+r)2….. + Cn/(1+r)n + TV/(1+r)n
Where:
• DCFV = Value indication on a discounted cash flow basis
• C1, C2….Cn = The forecast cash flows in each of the time periods from time 1
to time n (the explicit forecast period)
• r = The discount rate
• n = The number of time periods in the explicit forecast period
• TV = Terminal Value (the value at the end of the explicit forecast period)
WACC = E/V * Re + D/V * Rd * (1 − Ct)
• WACC = Weighted average cost of capital
• Re = cost of equity
• Rd = cost of debt

• E = market value of the firm's equity
• D = market value of the firm's debt
• V=E+D
• E/V = percentage of financing that is equity
• D/V = percentage of financing that is debt
• Ct = corporate tax rate
The formulae above show how complex using the DCF method to set the transfer
price is and the number of variables implies that all valuations are subject to
sensitivity. The more information the MNE can provide, the more precise the
valuation can be; however, it is always advisable to run sensitivity analysis on the
main variables (i.e. WACC, growth rate for terminal value, etc.).
It is often useful to run two methods in parallel to ensure that the results are
comparable and increase accuracy.
Due to the complexity in valuing IP and determining where IP is created (or where
it should generate profits) tax authorities have been focusing more on assessing
the transfer pricing for large MNEs holding valuable IP.
14.8 Case law on valuation of IP
The Glaxo group recently settled a transfer pricing dispute in the US for $3.4 billion.
The magnitude of this settlement helps illustrate the scope of the problem in
valuing IP and exploiting it correctly without triggering potential tax avoidance.
Glaxo is headquartered in the United Kingdom and holds several subsidiaries in the
US. Glaxo's primary business is the development and manufacturing of
pharmaceutical drugs. Cross-border transactions of valuable pharmaceutical
drugs generating large profit margins have attracted the attention of revenue
authorities.
In 2000, when the predecessor of Glaxo (GlaxoWellcome) merged with SmithKline

Beecham to form Glaxo, the merger triggered a transfer pricing audit in the United
States. Glaxo also faced transfer pricing audit adjustments in Canada and Japan.
Glaxo's sales of drugs in the United States generated almost $30 billion in revenues
from 1989 to 1999. During this period, Glaxo paid about $1.3 billion in U.S. taxes.
Glaxo claimed that the United Kingdom had already taxed the MNE Group's
profits under dispute with the IRS, arguing that any reallocation by the United
States would result in double taxation of Glaxo.
Approximately 75% of Glaxo's income in the United States was attributable to

Zantac.
The drug had been patented in the UK and hence, the US subsidiary was acting as
distributor for the US market. However, the IRS argued that the US subsidiary of
Glaxo overpaid its UK parent for the patent it held. The IRS also argued that
marketing efforts by the US subsidiary were the determining factor in the success of
Zantac. Also, as the US was the largest market for the drug, which was also
manufactured in the US, the economic ownership of the IP was challenged. The
IRS demanded about $8 billion in tax adjustments and penalties.

Glaxo tried to reach settlement with the IRS by referring the dispute to a
competent authority under the MAP procedure. The governmental discussions did
not reach common ground and the IRS took Glaxo to court to preserve evidence
in preparation for the anticipated trial.
In settling the Glaxo case, IRS Commissioner Mark Everson stated that transfer
pricing issues “are one of the most significant challenges” tax agencies face.
The success and profits of Glaxo's “number two” drug in the United States were
primarily based on successful marketing and sales in the US market, rather than the
patents that led to the new drug. Glaxo also was not able to prove clear
ownership of the IP especially in relation to research activities within Group
(economic ownership versus legal ownership).
There is an argument that just as IP law merged with international trade law to form
international IP law, it is now time to consider merging transfer pricing regulation for
IP with international IP law to create more uniform and sophisticated international
transfer pricing regulation. While a tax policy goal is to acquire a fair share of taxes
and prevent abusive tax avoidance, the goal in international IP law is to promote
the development of IP, particularly with respect to patents for new inventions.
Some would say international transfer pricing regulation should consider all of
these policy goals. It is possible for both the international IP legal system and
governmental tax regimes to adopt these fundamental goals while simultaneously
creating a more effective legal system regulating the transfer pricing of IP.
The fast growth in transfer pricing legislation and regulations represents cross-
border expansion in the law. This expansion of transfer pricing regimes arises mostly
from the legitimate concern that if a country does not adopt detailed transfer
pricing regulation and penalties, MNE Groups will favour attributing income to a
related MNE located in a second country that has transfer pricing laws and
regulations in place.
Through transfer pricing regulations governments are attempting to limit tax

avoidance by MNE Groups engaged in transfer pricing manipulation. However,
effective and fair transfer pricing regulations must allow MNEs to use valuation
approaches as appropriate transfer pricing methods for IP. Clearer rules on
valuation of IP will translate in fewer “grey areas”, which can translate in
challenges by the tax authorities and large tax adjustments.
14.9 OECD latest developments
The OECD has been consulting on possible changes to the intangible provisions in
the Transfer Pricing Guidelines since the release of the new 2010 version.
After three public consultations an interim discussion draft was published in June
2012, which includes a rewrite of Chapter VI of the guidelines.
The draft provides further guidance on:
• Identifying intangibles; here the focus is on assets that can be owned or

controlled for commercial activities rather than focussing on legal or
accounting definitions. The discussion drafts states that; the concept of
intangibles for transfer pricing purposes and the definition of royalties for
purposes of Article 12 of the OECD Model Tax Convention are two different
notions that do not need to be aligned.

• Identifying parties entitled to intangible-related returns; the discussion draft

states that it is important to look at the conduct of the parties to see if it
complies with the legal documentation.
• Transactions involving the use or transfer of intangibles; the distinction is made

between transactions where the intangible is not transferred and transactions
involving the transfer of the intangible. The draft also looks at transfers involving
a combination of intangibles where they may be so unique that the CUP
method may not be appropriate as a comparable uncontrolled transaction
(CUT) is not available and situations where intangibles are transferred along
with other assets pointing out that it may not always be appropriate to
segregate them for valuation purposes.
• Determination of arm's length conditions in cases involving intangibles. The

emphasis here is on the importance of comparability analysis. The discussion
draft says that the selection of the method should not be based on an
arbitrary label but should take account of economic consequences, it goes
on to say that “caution should be exercised in adopting a transfer pricing
methodology that too readily assumes that all residual profit from transactions
after routine functional returns should necessarily be allocated to the party
entitled to intangible related returns”.
This report is discussed further in the chapter on latest developments.
Further discussion drafts will be released on:
• Modification to cost contribution chapter as required by these proposed

changes;
• Transfer pricing consequences of various items as comparability factors rather

than intangibles, such as market specific advantages, local-based
advantages, corporate synergies and workforce issues;
• Any other changes requested pursuant to the Chapter VI amendments.
In November 2012 meetings were held in Paris by the OECD to discuss the
comments received on the June 2012 draft. Those attending (approximately 100)
voiced concern about the broad definition of intangibles and the focus on
abusive behaviour. It was suggested that discussion on those entitled to returns
from intangibles should focus on risk bearing.
For information on the feedback go to the OECD website

http://www.oecd.org/ ctp/transfer-
pricing/ publiccommentsreceivedonthediscussiondraftonthetransferpricingaspects
ofintangibles.htm
In July 2013 the BEPS (Base Erosion and Profit Shifting) action plan was released by
the OECD. It is a detailed plan with 15 actions. Action 8 deals with the prevention
of BEPS via the movement of intangibles within a group.
Action 8 is as follows:
Develop rules to prevent BEPS by moving intangibles among group members. This
will involve: (i) adopting a broad and clearly delineated definition of intangibles;
(ii) ensuring that profits associated with the transfer and use of intangibles are
appropriately allocated in accordance with (rather than divorced from) value
creation; (iii) developing transfer pricing rules or special measures for transfers of

hard-to-value intangibles; and (iv) updating the guidance on cost contribution

arrangements.
The action plan states that the work will result in changes to the Transfer Pricing
Guidelines and the OECD Model DTC in relation to intangibles. It is envisaged that
some changes will be introduced by September 2014 with a final date of
September 2015 for all changes. Throughout the section on intangibles the focus is
on ensuring that pricing outcomes are in line with “value creation”.

CHAPTER 15
SPECIFIC TRANSACTIONS: BUSINESS RESTRUCTURING
In this chapter we are going to look at the transfer pricing implications of business
restructuring, in particular:
– the rationale for restructuring and the role of tax;
– typical models applied during restructuring;
– the OECD approach;
– tax authority response to business restructuring.
15.1 Introduction
Chapter IX of the OECD 2010 Transfer Pricing Guidelines on the transfer pricing
aspects of business restructuring attempts to deal with the growing trend of large
groups undergoing structural changes.
In an economic environment where globalisation has become the norm and

stronger competition has forced many big players out of business, looking at how
a business can function more efficiently, reducing cost and maximising profitability
potential are key to the survival of the business itself. In many cases, when a group
undergoes a structural change it often leads to centralisation of functions and risks.
Through selection of location of these centralised activities, many multinational
groups seek to maximise the tax benefits of restructuring as well.
Business restructuring is often a necessity; however, when looking at restructuring

groups also try to maximise profitability potential by looking at cost and tax
efficiencies. This is a concern for tax authorities, who are concerned that the
restructuring may be wholly or predominantly for tax purposes, and who are
therefore keen to protect their tax base from erosion through abusive planning.
Following business restructuring activities, operating companies will typically earn

lower profits than pre-restructuring, with related party transactions with a central
entity in a low-tax jurisdiction being the mechanism by which those profits are
reduced. Therefore, understanding the transfer pricing implications of business
restructuring is critical.
This chapter addresses the following issues:
• The rationale for business restructuring and the role of tax
• Typical models applied during restructuring
• OECD Guidelines response to business restructuring
• Tax authority response to business restructuring
15.2 The rationale for restructuring and the role of tax
Recently there have been many headlines accusing large groups of trying to
evade tax by setting up principal entities in low tax jurisdictions with the “excuse”
of restructuring and making the group more efficient. Whilst it would not be fair to
comment on individual cases, it is reasonable to say that companies have

adopted a wide range of strategies to business restructuring, with some moving

thousands of employees to different locations and others simply changing the
form of transactions.
Although it is true that some groups have viewed business restructuring as a means
of driving down the group effective tax rate, there are a wide range of
operational reasons why companies seek to restructure. These include:
• Business control – It is often the case that in growing companies, management

will seek to exercise greater control of the business through a centralised
structure. This will allow greater control over key value drivers, such as global
customer relationships or intellectual property, and enable faster and more
effective execution on global strategy.
• Cost management – In the tough economic climate experienced by most

industries and countries in recent years, there is increased pressure on
companies to manage costs to maintain profitability. Business restructuring
allows multinational companies to take advantage of economies of scale,
either through purchasing efficiencies or restructuring the supply chain to
make optimal use of the existing manufacturing footprint.
• Business integration – companies will often seek to restructure either to enable

better integration of a recently acquired business, or to position themselves
better for future merger and acquisition activity. It is much easy to “bolt on” a
newly acquired business to a centralised structure than a decentralised one.
Clearly, an efficient operational and organisational structure is not only a way to

increase revenue, but also a necessity for a group to be able to manage all
operations efficiently and stay competitive. Therefore, although there are cases
where restructuring projects have been driven by tax, in most cases tax is looked
at to ensure that the cost efficiencies are not eaten away by tax implications.
It should be noted that true business restructuring is a commercially-led activity

often involving changes to key operating processes and movement of personnel.
In most organisations it would be very difficult for tax to drive decision making
around such a restructure. They tend to be disruptive and potentially put a
business at risk for the sake of a lower tax rate (as much as all tax practitioners
would love to be the ones driving, it is normally the case that business and
commercial considerations come before tax).
It should also be noted that tax efficiency is in fact the responsibility of a company,
rather than a negative characteristic. Companies have a duty to shareholders to
optimise the value of a business, albeit in a responsible manner. Tax costs are
simply one element of cost to a business, and need to be factored into any major
business decision. As the OECD Guidelines note:
“MNEs are free to organise their business operations as they see fit. Tax
administrations do not have the right to dictate to an MNE how to design its
structure or where to locate its business operations. MNE groups cannot be forced
to have or maintain any particular level of business presence in a country. They
are free to act in their own best commercial and economic interests in this regard.
In making this decision, tax considerations may be a factor.” (See OECD 2010
Transfer Pricing Guidelines Chapter IX, 9.163).
Structural changes will almost invariably lead to changes in the intragroup pricing,
financing and allocation of risk and functions; therefore, transfer pricing is a key
subject and a planning tool when setting up the new structure.

15.3 Typical models applied during restructuring
Before considering the OECD approach to business restructuring, it is necessary to

understand what it means in practice in terms of the models used and related
transactions. The theory behind business restructuring, as targeted by the OECD
Guidelines, is relatively straightforward. It typically involves the movement of
economic activity from high-tax jurisdictions to low-tax jurisdictions, with an
accompanying shift in transfer pricing model to reflect the new balance of
activity.
The first step is to establish the entity that will undertake increased activities. This
entity is commonly known as the Principal. Location will often be determined by a
number of factors, including amongst other things:
• Proximity to the markets the Principal will be responsible for
• Cost and standard of living (since often senior personnel will need to be
located there)
• Availability of skilled resource to support the Principal’s activity
• Ease of doing business
• Tax profile
In many cases, the location chosen will have a low tax rate. This could be for a
number of reasons, including a low underlying corporate tax rate, the availability
of significant tax losses to offset future profits, or tax incentives offered by the local
government to encourage the relocation of certain qualifying activities to that
territory.
Having established the Principal, some or all of the business value chain is
reorganised to move value to the Principal. These may involve:
• Manufacturing – whilst core manufacturing operations are unlikely to move to

the Principal, key decision-making processes might. The Principal may
undertake the planning and scheduling process, take responsibility for
capacity and inventory planning, and insulate the manufacturing entities from
key risks beyond the delivery of core manufacturing processes. Centralised
structures typically involve conversion of manufacturing operations to contract
manufactures, whereby the Principal determines what the local
manufacturing operation should produce and purchases all the output.
Alternatively, some structures adopt a toll manufacturing model, whereby the
Principal owns the raw materials through the manufacturing process, and the
local operations simply provide a conversion service.
• Purchasing – the centralisation of procurement can often have obvious

advantages in generating economies of scale through simple aggregation of
demand. However, further cost advantages can be achieved through taking
a more strategic approach to purchasing, including supplier management,
redefining product requirements and timing of purchases. Centralised
purchasing operations may either purchase the materials directly from
suppliers and sell on to related party operations (earning a margin on the
resale price) or else facilitate global purchasing arrangements for operations
to purchase directly from suppliers, but pay the central procurement entity a
fee.

• Development and maintenance of intellectual property – a fundamental

feature of many business restructurings is the movement or development of IP
within the Principal. For new IP, this will involve either direct development
within the Principal entity, or engaging related parties (or third parties) to
undertake development work on a contract R&D basis. This would require
sufficient management and control of the R&D process from the Principal,
which would need people with sufficient technical capability to understand
the R&D process, as well as responsibility for budgets and key decisions
through various development tollgates. For existing IP, this would need to be
transferred to the Principal in some form (discussed in more detail below), and
would require active management to protect and maintain its value. Reward
for owning valuable IP would be either through royalty charges to related
parties using and benefitting from that IP, or else would be embedded in the
price of products sold by the Principal to related parties.
• Selling – business restructuring exercises will also often involve centralisation of

functions around the selling process, with distributors being converted to
‘limited risk distributors’ (LRDs). The term LRD is a catch-all term, and can
actually involve a range of functions being undertaken. Typically, as the
Principal entity takes greater responsibility for demand planning, key account
management, pricing and portfolio and management, and key risks such as
inventory or credit risk, the profit earned by the LRD is reduced. This is
achieved through an increased sales price, often with purchases being direct
from the Principal entity. In some cases, responsibility for customer contracting
is removed from the local sales operation, which would be converted to some
form of sales agent earning a commission.
The above are just some examples of the shift in functionality seen in business
restructuring. Some industries, such as consumer goods, have seen many
companies adopt all aspects of these within their value chain. For others, it is more
common to see only some aspects. Many companies find it difficult to transition to
a full centralised model in one go, either because of system constraints, lack of
resources to manage the transition or the scale of disruption that it would entail.
Therefore, these Principal structures may initially involve only one aspect (such as
procurement) but develop into a full Principal over time.
It should also be noted that often the Principal may not be part of the title chain.
This may again be due to system constraints, or else complexities arising from
where the manufacturing and sales activities take place in the same country. In
those cases, the Principal may be rewarded through some form of service fee that
is sufficiently high to reflect the value that it contributes.
15.4 The OECD approach
Business restructuring is addressed explicitly (and extensively) in Chapter IX of the

OECD 2010 Transfer Pricing Guidelines which is organised into four key areas:
• Special considerations for risks;
• Arm's length compensation for the business restructuring itself;
• Remuneration of post-restructuring controlled transactions; and
• Recognition of the actual transaction undertaken.
The principles that are established earlier in the OECD Guidelines regarding the
treatment of related party transactions apply equally to business restructuring: “This

chapter starts from the premise that the arm’s length principle and these
Guidelines do not and should not apply differently to restructurings or post-
restructuring transactions than to transactions that were structured as such from
the beginning.” (See OECD 2010 Transfer Pricing Guidelines Chapter IX, 9.9)
Nevertheless, it is feature of business restructuring that they often include structures

and constructs not typically seen between independent parties, creating
substantial complexity. Furthermore, the amounts of tax at stake are often
substantial. These factors therefore explain the specific consideration given to
business restructuring within the OECD Guidelines.
Risk
In transfer pricing, the concept of risk is an important one, especially when dealing
with added value functions and transfer pricing models. Along with functions and
assets, they are one of the key economic drivers of value within a business. In
broad terms, entities bearing more risk would expect to earn higher profits, albeit
with a higher variability in the returns earned.
Although risks are important in relation to any related party transaction, there is an
increased focus on risk when it comes to business restructuring. This is because
many business restructurings rely on the transfer of risk from operating company to
Principal to justify the transfer of profit. For example, LRDs, as their name suggests,
rely on the idea that risks relating to the sales process are transferred to the
Principal. These may be specific risks such as inventory obsolescence risk or
warranty risk, or more nebulous risks such as market risk. The same principles apply
to other structures, with key risks transferred to the Principal under a contract
manufacturing or contract R&D model.
For tax authorities seeking to evaluate the arm’s length price under a restructured
model, it is important to understand whether the purported allocation of risk
between parties is correct. The starting point for evaluating this is to consider the
contractual allocations. As with transactions under normal circumstances, the
contractual allocation of risk should not be immediately discounted. Nevertheless,
tax authorities are entitled to consider whether the behaviour of the parties
accords with the division of risk (and the returns for risk).
The first consideration is to whether the division of risk is consistent with what is seen
at arm’s length. If independent parties engaging in comparable uncontrolled
transactions have a similar division of risk, then arguably the risk allocation is
defensible. However, one of the features of business restructurings is that they
often take a form not seen between unrelated parties. This does not mean in itself
that the allocation of risk is not arm’s length, but just that further analysis is required.
One of the key issues to consider is whether the party that supposedly bears a risk
has control over that risk. To exercise control, a party should be able to
demonstrate that it makes the key decisions necessary to manage that risk. A
simple example might be in relation to inventory risk. If inventory risk is allocated to
a Principal, it would be expected that the Principal would make the key decisions
around management of that risk. For example, it might make decisions about
inventory holding levels, and when to write off stock. If those decisions were made
by the distributor, it may be necessary to reconsider the allocation of risk.
A further issue to consider is whether an entity actually has the capacity to bear
the risk that it has been allocated. This would mean that a Principal should have a
balance sheet that is strong enough to bear the risks allocated. If it did not, this
would cast significant doubt over whether those risks would be allocated to that
party at arm’s length.

A third consideration is whether the risks that have been transferred are
proportionate to the value that has been transferred during the restructuring. For
example, consider a fully-fledged distributor that typically earns 8% to 12%
operating margins before restructuring, but is converted to an LRD earning 2%
operating margin after restructuring. The risks transferred to the Principal to justify
this reduction in return might be inventory risk, warranty risk and credit risk.
However, upon closer examination of historical performance, it is identified that
average inventory obsolescence is 1% of revenue, warranty risk is less than 0.5% of
revenue and there is no history of bad debt write offs. Under those circumstances,
it could be challenged whether the drop in profit truly reflects the value
associated with the risk transferred. This would lead tax authorities to question
whether the post-restructuring transfer pricing leaves sufficient profit for the LRD, or
indeed whether something else of value has been transferred to the Principal
during the restructuring that might give rise to broader tax considerations.
The OECD Guidelines also raise the fundamental challenge about whether a
transfer pricing method can create a low-risk environment. It has been argued in
the past that a contract manufacturer earning a cost plus return is by definition
low risk, because it will earn a low guaranteed return. The Guidelines
acknowledge that the pricing mechanism cannot be ignored in evaluating risk,
since the mechanism may legitimately insulate one party from risk in a way that is
seen at arm’s length. Nevertheless, the basic principle should be to choose the
method that best applies given the circumstances. As the Guidelines note:
“...it is the low (or high) risk nature of a business that will determine the selection of
the most appropriate transfer pricing method, and not the contrary.” (See OECD
2010 Transfer Pricing Guidelines Chapter IX, 9.46)
Arm’s length consideration for the restructuring itself
The OECD Guidelines recognise that the process of business restructuring itself may
give rise to a cross-border transfer of something of value. A payment to reflect
such a transfer is commonly known as an ‘exit charge’. In some cases, this may be
obvious, such as tangible or intangible assets. In those cases, the same principles
apply as would be the case if those assets were being sold in normal
circumstances.
Complexities arise where there is a business restructuring resulting in a significant

shift in the profit profile of entities restructured but no obvious transfer of assets.
Consideration needs to be given as to how the arm’s length principle would apply,
by challenging whether the restructured entity operating on a standalone basis
would be prepared to accept the restructuring without need for additional
payment.
The first step of this process is to understand the nature of the restructuring.
Specifically, it is important to identify the difference in functional and risk profile
pre- and post-restructuring, and the economic nature of what has been shifted.
Furthermore, it is also important to understand the business rationale for
restructuring. Understanding where the expected benefits should arise will inform
the likelihood of whether the restructuring would have been accepted at arm’s
length.
Having undertaken this analysis, consideration should then be given to the options
realistically available to the restructured party. By evaluating the restructured
entity as if it were operating independently from the rest of the group, it should be
evaluated whether it would be prepared to accept the restructuring or whether it
would have had more profitable options available to it. This is not to say that the
mere reduction in its future profits should give rise to compensation. Nevertheless,

if it can be established that the restructured entity had material profit potential
that it has given up, then at arm’s length, this would be rewarded.
When addressing this question, the rights of the party need to be considered. Take
the case of a distributor with long-term contractual rights (either written or implied
by behaviour) to distribute a product. In the event of a restructuring, it would
need to be questioned whether the distributor would accept a lower, more stable
return for its activities. If margins pre-restructuring were volatile, or there are
declining margins in the industry, it may be possible to make the case that no
compensation would be required as it would be rational to accept the terms of
the restructure. However, if the party would expect to maintain higher, stable
profits, and would ordinarily have the contractual rights to be able to do so, then
some compensation must be given to recognise this profit potential foregone.
The OECD Guidelines also address whether it is necessary for the restructured party
to be indemnified against restructuring costs (such as plant closure and
redundancy costs). In doing so, consideration is given to the terms of the
agreement(s) between the parties, both written and what is implied by the
behaviour of the parties pre-restructuring. This should be evaluated in the context
of local commercial law. The overriding principle is whether at arm’s length
another party would be willing to indemnify the restructured entity. Although the
answer is heavily dependent on the specific facts and circumstances, it could be
the case that Principal, the parent company or a new entity benefitting from
additional business (or a combination of all three) could be willing to pay.
Post restructuring Transfer Pricing
As a guiding principle, the determination of arm’s length transfer prices following a

business restructuring should be no different to any other related party
transactions. Nevertheless, the OECD Guidelines acknowledge that there are
certain features of a business restructuring that create specific challenges.
One issue is that comparability analysis may be harder to apply. There are already
inherent difficulties in identifying comparable data from independent parties to
test related party transactions given there are often fundamental differences in
the way that multinational groups and independent firms operate. This is often
placed under further stress following business restructuring where transactions are
frequently structured in a way that is not seen between unrelated parties, with
substantial differences in the division of responsibility and risk. Such a fact pattern
does not necessarily mean that a controlled transaction is not arm’s length, and it
is necessary to find a reasonable solution. This places increased importance on a
thorough functional analysis to identify the key economic drivers of the
transaction.
A further difference for the application of transfer pricing models to business

restructuring is the interaction with the restructuring itself. Although it is discussed
at length whether payment is required to compensate for foregone profit
potential, it is important to consider whether the same outcome can be achieved
through post-restructuring pricing. It may be the case that parties would agree to
forego an upfront payment in return for a more beneficial transfer price. As such,
the arrangements would need to be considered holistically to determine whether
they comply with the arm’s length standard.
The OECD Guidelines also consider the concept of location savings. In many
cases, business restructurings result in the shift of labour-intensive activity from high-
cost countries to low-cost ones to create efficiencies within the business. However,
it has become an increasing trend for tax authorities in those low-cost territories to

assert that a proportion of those cost savings should be shared with the new
operations creating the savings.
The Guidelines do not directly rule out the case for sharing the savings. However,
they note that in the case of routine activities operating in a competitive market, it
is likely that the Principal would have the option realistically available to use third
parties in that territory. As such, at arm’s length, very little would be attributed to
the routine entity, and standard benchmarking could be used to determine the
appropriate return. However, in the case where the new entity performs more
specialised services, there may be a case for attributing greater returns. However,
it is arguable that these additional returns relate more to the nature of the services
being provided than to a share of location savings.
Recognition of actual transactions
The fourth part of the business restructurings chapter focuses on whether tax
authorities, in challenging and adjusting transfer prices, should recognise the
transactions as structured by the taxpayer. The Guidelines reinforce the point that
taxpayers are free to organise their business operations as they see fit.
Nevertheless, they also recognise that tax authorities have the right to determine
the tax consequences of the structure in place.
In general, tax authorities should only disregard the structure of the transaction in
exceptional circumstances: where the economic circumstances of the transaction
differs from the form, or where independent parties would not have structured
their transactions in such a way and the arm’s length price cannot reliably be
determined (ie. the same circumstances where a tax authority could disregard a
transaction that would apply to all transactions, not just business restructuring.)
Whilst the first circumstance is relatively straightforward to apply, based on a robust

functional analysis, the second is more challenging. It has already been
established that transactions following business restructuring frequently differ from
those structured between independent parties. Nevertheless, if an appropriate
transfer price, taking into account all factors of comparability analysis, can be
identified, then the transaction should be recognised as structured. This would
apply even if the tax authority doubted the commercial rationale for the
arrangements.
Even if the tax authority were to disregard the transactions as structured by the
taxpayer, the alternative characterisation used for taxation would nevertheless
need to recognise certain commercial realities. For example, if the restructuring
involved the closing of manufacturing activities, any recharacterisation would
need to recognise that such functions no longer exist in a country. Likewise, if
property (tangible or intangible) were legally transferred between parties, the
recharacterised post-restructuring transactions could not disregard this. We will
look at these issues in more detail in the next chapter.
15.5 Tax authority response to business restructuring
The issue of business restructuring is a major concern for many tax authorities, given
the significant erosion of the tax base that it can create. Tax authorities have
sought to address the issue in a number of ways:
• Identifying and targeting restructuring
• Imposing exit charges

• Additional tax challenges
These are discussed in more detail below.
Identifying and targeting restructuring
The most obvious step taken by tax authorities has been to focus efforts on
identifying where business restructuring has taken place. In some instances, this
involves formal disclosures – in Australia, the new International Dealings Schedule
(replacing the Schedule 25A) requires taxpayers to disclose any business
restructuring as part of the tax return, whilst in the UK, any taxpayer hoping to
maintain a low risk status with HMRC would be expected to discuss the
restructuring with the Customer Relationship Manager at an early stage in the
process.
In other cases, tax authorities are looking for the signs of potential restructuring.
This might be in the form of significant changes to the profit profile of the taxpayer,
as disclosed through the tax return, or through news and media releases about
organisational changes. Tax authorities will often look at public disclosures about
business restructuring (including the purpose and expected benefits) to determine
whether they accord with tax position being taken, and challenge any
discrepancies.
Imposing exit charges
As noted in the OECD Guidelines, there needs to be consideration of whether

there should be a payment to reflect the restructuring itself. In practice, tax
authorities take a range of approaches to this. In part, it depends on the scope of
local tax legislation. For a lot of countries, exit charges are restricted to Capital
Gains Tax applied where a tangible or intangible asset has been transferred. If it is
not possible to identify such an asset that has been transferred, then no exit
charge can be applied, even with a significant reduction in local profit (although
the natural consequence of this is increased focus on post-restructuring transfer
prices).
At the other end of the spectrum, some countries, such as Germany, will seek to
apply an exit charge based on the net present value of profits transferred out of
the jurisdiction, with considerable efforts required to demonstrate that such a
charge is not payable.
Additional tax challenges
Although there is considerable focus on transfer pricing, there are a range of other
avenues that tax authorities will consider when challenging business restructuring:
• Permanent Establishment (PE) (A subject we will look at in detail in later

chapters) – Tax authorities will often seek to establish whether the Principal
created through the business restructuring has a taxable presence in the local
country. Many aspects of a centralised model can give rise to a PE risk,
including (but not limited to) ownership of stock in country, time spent in
country delivering local country support, the need to register the Principal for
local Goods and Services Tax (GST)/Value Added Tax (VAT)/customs purposes,
and local sales operations legally binding the Principal in its negotiations with
customers. If a PE is established by the tax authority, profits would need to be
attributed to the PE in the same way that would apply to a branch, and as a
result, a significant portion of the profits transferred to the Principal may once
again become taxable in the local country. Furthermore, additional penalties
may apply. In determining whether a PE exists, consideration needs to be

given to both the underlying tax legislation in a country, and the relief
provided by any relevant double tax agreements (DTAs). The variation that
exists in both legislation and DTAs means that a structure rolled out identically
in a number of countries may have a different PE analysis in each
• Withholding tax (WHT) – WHT may well apply to certain payments made by
local operations to a Principal. Although this is not relevant to a basic buy-sell
Principal structure where the only transactions involve the flow of physical
goods, it is relevant to more complex models where payments to the Principal
may be in the form of variable royalties or value-added service fees. Under
such circumstances, the local tax authorities may seek to recharacterise
transactions in such a way that carries the largest WHT burden
• Controlled Foreign Company (CFC) rules – Where the Principal entity is not the
parent company within a group, consideration needs to be given to CFC
legislation in the parent jurisdiction (and any jurisdictions for holding
companies between the parent and the Principal). CFC legislation is complex
and requires separate analysis, but broadly speaking, depending on the tax
rate in the Principal, the nature of the income it earns and the extent of the
activities it undertakes, the tax authority might seek to deem the Principal to
be a CFC of the parent and tax the profits it earns. Mitigation against this risk
depends on the specific rules of the jurisdiction in question but generally
requires an appropriate level of substance in the Principal through undertaking
sufficient economic activities.
• Indirect taxes – Changes to the transaction model will have a knock-on effect
for indirect taxes, which can be an area that tax authorities will seek to
challenge. Following conversion to a typical Principal structure, it is often the
case that prices for goods sold into distribution territories will increase. In some
cases this will be a dramatic increase. Whilst this is of benefit to customs
authorities charging duty on an ad valorem basis, this nevertheless brings with
it the challenge of why prices have changed. In can be difficult to justify to
customs officials why prices have significantly shifted when the underlying
product entering the country has not changed at all. The challenge to
defend against is that historic pricing has been incorrect, and business
restructurings can often lead to customs audits for periods prior to the
restructuring,
15.6 Conclusion
Disputes may occur between a parent company and tax authorities in relation to
whether business decisions are commercial and not purely tax driven. Furthermore,
tax authorities are likely to be concerned if valuable intangibles are transferred
from existing manufacturers without adequate compensation.
From a business perspective, restructuring seen as a whole may constitute a

commercially sound business decision, focusing on optimisation, removing
duplication and reducing costs. However, tax authorities may see it as a taxable
transfer of intellectual property rights as well as a significant part of the business.
Documentation, proof of sound commercial rationale and risk analysis are key to
supporting the business decision. The fact that transfer pricing is high on the to-do
list of most tax authorities is a clear warning. It is also important to understand that
although most countries comply with the OECD Guidelines and would actually
follow the OECD paper on business restructuring there are still differences in
approach and methodology amongst different jurisdictions, so it is very important
to look at the overall picture when considering a transformation project, map the

tax effects in each jurisdiction and consider any transfer pricing issues that may
arise. Any cost or tax benefit should be checked against any tax risk or exit charge,
which might be triggered by the restructuring process. Last, but not least, robust
documentation, clear intragroup agreement and strong proof of commercial
rationale driving the transformation are essential in reducing the risk of potential
tax audits and consequent adjustments.

CHAPTER 16
RECHARACTERISATION ISSUES
In this chapter we are going to look examine the circumstances in which a tax authority
may seek to disregard or recharacterise a transaction between associated enterprises.
16.1 Introduction
Recharacterisation refers to the extent to which a tax authority may, for tax
purposes, set aside the contractual terms of a transaction entered into by the
parties. This setting aside may take two forms:
• disregarding the actual transaction, or
• additionally substituting another, notional, transaction which the tax authority

asserts is closer to the substance that might be expected if the taxpayer had
been dealing at arm’s length with an independent party.
The arm’s length principle certainly governs the prices and other conditions of the
controlled transaction. However, there are cases where it is not just the prices or
other conditions associated with the controlled transaction which are being
challenged by the tax authorities, but also the nature of the transaction.
There is a wide variety of domestic tax law anti-avoidance approaches which may
permit recharacterisation other than through transfer pricing measures per se.
These approaches include:
• “Substance over form” and “abuse of law” doctrines: these are, respectively,
common law and civil law concepts which require that the purpose of the
legislator prevails over the actual form of a transaction if that form is not
specifically contemplated by the law and the same economic results could
have been obtained in another manner.
• “Sham” doctrine: legal form of the transaction does not cover the reality
intended by the parties.
• General anti-avoidance rules.
• Targeted anti-avoidance rules, such as the United States economic substance

doctrine which may disallow tax benefits if there is no purpose or effect to a
transaction other than tax minimisation.
However, the main focus of this chapter is on the OECD approach to

recharacterisation in a transfer pricing context. The content of the OECD 2010
Transfer Pricing Guidelines in this context is important because in many countries
there is an explicit or implicit requirement to respect the Guidelines in domestic tax
law.

16.2 The OECD 2010 Transfer Pricing Guidelines
Generally speaking the OECD 2010 Transfer Pricing Guidelines prohibit

recharacterisation. They emphasise that contractual terms and division of
functions, risks and assets between the associated enterprises are prima facie to
be respected, but also scrutinised to ensure that purported terms are matched by
substance.
Paragraph 1.64 of the Guidelines states that:
“In other than exceptional cases, the tax administration should not disregard the
actual transactions or substitute other transactions for them”.
However the Guidelines do permit recharacterisation in two narrowly defined

circumstances (See Paragraph 1.65). These are:
• the economic substance differs from its form, or
• while the form and substance of the transaction are the same, the
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 and the actual structure
practically impedes the tax administration from determining an appropriate
transfer price.
Paragraph 1.66 explains that, in both circumstances above, the totality of the
terms of the controlled transaction would not have been found at arm’s length
and therefore tax authorities are to include in the profits of an enterprise any profits
which would have accrued to it, but for these conditions ‘‘which differ from those
which would be made between independent enterprises.’’ (OECD Model Tax
Convention, Article 9.1).
Paragraph 1.65 provides an example of each type of exceptional circumstance.

The example given for the first type is an interest bearing loan to an associated
enterprise in circumstances where, at arm’s length, it might be more appropriate
to characterise the investment as a subscription of equity capital. The example
given for the second type is a transfer under a long-term contract, for a lump sum,
to an associated enterprise of the benefit of intellectual property rights arising from
future research. It is suggested that a more “rational” characterisation might be
an on-going contract research agreement.
 Illustration 1
As an illustration of differing tax authority approaches to the debt/equity example

referred to above, consider the position for the Zeta group of companies:
Zeta Holdings Ltd (resident in

Cayman Islands)
Zeta (UK) Limited (resident in UK) Zeta Espana SRL (resident in

Spain)
The UK and Spanish subsidiaries are established with nominal equity capital of
£1/€1 respectively. They are both financed by Zeta Holdings Ltd by way of loans of

£1 million each at an interest rate of 6%. They have both incurred substantial losses
and have few assets.
In the UK, it is likely that transfer pricing rules would operate so as to deny a tax
deduction for the interest charged on the basis that taking into account all
factors, at arm’s length, Zeta (UK) Limited could not have borrowed £1 million
However, that is the full extent of the transfer pricing impact – the UK rules would
not then provide for the loans to be recharacterised as share capital and the
interest payable to be recharacterised as dividends.
In Spain, the thin capitalisation rule of 3:1 debt:equity applies. Because this is
breached, a tax deduction will be denied to Zeta Espana SRL for the interest
charged. Moreover, the interest is classified as a dividend and withholding tax is
applied accordingly.
Factors to be considered
Against what criteria can it be assessed whether or not “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”?
Options realistically available
The OECD Guidelines note, at Paragraph 1.34, that an independent enterprise will
compare a proposed transaction with the other “options realistically available” to
it. This is in the context of comparability analysis rather than recharacterisation, but
if faced with an “irrational” controlled transaction it would appear instructive to
ask the question “Is there another option realistically available which independent
parties acting at arm’s length might have chosen?” If so, that option may provide
a means of recharacterising the actual transaction undertaken. (Andrewa Bullen,
in a doctoral thesis examining recharacterisation issues argues that there are five
reasons why the “options realistically available” concept is relevant in a
recharacterisation context)
This concept is clearly not without difficulty. Practical issues include: How are the
options identified? What is “realistic”? When is that judgement to be made? The
Guidelines do not seek to answer such questions. In the absence of objective tests,
there is clearly scope for disagreement between taxpayers and tax authorities and
a risk that tax authorities will use hindsight to argue that the taxpayer could at
arm’s length have chosen a “clearly more attractive” option.
Risk
When looking at the question of recharacterisation the allocation of risk is

important. The OECD Guidelines pay special attention to the allocation of risks,
underlying contractual terms as well as the capabilities and responsibilities to
manage those under Paragraphs 1.47 to 1.49, as expanded in the Business
Restructurings Chapter at Paragraphs 9.22 to 9.43. Emphasis is placed on whether
the parties conform to the purported allocation of risks and whether the party to
which the greater risk is allocated has the capacity to control it. In this context,
control does not mean day to day management but the ability to strategically
assess the risk.
Business restructuring aspects
In recent years a large number of MNEs have embarked on complex value chain
restructuring projects leading to the formation of principal entities in lower tax

jurisdictions, which are meant to take on the more “non-routine” functions and the
major business risks (e.g. stock, customer, product, etc.) and therefore, attract a
large portion of the group profits.
Centralisation is often pursued by large MNEs not as way to achieve tax

advantages, but in the pursuit of cost efficiencies, better control and as a way to
stand against the competition.
However, when centralisation also generates a tax advantage it is crucial for the
contractual arrangements to match the economic substance in each of the
parties.
For example, the common use of limited risk distributors or sales agents, which act
on behalf of a main super distributor, is often challenged by tax authorities, which
try to re-characterise the limited risk distributor as a full risk distributor, when it
appears that the local entity is indeed taking on more risk and functions than the
main distributor.
Another classic example is in relation to contract R&D arrangements, where an

enterprise pays a related party for the development of IP, which is then exploited
by the paying enterprise. Tax authorities often argue that the R&D company might
be acting on its own behalf and the IP being created resides locally and does not
belong to the enterprise paying for the R&D expenses. It is important to ensure that
not just the pricing reflects the nature of the transaction (e.g. using net cost plus to
remunerate the R&D service provider), but also the risk and functional profile (e.g.
a clear direction on the R&D has to be provided, all losses that might arise from
unsuccessful launch or use of the IP should be covered by the paying enterprise
and not by the R&D service provider, etc.).
Commercial evidence is also very important when assessing the nature of a

transaction or facing a recharacterisation challenge by a tax authority.
The existence of official documents (e.g. board papers) clearly showing the
commercial goal to be achieved when setting up a contractual arrangement
between related parties does not prevent challenges from tax authorities, but it
provides evidence that the reason for entering into the contract was driven by
commercial needs (e.g. cost reduction, market penetration, volume discounts,
etc.).
Paragraphs 9.161 to 9.194 in Chapter IX of the Guidelines address the issue of

recharacterisation from a business restructuring perspective. This confirms the
following:
• The taxpayer has the freedom to decide whether and to what level they
perform the functions and take on the risks, and what resources they employ.
The entrepreneurial freedom of disposition also includes that taxpayer can
freely decide if the functions are performed by the taxpayer themselves or by
another company within the group, are allocated to several companies or are
assigned to a subcontractor.
• Only in rare and unusual cases will recharatarisation be appropriate.
• MNE groups implement business models that may be rarely, if ever, found at
arm’s length. That does not automatically make them irrational.
• It is not appropriate to expect the members of a MNE group to behave as if

they were independent of each other – what matters is the outcome.

• In evaluating “options realistically available” a wide range of factors needs to

be assessed including all the conditions of the restructuring, rights and assets of
the parties, compensation for the restructuring itself and post-restructuring
remuneration.
• The restructuring must make commercial sense for the individual members of
the MNE group, as well as the group as a whole.
• A notional transaction to be substituted for the actual transaction must

respect as closely as possible the facts of the case
Paragraphs 9.190-9.192 give an example of restructuring transactions where

recharactarisation may be appropriate. This is replicated, in slightly modified and
abbreviated form, below.
 Illustration 2
Pre-reorganisation
Company A in Country A: Head

Office and valuable brand owner
Contract manufacturing Distribution company in Country

company in Country B C
Post-reorganisation
Company A in
Country A: Head
Office
Transfer of
brand
↓
Contract Distribution company Company Z in Country

manufacturing in Country C Z: valuable brand
company in Country owner – No staff
B
No risk-bearing
capacity

The MNE group headed by A manufactures and distributes branded goods. The
group derives most of its revenues and profitability from its valuable brand which is
owned by Company A and maintained and developed by 125 staff in Country A.
Company Z is formed in Country Z. The brand names are transferred from
Company A to Company Z in exchange for a lump sum. Thereafter, Company A is
remunerated on a cost plus basis by company Z (and Companies B and C) for the
services it performs, but the excess profits after remunerating companies A, B and
C for their “routine” functions now accrue to company Z.
• No reliable evidence can be found of independent enterprises allocating the

valuable brand, and attached risks, as Companies A and Z have done;
• Company Z lacks substance: it has no staff to control risks associated with the
brand development. Those functions in fact continue to be performed in
Company A whose senior management team visit Company Z once a year to
formally validate strategic decisions already taken in Country A.
There is a blatant disconnect between the legal ownership of the brand on one
hand and the economic substance and continuing beneficial ownership on the
other hand. A tax authority may well be expected to seek to set aside the brand
transfer. In practice, one would not expect a properly advised taxpayer to enter
into a cross-border reorganisation so blatantly lacking in substance.
Base Erosion and Profit Shifting (“BEPS”) Action Plan
In July 2013, the OECD published its wide-ranging Action Plan to combat a number
of international tax planning strategies used by MNEs and to modernise long-
standing tax rules which are considered not to have kept pace with globalisation,
technology and the growing role of intangibles and services.
Three of the 15 action points are concerned with transfer pricing outcomes
relating, respectively, to intangibles, risks and capital, and “other high-risk
transactions” . It should be noted that one of these action points is to:
“develop rules to prevent BEPS by engaging in transactions which would not, or

would only very rarely, occur between third parties. This will involve …rules..to
clarify the circumstances in which transactions can be recharacterised…”
The OECD has set the relevant working party a deadline of September 2015 to
generate proposed changes to the Transfer Pricing Guidelines.
Many commentators are heralding the BEPS work as a turning point, and although
the 2015 deadline is rather ambitious, given all the other workstreams of this
project, it might be expected that tax authorities will gain confidence in mounting
recharacterisation arguments even in advance of agreed changes to the
Guidelines.
16.3 Country examples of case law and other guidance on

recharacterisation
There are only a limited number of cases in which national courts have agreed to
set aside for tax purposes contractual arrangements entered into between related
parties, or substitute different notional arrangements. That reflects the fact that
most national tax systems will, unless there is a huge variation between substance
and form, respect the actual transactions undertaken and instead challenge the
transfer pricing. Each proposed transaction nevertheless needs to be evaluated
against the landscape of the national tax systems of each of the associated

enterprises. Relevant developments in Canada, the United States and the United
Kingdom are considered below.
Canada
A recent court case in Canada (which at the time of writing has yet to be
resolved) illustrates how controversial and difficult recharacterisation and
adjustments can be especially when in relation to intangible property. The case is
The Queen v. GlaxoSmithKline Inc. (This is a case we look at in other parts of this
manual as it covers many issues).
This case highlights two main issues:
• How the OECD Guidelines are applied within the local legislation; and
• Whether a transaction can be taken in isolation when applying the arm's

length principle.
The court case revolves around the fixing of the price paid by a Canadian
subsidiary (Glaxo Canada) of a pharmaceutical company to a related non-
resident company for Ranitidine (the main ingredient used for manufacturing a
branded prescription drug).
Glaxo Canada was paying a price over five times higher to buy the ranitidine from
the Glaxo Group than it would have paid to buy the ranitidine from generic
manufacturers.
Glaxo Canada paid a royalty to its UK parent company (and IP owner) to

manufacture and sell the branded drug Zantac in the Canadian market. Glaxo
Canada's rights under the intragroup agreement allowed the Canadian entity to
manufacture, use and sell various Glaxo Group products (including Zantac), make
use of other trademarks owned by the Glaxo Group, gain access to new Glaxo
Group products and receive technical support.
However, Glaxo Canada was also obliged to acquire the main ingredient for the
drug (i.e. ranitidine) from a Glaxo approved source (i.e. Adechsa, a Swiss
subsidiary of the GSK Group).
The price paid by the Canadian subsidiary for the active ingredient was
significantly higher than the price paid by Canadian generic manufacturers.
The CRA reassessed Glaxo Canada by increasing its income on the basis that the
amount it had paid Adechsa for the purchase of ranitidine was “not reasonable in
the circumstances” within the meaning of the transfer pricing rules.
Glaxo Canada's position was that the price paid to Adechsa was reasonable in
the circumstances when viewed in consideration with the License Agreement and
its business to sell Zantac.
Glaxo Canada appealed the CRA's reassessment to the Tax Court of Canada
(TCC), which affirmed the CRA's adjustment of the transfer price on the basis of
the prices generic drug companies were charged for ranitidine. The TCC
supported the CRA's position that, in determining the reasonableness of the
amount paid, the License Agreement was an irrelevant consideration because
“one must look at the transaction in issue and not the surrounding circumstances,
other transactions or other realities”.

Without the licensing agreement the Canadian subsidiaries would not have been
in a position to use the active ingredient patent and the Zantac trademark.
Therefore, the only way for Glaxo Canada to conduct business in Canada would
have been to enter the generic market where the cost of entry would have been
much higher.
The key question to be answered is whether the tax payer is to factor in all
circumstances in determining the arm's length price.
The CRA's position is that the appropriate analysis is what is the arm's length price
for the active ingredient and any other circumstances should be disregarded.
According to the CRA, it is not important whether the buyer wanted to acquire the
ranitidine for the generic market or the premium brand market.
Glaxo Canada replied that it is not uncommon in Canada for enterprises to

purchase goods that clearly have an intangible property component (e.g. Nike).
As far as the value proposition (from the branded product), a third party might
decide to acquire a product from a “well-known” manufacturer because it
guarantees better quality and/or it could be used as a way to better market the
product (e.g. computer manufacturers advertise the “Intel inside” to let potential
customers know their laptops/computers are built using premium hardware). The
choice might result in higher purchasing costs.
On the other hand, the Canadian entity already held an agreement with the UK
parent that allowed it to use its intangible property (already subject to a fee);
hence, the question is whether the fee includes the use of the IP in relation to other
products purchased from related parties.
The CRA views the transaction as a separate item and not in the context of the
larger picture. The lack of clear guidance in the legislation leaves room for
interpretation.
The Supreme Court of Canada has now upheld Glaxo Canada’s appeal that the
licence agreement must be taken into account in examining the purchase price
for ranitidine; the case has been remitted back to the TCC to determine pricing.
The Supreme Court decision was also interesting in holding that OECD Guidelines
are not binding.
This case shows how difficult and controversial the application of transfer pricing
principles can be. The taxpayer should carefully consider all the implications when
making decisions on contractual arrangements for intragroup purposes. When the
transactions are particularly complex (e.g. involving IP or where several related
parties are involved) or the figures associated with the transactions are large, it is
good practice to consider all the transfer pricing implications and how the
transactions might be viewed by the tax authorities in the relevant jurisdictions.
United States
US transfer pricing regulations permit the Internal Revenue Service to

recharacterise transactions that lack economic substance to a form which more
closely equates to the economic substance. (Treasury Regulation s.1.482–
1(d)(3)(ii)(B))
There are a number of leading cases where the IRS has failed to persuade the
Courts that recharacterisation is appropriate. For example, in Eli Lilly v
Commissioner 856 F.2d 855, a US corporation transferred patents and know-how
to a Puerto Rica manufacturing subsidiary. The IRS asserted that this transfer should

be disregarded on the basis that the US company could have retained the
revenue streams from the intellectual property transferred. That was rejected by
the Tax Court and Court of Appeals.
In a 1992 decision of the Tax Court, Kwiat v Commissioner 64 TCM (CCH) 327, a
purported lease with reciprocal put/call options was recharacterised as a secured
loan. This was not a transfer pricing case as such because the parties to the
transaction were not associated enterprises. However, it serves as a contextual
reminder of the need to consider all possible legal tools at the disposal of the tax
authority which might ultimately result in the disregard or recharacterisation of a
transaction. In the Kwiat case, the appellant taxpayers leased shelving equipment
to another party. There was a put option permitting the taxpayers to sell the
equipment at a projected profit to the taxpayers. The Tax Court held that the
rights and responsibilities of ownership of the shelving had passed to the purported
lessee: the lease was in substance a sale and the taxpayer was denied tax
depreciation in respect of the assets in question.
United Kingdom
There are no UK case law decisions which address recharacterisation in a transfer

pricing context.
HM Revenue & Customs’ guidance in the International Manual (INTM 440200)

summarises the OECD guidelines and concludes:
“It is important to note that this is a very difficult area and it would be necessary to
ascertain all the facts and circumstances of a case, together with any evidence
that such arrangements would not have existed between third parties, before
concluding that a provision should be set aside. Any evidence of the provision and
the price that would have existed would also have to be considered. In all such
instances, consult the Transfer Pricing Team at CTIAA Business International.”
INTM 441070, which addresses commissionaire structures in a UK context, suggests

that HMRC might seek to set aside such structures if the facts show that they would
not have been adopted at arm’s length.

CHAPTER 17
PERMANENT ESTABLISHMENTS
In this chapter we will look at the OECD guidance on transfer pricing in relation to
Permanent Establishments including:
– identification of a PE;
– further developments on PEs;
– double taxation relief;
– case law.
17.1 Introduction to Permanent Establishments (PEs)
In order to look at transfer pricing in relation to permanent establishments (PEs) the

first step is to understand when a PE exists. The second step is to look at how profits
are attributed to that PE (this is done in conjunction with considering the tax
implications). We will look at the second step in the next chapter. The whole topic
of PEs has been in discussion for many years and although there is a consensus
within the OECD on their identification and on the attribution of profits and
subsequent taxation there are still “grey” areas and different views taken by tax
authorities. This chapter does not attempt to look at all the ways tax authorities
across the world approach the taxation of PEs but primarily examines the latest
guidance from the OECD.
In its simplest form a PE exists where a company is resident in one country (referred
to as the head office) but also has a business conducted from a fixed base in
another country (the branch). The income attributable to the other fixed base
usually attracts a tax liability in the second country. In many businesses the branch
will have its own management structure maintaining separate accounts. It will not
have a separate legal persona as it is just part of the company.
The fundamental rationale behind the PE concept is to allow, within certain limits,
the taxation of non-resident enterprises in respect of their activities (having regards
to assets used and risks assumed) in the source jurisdiction.
A practical example of the use of a branch is where a bank or regulated financial

business with capital requirements starts a business in a foreign country. It will use a
branch so it can meet its local regulatory capital requirements by relying on the
capital of the whole entity.
In its more complex form of deemed PE, it is a tax “fiction” enabling tax authorities
to impose corporate taxes on the deemed branch. A third type of PE is again a
tax “fiction” where there is a deemed branch providing services.
17.2 Identification of a PE
The first source of reference on the taxation of PE's is the OECD Model Tax
Convention and its commentary.
This is the agreement reached between member states of the OECD that acts as
guidance when negotiating tax treaties. The convention consists of articles,
commentaries, position statements and special reports on evolving tax issues. Its
primary application is in guiding the negotiation of bilateral tax treaties between

countries. The OECD Model Tax Convention has to be read in conjunction with the
detailed commentary on its interpretation. The Model and the Commentary are
the work of the Committee on Fiscal Affairs of the OECD, which is composed of
senior government officials drawn from the OECD members.
The aim of the OECD Model Tax Convention is to provide certainty to international
trade transactions. The commentary is used to provide guidance on treaty
interpretation and to try to provide conformity in international tax.
In the OECD Model Tax Convention there are two types of PE which are defined in
Article 5. These are the fixed (premises) PE and the dependent agent PE. In
addition some Double Tax treaties have extra clauses relating to PE's e.g.
identification of service PE's.
Of course the articles in the OECD Model Tax Convention are or will not always be
adopted in full in all international tax treaties and therefore when looking at
specific cases specific country treaties have to be examined together with any
specific country legislation and international tax cases.
It should also be noted that the UN has also produced a Model Tax Convention
that is used by developing nations when negotiating tax treaties. The UN Model is
designed to aid developing states to tax a larger part of the overseas investor's
income than the other two Models. In particular the UN convention recognises
services PEs without a fixed base (discussed later).
There is also a model tax convention produced by the USA that in general reflects
the OECD Model Tax Convention articles relevant to PEs.
Fixed PE
Reproduced below are paragraphs 1 to 4 of Article 5 of the OECD Model Tax

Convention (in italics). Underneath the paragraphs there are the key issues raised
in the commentary on the article:
1. For the purposes of this Convention, the term “permanent establishment”

means a fixed place of business through which the business of an enterprise is
wholly or partly carried on.
It should be noted that the place of business has to be a “fixed” one. There
also has to be a link between the place of business and a specific
geographical point. As the place of business must be fixed, it also follows that
a PE can be deemed to exist only if the place of business has a certain degree
of permanency, i.e. not of a purely temporary nature.
2. The term “permanent establishment” includes especially:–
a. a place of management;
b. a branch;
c. an office;
d. a factory;
e. a workshop, and

f. a mine, an oil or gas well, a quarry or any other place of extraction of

natural resources.
A place of management is separately included as it does not necessarily have

to be an office.
3. A building site or construction or installation project constitutes a permanent

establishment only if it lasts more than twelve months.
4. Notwithstanding the preceding provisions of this Article, the term “permanent

establishment” shall be deemed not to include:–
a. the use of facilities solely for the purpose of storage, display or delivery of
goods or merchandise belonging to the enterprise;
b. the maintenance of a stock of goods or merchandise belonging to the

enterprise solely for the purpose of storage, display or delivery;
c. the maintenance of a stock of goods or merchandise belonging to the

enterprise solely for the purpose of processing by another enterprise;
d. the maintenance of a fixed place of business solely for the purpose of

purchasing goods or merchandise or of collecting information, for the
enterprise;
e. the maintenance of a fixed place of business solely for the purpose of

carrying on, for the enterprise, any other activity of a preparatory or
auxiliary character;
f. the maintenance of a fixed place of business solely for any combination

of activities mentioned in subparagraphs a) to e), provided that the
overall activity of the fixed place of business resulting from this
combination is of a preparatory or auxiliary character.
For a place of business to constitute a PE the enterprise using it must carry on its
business wholly or partly through it. A PE begins to exist as soon as the enterprise
commences to carry on its business through a fixed place of business. In general
the common feature of the activities that are treated as exceptions are
preparatory or auxiliary activities.
In summary a fixed PE exists where a company is resident in country 1 and carries

out its business or part of its business using fixed premises in country 2 as defined in
Article 5. The consequence is the company is then taxable in country 2 on the
profits attributable to that business. How to attribute profits is considered in the next
chapter.

Dependent agent PE
Paragraphs 5 to 7 of Article 5 of the Model Taxation Convention are reproduced

below (in italics) as again this (or its actual treaty equivalent) is the starting point of
any analysis. Underneath the paragraphs there are the key issues raised in the
commentary on the article.
5. Notwithstanding the provisions of paragraphs 1 and 2, where a person –

other than an agent of an independent status to whom paragraph 6
applies – is acting on behalf of an enterprise and has, and habitually
exercises, in a Contracting State an authority to conclude contracts in the
name of the enterprise, that enterprise shall be deemed to have a
permanent establishment in that State in respect of any activities which
that person undertakes for the enterprise, unless the activities of such
person are limited to those mentioned in paragraph 4 which, if exercised
through a fixed place of business, would not make this fixed place of
business a permanent establishment under the provisions of that
paragraph.
The most relevant issues contained in the commentary are as follows:
• It is necessary to distinguish between dependent and independent

agents.
• They can either be either individuals or companies. They do not have

to be resident or have a place of business.
• The dependent agent must have authority to conclude contracts.
• Contracts do not have to be in the name of the company. They just

have to bind the company.
• One off transactions would not usually create a dependent agent

relationship.
• The authority to conclude contracts must cover contracts relating to

commercial deals which are part of the company's business.
• The authority has to be habitually exercised in the other State. This is

determined by the facts of the situation. For example where a
contract has been completely negotiated by the agent but signed by
the company, the authority in most cases has been exercised by the
dependent agent.
6. An enterprise shall not be deemed to have a permanent establishment in

a Contracting State merely because it carries on business in that State
through a broker, general commission agent or any other agent of an
independent status, provided that such persons are acting in the ordinary
course of their business.
The most relevant issues contained in the commentary are as follows:
• An agent will not constitute a PE of the company if the agent is legally

and economically independent of the enterprise and acts in the
ordinary course of its business when acting on behalf of the company.

• Independence is determined by the rights and obligation the agent

has with the company. Factors that should be considered are the
amount of control exercised by the company, who bears
entrepreneurial risk, skill and knowledge of the agent, the number of
clients represented by the agent.
7. The fact that a company which is a resident of a Contracting State

controls or is controlled by a company which is a resident of the other
Contracting State, or which carries on business in that other State (whether
through a permanent establishment or otherwise), shall not of itself
constitute either company a permanent establishment of the other.
It should be noted that just because a company is a subsidiary of another

company it is not automatically a PE of its parent. When determining
independence the same tests are applied to a subsidiary as applied to a
third party agent.
In summary the dependent agent is deemed where a company/person A

is resident in country 2 and has the authority to secure orders / conclude
contracts on behalf of company B resident in country 1. Then the
company/person A can be deemed to be a dependent agent PE of
company B. As a consequence company B's profits attributable to those
activities are taxable in country 2. The exception to this is where the agent
is an Independent Agent (not acting mainly for the foreign company) and
acting in the ordinary course of his business.
Service PE
In certain international tax treaties there is also provision to tax a service PE. A
company tax resident in country 1 is deemed to have a Service PE if the
employees / personnel of that company render services in country 2 for a period
exceeding that specified in the specific Tax Treaty. It may not be necessary to
have fixed premises in country 2. As a consequence the company will be taxed by
country 2 on the profits attributable to the services performed in country 2.
Service PE's are not within the OECD Model Tax Convention. They are however
discussed in some detail in the commentary. The background is that some
countries consider that profits from services performed in a given state should be
taxable in that state. This is based on the policy principles relating to taxation of
business profits.
With a service business, a company may not require a fixed place of business to
transact high levels of business. Some countries look to impose taxation on these
services in the country where the services are received under their domestic law
even in the absence of a PE.
17.3 Further developments on PE's
The OECD proposed changes to the Commentary on Article 5 (Permanent

Establishment) of the OECD Model Tax Convention in October 2011. (See
discussion draft 12th October 2011 to 10th February 2012 available on the OECD
website). This covers a number of topics; the most important are as follows:
• Home office as a PE.
• Time requirement for the existence of a permanent establishment

• Presence of foreign enterprise's personnel in the host country
• Meaning of “place of management”
• Must the activities referred to in paragraph 4 be of a preparatory or auxiliary

nature?
• Meaning of “to conclude contracts in the name of the enterprise.
• Does paragraph 6 apply only to agents who do not conclude contracts in the
name of their principal?
Comments received from some 30 interested parties were to be discussed in

February 2013. At the time of writing no response to the comments had been
published by the OECD.
The BEPS action plan released by the OECD in July 2013 which places a high
importance on substance, contains a plan to consider changes to the definition of
a PE (Action 7). In particular there will be a focus on the use of commissionaire
arrangements as it is stated that they can lead to an outbound shift of profits from
a country.
17.4 Double taxation relief
Double taxation relief is a connected issue that arises from a company having a
PE. In most of the examples the companies would incur double taxation in country
1 and 2. Therefore the OECD Model Tax convention under Article 23 grants double
taxation relief i.e. either the amount of tax paid in country 2 to be offset against
the tax payable in country 1 or the income is exempted in country 1. Of course if
the company is located in a tax haven then there is the potential of double
taxation as this relief is rarely available.
17.5 Case Law
Phillip Morris Case
One of the best known cases on PEs heard before a European Tax court is the
Phillip Morris case heard by the Italian Supreme Court (L Ministry of Finance (Tax
Office) v Phillip Morris GMBH Corte Suprema di Cassazione 7682/02 25th May 2002).
Facts
The facts of the case were as follows:
Phillip Morris GMBH, a company tax resident in Germany, received royalties from
the Italian Tobacco Administration for a license to produce and sell tobacco
products using the Phillip Morris trademark. The execution of the agreement was
supervised by Interba SPA a group company resident in Italy. The company
performed agency and promotional activities for Phillip Morris in duty free zones. Its
other main activity was the manufacture and distribution of cigarette filters.
The Italian tax authorities argued that Interba Spa was a PE of the group as it
participated in the royalty agreement negotiations as well as other group business
activities with no remuneration. Accordingly the royalty income should be
allocated to a PE of Phillip Morris Gmbh. They also argued that the Italian
subsidiary had been formed to avoid a PE.

Decision
The Italian Supreme court found a PE existed. The activity could not be considered
auxiliary for the purposes of Article 5 of the German/Italian tax treaty (similar
provisions are contained in the model tax treaty). It was found that participating in
contract negotiations can be construed as an authority to conclude contracts. A
PE will also be established where a principal entrusts some of its business operations
to a subsidiary.
Zimmer Case
Facts
Zimmer SAS, a former distributor in France for Zimmer Ltd products, was converted
in 1995 into a commissionaire. The French tax authorities then assessed Zimmer Ltd
to French corporate income tax for the years 1995 and 1996 on the grounds that it
had a PE, contending that the UK Company carried out a business through a
dependent agent (i.e., the French company Zimmer SAS) under Art. 4(5) of the
France-UK tax treaty.
Decision
The Paris Administrative Court of Appeal decided in February 2007 that the French
commissionaire of the UK principal constituted a French PE of that company.
Zimmer Ltd appealed against this decision before the French Supreme
Administrative.
The Supreme Court made its decision on a pure legal analysis of the provisions of
the French Commercial Code, according to which a French commissionaire has
no legal authority to conclude a contract in the name of its principal.
The Supreme Court referred to Article 94 of the former Commercial Code (L 132-1
of the new Code) which states that a commissionaire acts in its own name on
behalf of its principal. Contracts concluded by a commissionaire, even on behalf
of its principal, cannot directly bind the principal to the co-contracting parties of
the commissionaire. The Court concluded that a commissionaire cannot create a
PE simply as a result of the commission agreement with the principal.
However, that there may be exceptions to this rule, such as where the terms of the
commission agreement or other aspects of the instructions demonstrate that,
despite the qualification of the contract given by parties, the principal is bound by
contracts entered into by the commissionaire with third parties.
Key points arising from the case
Where the wording of the commissionaire agreement follows the legal nature of a
commissionaire, in accordance with French civil and commercial regulations, it
cannot be re-characterised by the tax authorities as a contractual arrangement
of a different nature.
A commissionaire agreement can grant sufficient flexibility to the commissionaire

for carrying out its daily activities without constituting a PE of its principal.
The decision is based on legal principles and does not look at what is actually
happening in the business and how it actually operates.

CHAPTER 18
ATTRIBUTION OF PROFITS TO PEs
In this chapter we will look at the attribution of profits to a PE in particular:

– the functionally separate approach;
– former Article 7 of the OECD Model Tax Treaty;
– new Article 7 of the Model Tax Treaty;
– summary of main changes in new Article 7;
– implementing the revised Article 7: the two step approach to profit attribution;
– practical application of the transfer pricing process;
– special considerations for dependent agent PE’s;
– E-commerce and PEs;
– rejection of force of attraction principle;
– attribution of profit in excess of the total profit of the enterprise;
– comparison of the Article 7 OECD approach to Article 9.
18.1 Introduction
Having established the existence of a PE the second and probably more difficult
issue is how to attribute profits to the PE.
Again the starting point of the analysis is OECD Model Tax Convention. The
convention determines in several of the articles the countries rights to tax income
dependent on residence or source. The two articles that are most directly relevant
to transfer pricing are Articles 9 and 7 of the convention.
In these articles the convention distinguishes between the attribution of profits to a

PE and transfer pricing between separate entities by including different articles for
each of these situations:
• Article 7 – attribution of business profits between the parts of a single entity

using the separate entity principle
• Article 9 – transfer pricing between two separate associated enterprises using

the arm's length principle.
We will concentrate on Article 7 as it is relevant to attribution of profits to PE

although of course reference is made to Article 9 Associated Enterprises. We have
looked at Article 9 in an earlier chapter but will look again here for information and
comparative purposes.
“1. Where
a) an enterprise of a Contracting State participates directly or indirectly

in the management, control or capital of an enterprise of the other
Contracting State, or
b) the same persons participate directly or indirectly in the

management, control or capital of an enterprise of a Contracting
State and an enterprise of the other Contracting State,

and in either case 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. Where a Contracting State includes in the profits of an enterprise of that

State – and taxes accordingly – profits on which an enterprise of the other
Contracting State has been charged to tax in that other State and the
profits so included are profits which would have accrued to the enterprise
of the first-mentioned State if the conditions made between the two
enterprises had been those which would have been made between
independent enterprises, then that other State shall make an appropriate
adjustment to the amount of the tax charged therein on those profits. In
determining such adjustment, due regard shall be had to the other
provisions of this Convention and the competent authorities of the
Contracting States shall if necessary consult each other”.
The key phrase in Article 9 is:
“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.
How to attribute profits to a PE has been an issue that has been looked at as far
back as 1977. Yet still the methodologies used by both OECD and non-OECD
member countries in attributing profits to PEs have varied considerably. Some tax
authorities have attributed profits to PEs on a global formulary or profit split
approach, regardless of the functional, asset and risk profiles of the PEs.
The two approaches that have been used are referred to as the functionally
separate approach and relevant business approach. The ‘relevant business
activity’ interpretation refers only to profits of the business activity in which the PE
participated.
Under the relevant business approach the profits of the PE are limited to the profits
earned by the company. If the company is in a loss position then the PE must be in
a proportionate loss position. In the functionally separate approach it is possible for
a PE to be profitable when the company is loss making.
The OECD have rejected the relevant business approach. The current Article 7 of
the OECD Model Tax Convention embodies the functionally separate approach
which is discussed in detail below.
18.2 The functionally separate approach
Since 2008 the OECD have produced several documents on profit attribution to
PE's culminating in a Report on the Attribution of Profits to Permanent
Establishments, July 2010 (‘2010 Report’ available on the OECD website). This
version of the report does not change the conclusions of the 2008 Report, but
merely aligns the Report's wording with that of the revised Article 7. (For the
remainder of this manual, we will refer to the ‘Report on the Attribution of Profits to
Permanent Establishments’ as the ‘OECD Report’).
The 2010 Report is the most important, as it sets out in detail the principles that the
OECD concluded should be used when attributing profits to PEs together with

detailed guidance as to how to apply those principles in practice. The document

itself is of over 200 pages. It is split into four sections:
• General application
• Application to banks (considered in the next chapter)
• Application to global trading of financial instruments (covered in the next

chapter in outline)
• Application to insurance companies (not covered in this manual).
The first section is covered in detail in this chapter. For the other sections this
chapter looks at salient points but does not go into the depth of analysis
contained in the OECD Report.
The latest pricing methodology is dealt with in Article 7 of the OECD Model Tax
Convention. The authorised (recommended) OECD approach to profit attribution
is that “the profits to be attributed to a PE are the profits that the PE would have
earned at arm's length, in particular in its dealings with other parts of the
enterprise, if it were a separate and independent enterprise engaged in the same
or similar activities under the same or similar conditions, taking into account the
functions performed, assets used and risks assumed by the enterprise through the
permanent establishment and through the other parts of the enterprise”.
The PE is hypothesised as a functionally separate and independent enterprise in

order to calculate the profits of the PE under Article 7. The arm's length principle is
then applied to this hypothesis. As this is a “fiction” the OECD approach is not to
directly apply the guidance given in the OECD 2010 Transfer Pricing Guidelines but
apply by analogy.
Of course this is only a model convention and the recent changes to Article 7
have not yet been implemented into specific country treaties. Therefore specific
country treaties or local tax legislation may also deal differently with profit
attribution issues. It may also be possible that countries do not accept the revision
to Article 7. The new Article 7 is considered in greater detail below.
There is also the ancillary point as to whether the commentary contained in the
latest Model Tax Convention can be applied to interpret previous Model Tax
Conventions. Article 31 (3) (b) of the Vienna Convention on the Law of Treaties
1969 states that “Subsequent practice is not only considered to the extent it
reflects the parties' intention upon conclusion of a treaty. Separate from the
original intentions of the parties, their current understanding of the treaty, as
established through subsequent practice, is held to be relevant” e.g. through
agreement to revised commentary in the Model Taxation Convention. However
the relevance of the Vienna convention is limited and what is more important is
local practice and local court decisions.
The OECD states that amendments to the Articles of the Model Convention and
changes to the Commentaries that are a direct result of these amendments are
not relevant to the interpretation or application of previously concluded
conventions where the provisions of those conventions are different in substance
from the amended Articles.
However the OECD adds that other changes or additions to the Commentaries
are normally applicable to the interpretation and application of conventions
concluded before their adoption, because they reflect the consensus of the

OECD member countries as to the proper interpretation of existing provisions and

their application to specific situations.
18.3 Former Article 7 of the Model Tax Treaty
Although the OECD have issued a revised Article 7, the former Article 7 will still be
applied in existing treaties and the new article will only be introduced as treaties
are renegotiated. In fact as can be seen in the commentary to the OECD Model
Tax Convention, several counties were opposed to the changes to the article.
Therefore it is possible that the existing Article 7 will continue to operate in many
treaties.
There is considerable variation in the interpretation of the former version Article 7.

The different approaches on interpretation can create problems of double
taxation and non-taxation. The main issue with the old Article 7 is that it does not
provide for a prescribed method of attributing profits (although it does recognise
the separate enterprise approach) to a PE and recognises using an
apportionment of the profits of the company as a whole. Because different tax
authorities have used different methodologies it has led to instances of double
taxation.
As it is still relevant the former Article 7 of the Model Tax Convention is reproduced
below:
Article 7
Business Profits
1. The profits of an enterprise of a Contracting State shall be taxable only in that

State unless the enterprise carries on business in the other Contracting State
through a permanent establishment situated therein. If the enterprise carries
on business as aforesaid, the profits of the enterprise may be taxed in the other
State but only so much of them as is attributable to that permanent
establishment.
2. Subject to the provisions of paragraph 3, where an enterprise of a Contracting

State carries on business in the other Contracting State through a permanent
establishment situated therein, there shall in each Contracting State be
attributed to that permanent establishment the profits which it might be
expected to make if it were a distinct and separate enterprise engaged in the
same or similar activities under the same or similar conditions and dealing
wholly independently with the enterprise of which it is a permanent
establishment.
3. In determining the profits of a permanent establishment, there shall be

allowed as deductions expenses which are incurred for the purposes of the
permanent establishment, including executive and general administrative
expenses so incurred, whether in the State in which the permanent
establishment is situated or elsewhere.

4. Insofar as it has been customary in a Contracting State to determine the profits

to be attributed to a permanent establishment on the basis of an
apportionment of the total profits of the enterprise to its various parts, nothing
in paragraph 2 shall preclude that Contracting State from determining the
profits to be taxed by such an apportionment as may be customary; the
method of apportionment adopted shall, however, be such that the result
shall be in accordance with the principles contained in this Article.
5. No profits shall be attributed to a permanent establishment by reason of the

mere purchase by that permanent establishment of goods or merchandise for
the enterprise.
6. For the purposes of the preceding paragraphs, the profits to be attributed to

the permanent establishment shall be determined by the same method year
by year unless there is good and sufficient reason to the contrary.
18.4 New Article 7 of the Model Tax Treaty
As outlined above Article 7 of the Model Tax Convention has been revised to
reflect certain proposals contained in the OECD Report. The basic rule of Article 7
on profit allocation is that it follows the arm's length principle contained in Article 9
and that a direct method approach should be used in profit allocation i.e. the PE
would be treated as a “fictional” separate entity.
As discussed the former Article 7 recognised that countries can use an

apportionment of total profits. This has meant that taxpayers have had double
taxation problems as one countries methodology may not match that of another
country. To alleviate this problem the OECD have considered this and issued their
report and a revised Article 7. The revised Article 7 is reproduced below:
Article 7
1. Profits of an enterprise of a Contracting State shall be taxable only in that

State unless the enterprise carries on business in the other Contracting State
through a permanent establishment situated therein. If the enterprise carries
on business as aforesaid, the profits that are attributable to the permanent
establishment in accordance with the provisions of paragraph 2 may be taxed
in that other State.
2. For the purposes of this Article and Article [23 A] [23B], the profits that are
attributable in each contracting State to the permanent establishment
referred to in paragraph 1 are the profits it might be expected to make, in
particular in its dealings with other parts of the enterprise, if it were a separate
and independent enterprise engaged in the same or similar activities under
the same or similar conditions, taking into account the functions performed,
assets used and risks assumed by the enterprise through the permanent
establishment and through the other parts of the enterprise.
The method of calculation of the profits that are attributable to a PE is

contained in paragraph 2. The paragraph also makes it clear that the method
of calculation applies to “dealings” between the PE and the enterprise. (A
dealing is the Article 7 equivalent of a transaction.)

The PE is treated as a separate enterprise that will deal at “arm’s length” (as
defined in Article 9 of the Model Tax Convention). This means that the PE can
be loss making and the enterprise can be profitable or alternatively the PE can
be profitable and the whole enterprise is loss making.
Where the PE transacts with an associated enterprise the price should be at

arm’s length and if adjusted by a tax authority it can be subject to an
application for a corresponding adjustment under paragraph 2 of Article 9 of
the Model Tax Convention.
The separate and independent enterprise concept does not extend to Article
11 of the Convention as this does not apply to a payment within a company.
(Article 11 is the Interest article within the Model Tax Convention and
determines the taxation rights of states on interest payments). Nevertheless if
there is an actual interest payment from a PE (and borne by the PE) it can be
taxed under paragraph 2 Article 11 by the PE host country.
The profits determined under paragraph 2 are taxed according to the laws of
the taxing state. Paragraph 2 does not cover deductibility or method of
calculation of taxable profits. Normally this is determined by local law subject
to paragraph 3 of Article 24 of the Model Tax Convention (Non-discrimination
article) i.e. the principle is that PEs should have the same rights as resident
enterprises to deduct the trading expenses from taxable profits.
Recognition is required together with arm's length pricing of the “dealings”

where one part of the enterprise performs functions for the benefit of the PE
(e.g. through the provision of assistance in day-to-day management). The tax
deduction is not limited to the amount of the expenses.
One of the issues relating to taxation of PE’s is the deductibility of expenses.

Expenses can fall into two categories:
• Costs directly incurred, such as wages.
• Costs attributed to the permanent establishment such as head office

administration.
Article 7 of the OECD Model Tax Convention deals with deductibility although
as always there has to be a check against the domestic law and specific
treaties.
One of the differences between the new Article 7 and the old version is to
remove from the article the right of the permanent establishment to deduct
“executive and general administrative expenses” even if not incurred in the
country where the PE is established.
The rationale for this change was that it was considered that the old Article
limited the deduction for expenses to the actual amount rather than the arm’s
length amount. In respect of general and administrative expenses this limited
the expenses charged to the cost of those services.
The new wording contained in paragraph 2 of Article 7 requires an arm’s

length charge for the provision of services (referred to as dealings) i.e. the
charge is not limited to cost, for example a charge can be made on a cost
plus basis.

The commentary to the both the new and old Article 7 goes on to say
(paragraph 30 on Article 7) that although paragraphs 2 and 3 determine the
amount of profit or loss they do not deal with the deductibility of those
expenses in the corporate tax return. This is determined by domestic tax law,
subject to Article 24 paragraphs 3 and 4 (Non-discrimination).
The commentary (paragraph 40) on Article 24 states that PEs must be given
the same right as resident companies to deduct trading expenses from
taxable profits. These deductions should be allowed without any restrictions
other than those also imposed on resident companies. The requirement is the
same regardless of how the expenses are incurred i.e. directly incurred (e.g.
salaries) or attributed (e.g. overhead expenses related to administrative
functions performed by the head office for the benefit of the PE).
3. Where, in accordance with paragraph 2, a Contracting State adjusts the

profits that are attributable to a permanent establishment of an enterprise of
one of the Contracting States and taxes accordingly profits of the enterprise
that have been charged to tax in the other State, the other State shall, to the
extent necessary to eliminate double taxation on these profits, make an
appropriate adjustment to the amount of the tax charged on those profits. In
determining such adjustment, the competent authorities of the Contracting
States shall if necessary consult each other.
This paragraph deals with the issue of competent authority resolution of

transfer pricing disputes.
As already outlined in order to further interpret Article 7, relevant guidance is

contained in the OECD Report.
18.5 Summary of main changes in new Article 7
Other changes contained in the revised Article 7 are:
• Adoption of the functionally separate approach.
• There is no notional income imputed for purposes of withholding taxes (Article

11).
• It eliminates the previous prohibition on recognition of internal interest expense

(that previously was applied to companies not in the financial sector) and
royalty expense.
• It clarifies and extends the situations where arm's length remuneration for
internal service dealings is required. Previously internal charges for services
were limited to cost. It is now clarified that these should be calculated on an
arm’s length basis.
• It introduces a new paragraph 3 on the double taxation relief mechanism,

similar to the mechanism in Article 9(2).
• Where other activities are undertaken by the PE, profits can be attributed to a
purchasing function. (paragraph 5 of old Article 7 removed)

• Article 7 only determines which expenses should be attributed to the PE for

purposes of determining the profits attributable to that PE. It does not deal with
the issue of whether those expenses, once attributed, are deductible when
computing the taxable income of the PE because that is determined by
domestic law subject to paragraph 3 of Article 24.
• The removal from the article the right of the permanent establishment to
deduct “executive and general administrative expenses” even if not incurred
in the country where the PE is established.
18.6 Implementing the revised Article 7: The two-step approach to profit

attribution
When we are looking at the new article and its related commentary we must read
them together with the OECD Report as the OECD states in Paragraph 7 of the
commentary to Article 7 that “the report represents internationally agreed
principles and to the extent that it does not conflict with this commentary provides
guidelines for the application of the arm’s length principle incorporated in the
article”.
The key principle arising from the report is that a PE is treated as “a legally distinct
and separate enterprise”. The profits attributable to the branch are the profits it
would have earned if it was trading at arm’s length as a separate legal entity.
Remember that the OECD Report sets a limit on the amount of attributable profit
that can be taxed in the host country of the PE. It is not intended to set the
methodology for the domestic taxation of the PE. In addition the object of the
report is not to tax PE and subsidiaries in an identical way. It is recognised that
legal form can have economic effects that can be taxed differently e.g. a PE is
often used in some sectors (banking and insurance) for efficient capital utilisation.
The OECD have recommended a two-step approach to the transfer pricing

process for both deemed and fixed PEs (Appendix B-5 paragraph 47 of the OECD
2010 Report).
There are some differences between the attribution of profits to a fixed PE and the
attribution a dependent agent PE which are discussed below.
Step One
The first step is to perform a functional and factual analysis.
The OECD Transfer Pricing Guidelines on functional analysis are applied to the
analysis of the PE. The key issues are to determine assets used and risks assumed.
One key issue that has to be borne in mind is that there can be no valid legal
contracts to analyse, as a PE cannot contract with its head office.
Transactions between the PE and its head office are referred to as “dealings”.
There are a number of aspects to the recognition (or non-recognition) of dealings

(the equivalent of group transactions) between a PE and its head office.

As a PE is not the same as a subsidiary the following should apply:
• Normally all parts of the company have the same creditworthiness. Any
dealings between a PE and the rest of the company are based on the same
creditworthiness;
• The head office of the company cannot guarantee the creditworthiness of

the PE;
• Dealings between a PE and the rest of the company have no legal

consequences. This implies a greater reliance on the functional and factual
analysis and any documentation that exists eg. accounting records and
contemporaneous documentation.
The OECD have introduced the concept of significant people functions i.e. the
entities transfer pricing profile is determined by the location of significant people
functions (and for financial entities key entrepreneurial risk takers.) Therefore the
risk analysis has to be based on a factual analysis of the functions performed by
staff of the PE and head office.
The OECD Report refers to paragraph 1.52 of the OECD 2010 Transfer Pricing
Guideline. The division of risks will have to be “deduced from their [the parties?]
conduct and the economic principles that generally govern relationships between
independent enterprises”. It is suggested that internal compensation
arrangements can be used for guidance.
It follows that risk will determine the amount of capital that needs to be attributed
to a PE i.e. the greater the risk the more capital is required. This is especially the
case for the development of intangibles where free capital available has to be
available to support the risk assumed e.g. pharmaceutical research as a principal.
This capital requirement is also very relevant for financial enterprises where the
assumption of risk drives the demand for capital.
This means that a PE can be treated as the economic owner or lessor of tangible
assets. A PE can also be the economic owner of developed intangible assets. This
ownership can be established by identifying significant people functions where
they are making decisions often relating to risk management and portfolio analysis
relating to the intangibles being developed. The key factor is whether the PE
undertakes the active decision-making with regard to the taking on and active
management of the risks related to the creation of the new intangible.
PE's can also economically own acquired intangible property. To establish

ownership it is necessary to look at the role of the significant people functions. In
particular decision making, evaluating the management of risk, decision making
on acquisition, decisions on development work and use of the intangible will be
key.
For marketing intangibles similar considerations apply. The role of the significant
people has to be examined e.g. control over branding strategies, trademark
protection decisions and maintenance of intangibles. However where intangibles
are developed over a period of time ownership is often difficult to establish.

The specifics items that have to be covered in the analysis are detailed in the
bullet points below:
• The attribution to the PE, as appropriate, of the rights and obligations arising
out of transactions between the enterprise of which the PE is a part and
separate enterprises.
Integral to the functional and factual analysis is an analysis of all the assets
and obligations of the total company. This analysis is linked to establishing
what assets are used and what risks are assumed by the PE.
• The identification of significant people functions relevant to the attribution of

economic ownership of assets, and the attribution of economic ownership of
assets to the PE.
The analysis has to establish a link between the significant people functions
and the economic ownership of assets. As already discussed the analysis will
look at the decision making on ownership and on-going management of
assets.
• The identification of significant people functions relevant to the assumption of

risks, and the attribution of risks to the PE.
Allocation of risk will be based on finding the significant people functions who
accept the risk and then manage that risk e.g. stock risk will be linked to the
person making decisions on stock levels. Credit risk will be linked to the
significant people functions making a sale and who are also responsible for
creditworthiness.
Of course it should be remembered that performing a credit rating could be a

routine function. In this case it is often the person acting on the rating that is
performing the significant people function.
Risk attribution is of particular significance to the financial sector where it has a

substantial impact on the attribution of both capital and income.
• The identification of other functions of the PE
It should be noted that all functions have to receive an arm's length

remuneration, even if they are not directly related to significant people
functions i.e. the routine functions.
The analysis examines the functions performed by the staff of the whole
company and then links to the significance those functions have in generating
profits. People functions can range from support or ancillary functions (routine
functions) to significant functions linked to the economic ownership of assets
and/or the assumption of risk.
• The recognition and determination of the nature of those dealings between

the PE and other parts of the same enterprise that can appropriately be
recognised, having passed the threshold test.
The analysis has to identify dealings between the PE and its head office.
• The attribution of capital based on the assets and risks attributed to the PE.

The PE is allocated a notional funding. This is comprised of interest bearing

debt and free (equity) capital. The first calculation is the amount of total
capital required by the PE to support its assets, functions and risks. Secondly
the amount of free capital is calculated. This calculation is used to determine
the amount of third party debt and interest cost to be allocated to the PE.
The initial assumption is that under the arm's length principle a PE should have
sufficient capital to support the functions it undertakes, the assets it
economically owns and the risks it assumes.
In the financial sector there are minimum levels of regulatory capital needed
to cover business risk and financial loss. In non-financial sectors capital
provides a reserve to cover risk e.g. research failure.
Step Two
The second step is the pricing on an arm's length basis of recognised dealings
through:
• Determination of comparability between the dealings and uncontrolled

transactions established by applying the OECD Guidelines' comparability
factors directly (characteristics of property or services, economic
circumstances and business strategies) or by analogy (functional analysis,
contractual terms) in light of the particular factual circumstances of the PE.
• Application of one of the OECD Guidelines traditional transaction methods or,

where such methods cannot be applied reliably, one of the transactional
profit methods to arrive at an arm's length compensation for the dealings
between the PE and the rest of the enterprise.
Step 2 applies the five comparability factors contained in the OECD Guidelines.
However, as there can be no legal contract or actual transactions between the PE
and the head office (HO), the functional analysis and contractual terms cannot
be applied directly to the analysis.
18.7 Practical application of the transfer pricing process
Firstly, the functional analysis is used to determine the pricing methodology. This is
done by selecting the functional profiles that will be linked to the pricing
methodology. This will be determined in most cases by the location of the
significant people functions.
By analogy with the principles in the OECD Guidelines it is necessary to determine

the least complex part of the organisation (PE or HO) in order to test for
compliance with the arm's length standard.
This is done through using the information obtained from the results of the
functional analysis. The tested entity is usually the entity where the pricing method
can be applied to give a reliable result and where comparable data can be
located. Normally this is the least complex entity (OECD 2010 Transfer Pricing
Guidelines paragraph 2.59).
So what is the least complex entity? It is the entity generally performing the routine
functions, owning limited intangible assets and incurring the least risks. This can
either be the PE or the HO.

As we saw in an earlier chapter when we look at the choice of transfer pricing

methodology, there are a number of recognised labels used in determining the
profile of an entity which can be used to link to the choice of the transfer pricing
method. For ease of reference these are reproduced here.
Examples of functional profiles and links to pricing methodologies
Functional profile Description Pricing method

Group This is the entity containing Residual profit after
entrepreneur/intangible the decision makers, taking rewarding the other
owner the investment risks (e.g. entities in the supply
research, new markets and chain for their
innovation). The group functions.
entrepreneur can take
several forms. For example it
can be a manufacturer, the
group researcher or the
group product designer.
Contract manufacturer A contract manufacturer CUP/Cost plus
produces goods under the method/ Transactional
direction and using the net margin method
technology of the group
principal (usually by
reference to a contract). Its
risks are primarily limited to its
efficiency and ability to
retain the group
manufacturing contract. In its
most limited risk form it will be
a toll manufacturer with the
principal supplying and
retaining ownership of all
materials
Service provider A service provider supplies CUP/Cost plus
services to other group method/ Transactional
companies usually by net margin method
reference to a contract. Its
risks are primarily limited to its
efficiency and ability to
provide contracted services
at budgeted costs.
Distributor A group distributor distributes CUP/Resale minus
goods supplied by its method/ Transactional
principal. It risk profile can net margin method
vary dependent on the
structure of the operation.
Of course entities exist that do not completely fall directly into these categories as
they may be performing multi-functions and more than one pricing method has to
be applied.
As noted in the earlier chapter, the functional analysis provides the information
required for performing the comparability studies (also referred to as economic
analysis or benchmarking) i.e. the information obtained from the functional
analysis will be used to select comparables using the five comparability factors
contained in the OECD Guidelines (which we have looked at in earlier chapters).

The type of comparability analysis will be determined by the choice of transfer

pricing testing method.
18.8 Special considerations for Dependent Agent PE's
Where a dependent agent PE exists, it has to be remembered that, following the

OECD authorised approach, there will be two entities in the host country that can
be taxed.
The first is the dependent company operating in its own right and secondly the
dependent agent PE. For transactions with the dependent company and the non-
resident company, Article 9 of the Model Tax Convention will apply i.e. the arm’s
length principle. An example of the type of income would be a commission paid
by the non-resident to the dependent company.
The second is the dependent agent, where Article 7 will be the relevant article to
apply. Profits are attributable to dependent agent PE's following the same
principles as used in attributing profits to other types of PEs. A functional and
factual analysis determines the functions undertaken by the dependent agent
company both on its own account and on behalf of the non-resident enterprise.
The dependent agent company will be rewarded for the services it provides to the
non-resident enterprise with reference to its own assets and risk. The dependent
agent PE will be attributed with the assets and risks of the non-resident company
relating to the functions performed by the dependent agent on behalf of the non-
resident, together with sufficient capital to support those assets and risks. Profit is
then attributed to the dependent agent PE on the basis of those assets, risks and
capital.
Key here is the functional analysis which determines the significant people
functions performed by the dependent agent PE for the non-resident company. If
the dependent agent PE does not perform any significant people functions it will
not be possible to attribute assets, functions and risk. In this case it is unlikely, even if
a dependent PE exists under a strict interpretation of the relevant treaty, whether
any profit can be attributed to the PE.
The OECD Report considers that acting as a sales agent may well be unlikely to
represent the significant people functions leading to the development of a
marketing or trade intangible so that the dependent agent PE would generally not
be attributed profit as the economic owner of that intangible.
When looking at the profits attributable to the dependent agent PE, any arm's
length profits earned by the dependent agent company have to be deducted
from the profits attributable to the dependent agent PE. In many cases it is possible
that no additional profits are left as attributable to the PE.
18.9 E-commerce and PEs
The OECD have issued a final report on Treaty rules and E-commerce (available on
the OECD website). The main conclusions reached by the OECD that are relevant
to PEs are as follows:
• a web site cannot, in itself, constitute a PE;
• web site hosting arrangements typically do not result in a PE for the enterprise
that carries on business through the hosted web site;

• except in very unusual circumstances, an Internet service provider will not be

deemed (under the dependent agent rules) to constitute a PE for the
enterprises to which it provides services;
• whilst a place where computer equipment, such as a server, is located may in

certain circumstances constitute a PE, this requires that the functions
performed at that place be such as to go beyond what is preparatory or
auxiliary
18.10 Rejection of Force of Attraction Principle
The first overriding principle of double taxation treaties is that a company resident
in one country will not be taxed on its business income in the other State unless it
carries on that business in the other country through a PE situated in that country.
The second principle is that the taxation right of the State where the PE is situated
does not extend to income that is not attributable to the PE.
The interpretation of these principles has differed from country to country. Some
countries have pursued a principle of general force of attraction, which means
that all income such as other business profits, dividends, interest and royalties
arising from sources in their territory was fully taxable in that country if the
beneficiary had a PE there, even though such income was clearly not attributable
to that PE. The approach has been rejected by the OECD.
18.11 Attribution of profit in excess of the total profit of the enterprise
Another issue is whether the profits of a PE can be higher than the profits of the
enterprise as a whole. This is a question of interpretation of Article 7 paragraph 1:
“the profit of the enterprise may be taxed in the other State but only so much of
them as is attributable to that PE”.
The OECD commentary states that Article 7 paragraph 1 should be read in

conjunction with paragraph 2, which states what profits should be attributed to a
PE i.e. a PE should be attributed the profits which it might be expected to make if it
were a distinct and separate enterprise engaged in the same or similar activities
under the same or similar conditions and acting wholly independently.
Therefore the view is that paragraph 1 does not restrict the amount of profits that
can be attributed to a PE to the amount of profits of the enterprise as a whole.
(OECD Model Treaty 2010 commentary Paragraph 17).
Profits may therefore be attributed to a PE even though the enterprise as a whole

has never made profits. The converse can also apply i.e. the application of Article
7 may result in no profits being attributed to a PE even though the enterprise as a
whole has made profits.
18.12 Comparison of the Article 7 OECD approach to Article 9
It has to be remembered that a PE cannot legally contract with its head office so
a contract approach cannot be used in determining attribution of profits to the
PE.
Therefore how far can the principle of attraction of profits to “significant people
functions” be applied to the interpretation of Article 9 i.e. the primary transfer
pricing article of the OECD Model Tax Convention?

Paragraph 1.64 of the OECD Guidelines states that “In other than exceptional
cases, the tax administration should not disregard the actual transactions or
substitute other transactions for them.” Nevertheless in the same section (OECD
2010 Transfer Pricing Guidelines paragraphs 1.65 and 1.66) there are examples of
transactions where under Article 9 of the OECD Model Tax Convention a tax
administration can adjust the conditions of an intra-group agreement to those
conditions an independent party would have adopted behaving in a
“commercially rational manner”, where the arrangements are made between
group companies. In particular this can apply where transactions have been
structured by the taxpayer to avoid or minimise tax.
The OECD give a lot of weight to legal contracts, however the question has to be
asked re how far group contractual relationships can be relied on. What would
appear surely more important is the conduct of the two group companies rather
than a legal arrangement that would hardly ever be enforced or in many cases
respected by two associated companies.

CHAPTER 19
PE: ATTRIBUTION OF PROFITS TO FINANCIAL INSTITUTIONS &

FINANCIAL INSTRUMENTS
In this chapter we are going to look at the guidelines relating to attribution of profits to PEs
of financial institutions and companies trading in financial instruments including:
– attribution of profits for branches of financial institutions;
– practical functional analysis for a traditional banking business;
– PEs of enterprises carrying on global trading of financial instruments;
– practical functional analysis for global trading of financial instruments.
19.1 Attribution of Profits for branches of financial institutions
For financial institutions a two-step process for attribution of profits is outlined in the
OECD Report on Attribution of Profits to Permanent Establishments (OECD
Report)(Page 77-78):
Step One
Step one is a functional and factual analysis covering the following items
contained in the bullet points below:
• The attribution to the PE as appropriate of the rights and obligations arising out
of transactions between the enterprise of which the PE is a part and separate
enterprises.
• The identification of the key entrepreneurial risk-taking functions relevant to

the economic ownership of financial assets and the assumption and/or
management (subsequent to the transfer) of related risks, and the attribution
of those assets and risks to the PE.
The key entrepreneurial risk-taking functions are classified as functions needing

active decision-making on risk. An example given is in a bank, the creation of
a financial asset and its subsequent management are likely to be the key
entrepreneurial risk-taking functions. It follows that economic ownership of the
financial asset (and the income and expense associated with holding that
asset, lending it out, or selling it to third parties) is usually attributed to the
location performing those functions. The marketing of loans is also classified as
a key entrepreneurial function together with the initial negotiation of the loan
and on-going active management of the loan. In contrast support, middle or
back office functions are unlikely to be classified as key entrepreneurial risk
taking functions.
• The identification of significant people functions relevant to the attribution of

economic ownership of other assets, and the attribution of economic
ownership of those assets to the PE.
• The identification of significant people functions relevant to the assumption of

other risks, and the attribution of those risks to the PE.
• The identification of other functions of the PE.

• The recognition and determination of the nature of those dealings between

the PE and other parts of the same enterprise that can appropriately be
recognised, having passed the threshold test; and
• The attribution of capital based on the assets and risks attributed to the PE.
The attribution of capital to a PE involved in a banking business is a key step in

the process of attributing profit to that PE. It determines the amount of capital
that the bank PE is allocated under the authorised OECD approach and the
appropriate treatment of Tier 1 and Tier 2 capital under the tax rules of the PE's
jurisdiction. As a PE of a bank, like any other type of PE, it should have sufficient
capital to support the functions it undertakes, the assets it uses and the risks it
assumes. Capital is looked at as free capital and other capital.
The attribution of free capital is a two stage process:
Stage 1
The first stage is to measure the risk of the PE. One possibility is to use a
regulatory based approach to measuring the risks attributable to a PE. One
example of a regulatory based approach would be to risk-weight the assets
by reference to the internationally accepted regulatory standards determined
by the Basel Committee (currently Basel III).
Stage 2
The next step is to determine how much free capital is needed to support
those risks identified in stage 1. This attribution has to follows the arm's length
principle. The two OECD approaches to capital attribution are:
– capital allocation approaches, where a bank's free capital is allocated in

accordance with the attribution of financial assets and risks. Capital is
allocated on the basis of the proportion that the risk-weighted assets of
the PE bear to the total risk-weighted assets of the entity as a whole (the
BIS ratio approach).
– thin capitalisation approaches, under which a PE would have attributed

to it the same amount of free capital as would be attributed to an
independent banking enterprise carrying on the same or similar activities
under the same or similar conditions in the host jurisdiction of the PE. This is
done by undertaking a comparability analysis of such independent
banking enterprises.
There is an alternative “safe harbour” approach:
– This methodology requires a PE to have at least the same amount of

regulatory free capital attributed as an independent banking enterprise
operating in the country where the PE is based.
The total funding of the PE is made up of free capital and interest-bearing

debt. The free capital is calculated as described above. The balance of the
funding requirement is therefore the amount by reference to which any
interest deduction is calculated.

Step Two
Step Two is the pricing on an arm's length basis of recognised dealings:
• Comparability between the dealings and uncontrolled transactions can be

established by directly applying the comparability factors contained in the
OECD Guidelines (characteristics of property or services, economic
circumstances and business strategies) or by analogy (functional analysis,
contractual terms) in light of the particular factual circumstances of the PE;
and
• Selecting and applying by analogy to the guidance in the Guidelines the most
appropriate method to the circumstances of the case to arrive at an arm's
length compensation for the dealings between the PE and the rest of the
enterprise, taking into account the functions performed by and the assets and
risks attributed to the PE.
19.2 Practical functional analysis for a traditional banking business
The OECD Report looks at some of the functions performed, risks incurred and
assets owned by a bank when creating and managing a financial asset (loan).
This is a useful starting point for structuring the factual and functional analysis.
Loan origination (functions involved Examples of functions

in creation of an asset)
Sales/Marketing Cultivating potential clients, creating
client relationships and inducing clients
to start negotiating offers of business;
Sale/Trading Negotiating the contractual terms with
the client, deciding whether or not to
advance monies and, if so, on what
terms, evaluating the credit, currency
and market risks related to the
transaction, establishing the
creditworthiness of the client and the
overall credit exposure of the bank to the
client, deciding what levels of credit,
currency and market risk to accept,
pricing the loan, considering whether
collateral or credit enhancement is
needed and committing the bank (and
its capital) to the loan and its associated
risks, etc.;
Trading/Treasury Raising funds and capital, taking
deposits, raising funds on the most
advantageous terms, making the funds
available;
Sales/support Checking draft contracts and
completing the contract formalities,
resolving any outstanding legal issues,
checking any collateral offered, signing
the contract, recording the financial
asset in the books and disbursing the loan
proceeds.

Loan management process Once a Examples of functions

financial asset (a loan) has been
created, the following functions
would normally need to be
performed by the enterprise as a
whole over the life of the asset
Loan support Administering the loan, collecting and
paying interest and other amounts when
due, monitoring repayments, checking
value of any collateral given;
Monitoring risk Reviewing creditworthiness of the client,
monitoring overall credit exposure of the
client to the bank, monitoring interest
rate and position risk, analysing the
profitability of the loan and return on
capital employed, reviewing efficiency
of use of regulatory capital, etc.;
Managing risks Deciding whether, and if so, to what
extent various risks should continue to be
borne by the bank, e.g. by transferring
credit risk to a third party by means of
credit derivatives or hedging interest rate
risk by purchase of securities, reducing
overall risk by pooling individual risks and
identifying internal set-offs and actively
managing the residual risks retained by
the bank-by hedging residual risks or by
leaving risk positions open in the hope of
benefiting from favourable market
movements, etc., deciding write-offs for
non-performing loans.
Sales trading Refinancing the loan, deciding to sell or
securitise the loan, marketing to potential
buyers, pricing the loan, negotiating
contractual terms of sale, completing
sales formalities, etc., deciding whether
to renew or extend the loan and, if so, on
what terms.

Key Risks incurred

Credit risk the risk that the customer will be unable
to pay the interest or to repay the
principal of the loan in accordance with
its terms and conditions
Interest rate the risk that market interest rates will
move from the rates used when entering
into the loan agreement. Market interest
rate risk can arise in a variety of different
ways depending on the nature of the
interest rate on the lending and on the
borrowing. For example, the borrowing
could be fixed but the lending floating or
even if both the lending and borrowing
are floating there could be a mismatch
in timing. Interest rate risk can also arise
due to the behavioural effects of market
movements on the bank's customers. For
example, a decline in interest rates may
encourage customers to prepay fixed-
rate loans.
Currency risk the risk that, where the loan is made in a
currency other than the domestic
currency of the bank (or the currency of
the borrowing), the exchange rate will
move from the rate used when entering
into the loan agreement.
Assets employed
Fixed assets/intangibles branch premises, computer systems
name, reputation, trademark or logo of
the bank. Other intangibles would be
more akin to trade intangibles, such as
proprietary systems for maximising
efficient use of regulatory capital and for
monitoring various types of risk
Capital Capital is relevant to the performance of
traditional banking business because in
the course of a traditional banking
business, banks assume risk, for example,
by lending money to third parties some of
whom may not repay the full amount of
the loan. In order to assume risk, a bank
needs capital. The amount of capital is
regulated by government authorities.
19.3 Permanent Establishments (PEs) of enterprises carrying on global

trading of financial instruments
Introduction
In the OECD Report, global trading refers primarily to those entities that engage in
market making on a global or 24-hour basis, but may also refer to the dealing or
brokering of financial instruments in customer transactions where some part of the
business takes place in more than one jurisdiction.

The OECD Report defines global trading as executing customers' orders in financial
products in markets around the world and/or around the clock. The examples
given include under writing and distributing products on a world-wide basis, acting
as a market-maker in physical securities (i.e. the traditional bond and equity
markets) and in derivative instruments, acting as a broker for client transactions on
stock and commodities exchanges around the world, and developing new
products to meet the needs of the financial institution's clients, for example credit
derivatives.
The income earned by the financial institution from these activities may consist of
interest and dividends received with respect to the stock it holds as a market-
maker for physical securities, trading gains from sales of that inventory, income
from derivatives, fee income from structuring transactions, gains from dealing in
liabilities, income from stock-lending and repo transactions, and brokers' fees from
exchange transactions executed for clients.
19.4 Practical functional analysis for global trading of financial

instruments
The approach for transfer pricing very closely follows that for banks discussed
above. In particular the report recognises the following functions, assets and risks:
Sales and marketing functions Responsible for all contracts with

customers. Often specialised staff
based in various geographic regions.
Usually they are not allowed to price
or trade in a product without a
reference to another part of the
entity.
Trading and day-to-day risk The trader initially assumes any risk
management function (this can be a market-making
function) and subsequently manages
that risk (this can be hedging).
The treasury function The treasury function is responsible for
overall fund management.
Support, back office, middle office This can include:
Systems development, Credit
Strategic risk management functions,
Operational risk
management/accounting/product
control.
Assets used These will often be hardware and
associated software.
It can also include intangibles such
as marketing intangibles such as the
name, reputation, trademark or logo.
Other intangibles would be
proprietary (software) systems for
pricing financial instruments on
prospective third party deals,
allocating capital, measuring,
monitoring and managing risk.
Risks Risks include: credit risk, market risk
and operational risk.
Capital The entity may have regulatory
capital requirements that have to be
considered in the analysis.


CHAPTER 20
COMPLIANCE ISSUES
In this chapter we are going to look at compliance issues, in particular:

– why documentation is important;
– the OECD Guidelines on transfer pricing compliance;
– domestic law approaches to transfer pricing compliance;
– unilateral or multilateral documentation;
– non documentation considerations;
– BEPS action plan and documentation;;
– safe harbours.
20.1 Introduction
In simple terms, compliance in the context of transfer pricing is predominantly

achieved by taxpayers through transacting with related parties on an arm's length
basis. If companies can achieve this, then the most significant costs of non-
compliance (being penalties and double taxation) are substantially mitigated.
However, it is not sufficient for taxpayers to transact on an arm's length basis; they
must also be able to demonstrate that this is the case. This chapter explains the
steps that taxpayers must go through to demonstrate compliance with transfer
pricing regulations. It also addresses some of the broader compliance
requirements of taxpayers as a result of transacting across borders.
Compliance with transfer pricing regulations comprises a number of aspects, with

the importance of each varying across different countries. These include:
• Maintenance of primary documents and records, including (but not limited to)
accounting records, invoices, and intercompany agreements
• Disclosures to be made to the tax authority at the time of filing the tax return
• Analysis to be maintained or prepared for the purpose of presenting to the tax

authority upon request
Whereas the first two tend to be factual or quantitative information, the third
aspect tends to be more qualitative in nature. It is analysis that provides the
evidence upon which taxpayers rely to demonstrate the arm's length nature of
their pricing, and is referred to as transfer pricing documentation. In terms of
resources used and cost to the taxpayer, transfer pricing documentation tends to
be by far the most significant aspect of transfer pricing compliance.
20.2 Why is documentation important?
It is worth considering the role of documentation for both the taxpayer and the tax
authority. It is generally the objective of tax authorities to ensure that taxpayers
pay appropriate taxes based upon the application of the arm's length principle. In
the absence of documentation, tax authorities would have only limited
information on which to evaluate transfer prices.
They would have access to statutory accounts, tax returns and publicly available
information, but none of these are sufficient to undertake anything but a high level

assessment of whether transfer prices are arm's length. From the perspective of the
tax authority therefore, the objective of documentation is typically not to provide
an exhaustive assessment of all aspects of transfer prices, but rather to allow them
to be able to assess whether or not to pursue a transfer pricing enquiry.
Furthermore, if a tax authority does start a transfer pricing audit, documentation
allows them to be a lot more focused on the issues with the highest risk. Thus, for
tax authorities, documentation is a crucial part of the process in allowing them
optimal use of their resources in the policing of transfer pricing.
For the taxpayers, preparation of transfer pricing documentation should be more

than simply about meeting a compliance requirement. Through the preparation of
documentation, taxpayers are able to proactively manage their transfer pricing
risk. Documentation provides a platform for the taxpayer to present its case.
Clearly any analysis needs to be factually accurate and economically sound.
Nevertheless, through the preparation of robust documentation, the taxpayer has
the opportunity to present the facts in the most favourable light and to a large
extent, determine the criterion through which transfer prices are evaluated.
Provided the taxpayer has made a reasonable attempt to follow OECD principles
in determining the choice of method and the means of application, it can be very
difficult for tax authorities to successfully apply a radically different framework. The
preparation of adequate transfer pricing documentation is often sufficient to
discharge the burden of proof regarding the arm's length nature of prices (where
this rests with the taxpayer), and put the onus back on the tax authority to
demonstrate that the arm's length standard has not been met.
Furthermore, the very process through which taxpayers prepare documentation

can help in the identification and management of transfer pricing risk.
Documentation can require the collection of considerable amounts of facts and
data regarding the nature of cross-border dealings. As a process, it can therefore
provide some discipline to tax risk management in the area of transfer pricing,
allowing the tax function within a multinational company to identify early those
countries or transactions with significant risk and devote resources accordingly.
20.3 The OECD Guidelines on transfer pricing compliance
There are two key reference points for taxpayers when considering transfer pricing
compliance. Clearly, local country legislation, regulation and tax authority
guidance are crucially important. However, in many cases, such guidance is built
(either explicitly or implicitly) upon the principles set out in the OECD Transfer
Pricing Guidelines. Therefore, it is important to consider in the first instance what
the OECD Guidelines have to say about compliance and documentation.
The OECD Guidelines addresses a number of aspects of compliance. Chapter IV

of the 2010 edition focuses on administrative approaches. In addressing tax
authorities, the OECD Guidelines has no strict authority, and it acknowledges that
tax compliance procedures are a matter of domestic sovereignty. It is within the
rights of every jurisdiction to establish its own compliance procedures.
Nevertheless, it seeks to offer guidance for administrative procedures that enforce
compliance. The OECD Guidelines encourage restraint and reasonableness in
administrative practices, consideration of the burden of proof and the application
of penalties.
The more detailed consideration of compliance matters is provided in Chapter V

of the OECD Guidelines, which is entirely devoted to transfer pricing
documentation. As with many parts of the OECD Guidelines, its objective is not to
be prescriptive, acknowledging that tax authorities can set their own rules and
procedures around documentation and compliance. The intention of the OECD

Guidelines is not to create additional burden for taxpayers above what is already
created by tax administration rules. Instead it seeks to provide balanced guidance
for both tax administrations and taxpayers as to what would be reasonable and
helpful in achieving the ultimate objective of determining the arm's length price
for related party transactions. The chapter is split in two parts; the first part provides
guidance on documentation rules and procedures, addressing behavioural issues
from both parties, whilst the second part provides more explicit guidance as to
what would be useful to include in a transfer pricing documentation study.
Rules and Procedures
From the perspective of the taxpayer, there is an acknowledgement that some

work will be required on their part in order to demonstrate that transfer prices meet
the arm's length standard. Taxpayers are advised to give consideration to what
transfer pricing arrangements are appropriate before pricing is established
through the application of principles established in earlier chapters of the OECD
Guidelines. For example, it would be prudent for taxpayers to understand whether
CUPs exist, and whether conditions have changed from previous years to inform
whether transfer prices should change. Taxpayers should apply the same prudent
management principles that would govern other business decisions of similar
complexity, and should therefore expect to prepare and obtain certain materials
to help achieve this.
In this regard, taxpayers should accept that it may be necessary to prepare

written documents that would not otherwise be required in the absence of tax
considerations. However, it is also clear that the taxpayers should not be expected
to incur disproportionately high costs relative to the complexity. For example,
taxpayers should not have to undertake an exhaustive search for CUPs if there is a
reasonable case for believing that such CUPs do not exist. Notwithstanding this,
taxpayers should recognise that tax authorities will need to make assessment on
the arm's length nature of transactions based on information presented by the
taxpayer, however incomplete that information is. See paragraph 5.6 of the OECD
Guidelines.
Furthermore, there should be an acknowledgement that the greater the

complexity of the issues, the more significance will be attached to the
documentation. Therefore, the taxpayer should take responsibility to ensure
adequate document retention and voluntary disclosure of information, in order to
help to improve the persuasiveness of analysis.
For their part, tax authorities are discouraged from being too onerous in their
expectations of taxpayers. They should seek from taxpayers only the minimum
documentation needed to make reasonable assessment of transfer prices. They
should request information to be prepared only if it is indispensable for verifying
arm's length nature of transactions. Tax authorities are discouraged from imposing
contemporaneous filing requirements for when pricing is set by taxpayers, or
indeed when a tax return filed. Instead they should be reasonable in requesting
documentation to be provided in timely manner upon request.
Furthermore, tax authorities should be reasonable in the type of information they

request from taxpayers in documentation. Requests for documents that became
available only after the transaction was entered into should be limited to avoid
the use of hindsight. Instead, tax authorities should have regard for what the
taxpayer would have reasonably had available at the time of the transaction.
They should take care not to ask for what is not in the possession or control of the
taxpayer. This includes acknowledgement that it may be difficult to identify data
from foreign affiliates, particularly where such information is in practice not

necessary to make a reasonable assessment of the taxpayer. See paragraphs 5.9

to 5.11 of the OECD Guidelines.
Guidance on content of documentation
It is not possible to provide any definitive list for the contents of transfer pricing
documentation, either as a minimum set of requirements or an exhaustive list.
Instead, the appropriate content of the documentation will be driven by the
individual facts and circumstances of each case. Nevertheless, there are some
common features that might typically be helpful to include in documentation (see
paragraphs 5.16–5.27 of OECD Guidelines). These include:
• Information about associated enterprises – this is to provide context to the

related party dealings, and includes such information as an outline of the
taxpayer's business, an overview of related parties with which the taxpayer
transacts, legal and organisational structure, and financial performance of
group
• Nature of related party transactions – this is to provide clarity on the type of

transactions, counter-party to each transaction, quantum of transaction, and
transfer pricing policy applied
• Economic conditions surrounding the transaction – this is to understand any

external market conditions or specific business strategies that may have a
bearing on the arm's length price.
• Functional analysis – this is necessary to understand the relative contribution of

each of the counter parties in relation to the transaction under consideration.
This includes providing information on the full range of functions, and key
activities in the management of risk.
• Financial information – as described elsewhere in the OECD Guidelines, the

application of methods to determine the arm's length price for transactions
typically requires comparison of tested party data with comparable data
relating to uncontrolled transactions (either at a transaction price or profit
margin level). Documentation should therefore include information derived
from independent enterprises, and appropriate financial data for the taxpayer
that would allow for such comparison. In addition, further financial information
that might help to explain the profit and loss to the extent necessary to
evaluate the arm's length nature of transactions could also be provided.
Business Restructuring
Further guidance on compliance is provided in relation to business restructuring. In

terms of direct reference to compliance matters, the OECD Guidelines simply
observes that processes established by a taxpayer around compliance should
take into account complexity of the transactions; where business restructuring is
undertaken it can result in significant changes to risk allocation and risk profile
(implying more detailed analysis on the part of the taxpayer would be
appropriate). In a broader terms, the OECD identifies a range of issues thrown up
by business restructuring, including changes to functional and risk profile, change
in profit profile, transferring of value in the context of options realistically available
and profit potential, and post-restructuring transfer pricing, all of which are
discussed elsewhere in this manual. However, there are obvious consequences for
taxpayers in relation to compliance. There will clearly be a higher risk of challenge
from tax authorities, and the necessity to provide evidence of business change will
be that much greater. This will include factual (details of changes to functional
and risk profiles), commercial (rationale for business change), and analytical

(evaluation of alternative options, and of assets transferred) evidence. It is clear

from the OECD Guidelines that, other things being equal, the compliance burden
will be significantly higher for a group undertaking business restructuring than one
in steady state.
20.4 Domestic law approaches to transfer pricing compliance
It is not possible to set out all the requirements in all countries. Nevertheless, there
are common themes of which taxpayers should be aware:
• Legislative requirement for documentation – In some countries (such as the

United States), taxpayers are required to have in place documentation at the
time that a return is filed with the tax authority. Indeed in certain jurisdictions,
taxpayers meeting certain criteria are expected to submit that
documentation with the return to the tax authority.
• Administrative practices around documentation – In some territories, while

there is no legislative requirement for documentation, the administrative
practice of the tax authority renders it essential to prepare contemporaneous
documentation. Short response times (sometimes two weeks or less) to a
request for the submission of documentation ensure that taxpayers are well
advised to maintain analysis. This can be compounded by a refusal by tax
authorities to consider any evidence not submitted with the initial response to
a documentation request.
• Specific content – taxpayers should be aware that some tax authorities impose
specific requirements on the content of documentation. This may be as simple
as requiring documentation to be maintained in local language or a specific
format. Alternatively, tax authorities may require specific information to be
included, such as transactional data or information relating to the local
business operations. In addition, the tax authority may specify the form of the
analysis, such as requiring the local entity to be the tested party irrespective of
the policy applied by the taxpayer, or requiring the use of local comparable
data rather than regional or global sets.
• Transfer pricing disclosures – a growing trend is for tax authorities, including

those of countries such as Australia, Denmark and Malaysia, to request
information relating to transfer pricing as part of the tax return. Information to
be provided typically discloses the size and type of transactions involving the
taxpayer, as well as the location of the counter parties. Taxpayers may also be
required to provide information on the transfer pricing method(s) applied and
the level of contemporaneous documentation maintained.
• Safe harbours – These are simple rules or provisions that taxpayers can follow to
have certainty over tax treatment (eg. Cost plus a defined margin for
specified services). The existence of safe harbours may provide relief from tax
compliance burdens, where tax payers meet the defined criteria. We look at
these in more detail below.
Many countries use the OECD Guidelines as the starting point for establishing
documentation requirements. However, taxpayers should avoid the assumption
that preparing documentation consistent with OECD principles will be sufficient to
avoid compliance penalties. In particular, for countries where taxpayers are
aware that they have significant transfer pricing risk (typically arising from
losses/low profit or complex transactions), careful consideration should be given to
local tax authority requirements and expectations.

20.5 Unilateral or multilateral documentation?
The range of different environments created by tax authorities provides taxpayers

with a choice of how best to approach compliance. Once mandatory
compliance issues have been dealt with, the most fundamental choice to be
made is around approach to documentation, both in terms of the level of
resources to commit and the degree of global co-ordination.
In many ways the simplest is to compile unilateral documentation in countries that

are deemed to be sufficiently at risk of an enquiry. Such analysis is prepared on a
standalone basis, often by the local tax team rather than the global one and is
designed to meet the specific requirements of an individual country. The
functional analysis and benchmarking are likely to be focused on the country
being documented, rather than a broader perspective of the supply chain. Such
an approach has the obvious drawback that it can be highly inefficient, as there is
likely to be significant duplication in effort where unilateral documentation is
prepared in multiple territories. More significantly, it can result in inconsistencies in
the analysis being prepared. One of the key developments in tax authority
behaviour in relation to transfer pricing has been the increased sharing of
information. Companies taking the approach of preparing separate reports in
different territories run the risk of contradictory analysis (such as different
approaches to the use of CUPs, different benchmarking approaches) which can
significantly undermine the analysis prepared.
The alternative is to prepare some form of multi-jurisdiction documentation. This

could take the form of bilateral, regional, business unit-focused, or even global
analysis. Such documentation presents consolidated analysis for the purposes of
supporting cross border transactions in a number of territories in a single report. It
provides the tax authority with a more complete overview of the taxpayer's value
chain. It can be more onerous to prepare, requiring potentially substantial co-
ordination of resources by taxpayers. Nevertheless, there are likely to be
efficiencies in production and benefits in the ability it creates to monitor and
control a group's transfer pricing risks from a central perspective.
One potential drawback from the multi-jurisdiction approach is the lack of

flexibility to meet individual country requirements. Taxpayers may produce robust
analysis that is consistent with the approach set out in the OECD Guidelines, yet fail
to meet country-specific compliance needs. There have been several initiatives to
address this matter. The Pacific Association of Tax Authorities (PATA) has provided
guidance on a documentation package that, if followed by taxpayers, would be
accepted as appropriate documentation in Australia, Canada, Japan and the
United States.
Within Europe, the EU Joint Transfer Pricing Forum has also provided guidance on
documentation that should meet compliance requirements in Member States. The
approach supported is that of the masterfile concept. Under this approach,
documentation is compiled in two parts: a centralised masterfile contains relevant
standardised information for the global group, and this is supplemented by
country-specific appendices addressing local country issues. The combination of
efficiency and flexibility created by this approach means that it is being
increasingly used by taxpayers, not just to address their European compliance
needs but indeed their global ones as well.
20.6 Non-Documentation Considerations
Transfer pricing compliance issues extend beyond the realms of documentation,

even if that is often the focus of consideration. Throughout the lifecycle of related

party transactions, there are a number of areas where compliance issues need to
be addressed. Even if the driver behind these issues is not corporate tax, the tax
practitioner still needs awareness of what needs to be done.
Before the transaction
As well as analysis to ensure that transfer prices are set on arm's length basis,
companies must also ensure that several other factors are addressed before
transactions are even entered into. Most notably, there is the issue of
intercompany agreements. From the perspective of the OECD Guidelines,
intercompany agreements are relevant, insofar as they can provide a starting
point for understanding the expected division of responsibility, risks and assets
between the parties. However, from an OECD perspective they are not essential,
and in their absence the terms of the legal arrangements between the parties can
be deemed from the behaviours exhibited.
However, in practice this approach is not followed by all jurisdictions. In certain

territories, it is required to have a legal agreement in place before deductions will
be given in relation to intercompany charges. Predominantly, this relates to royalty
payments for use of intellectual property, and fees paid for related party services.
Indeed, royalty payments may require pre-approval by tax or finance authorities
and be subject to strict limits.
Related to this is the interaction between transfer pricing and foreign exchange
controls. Foreign exchange controls are particularly prevalent across BRIC (Brazil,
Russia, India and China) and developing economies, and can restrict
multinational companies' ability to remit payment for services provided. Thus, even
where it can be demonstrated that the terms of a transaction meet the arm's
length standard, executing the transaction on the terms desired may not be
possible. For countries where foreign exchange controls are relevant, appropriate
approvals should be sought before the transaction is entered into where possible.
Executing the transaction
Where a related party transaction is entered into, due consideration should be

given to accounting requirements. Transactions should be recorded appropriately
and records maintained to support the statutory accounts, with appropriate
remittance. In some cases, taxpayers may choose to offset transaction flows in
opposite directions. This concept of intentional offsetting is acceptable under
OECD principles, although care needs to be taken to evaluate the arm's length
nature of each side of the series of transactions, and recording the basis for
believing that the set off is reasonable. Furthermore, consideration needs to be
given to secondary tax implications from offsetting transactions (such as indirect
tax or withholding tax).
Appropriate invoicing is also important, particularly where transactions involve the

provision of related party services. In some countries, tax deductions will not be
given for related party service charges unless supported by an invoice giving an
adequate description of the services provided. Other countries may require the
basis for calculating the charge to be included with the invoice.
Where intercompany transactions relate to services, royalty payments or interest,

consideration needs to be given to withholding tax obligations. Taxpayers should
be aware not only of the rate that is payable, but also the timing of the
obligations. In some territories, the timing will be determined by when payment is
actually made, but in others, it will be determined with reference to when the
service is provided (or interest or royalty becomes payable), which may well be at
an earlier date. Furthermore, where withholding tax rates are reduced under a

double tax treaty, taxpayers should ensure they understand whether this reduction
is automatically applied, or whether a further process needs to be followed in
order to benefit from the treaty rate.
After the transaction
Many companies manage their transfer pricing through the use of adjustments.
These adjustments are made either periodically through the year, or at year end,
to ensure that the group's transfer pricing policy is met. For example, there may be
retrospective adjustments to intercompany selling prices to ensure that a
distributor earns an operating margin within a targeted range. Consideration
should be given to the acceptability of such adjustments for local tax authorities.
Furthermore, there should be awareness of the potential customs implications of ex
post adjustments to the transfer price.
Where adjustments result in a downward adjust to the price, then the taxpayer will
have overpaid customs duties. However, claiming refunds from customs authorities
can be an arduous process, and indeed is not always possible. A more significant
risk arises where the adjustment results in an increase to the transfer price. This
could result in additional customs liability that may need to be disclosed, with
potential penalties and likely increased attention from customs authorities in future.
20.7 BEPS action plan and documentation
The Base Erosion and Profit Shifting (BEPS) action plan released in July 2013 (see
latest developments chapter for further detail) contains proposals relating to
documentation.
Action 13 is as follows:
“Develop rules regarding transfer pricing documentation to enhance

transparency for tax administration, taking into consideration the compliance
costs for business. The rules to be developed will include a requirement that MNE’s
provide all relevant governments with needed information on their global
allocation of the income, economic activity and taxes paid among countries
according to a common template.”
Thus it is proposed that there should be a common template for documentation

going forward. The OECD see this action plan as leading to changes to the
transfer pricing guidelines. The aim is to publish recommendations regarding the
design of domestic rules by September 2014.
20.8 Safe harbours
In May 2013 a revised section E to chapter IV of the 2010 OECD Transfer Pricing
Guidelines was approved by the OECD.
The revised section E changes the stance on safe harbours. Paragraph 4.94
acknowledges that the original guidelines were generally negative towards the
use of safe harbours. Up to May 2013, the Guidelines concluded that transfer
pricing safe harbours were not generally advisable, and consequently the use of
safe harbours was not recommended. Despite this recommendation many
member countries did have some form of safe harbour rules.
The revised Guidelines state that safe harbours will be most appropriate when
directed at low risk transactions and/or taxpayers (see paragraph 4.96 revised
section E).

The revised Guidelines recognise that safe harbours can be a benefit to tax
administrations as well as taxpayers.
Paragraph 4.100 of the revised section E contains the following definition:
“A safe harbour in a transfer pricing regime is a provision that applies to a defined

category of taxpayers or transactions and that relieves eligible taxpayers from
certain obligations otherwise imposed by a country’s general transfer pricing rules
A safe harbour substitutes simpler obligations for those under the general transfer
pricing regime. Such a provision could, for example, allow taxpayers to establish
transfer prices in a specific way, e.g. by applying a simplified transfer pricing
approach provided by the tax administration. Alternatively, a safe harbour could
exempt a defined category of taxpayers or transactions from the application of all
or part of the general transfer pricing rules. Often, eligible taxpayers complying
with the safe harbour provision will be relieved from burdensome compliance
obligations, including some or all associated transfer pricing documentation
requirements.”
So we can see that a safe harbour can take many forms.
Certain forms of safe harbour are not covered by the discussion in the revised
section E; these include administrative simplifications and exemption from certain
documentation requirements, APAs and thin capitalisation rules. (See paragraph
4.101 revised section E)
The Guidelines set out a discussion on the pros and cons of safe harbours covering
the same points as in the previous Guidelines. No new advantages or
disadvantages have been added, however the discussion is now more positive,
with suggestions of how bilateral or multilateral safe harbours could help reduce
the problem areas.
The advantages of safe harbours are identified as
• Simplification of compliance and reduction of compliance cost
• Provision of certainty
• Allowing tax administrations to redirect resources to higher risk taxpayers and

or transactions.
(See paragraph 4.103 revised section E)
The Guidelines also state the concerns that the use of safe harbours can give rise
to
• Use of safe harbours may mean that the arm’s length principle is not adhered
to
• Unilateral adoption of safe harbours may increase the risk of double taxation
or double non taxation
• There could be an increase in inappropriate tax planning. Taxpayers may shift

income or change the size of transactions to ensure they come within the safe
harbour rules
• There may be issues of equity and uniformity where apparantly similar tax
payers are not able to use the safe harbours because of the criteria.

(See paragraph 4.108 to 4.124)
The revised section E concludes that “However, in cases involving smaller

taxpayers or less complex transactions, the benefits of safe harbours may
outweigh the problems raised by such provisions.” (See paragraph 4.127 revised
section E).
The recommendations are that where safe harbours are adopted:
• There should be a willingness to modify safe harbour outcomes in the mutual

agreement procedure (MAP). (MAP will be covered in the next chapter.)
• The use of bilateral or multilateral safe harbours is best
• There should be a clear recognistion that a safe harbour, whether adopted on

a unilateral or bilateral basis, is in no way binding on or precedential for
countries which have not themselves adopted the safe harbour.
The Guidelines go on to state that for complex and high risk areas it is unlikely that
safe harbours can offer a workable solution.
The final recommendation is that tax administrations should carefully weigh the
benefits of and concerns regarding safe harbours, making use of such provisions
where they deem it appropriate. We can see this as somewhat of a move from
the previous negative stance on safe harbours.
20.9 Summary
The approach taken by taxpayers to transfer pricing compliance is influenced by

many factors. At its heart is the core assertion in the OECD Guidelines that transfer
pricing is not an exact science. The natural corollary to this is that it is impossible to
be prescriptive in matters of compliance because so much comes down to
matters of judgement. Ultimately taxpayers must decide how much resource they
are willing and able to commit to transfer pricing compliance, based upon their
risk profile and their own appetite for risk. Having done that, they must then use
that resource to produce analysis that best persuades tax authorities of the arm's
length nature of their pricing. The OECD Guidelines, as well as local country
guidance, provides some direction as to what might be appropriate, but not
certainty. As such, approach to transfer pricing compliance is fundamental part of
the strategic approach to global tax risk management for many companies.

CHAPTER 21
AVOIDING DOUBLE TAXATION AND DISPUTE RESOLUTION I
In this chapter we look at:

– transfer pricing audits
– corresponding adjustments
– secondary adjustments
– Article 25 of the OECD Model Tax Treaty (MAP)
– arbitration in double tax treaties
– the EU arbitration convention
21.1 Introduction
Despite the OECD 2010 Transfer Pricing Guidelines and the arm's length principle
being accepted by the majority of countries, tax authorities often seek to apply
the methodology in the OECD Guidelines differently. These differences can often
leave MNEs in the middle seeking to avoid double taxation as a result of the
differences in interpretation.
Double taxation can be either juridical or economic in nature. Juridical double

taxation occurs when tax is imposed in two (or more) territories on the same
taxpayer in respect of the same income. This may arise where, for example, a
company resident in one territory derives source income in another country and
the domestic tax legislation of both countries taxes that income. It can also arise
when more than one tax authority considers the taxpayer to be locally tax
resident. Economic double taxation occurs when more than one tax authority
includes the same income in the tax base of different taxpayers. Transfer pricing
disputes can trigger both economic and juridical double taxation.
There are a number of ways to reduce or eliminate the impact of double taxation.
The OECD Guidelines Chapter IV covers avoiding and resolving dispute resolution.
It is noted however, that in some circumstances taxpayers may accept a certain

amount of economic double taxation because it is more costly to defend an audit
than accept the additional tax. Furthermore, where a tax authority introduces
administrative simplification procedures, such as safe harbours, in order to access
the safe harbour and consequently reduce the compliance burden, the taxpayer
may accept an element of double taxation.
Taxpayers therefore need to consider the various ways in which the risk of double
taxation can be reduced or eliminated and/or whether a certain level may be
considered acceptable. This is often carried out by the tax department as part of
a MNEs transfer pricing risk management strategy. In considering their strategy,
taxpayers should weigh up the advantages and disadvantages of dispute
management versus dispute avoidance. The various options are illustrated in the
following diagram:

In this chapter we will concentrate on the dispute management aspect. We will

explore from a theoretical and practical perspective, how taxpayers can minimise
double taxation as part of the audit process and we will describe the dispute
resolution frameworks available (MAP, EU Arbitration Convention). We will also
consider how and why most tax disputes are settled away from formal dispute
resolution mechanisms. In the next chapter, we consider how advance pricing
arrangements (APA) can be used in order to avoid double taxation arising in the
first place.
In considering the options following settlement, it is interesting to note that against

a backdrop of budget deficits and increasingly aggressive tax authority enquiries,
the EU Arbitration Convention is not widely and routinely used. Given that transfer
pricing audits are widely reported as a key priority of tax authorities around the
world, it appears that taxpayers are not turning to EU arbitration to resolve their
issues. It seems, whilst factors such as cost and reputational risk have their part to
play in dissuading stakeholders from pursuing such channels, other influences such
as tax authority prudence and speed of resolution (or otherwise) have an impact
here.
21.2 Transfer pricing audits
Transfer pricing audits are the process whereby a tax authority undertakes a
review of an enterprise's transfer pricing affairs to ensure it is compliant with local
legislation. The OECD Guidelines note that examination practices will vary widely
among OECD member countries (see OECD 2010 Transfer Pricing Guidelines
paragraph 4.6). The burden of proof in determining whether pricing arrangements
are arm's length will also differ. Although in many jurisdictions it will be with the tax
administration, (see OECD 2010 Transfer Pricing Guidelines paragraph 4.1) the UK is
one of a growing group where the onus is on the taxpayer via self-assessment.
Transfer pricing audits constitute a significant business risk to MNEs. Transfer pricing
risk management is therefore crucial for taxpayers to identify risks areas prior to a
potential audit. Pre-audit planning can include defence strategies such as the
preparation of contemporaneous transfer pricing documentation or negotiation of
a unilateral or a bilateral/multilateral APA to obtain certainty going forward.
Transfer pricing disputes will include factual enquiries. The interpretation of the
facts in a transfer pricing context rarely offer one ‘correct answer’. As a result,

disputes may arise and the transfer pricing audit can be a long, drawn out
process.
The resolution of a transfer pricing dispute rests in an area where judgement and
degrees of differences apply. By working with the tax authorities to focus their
enquiries on relevant information and providing the information in a way that
supports the reasonableness and accuracy of the taxpayer's transfer pricing
policy, the company increases its chances of resolving transfer pricing audits
quickly. The best strategy for an early settlement involves:
• a cooperative approach;
• active involvement from the beginning;
• transparency and guidance; and
• submission of the supporting evidence such as transfer pricing documentation

file.
Joint audits are a method of monitoring compliance with transfer pricing

legislation. There are two possible options for joint audits, one being a joint team of
individuals from more than one tax authority acting as one team to jointly identify
issues. Independence would need to be protected, as there may be a loss of
individuality for tax authorities. The second being a three-way engagement
involving the taxpayer, the tax authority of Country A and the tax authority of
Country B. The advantages of this option are that risks can be assessed, there is a
reduction of compliance burdens and a discussion of the relevant factors can be
conducted at the same time. This should allow more collaboration whereby all
sides can hear the arguments put forward, also potentially avoiding double
taxation arising and the subsequent need to take adjustments to MAP.
21.3 Corresponding Adjustments
The conclusion of transfer pricing audits may result in the agreement of a transfer
pricing adjustment arising from the application of Article 9(1) of the OECD Model
Tax Convention. (See OECD 2010 Transfer Pricing Guidelines Paragraph 1.6.) Where
a transfer pricing adjustment has been made in one territory and there is no
corresponding adjustment in the second territory, prima facie there is double
taxation.
Article 9(2) of the current OECD Model Tax Convention seeks to address this by
providing that where an adjustment has been made as envisaged under Article
9(1):
“then that other State shall make an appropriate adjustment to the amount of
the tax charged therein on those profits. In determining the adjustment, due
regard shall be had to the other provisions in this Convention and the
competent authorities of the Contracting States shall if necessary consult with
each other.” (OECD Model Tax Convention (July 2010) Article 9(2))
Corresponding adjustments mitigate double taxation in cases where one tax

authority increases a company's taxable profits (i.e, by making a primary
adjustment) as a result of applying the arm's length principle to transactions
involving a related party in a second tax jurisdiction. The corresponding
adjustment in such a case would constitute a downward adjustment (a decrease
in profits) to the tax liability of the related party, made by the tax authority of the

second jurisdiction, so that the allocation of profits between the two jurisdictions is
consistent with the primary adjustment and double taxation is avoided.
The commentary to the OECD Model Tax Treaty notes that the adjustment is not
automatic and is therefore subject to the agreement of the other tax authority.
(See Commentary on OECD Model Tax Convention (July 2010) Article 9,
paragraph 7.) In practice, tax authorities consider requests for corresponding
adjustments under mutual agreement procedures (MAP) included in the relevant
double tax treaty (DTT), in order to address the economic double taxation caused
by a transfer pricing adjustment.
DTTs mitigate the risk of double taxation by providing agreed rules for taxing
income and capital. They also provide guidance on effective tax dispute
resolution mechanisms to be applied in cases where the competent authorities of
the contracting territories to a transaction are in disagreement.
Article 9 does not specify the method by which a corresponding adjustment

should be made and therefore the method used is left to the discretion of the
relevant tax authorities. OECD member countries use different methods to provide
relief in cases where a primary adjustment has resulted in double taxation. Tax
authorities bilaterally agree on what method is appropriate depending on the
facts and circumstances of each case. (See commentary on OECD Model Tax
Convention (July 2010) Article 9, paragraph 7.) A corresponding adjustment can
be made in two ways: by recalculating the profits subject to tax in the second
territory that is party to the transaction (ie, making the corresponding adjustment in
the tax return) or by granting the associated party in the second territory tax relief
against its own tax paid for the additional tax arising from the primary adjustment.
(See commentary on OECD Model Tax Convention (July 2010) Article 9 paragraph
7.)
Once a tax authority has agreed to make a corresponding adjustment, timing

needs to be considered as the corresponding adjustment may either be passed in
the year during which the original transaction took place or an alternative year
such as the year in which the primary adjustment was determined. This issue is not
addressed by the OECD Model Tax Convention. (See commentary on OECD
Model Tax Convention (July 2010) Article 9, paragraph 10.) The former approach is
generally preferred as it achieves a matching of income and expenses and more
accurately reflects the economic position as it would have been if the controlled
transaction had been at arm's length. (See commentary on OECD Model Tax
Convention (July 2010) Article 9, paragraph 10.) Timing issues may also raise a
question as to whether a party to the transaction is entitled to interest on the
portion of the overpaid tax.
Article 9 does not impose specific time limits within which corresponding
adjustments should be made and therefore the provisions of the tax treaty or
domestic laws of the relevant territory apply. Relief under Article 9 may not be
available if the time limit provided by the treaty or domestic law for making
corresponding adjustments has expired. (See commentary on OECD Model Tax
Convention (July 2010) Article 9 paragraph 10.)
21.4 Secondary Adjustments
Primary adjustments and their corresponding adjustments change the allocation

of taxable profits of MNEs for tax purposes as they result in the adjustment of tax
computations, where necessary, to reflect the position that would have existed
had the related party transaction taken place at arm's length. Unless these
adjustments in the tax computations are matched by payments between the

affected parties, the economic circumstances of the parties will be distorted. This
distortion can have a significant and continuing impact on capital structure and
more generally on profit potential, and thus on future tax liabilities. To address this
problem some territories have introduced provisions into domestic legislation that
require secondary adjustments to be made.
Secondary adjustments attempt to account for the difference between the re-
determined taxable profits and the original profits. They will treat additional profits
resulting from primary adjustments as having been transferred in some other form
such as a constructive dividend, equity contribution or loan and tax them
accordingly. (OECD 2010 Transfer Pricing Guidelines paragraph 4.66). Whilst they
do not themselves restore the financial situation of the parties to what it would
have been had the transaction which gave rise to the transfer pricing adjustment
been made at arm's length, secondary adjustments can be administered to
encourage the restoration of funds to their proper place or, failing this, allow
adjustment of the tax effects of the distortion that might otherwise arise. (See
OECD 2010 Transfer Pricing Guidelines paragraph 4.68).
The OECD Model Tax Convention does not address the topic of secondary
adjustments. (Commentary on OECD Model Tax Convention (July 2010) Article 9
paragraph 8). Secondary adjustments are however, discussed in the OECD
Guidelines although many countries do not actually require or recognise them.
(OECD 2010 Transfer Pricing Guidelines paragraphs 4.66-4.76).
The UK does not require secondary adjustments although the UK will consider
corresponding adjustments for secondary adjustments required by other
jurisdictions on their own merits. (SP1/11 paragraph 54).
Where countries have introduced provisions into their domestic legislation that
require secondary adjustments to be made they are usually compulsory, although
tax authorities will generally allow taxpayers to prove the exact nature of the
transaction and in some cases to repatriate funds, for example by way of a
constructive dividend, in order to avoid the secondary adjustment.
The exact form that a secondary transaction takes and the consequence of the
secondary adjustment will depend on the facts of the case and on the tax laws of
the country that asserts the secondary adjustment. (OECD 2010 Transfer Pricing
Guidelines paragraph 4.68). This example, taken from the OECD Guidelines,
illustrates the point:
Related parties located in Territory A and Territory B enter into a related party
transaction. As a result of the transaction being deemed not to occur at arm's
length, Tax authority A makes a primary adjustment that results in an increase in
taxable profits in Territory A. Tax authority A then elects to make a secondary
adjustment that treats the additional profits as being a loan from the related party
in Territory B. In this case, an obligation to repay the loan would be deemed to
arise. The loan approach therefore affects not only the year in which the
secondary transaction is made but also a number of subsequent years until such
time as the loan is considered to be repaid. (OECD 2010 Transfer Pricing Guidelines
Paragraph 4.67).
Tax Authority A could alternatively treat the additional profits as being a dividend
in which case withholding tax may apply.
Secondary adjustments are not a common occurrence. A questionnaire was

circulated to all member states by the European Union Joint Transfer Pricing Forum
in June 2011 to discuss secondary transfer pricing adjustments. Of the 27 member
states that responded to the questionnaire, only nine had legislation in place that

allowed for secondary adjustments. In practice, in most European countries,

secondary adjustments are rarely enforced. Within the 18 member states not
having such legislation, no member state planned to introduce this legislation.
 Illustration 1
The following illustrates the application of transfer pricing adjustments between the
UK and a foreign territory, in this case, the US:
UK Ltd, a subsidiary of US Inc, purchased finished goods and services from US Inc
for resale into the European market but left the amounts due outstanding on inter-
company account. The Internal Revenue Service (IRS) challenged the
accumulation of the trading balance and contended that part of the trading
debt should be re-categorised as long term funding debt on which an interest
charge should be imputed. The pricing basis for the underlying transactions was
not challenged. After lengthy negotiations, a settlement was reached and signed
between US Inc and the IRS. Interest income was imputed by the IRS on a deemed
loan for the four calendar years 2000 to 2003. In 2006, US Inc raised an invoice to S
Ltd for this interest, which was recorded as a profit and loss charge in UK Ltd's
statutory accounts and paid in 2007.
HMRC initially refused UK Ltd's deduction claimed for the interest on the basis that
there was no legal obligation for UK Ltd to pay interest to US Inc. HMRC also stated
that a taxpayer may not make a corresponding adjustment unilaterally and the
only mechanism by which to achieve deduction is through MAP. A MAP
application was made on the basis that a corresponding adjustment was being
claimed in the UK for a transfer pricing adjustment made in the US in accordance
with Article 9(2). The application was successful and UK Ltd were granted a
deduction for the interest charged from US Inc. In this case, it is noted that as the
interest was actually charged and paid, no secondary adjustment would have
arisen. The process took around nine months to complete once the application
was made to HMRC. Much of this time was waiting for the competent authorities
to discuss the matter in the first instance.
21.5 Article 25 of the OECD Model Tax Treaty (MAP)
Introduction
The Mutual Agreement Procedure (MAP) is a mechanism designed for dispute

resolution matters when dealing with double taxation. Where, as a result of the
actions of one or both fiscal authorities that is party to a double taxation
agreement, a taxpayer is suffering double taxation, most treaties contain a
mechanism for arbitration. The taxpayer states its case to the competent authority
of the state in which it is resident. If the competent authority is unable to resolve
the matter unilaterally, the competent authorities of both contracting states
consult to endeavour to resolve the matter by mutual agreement.
MAP is covered by Article 25 of the OECD Model Tax Convention. The July 2008
OECD Model Tax Convention included additional clauses on arbitration which
taxpayers can request if an outcome is not achieved as a result of competent
authorities consulting with each other. MAP arbitration together with the EU
Arbitration Convention which is a separate mechanism for EU countries, are
discussed in further detail below.
The commentary to Article 25 indicates that MAP should be used to resolve

difficulties arising from the application of the Convention in the broadest sense
(OECD Model Tax Convention (July 2010), commentary to Article 25, paragraph 1).

In practice it is used where double taxation has arisen in areas for which it is the
specific purpose of the Convention to avoid double taxation (OECD Model Tax
Convention (July 2010), commentary to Article 25, paragraph 9).
Common scenarios of double taxation where MAP is required include:
• cases of transfer pricing adjustment (and no corresponding adjustment) due

to the inclusion of associated enterprise profits by the taxing authority in one
state, under paragraphs 1 and 2 of Article 9;
• issues relating to attribution of profits to a permanent establishment, under

paragraph 2 of Article 7;
• excess interest or royalties under the provisions of Article 9, paragraph 6 of

Article 11 or paragraph 4 of Article 12;
• situations regarding 'thin capitalisation' when the state of the debtor company
has treated interest as dividends, based on Article 9 or paragraph 6 Article 11;
• cases of misapplication of the Convention with regard to residency

(paragraph 2, Article 4), or the existence of a permanent establishment
(Article 5).
Transfer pricing adjustments and MAP
Transfer pricing adjustments may give rise to economic double taxation (OECD
Model Tax Convention (July 2010), commentary to Article 9, paragraph 5 ). To
eliminate double taxation that may be caused by transfer pricing adjustments,
Article 9(2) of the Convention states:
"..that other State shall make an appropriate adjustment to the amount of the
taxes charged therein on those profits."
However, this adjustment is not automatic and only applies when the second state
agrees to the adjustment both in terms of the quantum and principle (OECD
Model Tax Convention (July 2010), commentary to Article 9, paragraph 6)
In order to give effect to this, Article 9(2) says that:
"… the competent authorities of the Contracting States shall if necessary consult
each other."
Such consultation will take place by way of MAP.
To prevent economic double taxation, the taxpayer may request the competent
authority of the first country to discard or decrease the transfer pricing adjustment.
Alternatively, the taxpayer may call for the competent authority of the second
country to enforce a corresponding adjustment. The UK competent authority is
open to receiving such representations from taxpayers although the decision will
of course be made between the competent authorities.
Article 7 of the Convention and the OECD Report on the Attribution of Profits to
Permanent Establishments, provides a mechanism for entering MAP where a
branch or permanent establishment exists, similar to that in Article 9 of the
Convention.

Administration of MAP
MAP can be entered into either at the request of the taxpayer or the request of
the tax authorities.
i. Taxpayer begins MAP proceedings
Dealings between the taxpayer and resident state – this allows the taxpayer to
apply to the competent authority of his state of residence regardless of any
remedies available under domestic law. The competent authority is obliged to
consider if the taxpayer's case is justified, and if so, take appropriate action. If
the complaint of double taxation is wholly or partly due to measures taken in
the taxpayer's resident state, a quick resolution may be provided by making
the necessary adjustment or allowing appropriate relief. Resorting to MAP in
this instance may not be necessary. However, the exchange of information
and opinions with the competent authority of the other contracting state may
be useful for interpretation purposes. If the competent authority of the resident
state views the objection to taxation to be in whole or part as a result of a
measure taken in the other state, it must commence proceedings for MAP.
ii. Tax authority begins MAP proceedings
Dealings between states – when the competent authority of the resident state
considers MAP to be the appropriate route in addressing the case, an
approach is made to the competent authority of the other state.
If we use the UK as an example, we see that the UK has no set form of

presentation for cases to be dealt with through MAP. Specific treaties may state
certain information that is necessary and the UK's treaty partner may have
domestic guidance too. UK taxpayers should specify the relevant year(s), the point
of taxation not in accordance with the treaty and the full names / addresses that
the MAP claim relates to.
Note, the UK stipulates that a taxpayer cannot pursue domestic legal remedies
and MAP simultaneously (SP1/11, paragraph 21). This approach is the same as that
adopted by most countries and is discussed in the commentary to Article 25 (
OECD Model Tax Convention (July 2010), commentary to Article 25, paragraph 76
). If a case is presented to MAP by the taxpayer and subsequently accepted by
the UK competent authority, a suspension of domestic remedies is a requirement
of the UK competent authority, or MAP will be delayed until these remedies are
expended. Potential domestic legal remedies of the opposing state should also be
suspended; however the UK recognises these could be time consuming, therefore
the UK competent authority may be willing to continue the MAP process in the
meantime. However, the relevant competent authority in the other state may not
take the same course of action. The competent authorities of both states are
obliged to use their best endeavours to reach mutual agreement and resolve
difficulties arising through the interpretation or application of the Convention to
eliminate double taxation. However, Article 25 of the Convention does not
guarantee relief from double taxation. Nevertheless, for MAP cases involving
transfer pricing adjustments, this has proved in the case of the UK to be a very
effective mechanism for eliminating double taxation in the UK (SP1/11, paragraph
14).
The MAP allows competent authorities to resolve, where possible, difficulties in the
application or interpretation of the Convention. MAP may also address more
complex situations of double taxation, such as cases of a resident of a third state
having a permanent establishment in both contracting states.

The UK encourages the use of Article 26 of the Convention, regarding exchange of

information, to assist competent authorities so they have all the necessary facts
during the decision making process. Competent authorities may communicate
directly, so it is not necessary to go through diplomatic channels. For transfer
pricing MAP matters, taxpayers may have the opportunity to present the relevant
facts to the competent authority orally as well as in a written format if invited to do
so.
Stages of MAP and illustrative time frames
The OECD has issued an illustrative process and timeline as part of its report issued
in 2007 (OECD Report: Improving the Resolution of Tax Treaty Disputes). The key
steps and illustrative time frames for MAP included in this report are detailed
below. The illustrative timeframe is generally applicable to the majority of MAPs,
which are initiated by taxpayers (as opposed to a tax authority) except where
specific treaty clauses state otherwise.
Stage 1 – Notification and acceptance into MAP process
The taxpayer initiates MAP by submission of a MAP request. A three year time limit
is provided for by the Convention, or a time period may be outlined by domestic
provisions. The taxpayer then receives confirmation of the receipt of the MAP
request from its domestic competent authority and the MAP request is forwarded
to the other competent authority. The taxpayer or associated enterprise in the
other country is also encouraged to contact their competent authority and
provide all supporting materials to both competent authorities promptly and
simultaneously. The case is reviewed by whichever competent authority is the
adjusting competent authority and subsequently there may be requests for the
taxpayer to provide additional information within a month after initiation of MAP
by the taxpayer. The adjusting competent authority determines the eligibility for
MAP and notifies the taxpayer if the case is accepted or rejected. If the case is
accepted, a proposal is made to the relieving competent authority to commence
MAP negotiations and an opening letter is issued.
Stage 2 – Negotiation
MAP is a process of consultation rather than litigation. MAP consultations with the
other state are initiated and a position paper is issued by the adjusting competent
authority. Ideally, this occurs within four months, but no later than six months after
agreement between the competent authorities to enter into MAP consultations. A
review of the case is conducted by the relieving competent authority, which
comprises a preliminary screening for completeness of the position paper,
notification of missing information and determination whether it can provide
unilateral relief to the taxpayer. The relieving competent authority provides a
response to the position paper within six months of receiving it. Negotiations then
occur between the competent authorities. (Face to face meeting(s) between the
competent authorities can be organised in this stage, or in any other stages when
necessary). The taxpayer is not a formal party to the consultation, however
experience has shown that it is advantageous for taxpayers to be involved at an
early stage, in particular where the case involves transfer pricing adjustments.
Stage 3 – Implementation
The mutual agreement between the competent authorities is documented in the

form of a 'memorandum of understanding' and should be submitted immediately
after conclusion of the mutual agreement. The approval process for MAP includes
a one month deadline for the taxpayer and other 'interested parties' e.g. where
the administrative-territorial subdivisions or any local tax authorities' consents are

necessary or required to respond. The mutual agreement is then confirmed with

the relevant terms and conditions and an exchange of closing letters occurs. After
acceptance of the mutual agreement by the taxpayer (and if relevant, other
parties), it is implemented, but no later than three months after the exchange of
closing letters. How it is implemented will depend on the domestic rules of the
adjusting state. Guidance on the methods of giving relief in the UK is included
within SP1/11 Para 51 and will depend on the facts and circumstances of the
particular case.
An efficient MAP process is largely dependent on the audit process being

effective. The time scales outlined assume that the dispute under audit which has
led to an initial adjustment, has an associated analysis which is well documented
and at an accepted standard (i.e. in line with the OECD Transfer Pricing
Guidelines). Where this is not the case, it will prolong MAP proceedings. The length
of each stage of MAP will vary depending on the nature of the case. Where
translation is required, this may also add to the length of time the process takes.
Taxpayers can invoke MAP under a UK treaty under domestic legislation at section
124(1) Taxation (International and Other Provisions) Act 2010. The time limits
applicable will depend on the specific terms of the treaty. In older treaties to
which the UK is a party, the relevant time period may not be stated, hence the UK
domestic limit applies (four years from the end of the chargeable period to which
the case relates). Time limits for invoking MAP are usually addressed in newer
treaties. Typically Article 25 of the Convention is applied by the UK. Under the
Convention the taxpayer is obliged to present its case within three years of the first
notification of the action which results or is likely to result in double taxation. The
first notification may occur after the four year limit; thus the relevant tax treaty
extends the basic domestic four year time limit.
The taxpayer does not play a formal part in the consultation and negotiation
process of MAP. However, as a major stakeholder, the taxpayer should always be
kept informed of important milestones in its case. In addition, the taxpayer has the
right to decide to accept (or decline) the agreement between the competent
authorities. MAP cases, especially transfer pricing cases, are often complex and
highly fact specific. Therefore it may be useful for the taxpayer to present facts
and related questions in person. So the taxpayer may be asked to informally
participate in the MAP process at the discretion of the competent authorities,
despite not being part of the consultations. The UK will support this where it
perceives such participation to be beneficial, although this will also depend on the
approach of the relevant treaty partner.
MAP is not an alternative to the usual transfer pricing enquiry process. A transfer
pricing enquiry seeks to determine an arm's length level of profits for the entity /
branch in question relating to the inter-company transaction(s) at hand. MAP
establishes how the double taxation of these profits will be relieved in principle by
the treaty partners.
It is advantageous for taxpayers to present cases early to invoke MAP, especially

for transfer pricing enquiries. For instance, if a UK treaty partner is applying an
unsuitable transfer pricing methodology during the course of an audit, the UK tax
authority may be able to help demonstrate that an alternative method is more
appropriate.
Of course there have been some instances where the MAP procedure has not
produced a solution, a key one being the Glaxo case in the US. The disagreement
between Glaxo and the IRS had been ongoing for many years (since the late
1980s). The IRS position was to challenge the transfer pricing used by Glaxo UK to

remunerate (or better “under remunerate”) the US subsidiaries for marketing drugs
developed in the UK.
Once Glaxo realised that the IRS would enforce the adjustment on the US profits,
the enterprise invoked its right under the DTA to force the tax authorities in the UK
and US to enter into negotiations under MAP and to arrive to a common
agreement as to the arm’s length transfer pricing.
Glaxo had possibly wished for the UK tax authorities to help convince the IRS that
they were being unreasonable and should perhaps reconsider the size of
adjustment.
The worst case scenario envisioned by Glaxo was probably that in case the IRS
had convinced the UK tax authorities that the adjustment was legitimate, on the
basis that the transfer pricing was wrong there should be a corresponding
adjustment to reduce UK taxable profits by the same amount.
However, as per previous paragraphs, the MAP does not force the two competent
authorities to come to an agreement. The competent authorities are asked to
“endeavour” to resolve “any difficulties or doubts arising as to the interpretation or
application of” the DTA. Unluckily for Glaxo, the tax authorities did not reach an
agreement.
In summary MAP has become an increasingly important tool for taxpayers and tax
authorities alike in addressing double taxation, as it allows for competent
authorities to consult with each other on the application of double taxation
treaties. A collaborative global environment has allowed the process to become
more efficient, where authorities exchange information to reach an appropriate
outcome. The EU Arbitration Convention also provides an alternative to MAP and
tax treaty arbitration, in dealing with the elimination of double taxation related to
adjustments of associated enterprise profits, and this is discussed further in the
sections below.
21.6 The tax treaty arbitration procedure
Under Article 25 (5) of the OECD Model Tax Convention, a taxpayer can initiate
arbitration proceedings by filing a request for arbitration with one of the relevant
competent authorities no earlier than two years after the date on which the case
was first presented to one of the competent authorities and forwarded to the
other competent authority party to the dispute. (See OECD Model Tax Convention
(July 2010) Article (5 b)). Taxpayers cannot request arbitration where a decision on
the matter at hand has previously been made in the domestic court or
administrative tribunal of either treaty partner state. (See OECD Model Tax
Convention (July 2010) Article 25 (5) and Commentary on OECD Model Tax
Convention (July 2010) Article 25 paragraph 76). Only unresolved matters can be
submitted to the arbitrators. A taxpayer cannot request arbitration just because
they do not agree with the outcome of MAP, as arbitration is an extension to MAP
and not an alternative. (See Commentary on OECD Model Tax Convention (July
2010) Article 25 paragraph 64).
The annex to the commentary on Article 25 includes a sample mutual agreement

on arbitration. The sample is a form of agreement that competent authorities may
make based on the ‘independent opinion’ approach to arbitration. (See
Commentary on OECD Model Tax Convention (July 2010) Article 25 Annex
paragraph 2).

The sample agreement includes details of the application of the arbitration

process including the timetable that should be followed. The time line included in
this sample is illustrated in the table below. It is noted that this is only an example
and the competent authorities can amend this when they conclude their bilateral
agreement. (See Commentary on OECD Model Tax Convention (July 2010) Article
25 Annex paragraph 1).
The arbitration process addresses the issues in respect of which competent

authorities were unable to reach a decision through MAP, rather than focusing on
the overall case itself. The objective of the arbitration process is to enable the
competent authorities to decide upon the overall case based on the arbitrator's
determination of the unresolved issues.
An example of the arbitration process timeline
The above time line is taken from the Commentary on OECD Model Tax
Convention (July 2010) Annex – Sample Mutual Agreement on Arbitration: 2. Time
for submission of the case to Arbitration, Commentary Article 25(5).
21.7 EU Arbitration Convention
The EU Arbitration Convention, the convention on the elimination of double

taxation in connection with the adjustment of profits of associated enterprises
(90/436/EEC), was introduced in 1995 as a mechanism by which double taxation
arising from transfer pricing adjustments for transactions between two EU member
states would be eliminated. It should apply to all transactions although some
jurisdictions, such as Bulgaria and Italy, do not accept that it covers financial
transactions.
An application for relief under the EU Arbitration Convention should be made

within three years of the notification of the adjustment that is likely to lead to
double taxation. (See (90/436/EEC), Article 6 paragraph 1). Disputes settled under
the EU Arbitration Convention should reach their conclusion within a three-year
timescale from the commencement of proceedings. (See revised code of
conduct for the effective implementation of the Convention on the elimination of
double taxation in connection with the adjustment of profits of associated
enterprises, paragraph 4.).
Article 4 of the EU Arbitration Convention includes similar wording to Article 9 of the

OECD Model Tax Convention. The conclusion reached under the EU Arbitration

Convention should therefore be in accordance with the arm's length principle as

detailed in the OECD Guidelines.
The procedure is a two stage process: firstly, following a request by a taxpayer, the
tax authorities should negotiate under a mutual agreement procedure (similar to
MAP) to agree a resolution to the double taxation and then a second, arbitration
phase, if resolution is not reached, whereby the tax authorities consult
independent experts to make a binding decision.
Phase 1 – Mutual Agreement
When an application for relief under the EU Arbitration Convention is made, the
onus is on the taxpayer to initiate the relief; this may be done at the same time as
a MAP application under a DTT.
There is no set form of presentation of the application. However, the code of

conduct has a list of information that should be provided with the request. (See
Revised code of conduct for the effective implementation of the Convention on
the elimination of double taxation in connection with the adjustment of profits of
associated enterprises, paragraph 5), which includes:
– Identification of the taxpayer that has suffered double taxation;
– Identification of the other parties to the transactions;
– Details of the facts of the case;
– Details of the periods for which the transaction(s) cover; and
– Copies of the tax assessment notices and details of any appeals, the result of
which have led to double taxation.
The code of conduct states that the competent authority should respond within
one month.
If the competent authority believes that the enterprise has not submitted the
minimum information necessary for the initiation of a mutual agreement
procedure as stated under point 5(a), it will invite the enterprise, within two months
of receipt of the request, to provide it with the specific additional information it
needs.
Member States undertake that the competent authority will respond to the
enterprise making the request in one of the following forms:
i. if the competent authority does not believe that profits of the enterprise are
included, or are likely to be included, in the profits of an enterprise of another
Member State, it will inform the enterprise of its doubts and invite it to make
any further comments;
ii. if the request appears to the competent authority to be well-founded and it

can itself arrive at a satisfactory solution, it will inform the enterprise
accordingly and make as quickly as possible such adjustments or allow such
reliefs as are justified;

iii. if the request appears to the competent authority to be well-founded but it is

not itself able to arrive at a satisfactory solution, it will inform the enterprise that
it will endeavour to resolve the case by mutual agreement with the
competent authority of any other Member State concerned.
If a competent authority considers a case to be well-founded, it should initiate a

mutual agreement procedure by informing the competent authority(ies) of the
other Member State(s) of its decision and attach a copy of the information as
specified under point 5(a) of the Code of Conduct. At the same time it will inform
the person invoking the Arbitration Convention that it has initiated the mutual
agreement procedure. The competent authority initiating the mutual agreement
procedure will also inform – on the basis of information available to it – the
competent authority(ies) of the other Member State(s) and the person making the
request whether the case was presented within the time limits provided for in
Article 6(1) of the Arbitration Convention and of the starting point for the two-year
period of Article 7(1) of the Arbitration Convention. (see paragraph 6.3 f to g of the
revised code of conduct for the effective implementation of the Convention on
associated enterprises)
Where the competent authority agrees that an enterprise is suffering double

taxation, the competent authority is responsible for initiating negotiations with the
other tax authorities to agree a resolution. This resolution may be achieved by any
method deemed suitable, such as telephone calls or meetings between the two
tax authorities. (See revised code of conduct for the effective implementation of
the Convention on the elimination of double taxation in connection with the
adjustment of profits of associated enterprises, paragraph 6.1 (c)).
The taxpayer is not a formal party to the negotiation although in practice they
may have some involvement such as presenting their case to the competent
authorities. The taxpayer should also be kept informed of any developments to the
application for relief of double taxation as the case progresses. (See revised code
of conduct for the effective implementation of the Convention on the elimination
of double taxation in connection with the adjustment of profits of associated
enterprises, paragraph 6.3 (b)).
If the authorities are able to agree a suitable resolution, then the tax authorities are
advised in the code of conduct to sign a declaration of acceptance. The
outcome of the negotiations should be communicated to the taxpayer. The
taxpayer should be part of the negotiation at this stage and is permitted to reject
an agreement that has been reached between the two tax authorities if it
believes that the outcome is not consistent with the arm's length principle. (See
revised code of conduct for the effective implementation of the Convention on
associated enterprises, paragraph 6.3 (b)).
Phase 2 – Advisory Commission
The second phase of the EU Arbitration Convention is the setting up of an advisory

commission. Although there have been a number of cases under the mutual
agreement phase of the EU Arbitration Convention, it is rare for this second phase
(arbitration) to be used.
If the tax authorities are unable to agree a resolution within a two-year period from
the application date, then the tax authority that initiated the proceedings is
responsible for setting up an advisory commission to arbitrate on the matter. The
advisory commission should be provided with all of the information necessary to
make their judgement and make their decision within six months of being

established. Within the next six months, the tax authorities may agree an
alternative decision which differs to that of the Advisory Commission. If no
alternative is agreed, then the tax authorities must act in accordance with the
decision of the Advisory Commission. (See Convention on the elimination of
double taxation in connection with the adjustment of profits of associated
enterprises (90/436/EEC), Article 12). Once the decision has been made, the
decision should be communicated to the taxpayer and it may be published if the
taxpayer agrees.
Base Erosion and Profit Shifting (BEPS) action plan and MAP
Action 14 of the BEPS action plan released by the OECD in July 2013 looks at
making dispute mechanisms more effective. The aim of Action 14 is to “Develop
solutions to address obstacles that prevent countries from solving treaty-related
disputes under MAP, including the absence of arbitration provisions in most treaties
and the fact that access to MAP and arbitration may be denied in certain cases”.
The target date to make changes to the OECD model DTC is September 2015.

CHAPTER 22
AVOIDING DOUBLE TAXATION AND DISPUTE RESOLUTION II
In this chapter we look at further aspects of avoiding double taxation and dispute
resolution in particular:
– Advance Pricing Arrangements (APAs);
– international perspective and trends.
22.1 Introduction
An advance pricing arrangement (APA) is an administrative approach to avoiding

transfer pricing disputes from arising by agreeing in advance the criteria for
applying the arm's length principle to transactions. It is a procedural arrangement
between parties that differs from classic tax ruling procedures as it is more fact
specific. (See OECD 2010 Transfer Pricing Guidelines Annex to Chapter IV
paragraph 3). Agreeing an APA allows taxpayers to gain certainty over their tax
affairs from a transfer pricing perspective. The OECD Guidelines include
commentary on APAs in chapter IV, together with an annex to chapter IV,
adopted in 1999, which details ‘Guidelines for conducting APAs under MAP’ (MAP
APAs). The process gives tax authorities and taxpayers the opportunity to consult
over transfer pricing issues in a less adversarial way than may be the case as part
of an enquiry or during litigation. (See OECD 2010 Transfer Pricing Guidelines
paragraph 4.143).
22.2 What is an APA?
An APA is defined in the OECD Guidelines as an agreement between a taxpayer,

one or more associated enterprises and one or more tax administrations, to
determine in advance an appropriate set of criteria that satisfies all parties, and
can be used to determine arm's length transfer pricing for the transactions
covered by the APA over the duration of the agreement. (See OECD 2010 Transfer
Pricing Guidelines paragraph 4.123). An APA can be unilateral, bilateral or
multilateral, although tax administrations, where they allow APAs, generally prefer
bilateral or multilateral APAs. (See OECD 2010 Transfer Pricing Guidelines
paragraph 4.130).
A unilateral agreement is made between the taxpayer and their respective tax
administration. As unilateral APAs only deal with tax issues within one jurisdiction
there is still a risk that double taxation can occur (as the counter-party tax
authority may take a different stance on the matter). When a taxpayer makes an
application for a unilateral APA it is recommended that, where a suitable treaty is
in place, the tax authority informs the competent authority of the other territory
and invites them to participate in a bilateral APA. (See OECD 2010 Transfer Pricing
Guidelines paragraph 4.129).
Some tax authorities may still agree unilateral APAs in particular circumstances, for
example where the amounts at stake are small so there is very little to gain with a
bilateral agreement and/or the majority of the transfer pricing risk lies in the
taxpayer's home country or where the other party to the transaction is resident
within a jurisdiction with which there is no treaty or the treaty partner has no formal
APA process. There may be good reasons why unilateral APAs may be preferred
not least, as they only involve one tax authority, they tend to be easier to agree.

In bilateral or multilateral arrangements, two or more countries participate. A

multilateral APA is simply a series of complementary bilateral APAs with each of
the countries using the bilateral APA procedure. Bilateral or multilateral APAs are
often referred to as MAP APAs and will be agreed under mutual agreement
procedures with the other tax authority. MAP is covered in Article 25 of the Model
Tax Convention, although this article does not expressly mention APAs. It is
however considered within the OECD Guidelines that this article covers MAP APAs,
as the specific transfer pricing cases subject to an APA are not otherwise provided
for in the Tax Treaty. (See OECD 2010 Transfer Pricing Guidelines paragraph 4.139)
As well Article 25 does not oblige a competent authority to enter MAP and the
willingness may depend on the policy of the two countries involved (See OECD
2010 Transfer Pricing Guidelines Annex to Chapter IV paragraph 16).
There is flexibility over which transactions can be the subject of an APA, although
some tax authorities prefer all issues to be covered. (See OECD 2010 Transfer
Pricing Guidelines paragraph 4.136). The criteria that is to be agreed can include
the transfer pricing method to be used to demonstrate arm's length pricing, the
comparables and/or method of selection and appropriate adjustments to the
comparables and the critical assumptions in relation to future events. (See OECD
2010 Transfer Pricing Guidelines paragraph 4.123). It is difficult for APAs to go
beyond agreeing methodology and for example agree fixed results as these
would rely potentially on forecasts and budgets. For example, it may not be
reasonable in the case of a financing transaction to agree a fixed interest rate but
it may be reasonable to agree a percentage point pegged to an index such as
LIBOR or EURIBOR. (See OECD 2010 Transfer Pricing Guidelines paragraph 4.125).
There are four separate steps to the APA process, which are: expression of interest
or preliminary discussions, formal submission of an application, evaluation and
agreement.
The above diagram illustrates the APA process.
Step 1 – Initial package submission
Prior to the expression of interest or pre-filing meeting stage some tax authorities
may require certain documents, pertaining to the APA, to be submitted for
consideration.

Step 2 – Expression of Interest
This is a feature of many domestic APA processes, which can assist in dealing with
the actual APA application more quickly. (See OECD Guidelines Annex to Chapter
IV paragraph 29). The expression of interest stage makes the process more efficient
and limits waste of resources by determining whether the APA process will be
beneficial for the parties. For MAP APAs this will also allow the relevant competent
authorities to have preliminary discussions, which will also help clarify expectations
from the process.
Step 3 – Formal Application
If informal approval is received by an enterprise to enter the APA process, a formal

written application should be submitted. This will usually be in the form required by
domestic procedure.
The same information should be provided regardless of whether it is a bilateral or

multilateral APA application. The actual contents will also depend on the facts
and circumstances but should include all information necessary for the tax
authorities to consider the application. (See OECD 2010 Transfer Pricing Guidelines
Annex to Chapter IV paragraph 38).
The information provided should include the critical assumptions in respect of the
operational and economic conditions that will affect the transactions under
consideration during the course of the APA. An assumption will be critical if, where
the assumption is incorrect, this will result in the methodology not reflecting an
arm's length price.
Step 4 – Review and Evaluation
Once an application has been received, the tax authorities will evaluate its
contents and continue to liaise with the business as necessary.
Step 5 – Negotiation
The MAP APA process is a two-stage process: Stage 1 fact finding, review and
evaluation and Stage 2 the competent authority discussions. Under the first stage
all the relevant information is gathered and the taxpayer may have a high level of
involvement in this process. The second stage is a government to government
process and so may have less taxpayer involvement. (See OECD 2010 Transfer
Pricing Guidelines Annex to Chapter IV paragraph 63.)
Step 6 – Final Signing
Both a MAP APA and a unilateral APA will be normally a written document, signed
and agreed by all parties to the agreement.
The amount of time taken to complete the APA process is dependent on the
complexity of the case and the type of agreement sought.
Step 7 – Implementation and Monitoring
Tax administrations will want to monitor compliance with the APA. This can be
carried out either by way of the filing of annual reports on compliance with the
APA requirements and/or the tax authority continuing to monitor the compliance
with the APA as part of the regular audit cycle. (See OECD 2010 Transfer Pricing
Guidelines, Chapter IV 4.137).

Where the terms of an APA have not been complied with or there has been a
change in circumstance that for example affects one or more material
assumptions, the APA will be reconsidered. In these circumstances, an APA may
be revoked from an effective date, cancelled either from an effective date or
from the start or renegotiated. (See OECD 2010 Transfer Pricing Guidelines Annex
Chapter IV paragraphs 74-85).
22.3 International Perspective and trends
Many countries have an APA process in place, including the USA, Australia,
Canada, France, Germany, and Japan. There are some notable exceptions, for
example, India is only just introducing a process. Some countries have only
recently instigated APA programs in 2012 such as Russia, Hong Kong, and India.
Many countries such as Switzerland do not have formal APA programs, but have
previously allowed informal unilateral and bilateral APAs to be completed.
The APA programs will be at varying stages of development and will also vary as to
whether a territory will allow unilateral, bilateral or multilateral APAs, a combination
of all three or not at all. This can be illustrated by the differences between the
territories in the European Union. The EU Joint Transfer Pricing Forum gathered data
on the availability and number of APAs in the EU, which was discussed in June
2012.
As of the end of 2011, 14 out of the 27 countries that participated in the survey and
had statistical data available had agreed APAs. In total, there were 302 APAs of
which 166 were agreed with another EU territory and 136 agreed with a territory
outside the EU. 189 of the APAs were unilateral APAs.
The regulations relating to the APA process are found in the domestic legislation of
each country and therefore differ from one country to another. In order to illustrate
the different approaches to the APA process, and the various stages of
development, we will summarise the approaches to the APA process in the US,
China, India and the UK.
US
The US was the first country to introduce a formal APA process by outlining a set of
procedures for a business to follow. The most recent guidance was issued in
December 2005 (See IRS website) which was modified in 2008. The process has
been popular in the US and the IRS has a backlog of claims. In order to reduce the
backlog of claims and align process with MAP, the IRS underwent a period of
reorganisation and the APA program is now included within an advance pricing
and mutual agreement program.
The US will agree all forms of APAs including unilateral, bilateral or multilateral. The
taxpayer has to propose and present to the IRS a transfer pricing method and all
relevant facts so that a proper transfer pricing analysis can be performed. As with
the APA process in the UK, the administration evaluate all the information and
liaise closely with the taxpayer to ensure all information is disclosed so the analysis
is a fair representation of the taxpayer's affairs.
Following agreement, the taxpayer must submit an annual report for the duration
of the agreement. The APA applies for the agreed term from the effective date of
the APA, which can be prior to the agreement being finalised. Rollbacks are also
possible with the permission of the IRS, allowing the APA to cover earlier tax years,
which can resolve existing enquiry issues.

Unlike the UK, a user fee is charged for participation in the programme, which
ranges from US$10,000 to US$50,000, and is dependent on the specific
circumstances. The US also has a slightly different, simplified and more streamlined,
program for taxpayers with either less than US$200 million total income or covered
transactions less than US$50 million (or less than US$10 million for intellectual
property).
The IRS issues a quarterly report on the APA program. The report issued for 31
December 2011 showed that during that quarter 12 APA matters were completed
including one withdrawal, two unilateral APAs and nine bilateral APAs. As at 31
December 2011 the IRS had 445 APA matters open.
China
China began using APAs on a trial basis in the late 1990s however, the first bilateral
APA was not agreed until 2005. In 2010, the China Advance Transfer Pricing Annual
Report was issued covering APA arrangements from 2005 to 2009. This was
updated in 2012 to cover 2010. During this period, China had agreed 45 unilateral
APAs and 16 bilateral APAs of which eight were agreed in 2010. The number of
applications for APAs in China is expected to increase, especially the number
related to finance or intangible assets or services.
The State Administration of Taxation (SAT) has offered multiple reports giving
guidance on the APA process. The current guidance regarding the APA process
and procedures is provided in Articles 46 through 63 of Guoshuifa (2009) No. 2.
Access to the APA program is limited to the largest taxpayers, as an applicant's

annual related-party transactions must exceed RMB 40m. In the 2010 APA Annual
Report the SAT also states that ‘during the term of the APA, if the enterprise's
overall profit level stays below the median most of the time, where an arm's length
range is used, the tax authority may no longer accept an application for renewal
of an APA’.
Most APAs completed within China have been unilateral APAs, however bilateral
and multilateral APAs are also available. Applications for APAs should be sent to
the SAT and the municipal tax authority simultaneously. The APA process follows
the same process as described in the OECD Guidelines and as with the UK, pre-
filing meetings are encouraged. This is followed by examination, evaluation and
negotiation, which usually leads to completion of the APA. The overall processing
time for most APAs in China is less than two years, and this is likely to reduce over
time.
In the case that an APA is not followed through to completion, a new chapter
protection of taxpayers' rights on confidentiality was introduced in 2010, whereby
non-factual information about the enterprise cannot be used in future tax
investigations of the transactions covered by the proposed APA. This should
encourage taxpayers to access the program.
SAT allows for APAs to be rolled back to previous years as long as the relevant
transactions are the same or similar to those covered by the APA.
India
To address the increasing number of transfer pricing disputes arising in India, the
Union Budget 2012 introduced APAs into the Indian transfer pricing regime. The
APA scheme formed a part of the direct taxes code (DTC) (Section 118(7) of the
direct tax code), which was proposed in 2010 but had not yet been implemented.
The basic framework has been inserted in the Finance Act 2012.

Under the APA provisions (Sections 92CC and 92CD of the Income Tax Act, 1961)
applicable from 1 July 2012 access to the APA program will be available to all
taxpayers falling within the ambit of Indian transfer pricing legislation as no
threshold limit is currently prescribed.
The central board of direct taxes has announced APA officers will be based in
Delhi, Mumbai and Bangalore. The APA team is initially a nine member team with
two officers each in Mumbai and Bangalore and five officers in Delhi. These
officers will report into a central commissioner of income tax designated as the
APA Director, who will be based in Delhi. Bilateral APAs will have to be approved
through the office of the competent authority.
As the APA regime is newly introduced there is still uncertainty surrounding the
Indian APA scheme and thus far, only a basic framework has been provided in the
2012 Budget. It is also anticipated that the minimum fee level for the APA
application would be approximately INR 1 million (ie US$ 20,000) and would
increase in proportion with the value of the international transactions. Also the way
the basic rules read, provisions for rollback of the APA do not seem to be
available. The finer details of the APA regime such as the time frame, detailed
procedure, fees or whether APAs will be bilateral or unilateral are yet to be
released and thus taxpayers cannot yet access the APA route until the detailed
rules and forms are prescribed.
UK
In the UK, HMRC define an APA as ‘a written agreement between a business and
the Commissioners of HMRC, which determines a method for resolving transfer
pricing issues in advance of a tax return being made’. (See Statement of Practice
2/2010 paragraph 1). HMRC have published guidance on how they interpret APA
legislation and its practical application in Statement of Practice 2/2010 (the
contents of which are repeated in the HMRC International Tax Manual).
HMRC have operated an APA programme since 1999 (Statement of Practice

2/2010 paragraph 50) and so now have considerable experience of working on
and negotiating APAs. The APA program is open to UK taxpayers, including a non-
resident entity trading in the UK through a permanent establishment. Due to limited
resources allocated to the APA process, HMRC generally only consider more
complex and challenging transfer pricing issues. This is in line with the OECD
Guidelines as it is noted by the OECD that the APA program will not be suitable for
all taxpayers due to the expense and time taken by the procedure. (OECD 2010
Transfer Pricing Guidelines paragraph 4.158)
Even though transactions where both parties are within the UK have been subject
to transfer pricing legislation since April 2004, they are not generally included in
APAs, apart from a few exceptions such as oil-related ring fenced trades.
(Statement of Practice 2/2010 paragraph 16).
As we saw earlier in this chapter bilateral or multilateral APAs are often referred to
as MAP APAs and will be agreed under mutual agreement procedures with the
other tax authority. MAP is covered in Article 25 of the OECD Model Tax
Convention. From a UK perspective, access to bilateral and/or multilateral APAs
will only be possible where the relevant clause is included within the tax treaty in
question.
Statement of Practice 2/2010 gives guidance on this process in the UK. HMRC
recommend that any enterprise that is considering entering into the APA process
should first express their interest and informally discuss their transfer pricing issues
with HMRC. (Statement of Practice 2/2010 paragraph 18). The information that

should be included in an APA application in the UK to HMRC is detailed in Annex 1

to Statement of Practice 1/2010, which should fulfil the requirements of UK
domestic legislation. (TIOPA 2010 s223).
HMRC currently aim to complete an APA application process within 18-21 months
of formal submission. (Statement of Practice 2/2010 paragraphs 36-41). Unilateral
APAs are generally completed in a shorter time frame.
The table below gives statistics on APA applications in the UK from 2009 to 2011.
Table 1: Table showing APA statistics for the 3 years ended 31 March 2012.
2009/10 2010/11 2011/12

Applications made during the year 32 49 32
Applications turned down 3 1 0
Applications withdrawn 2 2 1
APAs agreed during year 20 35 32
Applications on hand at year end 56 67 66
Average time to reach agreement (months) 20.3 22.7 16.9
50% agreed within (months) 16.5 14.0 10.7
An applicant can withdraw from the APA application process at any time before
a final agreement is achieved. However, if an agreement cannot be achieved, a
formal statement recording the reasons for this will be prepared.
A taxpayer will be required to send an annual report with their annual tax return to
their normal tax office. (Statement of Practice 2/2010 paragraph 42). The required
contents will be agreed as part of the APA process. HMRC have stated that a
renewal application should be made not later than six months before expiry of its
existing term. (Statement of Practice 2/2010 paragraph 48).
The UK also has advance thin capitalisation agreements (ATCA) which are a form
of unilateral APA. Other than ATCAs, the UK previously favoured bilateral APAs
although there has been a softening of this attitude in the latest Statement of
Practice.
An ATCA is a unilateral APA, which is governed by the APA legislation in the UK,
although the ATCA application process is subject to separate guidance and is
separately administered. Guidance on the ATCA process is included in Statement
of Practice 01/12, which is supplemented by the Revenue & Customs Brief 01/09.
Further guidance has been issued in the HMRC Manuals. (HMRC Manual
INTM573000 onwards).
An ATCA is a process designed to help resolve financial transfer pricing issues.

(Statement of Practice 01/12 paragraph 11). It can be used to agree in advance
whether or not HMRC considers that a company is thinly capitalised and what
transfer pricing adjustments are required to affect an arm's length result.
The process for entering into an ATCA with HMRC is similar to that of other APAs
described above, although a taxpayer is more likely to make the first approach to
HMRC by way of a formal written application than as an expression of interest. In
this sense, HMRC's permission is not required to make an ATCA application.
22.4 Conclusion
As we discussed at the beginning of the chapters on double taxation taxpayers

will need to consider the various ways in which the risk of double taxation can be

reduced or eliminated as part of their transfer pricing risk management strategy.

APAs are likely to become an increasingly popular strategy particularly where tax
authorities can streamline the process and make it more accessible to smaller
taxpayers. APAs are also seen as less adversarial than other forms of dispute
resolution. Although often costly and time consuming they can have less
reputational risk as the APA process takes place behind closed doors as opposed
to the open court of litigation.
In the future, it is anticipated that the number of APA programs will increase and,
as the US has recently implemented, will increasingly be closely aligned with the
MAP programs. Although there is no fee in a number of territories, like the UK where
there does not seem to be a plan to introduce one, the APA process is resource
intensive for tax authorities and so it is likely that an increasing number of them will
impose fees to access the program. As APA programs are perceived as difficult for
all but the largest taxpayers additional fees may be a good thing where this allows
tax authorities to increase resources to allow greater access to the program.

CHAPTER 23
ROLE OF STRATEGIC & MANAGERIAL TRANSFER PRICING
In this chapter we are going to look at the broader role of transfer pricing, beyond tax
planning and compliance, within a multinational organisation, including:
– transfer pricing and public affairs;
– the impact of taxation on business decisions;
– transfer pricing as a management tool;
– customs duties and transfer pricing.
23.1 Introduction
Most of the analysis of transfer pricing so far in this manual has focused on its role
for corporate tax purposes. Broadly speaking, two key dimensions have been
identified: the challenges for compliance created by complexities surrounding
transfer pricing, and the opportunity for tax planning due to the relationship
between transfer prices and taxable profit.
However, transfer pricing is not only important for corporate tax purposes. It also
has an important role to play across a range of important aspects of the internal
operation of multinational groups. In particular, in this chapter, we will consider
the relationship between transfer pricing and each of the following:
• Public affairs
• Business decisions
• Management incentives
• Customs Duties
23.2 Transfer pricing and public affairs
For a long time, transfer pricing has had very little profile amongst the broader
public, with few people being aware of the term, much less what it means. That
situation has changed dramatically within the last 12 months. One of the main
reasons for this is the increased focus on the level of corporation tax paid by
subsidiaries of global multinational groups.
In the UK in particular, Amazon, Google and Starbucks have all come under fire,
having been called to testify in front of Public Accounts Committee in November
2012. Notwithstanding that at various points HMRC had considered the transfer
pricing of these operations, these companies were never the less called to explain
their tax affairs, and why they appeared, prima facie, to be paying relatively little
corporate tax for their size of operation. At the heart of the questions was the
transfer pricing arrangements, which placed significantly greater value on the
activities taking place overseas than in the UK.
Justified or not, it is clear that the Public Accounts Committee approached the
subject with an agenda. It comprises MPs rather than transfer pricing experts, and
therefore its approach was not based on OECD principles or a recognition of a
taxpayers need to comply with transfer pricing requirements in multiple

jurisdictions. However, its impact was clear; the brand reputation of each of the
parties under scrutiny was tainted. Indeed the response was such that Starbucks
even ‘volunteered’ to pay additional tax in the UK, whilst not seeking relief for
those payments with the Netherlands (the counterparty to its transactions).
In many ways, the companies identified by the Public Accounts Committee could
consider themselves unlucky. There are many other multinational groups with
similar transfer pricing arrangements. Indeed, following on from this, a number of
other companies, including Apple and Rolls Royce, came under the public
spotlight for the amount of taxes paid.
Nevertheless, the consequences of this shift are likely to be felt by all taxpayers. In
the short term, there are strong associations for the public between transfer pricing
and tax evasion. In many parts of the media, transfer pricing has been portrayed
as purely a planning tool, ignoring the complex compliance issues faced by any
company seeking to operate in multiple jurisdictions. Thus, the consequences for
any transfer pricing controversy issues that arise are likely to be magnified.
In the longer term, transfer pricing seems to have shifted from a policy issue for tax
authorities to a political issue. It has driven the OECD to indicate it will consider
significant changes to the way it approaches Base Erosion and Profit Shifting
(where transfer pricing is considered along with more structured tax planning
techniques), whilst governments, including the UK, are considering fundamental
overhauls of tax legislation.
The consequence of all this is that for most multinationals, transfer pricing has been
elevated from purely an issue to be resolved within the tax function to a board-
level consideration. The potential consequences of a tax strategy that might be
perceived as overly aggressive is no longer limited to the risk of double taxation,
plus interest and penalties. It is instead a potential threat to brand value, revenue,
profitability and ultimately share price. There is much to be played out before the
tax environment can again be said to be in a stable state. In the meantime, there
are a much broader set of parameters and stakeholders for taxpayers to consider
in respect of their transfer pricing than simply seeking an appropriate balance
between compliance and tax optimisation.
23.3 The impact of taxation on business decisions
In order to survive, and ultimately thrive, companies must be profitable. At a basic

level, companies exist to generate an economic return for their shareholders.
There are a range of strategies for achieving this, from high growth strategies
designed to increase the underlying share price, to profit maximisation in more
stable businesses to fund dividend payments to shareholders. A key part of
delivering such strategies relates to managing both costs and uncertainties within
businesses.
There is a clear link between transfer pricing and the tax cost to a business. The
transfer prices that are acceptable to the tax authorities will affect the tax charge
in each section of the business. Non compliance with transfer pricing legislation
can lead to penalties which in turn will impact on the cost to the business.
Thus we can see a direct link between the transfer price for taxation purposes and
the company’s overall performance. Managing tax cost is as important to a
company as any other costs, since dividends are paid out of post-tax profits.
Transfer pricing has an important role to play in managing cash flow within the
business, since it determines where profits are earned. By managing transfer
pricing to ensure that profits are earned in the right location, companies can

make sure they have cash available to fund dividends, capital investment or
acquisitions without need for recourse to external borrowing. Furthermore, it is
important to consider that some countries, such as China and India, have tight
foreign exchange controls, making it difficult to take cash out of those markets.
An appropriate transfer pricing strategy is required to avoid having trapped cash
in those countries.
In addition to being a potentially high cost to the business, tax and transfer pricing
carry a significant degree of uncertainty. As new strategic initiatives are
developed and rolled out by companies, it is important for them to manage the
tax consequences. This means considering the most likely tax treatment, the
possible alternatives and related costs, and the mitigation of unnecessary risk
through appropriate business activity. Failure to do so can lead to significant
additional cost to the business through unmanaged transfer pricing exposures. It
is impossible to decouple significant business decisions from tax (and typically
transfer pricing) consequences. Consider a number of examples of decisions that
a company might face:
• Expansion into a new territory – As companies seek to grow, they will often
seek new markets for their products. In setting up a new business, transfer
pricing considerations will affect the legal structure (branch or subsidiary), how
the new operations will be financed (debt or equity), where the set up costs
will be borne, how the new entity will transact with the rest of the group, and
forecast expected benefits (based on the tax impact of where profits will be
earned). In addition, if the business decides to enter a new territory through a
strategic relationship with a third party, this will be of relevance to transfer
pricing as the terms agreed may create a CUP (which may support or
undermine existing transfer pricing arrangements)
• Business acquisition – Where companies grow through merger or acquisition,

transfer pricing also has a key role to play. During the due diligence process, it
is important to understand the historic transfer pricing position within the
business to be acquired, as the acquirer will be taking on the risk associated
with this. Post-acquisition integration can be a challenging exercise involving
merging of two transfer pricing policies. Where policies are conflicting (for
example, one group operates a centralised business model with a Principal,
and the other uses a decentralised model with key decisions taken at a local
level), it can be a long and costly process to align the operating models.
• Closing of facilities – In the event that a company chooses to close a facility,

or even entire operations in a country, transfer pricing will help to determine
the tax cost of doing so, and specifically where those costs should be borne.
• Change of brand name – Companies that maintain a brand portfolio will need
to actively manage it, and in some cases that might involve brand refreshes.
Transfer pricing will inform the company where costs relating to brand
refreshes should be borne, and will help to determine the value of the new
brand to the brand owner through the mechanism by which it is remunerated
by other group entities.
In relation to significant business decisions, there should be a two-way flow of

information. The business needs to inform the tax function, as changes will impact
on transfer pricing risk, and may need to be managed through amendments to
policy. However, transfer pricing will also need to provide input to key decisions,
as it can be an important part of delivering returns on investment, both in terms of
absolute level of post-tax profit earned and also in controlling variability around

those returns through tax risk management. Transfer pricing should not be driving
key business decisions. Nevertheless, it is a significant factor to be considered.
PART FINISHED PRODUCT
↓
ENTITY A ENTITY B
Part finished Finished product & → 3rd party sales
product Marketing
↑
Transfer Price
23.4 Transfer pricing as a management tool
To be successful, companies rely upon individuals within organisation making the

decisions that are in its best long-term interest. In a small company, this is relatively
easy for senior management to monitor, because they will have more visibility over
the decisions being made. However, this is much harder in a larger company with
a global reach. In those cases, senior management must delegate a lot more
responsibility, and put in place infrastructure to ensure that the decisions made
align with the broader business strategy.
A key part of the infrastructure is the series of incentives given to management of

different parts of the business. Transfer prices form part of this incentive process in
that they help to determine profitability at a local level. When a product is
transferred between different parts of the business, the transfer price will determine
the profit for that division/unit. Likewise, there will be an impact from service
charges or royalty flows. Within an organisation the use of the optimal transfer
price for remuneration purposes will enhance cooperation and transparency
within the business.
Incentive conflicts created by transfer pricing
Nevertheless, the challenges of a transfer pricing model and its impact on

behaviour are best demonstrated through a number of illustrations. The scenarios
set out below relate to manufacturing, but the same issues arise in other parts of
value chain.
 Illustration 1
Contract manufacturer
Take the case of a simple contract manufacturing operation, producing products

solely on behalf of a Principal company.
Product
Contract →→→→→→→
Principal
manufacturer ←←←←←←←←
Payment
Typically under these circumstances, the manufacturing operation would be

remunerated on a cost plus basis. However, challenges arise if the management
of the manufacturer is assessed based on plant profitability. The revenue earned
by the manufacturer comes from sale of products to the Principal, and the transfer
price of products is set based on the cost of production. As such, the only way
that a manufacturer can increase its absolute level of profit is to increase costs.

Whilst this may create more profit for the manufacturer, this is reduces overall
profitability for the group.
It may be that transfer prices are based on budgeted costs. In such

circumstances, the manufacturer could strive to operate more efficiently in order
to lower actual cost compared to budget. However, such efforts would only
temporarily increase profits as the new efficiencies would be factored into prices in
the following budget cycle.
The natural conclusion is therefore that plant management shouldn’t be

incentivised on profitability, but instead be measured on performance against
factors that they can control, such as quality and efficiency. These factors would
contribute to the group’s overall profitability. This is generally straightforward
where a plant is initially set up as a contract manufacturer. However, where a
plant is converted to contract manufacturer as part of a business restructuring, this
can cause conflict. Under such circumstances, the role/responsibility of the
manufacturer is reduced and as such the scope of responsibility for the
management of the manufacturer is reduced (with potential impact to salary and
business), creating potential conflict.
 Illustration 2
Fully-fledged manufacturer
Consider now the case of a fully-fledged manufacturer selling direct to distributors.
Fully-fledged
manufacturer
Product ↓
↑Payment ↑Payment ↑Payment

(Price A) (Price B) (Price C)
Related Party Related Party Third Party Distributor
Distributor (Country A) Distributor (Country (Country C)
B)
In such a scenario, it is conceivable that a resale price method would be applied.

Under this method, Price A and Price B shown above would be set separately with
reference to operating costs and end market price for the product. In all
likelihood, this would produce two different transfer prices for the same product.
Let’s assume that this results in a higher transfer price for Country A.
If the management of the manufacturer were incentivised purely on plant

profitability, this would influence behaviour. In the event that there was limited
capacity, the manufacturer would be incentivised to prioritise production for
Country A. Whilst this may consistent with short-term profit maximisation for the
group as a whole, it may not align to the business strategy. It may be the case
that Country B is the long-term strategic priority representing a higher growth
market. Some mechanism is therefore required to align manufacturer behaviour
with overall strategic priorities.
Now let’s assume that the manufacturer also sells to Country C through a third
party distributor. If Price C is higher than both Price A and B (for reasons of
different economic circumstances, rather than creating a CUP), this will further
impact behaviour. In the event of capacity constraints, the manufacturer may be

incentivised to prioritise sales to Country C rather than either of the two related
party markets. This would maximise profit for the manufacturer, but reduce overall
group profit as profits earned in Country A and Country B would be lost to the third
party in Country C.
 Illustration 3
Procurement company
Now let’s consider the impact of a procurement company
Third Party Supplier

Material ↓
↑Payment ↑Payment
(Price A) (Price B)
Fully-fledged ← Material Related Party
Manufacturer → Payment (Price C) Procurement
Company
↓Material
↑Payment
(Price C)
Related Party
Manufacturers
Assume that the fully fledged manufacturer requires Material as part of the
manufacturing process, which it is sources from the Supplier. Given its size, it is able
to negotiate Price A as the price for the Material.
Now assume that the group establishes Procurement Company to strategically

manage purchasing and leverage from the group’s global spend. Although the
fully fledged manufacturer in this case is the largest manufacturer in the group, by
combining its requirements with those of other manufacturing sites, it is able to
negotiate a slightly lower price (Price B).
The Procurement Company then purchases the materials from the Supplier and
sells on to all manufacturers at Price C. This price includes a margin for the
Procurement Company that covers its costs and provides it with an economic
return for its activities. For all other manufacturers, Price C represents a saving on
what they could have purchased the Material for on their own. However, for the
fully fledged manufacturer, the addition of a margin means that Price C exceeds
Price A – the price it was able to negotiate by itself.
Such a scenario creates a conflict. If the management of the fully fledged

manufacturer in question are seeking to maximise their own profit, they will
negotiate their own supply at Price A. However, if their requirements are removed
from the spend managed by the Procurement Company, then the Procurement
Company will not be able to negotiate as good a price, and as a result overall
group profit will reduce.
Split of Management and Statutory Accounts
In each of the illustrations above, the conflict that arises could be alleviated by a
different transfer price that creates an alternative incentive for the manufacturer.
The question therefore arises: is it possible to two operate with two sets of transfer

prices – one for statutory reporting purposes and the other management accounts
to assess performance? Management accounts may not reflect certain
intercompany charges, such as management fees or royalties, and may set
product prices on a different basis than the statutory accounts (for example, with
reference to total system profit).
A report by Czechowitcz et al in 1982 stated that 89% of MNEs used one transfer
price for both internal and taxation purposes. More recently (1999) Ernst & Young
found that MNEs are now more inclined to use two sets of prices. An article in The
European Financial Review in October 2012 by Hieman and Reichelstien noted
that most MNEs rely on one set of transfer prices but that a growing number are
moving towards “decoupling” their internal transfer prices from those used for tax
purposes. Hieman and Reichelstien believe that taxation cannot be ignored in
this analysis. They conclude that:
“The preferred internal transfer price is generally a function of the tax-admissible

price and the corporate income tax rates that apply in the jurisdictions the firm’s
divisions operates in.”
The use of two sets of accounts has some appealing features. It allows greater
control for management over their area of the business. It also reduces the time
spent by senior management on dealing with internal charges. Ultimately,
intercompany pricing determines how profit is shared within a group, but does
nothing to directly increase the amount of pre-tax profit that a group earns. As
such, management time and resource would seemingly be better spent
elsewhere. The tax function could put in place charges necessary to meet
statutory and fiscal requirements, and the business could be run based on
management charges.
However, this approach has two discernible drawbacks. Firstly, it is very time-
consuming and burdensome to run two sets of accounts. It adds complexity to
the management of the business that may be difficult to justify.
Secondly, and arguably more importantly, a transfer pricing framework should

reflect the economic reality of a business. If there is a need for a set of
management accounts that significantly diverges from the statutory accounts, it is
a strong indication that the pricing method used for the statutory accounts is not
arm’s length.
Consider the case of a limited risk distributor (LRD). If an LRD is remunerated based
on a low stable operating margin, it would be assumed that its activities could be
characterised as relatively routine, and that the key economic decisions
managing risk and driving profit would be made elsewhere. If however, there is a
second set of management accounts whereby the management of the distributor
is incentivised to maximise profit in the country (rather than for example maximising
sales within certain profit parameters), this implies that management is able to
exercise control over that profit. It suggests there is local decision making that is
capable of materially influencing local profit, and therefore undermines the
characterisation on which the transfer pricing is based.
Therefore, caution should be exercised before using separate management and

statutory accounts. In some cases, it is unavoidable. However the very existence
of separate management accounts and incentivisation structures can create
significant risk to the transfer pricing framework.

23.5 Customs Duties and transfer pricing
Much of the focus on transfer pricing is on the impact for corporate tax purposes.
However, as we have seen, many related party transactions will involve cross
border transactions. Customs duties are normally applied when goods enter a
territory.
Customs duties are a further way of raising tax revenues; the higher the value of
the goods at importation, the greater the customs duty, which is normally applied
on an ad valorem basis. This means that the value of the product imported (ie.
the transfer price) is directly correlated with the customs duty payable. As such,
strategic consideration of the customs duty impact is required when determining
transfer prices.
Regulatory overview
The OECD 2010 Transfer Pricing Guidelines recognise that the valuation methods
for customs purposes may not be aligned with the OECD recognised transfer
pricing methods (see Para 1.78). Having recognised this, the Guidelines go on to
state that the customs valuation may still provide useful information as customs will
have contemporaneous information on the taxpayer and documentation.
There are of course some key differences between the valuation methods used for
customs duties and the transfer pricing methodologies. Customs pricing does not
take account of related party transactions; they deal with both related and
unrelated parties and include individuals. For customs purposes the focus is on the
value at the point of import; for transfer pricing there is more focus on profits that
are made and how they need to be split across an organisation.
The World Customs Organisation (WCO) and the OECD organised two
conferences (2006 and 2007) to discuss how the gap could be bridged between
direct and indirect taxation on the valuation of transactions between related
parties, and to explore possible areas for strengthening coordination between
customs and tax specialists. The conferences concluded that more analysis is
needed and that harmonisation will require changes and adjustments on all sides.
The OECD 2010 Transfer Pricing Guidelines at Para 1.79 suggest greater
cooperation between income tax and customs administrations within a country.
Countries are recognising the need for co-ordination and cooperation. Canada
and the USA have provided guidance on the acceptability by customs authorities
of transfer pricing valuations and adjustments. In the UK HMRC can conduct
audits into both taxes.
Practical considerations
From the perspective of strategically managing transfer prices, there are a range
of practical issues that need to be taken into consideration:
• Competing objectives of authorities – customs and corporate tax authorities in

any given country have diametrically opposed objectives. Where a product is
imported into a country, customs authorities are looking to increase transfer
prices where products have been underpriced to increase duty yield.
Conversely, corporate tax authorities are seeking to decrease transfer prices
that are too high in order to increase taxable profit. This creates significant
challenge in creating analysis that justifies pricing from both perspectives.

• Timing – Customs duty is payable upon importation of products. It is unlikely

that the arm’s length nature of the prices applied will be challenged, adjusted
and resolved before the financial year is complete, much less before the
corporate tax return is submitted and assessed. This makes it very challenging
to manage corporate tax and customs duty risk in parallel. Although there is a
natural tension between the requirements of customs and corporate tax
authorities, in practice there will often be a gap of several years between
them considering the same issue.
• Unilateral nature of customs – the challenge in managing transfer pricing

compliance is balancing the needs and expectations of different tax
authorities in order to avoid double taxation. However, there is no such
concept of double taxation for customs purposes, since an increase to the
import price does not reduce the customs yield of another country. It may
have an impact on the corporate tax yield of that country if the adjustment
were reflected in the statutory transfer prices, but for the reasons described
above, that does not place much constraint on the customs authorities.
• Adjustments - Many companies operate transfer pricing models that rely on

periodic retrospective adjustments to ensure profitability stays between certain
parameters. Where these adjustments are made to product prices,
consideration needs to be given to whether the adjustments will have a
customs impact. Where the adjustment is an increase in product price, it is
likely for many countries that additional duty would be payable, which would
need to be disclosed to the customs authorities. This may in turn attract
additional costs such as interest, penalties and increased scrutiny from
customs officials going forward. Where the adjustment is a decrease in price,
then in theory a refund may be owed. However, in practice it can be very
difficult to obtain refunds from customs, and therefore the additional duty paid
will likely be lost.
• Dutiable items – For physical items imported, it is clear that duty is payable,
subject to rates applied under local regulations. However, there may also be
other transactions that are dutiable. For example, if separate payments are
made for IP or services that might otherwise be considered an inherent part of
the product, these may well also be subject to duty. For example, if a
distributor imports chocolate bars from a related party manufacturer, and
separately pays the distributor a royalty for the brand name used on the
wrapper, most customs authorities would consider the royalty payment
dutiable.
• Business restructuring – Where companies undertake business restructuring, this

often results in a change to the legal flow of products, even where the
physical flow is unaffected. Consideration needs to be given to the customs
impact of this. Not only might it create risk by increasing the import price
(creating risk for historic prices), but it may also jeopardise benefits arising from
Free Trade Agreements (FTAs) that the company may have been enjoying.
FTAs serve to reduce the duty for products moved between certain countries,
and analysis should be undertaken to consider whether interposing a principal
entity taking legal title will threaten this.

In reality, managing customs is a complex exercise and is often handled in a

separate part of the organisation to transfer pricing, despite the common
starting point of related party transactions. Nevertheless, in managing transfer
pricing and making decisions that will change prices and transaction flows,
there needs to be awareness of the customs impact to avoid creating
unnecessary risk.

CHAPTER 24
LATEST DEVELOPMENTS IN TRANSFER PRICING
In this chapter we look at some of the latest developments in transfer pricing including:
– transfer pricing in the news;
– the OECD report on Base Erosion and Profit Shifting (BEPS)
– Timing issues
– OECD work on intangibles
– exchange of information article 26
– UN transfer pricing manual
– OECD draft handbook on transfer pricing risk assessment.
24.1 Transfer pricing in the news
Transfer pricing was in the news a lot in 2012 and early 2013 as the UK Government
(through the Public Accounts Committee) closely scrutinised the transfer pricing
methodologies of Starbucks, Google and Amazon. The companies all recorded
high sales values in the UK but paid no or low levels of corporate tax in the UK. In
fact the Starbuck's UK business only made a profit in Britain in 2006. This close
scrutiny made international news.
The following was disclosed in the public domain:
• Google, Amazon and Starbucks were asked by the Public Accounts

Committee to explain structures such as using Ireland and Luxembourg
registered offices which incur lower tax rates, and also how they charge their
subsidiary companies for services.
• The Starbucks group had an agreement with the Dutch authorities that
allowed it to pay a “very low tax rate” on its operation there. Reports indicate
that a licensing fee of 4.7% (formerly 6%) of sales was routed through the
Dutch “roasting” operation.
• Starbucks's Swiss coffee trading unit charged group companies a 20% mark-up
on coffee beans. The Lausanne-based unit apparently bought 428 million
pounds of coffee beans for an average $2.38 per pound in 2011, suggesting a
total coffee bill of over $1 billion and income of more than $ 200 million for the
Swiss unit, which employs 30 people.
• Amazon reported European sales through a Luxembourg-based unit. This

structure allowed it to pay a tax rate of around 11% on foreign profits. The
Luxembourg business's turnover in 2011 was 9.1bn euros. It paid taxes of 8m
euros and posted after-tax profits of 20m euros.
• Google operated its European business out of Republic of Ireland using its
12.5% corporation tax rate. The Google Irish company was paying a fee to a
separate Dutch company within the Group.
• The rights to Google's non-US intellectual property rights were owned in

Bermuda.

Similarly in France there has been press comment on the transfer pricing practises
and the use of low tax jurisdictions of Google, Amazon and Facebook.
In October 2012 the U.S. Senate Permanent Subcommittee investigated the

shifting of profits to low tax jurisdictions by US based multi-nationals.
Case studies of offshore tax avoidance schemes by Microsoft and Hewlett-

Packard featured at the subcommittee hearing. The hearing concluded with a
statement by Senator Levin, in which he referred to multinationals' transfer pricing
arrangements as “gimmicks,” “dubious transactions,” and “legal fictions.”
The release of this information has created a perception that tax planning
(including transfer pricing) is reducing countries tax bases by moving profits to low
tax jurisdictions. In response to this in Europe the G20 finance ministers have asked
the OECD to look at the current international tax “rules” and make
recommendations to ensure multinational groups pay a “fair” amount of tax in the
countries in which they operate their businesses.
On 12 February 2013 OECD published a report entitled Addressing Base Erosion

and Profit Shifting (BEPS) which was targeted at addressing the problem of multi-
national groups using current international tax rules to ensure profits are
predominantly taxed in low tax jurisdictions and not in the countries where the
group sells its products or services. See below for more detail.
The OECD report was reviewed at a meeting of G20 Finance Ministers in Moscow
on 15-16 February 2013. Subsequently a letter from George Osborne, Pierre
Moscovici and Wolfgang Schäuble was published in Financial Times on 16
February 2013 entitled “We are determined that Multinationals will not avoid tax”.
The letter states the following:
“It found that the practices that some multinational enterprises use to reduce
their tax liabilities have become more aggressive over the past decade. Some
multinationals are exploiting the transfer pricing or treaty rules to shift profits to
places with no or low taxation, allowing them to pay as little as 5 per cent in
corporate taxes while smaller businesses are paying up to 30 per cent.”
The letter goes on to say it will address this by setting up three working groups.
These are as follows:
• The Transfer Pricing group chaired by the UK,
• The Base Erosion group chaired by Germany
• The group on “how to determine tax jurisdiction, particularly in the context of

extracting and reclaiming of profits shifted to low-tax countries”. This will be
chaired jointly by the US and France.

24.2 The OECD Report on Base Erosion and Profit Shifting (BEPS)
(This report can be downloaded at http://www.keepeek.com/Digital-Asset-

Management/oecd/taxation/addressing-base-erosion-and-profit-
shifting_9789264192744-en)
Issues Identified
There is a very relevant quote in the report which is a good summary of the effect
of globalisation; in particular the movement towards a matrix management
business model from a country based model:
“Globalisation is not new, but the pace of integration of national economies

and markets has increased substantially in recent years. The free movement of
capital and labour, the shift of manufacturing bases from high-cost to low-cost
locations, the gradual removal of trade barriers, technological and
telecommunication developments, and the ever-increasing importance of
managing risks and of developing, protecting and exploiting intellectual
property, have had an important impact on the way MNEs are structured and
managed. This has resulted in a shift from country-specific operating models to
global models based on matrix management organisations and integrated
supply chains that centralise several functions at a regional or global level.
Moreover, the growing importance of the service component of the
economy, and of digital products that often can be delivered over the
Internet, has made it possible for businesses to locate many productive
activities in geographic locations that are distant from the physical location of
their customers.”
In a one sentence summary it is saying groups are no longer managed on a

country basis but on a matrix basis based on corporate departments. Therefore
taxation of a group's profit on a country basis becomes more detached from the
way a multi-national group manages its business.
The report refers to key pressure areas, one of these is identified as transfer pricing.
An example given is the shifting of risks relating to intangibles and the artificial
splitting of the ownership of assets and transactions. It also points out that there has
been increased segregation between business location and where investment
takes place and the location of taxation of profits generated.
The report also refers to thin capitalisation rules, taxation of digital goods and
services and the availability of preferential regimes alongside a number of
mainstream tax related issues.
The full list is as follows:
• international mismatches in entity and instrument characterisation;
• application of treaty concepts to profits from delivery of digital goods &

services;
• the tax treatment of intra-group financial transactions;
• transfer pricing;
• the effectiveness of anti-avoidance measures;

• the availability of harmful preferential regimes.
The report recognises there has to be improvements to transfer pricing rules to

address current rules producing undesirable policy results. In particular there are
issues with the transfer of risks and how to value intangibles to low tax regimes.
Should the allocation be accepted, have they got substance or are they
deliberate base erosion? Further examples given are low risk manufacturing, low
risk distribution, contract R&D and captive insurance arrangements.
One consideration is the economic substance of risk allocation e.g. managerial

capacity. The report also questions whether the current transfer pricing guidelines
focus too much on legal structure.
The report gives a lot of information on Base rate erosion and examples of tax
planning structures. It notes that three Caribbean islands, Barbados, Bermuda and
British Virgin Isles together receive more foreign direct investment that Germany or
Japan.
On 19th July 2013 the OECD released a detailed action plan on BEPS. The action
plan has 15 action points and a time frame of 18 to 30 months. The action plan
looks at many points including transparency, treaty related actions and PEs. We
will concentrate on the points relating to transfer pricing (some of which have
been referred to in earlier chapters).
Actions 4,8,9,10 and 13 make direct reference to proposed changes to the transfer
pricing guidelines.
As noted in an earlier chapter, action 4 is concerned with interest deductions and

other financial arrangements. The action is broadly written and could affect many
types of financial intragroup transactions as well transactions within the financial
service industry. The action plan links the BEPS to the Harmful Tax Practices report
on low tax regimes and states that the work on financial deductions will be
coordinated with the actions on Hybrids and CFC rules.
Actions 8, 9 and 10 are linked together in the action plan. Action 8 deals with
intangibles (reference to this was made in the chapter on intangibles). The
proposal is to have “a broad and clear” definition of intangibles. There is to be an
update on the the guidance realating to cost contribution arrangements (CCAs).
In Action 9, the OECD state that they want to “ensure that inappropriate returns
will not accrue to an entity solely because it has contractually assumed risks or has
provided capital” Action 10 looks at other high risk transactions and (as noted in
the chapter on recharacterisation) hints that there may be more room for
recharacterisation of transactions in the future.
Action 13 relates to transfer pricing documentation. Here the aim is to enhance

transparency whilst taking account of compliance costs. The action plan includes
a proposal that “rules to be developed will include a requirement that MNE’s
provide all relevant governments with needed information on their global
allocation of the income, economic activity and taxes paid among countries
according to a common template.”
Some of the other actions, while not proposing changes to the transfer pricing
guidelines, will nevertheless have an impact for transfer pricing. In particular
Actions 14 and 7. Action 14 proposes to amend the Mutual Agreement Procedure
(MAP) article in the model DTC . Action 7 looks at the artificial avoidance of PE
status, with particular reference to commissionaire arrangements. It is noted in this
action that changes as appropriate will be made to the attribution of profits rules.

The next steps outlined by the OECD
The next steps were detailed as follows:
• Improvements and clarifications on transfer pricing including looking at

intangibles.
• Looking at deduction of financial transactions and withholding tax.
• The current relevant projects of the OECD will be accelerated. These are on
the following topics:
– Intangibles (discussed below)
– Documentation for evaluation of risk
– Safe harbours. A revision to section E to Chapter IV of the OECD

Guidelines was approved in May 2013. We have looked at this in an earlier
chapter
Finally, the OECD have issued a report on Timing Differences relating to Transfer
Pricing which is discussed below.
24.3 Timing Issues
Introduction
The issue of price checking versus price testing has been examined by the OECD
together with the choice of comparables in a recent report which is discussed
below. The following section examines the existing practises relating to the timing
of pricing and of choice of comparables.
Price checking versus price setting
In the 2010 OECD Guidelines one of the unresolved issues is whether tax payers
can rely on a price setting methodology or whether they should test the outcomes
of the methodology.
This issue is discussed in the 2010 OECD Guidelines paragraphs 3.67 to 3.70. The
price setting approach looks at information available at the date prices are set
using updated historical data (the price setting approach). The alternative is to
test the prices at a later date usually as part of the tax return process (the price
testing approach).
The 2010 OECD Guidelines fail to conclude on which the preferred method is and
recognises that tax authorities can take different approaches. However other
sections of the Guidelines appear to take a position on this issue. (In paragraph
9.44 the 2010 OECD Guidelines recognise that companies set prices using one
method but then another method can be used to test the outcome of the price
setting mechanism.)
True-ups
A second timing issue is the use of “true-ups” made by companies to ensure the
results achieved are adjusted to an arm’s length result. US taxpayers may make
upward or downward price adjustments in a tax return in order to get the transfer
prices right. However although year-end adjustments are accepted on an

administrative level by most EU member states, no legal right exists to make them.
Sometimes the acceptance of setting or testing will be determined by the most
favourable result for the taxing authority.
As recognised in the Guidelines, in practise one transfer pricing policy is often used
for ‘Price Setting’ when the inter-company transaction is entered into. However,
because of the lack of available third party comparable data, a separate transfer
pricing method is applied to carry out the price checking to ensure compliance
with the arm's length principle. One example of this is where prices are set using an
estimated gross margin (the resale price method) and then tested using the
transactional net margin method.
In 2011 the European Joint Transfer Pricing Forum issued a questionnaire to

member states tax administrations on their treatment of transfer pricing
adjustments. 8 member states had guidance on compensating adjustments. 1
intended to introduce guidance. The responses can be found at
http://ec.europa.eu/taxation_customs/resources/documents/taxation/company_
tax/transfer_pricing/forum/jtpf/2013/jtpf_019_rev1_2011_en.pdf
Use of Hindsight
A third timing issue is that the OECD Guidelines currently state that tax authorities
should not use the benefit of hindsight especially when valuation issues are
involved (paragraph 3.74). One unresolved issue is whether the valuation of a
transaction was so uncertain or fundamental changes occurred that, in a third
party arrangement, there would have been a renegotiation of the contractual
terms relating to the transaction. No specific answer is given on this issue other
than the tax authorities should not use the benefit of hindsight. This contrasts with
the approach taken by the US tax authorities (discussed below) where they can
apply the commensurate with income rule i.e. effectively hindsight can be used to
check whether a valuation was arm's length.
Report on Timing Issues Relating to Transfer Pricing (Revisions to existing

Paragraphs 3.67 to 3.70)
This draft report was released by the OECD on 6th June 2012. It can be
downloaded at http://www.oecd.org/tax/transfer-pricing/50519380.pdf
The OECD have identified the following issues resulting from the two different
approaches to pricing (setting versus testing):
• The timing of the information relating to potentially comparable transactions

that may be used by taxpayers and / or tax administrations in applying the
arm's length principle.
• The making of taxpayer initiated adjustments (also known as ‘true-ups’) to

prices reported by taxpayers in their accounts either at their financial year-end
or when filing a tax return. These adjustments are made in order adjust prices
to produce an arm’s length result. Specifically, whether these adjustments will
be respected by all tax authorities.
• The valuation of intangibles where the value is uncertain at the date the
transaction (see paragraphs 6.28 to 6.35 of the Guidelines). Specifically,
whether tax administrations should be permitted to assume the existence of a
renegotiation, price adjustment clause, milestone payment, or other risk
sharing mechanism within an agreement (other than under paragraph 1.65
recharacterisation of transactions which is discussed below).

The report therefore recommends amendments to paragraphs 3.69 to 3.70. These

amendments still leave the OECD relatively neutral on price setting versus price
testing. This is still a potential for double taxation where one country is testing prices
The current proposed amendments do not address the issue of uncertain values.
24.4 OECD Work on Intangibles
The OECD's work on intangibles in 2012 has seen the issue of a draft revised
Chapter 6 of the OECD Guidelines, together with a consultation with
representatives of organisations that had submitted written comments to the draft
report. A further draft was issued on 30 July 2013, with comments to be submitted
by 1st October 2013. The current draft can be downloaded
atwww.oecd.org/tax/transfer-pricing
Identification of intangibles
The report provides the following examples of intangible assets. The report states
that the list is not a complete listing and is subject to local legal and regulatory
requirements. The examples are as follows:
• Patents
• Know-how and Trade secrets
• Trademarks, trade names and brands
• Licenses and similar rights
• Goodwill and going concern (rejected accounting valuation)
• In some cases a work force
The following were rejected as intangibles:
• Group synergies
• Market specific characteristics
Intangible Related Returns
The intangible related return attributable to a particular intangible is defined using

the following formula:
The return from business operations involving use of that intangible
(Minus the costs and expenses related to the relevant business operations)
(Minus the returns to other intangibles, business functions and assets)
= Intangible related return.
This can be positive or negative.

Entitlement to Intangible Related Returns
Existing OECD Guidelines
Under the existing OECD Guidelines groups have to look at legal and economic
ownership to determine what companies in the group are entitled to the
intangible related returns. Economic ownership is effectively determined by the
group company that has funded the development of the intangible. This
economic ownership is currently key to determining which group company is
entitled to the return from the intangible. A couple of points should be noted:
• A few tax authorities still argue that legal ownership is key and should be
followed regardless of who has paid. This appears more and more out of step
with international practise on transfer pricing.
• Where a company investing in the intangible has no employees with the

seniority or capability of determining whether to carry out those projects and
evaluate the results, then they are not capable of investing in the intangible.
The argument follows that the company actually directing and organising the
investment and developing the intangible is actually entitled to the return from
that intangible.
Revised Guidelines
In the revised Guidelines the following factors should be considered in deciding

which companies in a group are entitled to the intangible related returns:
• the terms and conditions of legal arrangements including registrations, licence

agreements, and contracts;
• whether the functions performed, the assets used, the risks assumed, and the
costs incurred by members of the group in developing, enhancing,
maintaining and protecting intangibles are in alignment with the allocation of
entitlement to intangible related returns in the relevant registrations and
contracts;
• whether services rendered, in connection with developing, enhancing,

maintaining and protecting intangibles, by other members of the group to the
member or members of the group entitled to intangible related returns under
the relevant registrations and contracts, are compensated on an arm's length
basis.
The new draft Guidelines go on to set out the following tests for a company to be
entitled to the intangible return. The company should be responsible for the
following:
• Performing and controlling important functions related to the development,

enhancement, maintenance and protection of the intangibles and control
other related functions performed by independent or associated companies
that are compensated on an arm's length basis;
• Incurring and controlling the risks and costs related to developing and
enhancing the intangible; and,
• Incurring and controlling risks and costs associated with maintaining and
protecting its entitlement to intangible related returns.

The inference is that it will be necessary to identify where employees perform the
key functions, relating to the important day-to-day decision making and significant
high value contributions. This is quite a radical change and if adopted could
impact groups where intangibles are held in specialised companies. Here the
group will have to check the substance of those operations e.g. the staff of those
companies have the seniority, capability and authority to undertake the required
activities.
Distributor intangibles
The proposed revised Guidelines discuss marketing intangibles and the entitlement
to a share of the return from those intangibles. The proposed test is “what an
independent distributor would obtain in comparable circumstances”.
Pricing
Comparability analysis
The draft makes the following points on comparability analysis for intangibles:
• There should be a two sided analysis for transactions involving the use or
transfer of intangibles.
• It is necessary to assess whether the transaction makes commercial sense by

comparing the expected economic impact of the transaction with other
options that are realistically available to the company, including not entering
into the transaction at all.
The following specific comparability factors have to be considered factors to be

considered:
• Exclusivity
• Extent and duration of legal protection
• Geographic scope
• Useful life
• Stage of development
• Rights to enhancements, revisions, and updates
• Expectation of future benefit
• Comparison of risk in cases involving intangibles
Selection of pricing methods
The pricing method that should be used should be the most appropriate transfer
pricing method. These methods include:
• Valuation techniques (taking into account issues such as volatility, accuracy of

projections, growth rate assumptions, discount rates, terminal values and tax
rates)
• Profit split methods

• Comparable uncontrolled transactions
Methods based on intangible development cost are not recommended.
Uncertain valuations (discussed above)
The draft recommends that “the arrangements that would have been made in
comparable circumstances by independent enterprises” should be used in the
pricing process.
24.5 Exchange of information Article 26
(Revised Article 26 of the OECD Model Taxation Convention. This can be

downloaded athttp://www.oecd.org/ctp/exchange-of-tax-
information/120718_Article%2026-ENG_no%20cover%20(2).pdf
Another area of change that may impact on transfer pricing is the revision to
Article 26 of the OECD Model Tax Convention. This deals with the international
standard on exchange of information. Information will be exchanged on request,
where the information is “foreseeably relevant” for the administration of the taxes.
This exchange will be made regardless of bank secrecy and a domestic tax
interest.
The 2012 update explicitly allows for group requests. This means that tax authorities
are able to ask for information on a group of taxpayers, without naming them
individually (as long as the request is not what is described as a ‘fishing
expedition’).
Of course this will only be relevant as this change is adopted in specific treaties.
24.6 UN Transfer Pricing Manual
The United Nations have established a Committee of 25 members nominated by

Governments and appointed by the Secretary to firstly revise its current Model
Double Taxation Convention published in 2001 and secondly to consider transfer
pricing issues.
A major difference between the OECD and the United Nations Model Double
Taxation convention is that the latter preserves more of the taxing rights of the
country in which income arises (the ‘Source State’) which tends to favour less
developed countries.
Of course the UN Model Tax Treaty is only relevant when adopted between two
contracting countries. Most treaties are currently contracted in accordance with
the OECD Model Taxation Convention. However it should be noted that China,
India and Brazil have made significant contributions to the manuals and their
influence may be significant in the future.
The UN have produced an updated Manual on Transfer Pricing released in

October 2012. This can be downloaded from the internet at:
http://www.un.org/esa/ffd/tax/documents/bgrd_tp.htm

The manual now contains the following chapters:
• Foreword – (3 October Revision)
• Chapter 1 – Introduction
• Chapter 2 – The Business Environment
• Chapter 3 – The Legal Environment
• Chapter 4 – Building Capability
• Chapter 5 – Comparability
• Chapter 6 – Methods
• Chapter 7 – Documentation
• Chapter 8 – Audits
• Chapter 9 – Dispute Resolution
• Chapter 10 – Country practices: Preamble, Brazil, China, India, South Africa
• Appendix I – Comparability examples
• Appendix II – Documentation
It is not possible to summarise every chapter here. Instead specific themes have
been identified that are pointing towards global trends in transfer pricing.
Chapter 5: Control over risk
The UN manuals have adopted the approach to risk that OECD in its report on
Intangibles and previous reports on restructuring has taken i.e. that it is not only the
contractual obligation that determines allocation of risk but also whether there is
control over the contracted risk. Control is determined by competence and ability
to control risks.
The manual states that in any transfer pricing study it is necessary to identify risk
and which party bears the risk. Tax authorities have to check that the allocation of
risk within group contracts reflects the actual allocation of risk. This contractual
allocation should be arm’s length. The concept of control over risk is also
introduced to determine an arm’s length allocation of risk. Factors to consider in
determining control over risk are as follows:
• Core functions.
• Key responsibilities: formulation of policy, formulation of plan, budget, fixation

of goals and targets.
• Key decisions: strategic decisions which have greater potential to impact the
ability of an entity to generate profit and the amount of profits.

• Level of individual responsibility for the key decisions. Allocation of power to

senior management or a level below depends upon the location of core
functions in the country of the MNE or subsidiary, their contribution to core
components of the various functions, their authority, their responsibility and the
duties included in the employment contract of the MNE or subsidiary.
Chapter 5: Location savings
This chapter of the manual also has sections on location savings i.e. when an
operation is transferred to a low cost location there is the question of which group
company should benefit from the cost reductions generated from the relocation.
This savings can include: labour costs, raw material costs, transportation costs, rent,
training costs, subsidies, incentives and infrastructure costs. There may also be
location costs: poor infrastructure, power supply deficiencies, transport costs, cost
of quality control. The difference is the net location saving.
There may also be location advantages: highly specialised skilled manpower and
knowledge, proximity to growing local/regional market, large customer base with
increased spending capacity, advanced infrastructure (e.g. information/
communication networks, distribution system) or market premium. The manual
refers to the savings and advantages as location specific-advantages (LSA's).
A further term is used in the manual. This is location rent which is defined as the
incremental profit derived from LSA's. Even if LSA's exist there may be no location
rent e.g. where the market is competitive and LSA'S have to be passed to third
party customers through lower prices. In other cases the whole of the location rent
may pass to the group in the short term until competition erodes the profit.
The allocation of rent depends on the competitive factors in the market. Some
examples are given:
• The group could have production intangibles that allow it to manufacture at a

lower cost than competitors. At arm's length, the owner of the intangible
would be entitled to the rents associated with this cost saving.
• The group low cost producer may be the first to operate in the low cost
jurisdiction and there are no comparable low cost producers in its or other
jurisdictions. Therefore the low cost producer can take advantage of the
location rents.
The question is then how to split these profits. The guidance is fairly limited and
refers to the relative bargaining position of the group is offered as one solution to
how to do this split.
China and India contributions to the UN manual: Location savings
China has also contributed a section – Location specific advantages together with
examples.
It defines location savings as the net cost savings derived by a multinational group
when it sets up its operations in a low cost jurisdiction. Net cost savings are
commonly realised through lower expenditure on items such as raw materials,
labour, rent, transportation and infrastructure even though additional expenses
(“dis-savings”) may be incurred due to the relocation, such as increased training
costs in return for hiring less skilled labour.
India has also contributed to the UN manual on location savings. The Indian
transfer pricing administration states that the concept of “location savings” is one

of the major items to be reviewed when carrying out comparability analysis during
transfer pricing audits. Location savings is interpreted as any cost advantage. The
manual states that India provides operational advantages to groups such as
labour or skill employee cost, raw material cost, transaction costs, rent, training
cost, infrastructure cost, tax incentives.
In addition India also provides the following Location Specific Advantages (LSAs) in
addition to location savings: highly specialised skilled manpower and knowledge,
access and proximity to growing local/regional market, large customer base with
increased spending capacity, superior information network, superior distribution
network, incentives and market premium.
Again the incremental profit from LSAs is known as “location rents”. The main issue
in transfer pricing is the quantification and allocation of location savings and
location rents among a group.
The Indian transfer pricing administration believes it is possible to use the profit split
method to determine arm's length allocation of location savings and rents in cases
where comparable uncontrolled transactions are not available taking into
account the bargaining power of the parties.
India contributions to the UN manual: Market intangibles
The Indian tax authorities also point to the problems that may arise with payments
of brand and trade mark royalties where the Indian distributor has incurred costs of
promotion. In fact in many cases no royalty should be paid and in fact the Indian
distributor is entitled to a reward for developing the marketing intangible in India.
This issue has been examined in the recent case of LG Electronics India Pvt Limited
v ACIT (2013). On the facts of the case an adjustment made by the tax authorities
for creating a brand was upheld by the Delhi tribunal.
The marketing intangible issue has historically been raised by the IRS in its dispute
with Glaxo. Initially the IRS denied Glaxo US a deduction for the payment of trade
mark royalties because it was the economic owner of the marketing intangibles. It
appears that the Indian tax authorities have taken this point and more tax cases
may be expected on this topic.
24.7 OECD publish Draft Handbook on Transfer Pricing Risk Assessment
In April 2013 a Draft Handbook on Transfer Pricing Risk Assessment was produced
by the steering committee of the OECD Global Forum on Transfer Pricing. The draft
handbook sets out the steps countries can take to assess the transfer pricing risk
presented by an individual taxpayer’s operations. The OECD have stated that it is
intended that it will be sufficiently detailed such that it can serve as a manual for
both developing and developed countries to use in conducting transfer pricing risk
assessments.
The handbook defines “transfer pricing risk assessment” as “the process of

identifying the risk to the tax administration from the taxpayer’s transfer pricing
arrangements and determining whether the risk is worth pursuit by conducting a
resource-intensive audit,” (Para 14 of the draft handbook).
The handbook acknowledges that tax authorities have limited resources and as a
result they need to target those taxpayers where there is higher risk that the prices
are not arm’s length.

The report is some 40 pages long and is split into 5 key areas.
• The questions that need to be answered in a transfer pricing risk assessment
• Assessing when transfer pricing risk exists
• Sources of information available to assess the transfer pricing risk
• The process itself – selecting cases for a transfer pricing audit
• Building a relationship with the taxpayer – the enhanced engagement

approach
Section 6 includes country specific examples.
Interested parties were invited to comment on the draft handbook by 13

September 2013.

Tolley® Exam Training ADIT PAPER IIIF APPENDIX 1
APPENDIX 1
CASE LAW
For ease of reference we have listed some important transfer pricing cases below. You will
have come across many of these cases as you worked through the manual. All of the
following cases are long and complex. No attempt has been made to provide a full
analysis of each case; instead the following focuses on the aspects of the case that have
been most talked about in the Transfer Pricing press and that are likely to be most relevant
to the exam. There are of course other cases that you may have come across that you
can equally use to demonstrate a point in the exam room where necessary.
1.1 Aztec Software & Technology Services Limited v ACIT 294 IT

(Bangalore)
Aztec Software & Technology Services Limited (Aztec-India), an Indian company

providing software development services, has a wholly-owned subsidiary in the
United States of America (Aztec-US). Aztec-US was appointed as Aztec-India's
marketing agent in the US. Aztec-US rendered marketing services in relation to sale
of products of Aztec-India, ensuring minimum orders and prompt payment by
customers. It also performed certain ‘onsite services’ such as identification of client
requirements, installation of software at client's location and acceptance testing.
Designing and development of software (offshore services) was undertaken (in
India) by Aztec-India. In consideration of such services, Aztec-US received
remuneration based on a cost plus mark-up basis (5 percent for onsite services
and 10 percent for marketing services) from Aztec-India.
The point was raised that in India the transfer pricing law was designed as an anti-
avoidance tax measure, thus the Revenue could invoke the provisions only under
specific circumstances where there is existence of material evidence to suggest
avoidance of tax. Since Aztec-India enjoyed a tax holiday, there was no plausible
reason or motive for avoidance of tax (in India). Thus, the application of the
transfer pricing regulations (per se) under such circumstances was entirely
misplaced.
The Tribunal held that there was nothing in the statutory provisions to require that
the Assessing officer must demonstrate avoidance of tax.
It was further found the TP law can apply even if the income is exempt as was the
case here because of the tax holiday.
The case looked in detail at the methodologies used. It observed that the while
the use of cost plus was not disputed, not enough attention had been paid to the
computation of the cost. In this particular case it was stated that single year data
was more appropriate. The Tribunal approved of the Revenue's contention that for
the purposes of arm's length analysis, profits earned by Aztec–India (and not
Aztec-US) should have been benchmarked under TNMM analysis.
Reference was made to the OECD Guidelines where appropriate.

1.2 Baird Textile Holdings Limited v Marks & Spencer plc (2001)
While not a transfer pricing case, this is highly informative. Baird had supplied
Marks & Spencer for many years when Marks & Spencer terminated supply
arrangements between them. Baird sought damages for lost profits but failed as
there was no contract and none could be inferred. Where independent parties
would not expect remuneration, this will only be supportable between related
parties where it is possible to differentiate the third party position from a group’s
facts and circumstances.
1.3 DSG Retail and Others v HMRC
Perhaps of most interest to a multinational seeking to support its internal pricing in

the UK, DSG Retail and others v HMRC (TC00001) related to the sale of extended
warranties by one of the largest electrical goods retailers in the UK. As the first
instance of a tribunal considering application of ICTA88/SCH28AA, this case has
proved something of a watershed for HMRC, and while detailed analysis of the
supporting information presents a convoluted set of facts, a number of key
principles were identified in relation to profit allocations within a group.
Encompassing the brands Dixons, Currys and PC World, the Dixons Stores Group
(‘the Group’) included DSG International plc (‘the Parent’) and subsidiaries DSG
Retail Ltd (‘DSG’), Mastercare Coverplan Service Agreements Ltd (‘MCSAL’),
Mastercare Services and Distribution Ltd (‘MSDL’), and Dixons Insurance Services
Ltd (‘DISL’), the latter being the Group's captive insurance company which was
resident in the Isle of Man. While not licensed by the Isle of Man regulators to write
insurance in the UK, DISL was authorized to write reinsurance business. Under the
Income Tax (Exempt Insurance Companies) Act 1981, DISL was exempt from Isle of
Man Corporate Tax.
Point of sale insurance-backed extended warranties were routinely offered on

electrical goods for a fixed premium, as an optional supplement to any
manufacturer's warranty. Two sets of arrangements were considered by the
Tribunal. The first, referred to as the ‘Cornhill period’, was in place between 1986
and 1997, and involved the sale of policies in DSG stores written by an
unconnected 3rd party insurer, Cornhill Insurance plc (‘Cornhill’), through its
fronting agent Coverplan Insurance Services Ltd (‘CIS’). CIS was remunerated by
an initial sales commission as well as a profit commission based on the eventual
level of underwriting profit. Any repairs under the extended warranty were carried
out by MSDL, which was paid an administration fee, deducted from the CIS's
warranty contract price. Cornhill however only ultimately held 5% of the relevant
risk, reinsuring 95% with the DSG captive insurer DISL, which paid Cornhill a
commission of 1.5% of the premium being ceded. In 1993 the contract was
renegotiated, with Cornhill agreeing to increase the sales commission paid to CIS,
while the ceding commission received from DISL remained at 1.5%. The critical
assumption made by the taxpayer in relation to this arrangement was that DSG
had no contractual relationship with DISL, forming a fundamental part of DGS's
defence against application of transfer pricing and CFC rules.
The second arrangement was established from April 1997, in response to the
increase in the rate of Insurance Premium Tax from 2.5% to 17.5% that was
announced in November 1996, and which would have reduced premium revenue
by 15%. In response to this the Group stopped offering insurance cover as part of
its extended warranties, and started selling service contracts via a new 3rd party
company Appliance Serviceplan Ltd (‘ASL’), an Isle of Man company, with MCSAL
acting as its agent in the UK. As with the Cornhill period, the sales company
received a sales commission and passed on net premiums to an unconnected

third party company, now ASL. In this instance 100% of ASL's liability was
subsequently insured by DISL, which changed its regulatory status to allow it to
undertake insurance business with ASL. This effectively circumvented the IPT rate
hike as the insurance element of the structure no longer fell into the scope of UK
tax, with the counterparties to the insurance policy both being Isle of Man
companies.
HMRC contended that the terms of the arrangement did not sufficiently recognise
the advantage gained by DSG at the point of sale, and that DISL subsequently
gained more of an advantage than would have been available in the case of an
arm's length agreement. While DSG had no direct legal contractual relationship
with DISL, the interposition of a third party (Cornhill/ASL) into the overall transaction
did not preclude the application of ICTA88, S773(4), whereby the opportunity for
DISL to able to enter into such an attractive insurance arrangement amounted to
DSG providing a ‘business facility’ to DISL. Additionally, on analysing the series of
transactions as a whole, the Commissioners found that the arrangements were
effectively integrated by means of an ‘understanding’ between the Group and
Cornhill/ASL – although the series of contracts were not in themselves technically a
‘provision’ for the purposes of Schedule 28AA, the means by which they were
applied equated to a provision ‘as between’ DSG and DISL, and the arm's length
principle therefore applied to the advantage gained by any party.
Despite DSG maintaining that remuneration of the relevant parties could be

warranted as arm's length by providing a number of external comparables to the
pricing of the transaction, the Commissioners found that these prices were
inappropriate and it was not possible to make reasonably accurate adjustments
to the benchmarked prices such that they were directly comparable with the
tested transaction. Inadequacies found in the presented comparables revolved
around a number of areas, including DSG's dominance in the UK marketplace, the
relative complexity of the contractual arrangements, the wide variations in claim
rates across the product lines in question, and the significance of the gross retail
price that could be charged for the warranty, relative to which the retailer's
commission is generally expressed as a percentage.
The Commissioners subsequently determined that, in the absence of suitable

comparables, adjustments to DSG's profit for the relevant periods could only
reliably be made using a profit-split methodology. Application of this method was
specifically warranted by the relative bargaining power of the parties, with
particular note being made of the renegotiation of the arrangement during the
Cornhill period, when in 1993 Cornhill increased the commission paid to CISL, whilst
not requiring or seeking any equivalent renegotiation of the ceding commission
paid to it by DISL. Following on from this case, the concept of ‘relative bargaining
power’ now forms an important element of HMRC's operational guidelines for TP
enquiries. On this basis, particular care needs to be taken when considering
pricing of transactions, as well as identification of potential comparable
unconnected 3rd parties for comparability, to the extent that a tested party may
have a particularly strong or weak bargaining power when undertaking a
transaction at arm's length rather than with a connected party.
The Commissioners ultimately found that DISL was entirely dependent on DSL for its
profits, which arose directly as a result of DSL's significant brand strength and ‘point
of sale advantage’, and a profit split was determined on an arm's length return on
capital for DISL, with DSL receiving the residual profits.

1.4 Eli Lilly v Commissioner 856 F.2d 855
AUS corporation transferred patents and know-how to a Puerto Rica

manufacturing subsidiary. The IRS asserted that this transfer should be disregarded
on the basis that the US company could have retained the revenue streams from
the intellectual property transferred. That was rejected by the Tax Court and Court
of Appeals.
1.5 Ford Motor Company of Canada v Ontario Municipal Retirement

Board
In this case the minority shareholders brought the case questioning the level of the
transfer prices.
This case focused on the transfer pricing system between Ford U.S. and Ford
Canada. The system is a product of the Canada-United States Auto Pact and,
more recently, the free trade agreements that created a single, integrated market
for vehicles made and sold in Canada and the United States. To a large extent,
the structure of the system is tax driven. Canadian and U.S. tax regimes require
entities that do not deal with each other at arm's length to attribute arm's length
transfer prices to their goods and services to prevent entities from artificially
allocating losses in the high-tax regime and profits in the low-cost regime. For Ford
U.S. and Ford Canada, the transfer pricing system is the mechanism utilised to
comply with the tax laws in the two countries.
The transfer pricing system can impact on shareholders, such as the minority
shareholders of Ford Canada. If the system is unfairly skewed to assign losses to the
Canadian subsidiary, the subsidiary's minority shareholders will be deprived of their
fair share of Ford Canada's profits. The parent, Ford U.S., will not be injured since it
will offset the loss from its Canadian holdings through increased profits in its U.S.
operations. With minor exceptions, the taxing authorities in the two countries have
not faulted the Ford transfer pricing system.
Following a lengthy trial, involving numerous experts and voluminous documentary

evidence, the court found that the transfer pricing system benefited Ford US, the
majority shareholder, by approximately C$3 billion between 1985 and 1995, while
depleting Ford Canada of those assets. The court held that the value of a Ford
Canada share in the absence of the flawed transfer pricing system would have
been between C$555 and C$610 per share, rather than the C$185 offered.
The court concluded that a poor transfer pricing mechanism that had been
adopted amounted to oppression of the minority shareholders since it frustrated
their reasonable expectation that the company would operate to maximize
profits. This case is indicative of how transfer pricing can be a factor in a matter
that is essentially one of corporate governance.
1.6 General Electric Capital Canada Inc. v. The Queen (2009) DTC 563
This was a Canadian case where the Canadian tax authorities sought to deny the
deduction for payment of guarantee fees by GEC Canada to a US related party,
GEC US, during the tax years 1996-2000. In disallowing deduction of the guarantee
fees, the tax authorities had argued that the US guarantee conferred no
additional benefit to the Canadian taxpayer since the parent company would be
expected to support the subsidiary even in the absence of a formal guarantee.
However, the court found that there was real economic value to the guarantee
and reinstated the corresponding tax deductions.

1.7 The Queen v. GlaxoSmithKline Inc
The court case revolves around the fixing of the price paid by a Canadian
subsidiary (Glaxo Canada) of a pharmaceutical company to a related non-
resident company for Ranitidine (the main ingredient used for manufacturing a
branded prescription drug).
Glaxo Canada was paying a price over five times higher to buy the ranitidine from
the Glaxo Group than it would have paid to buy the ranitidine from generic
manufacturers.
Glaxo Canada paid a royalty to its UK parent company (and IP owner) to

manufacture and sell the branded drug Zantac in the Canadian market. Glaxo
Canada's rights under the intragroup agreement allowed the Canadian entity to
manufacture, use and sell various Glaxo Group products (including Zantac), make
use of other trademarks owned by the Glaxo Group, gain access to new Glaxo
Group products and receive technical support.
However, Glaxo Canada was also obliged to acquire the main ingredient for the
drug (i.e. ranitidine) from a Glaxo approved source (i.e. Adechsa, a Swiss
subsidiary of the GSK Group).
The price paid by the Canadian subsidiary for the active ingredient was
significantly higher than the price paid by Canadian generic manufacturers.
The CRA reassessed Glaxo Canada by increasing its income on the basis that the
amount it had paid Adechsa for the purchase of ranitidine was “not reasonable in
the circumstances” within the meaning of the transfer pricing rules.
Glaxo Canada's position was that the price paid to Adechsa was reasonable in
the circumstances when viewed in consideration with the License Agreement and
its business to sell Zantac.
Glaxo Canada appealed the CRA's reassessment to the Tax Court of Canada
(TCC), which affirmed the CRA's adjustment of the transfer price on the basis of
the prices generic drug companies were charged for ranitidine. The TCC
supported the CRA's position that, in determining the reasonableness of the
amount paid, the License Agreement was an irrelevant consideration because
“one must look at the transaction in issue and not the surrounding circumstances,
other transactions or other realities”.
Without the licensing agreement the Canadian subsidiaries would not have been
in a position to use the active ingredient patent and the Zantac trademark.
Therefore, the only way for Glaxo Canada to conduct business in Canada would
have been to enter the generic market where the cost of entry would have been
much higher.
The key question to be answered is whether the tax payer is to factor in all
circumstances in determining the arm's length price.
The CRA's position is that the appropriate analysis is what is the arm's length price
for the active ingredient and any other circumstances should be disregarded.
According to the CRA, it is not important whether the buyer wanted to acquire the
ranitidine for the generic market or the premium brand market.
In October 2012 the Supreme Court of Canada handed down a decision that
favoured Glaxo. In a unanimous decision, the Supreme Court disagreed with the

arguments put forward by the Canadian government, saying other factors, such
as licensing agreements, should be considered when determining a reasonable
arm's length price. But it declined Glaxo's request to actually decide whether the
price its Canadian subsidiary paid was fair, referring that question back to the Tax
Court of Canada.
1.8 GAP International Sourcing (India) PvT. Limited v CIT (2012)
GAP International Sourcing provides procurement services for its group in India.
The Indian tax authorities sought to challenge the company’s transfer pricing
policy of a mark up on value added expenses, preferring a commission of 5% of
the Free on Board price. The taypayer’s position was upheld as the Tribunal found
no evidence of local intangibles that would move its transfer pricing method away
from cost plus and that any location savings would be passed on to customers by
a third party.
1.9 GlaxoSmithKline Holding (Americas) Inc v Commissioners
The Glaxo group recently settled a transfer pricing dispute in the US for $3.4 billion.
The magnitude of this settlement helps illustrate the scope of the problem in
valuing IP and exploiting it correctly without triggering potential tax avoidance.
Glaxo is headquartered in the United Kingdom and holds several subsidiaries in the
US. Glaxo's primary business is the development and manufacturing of
pharmaceutical drugs. Cross-border transactions of valuable pharmaceutical
drugs generating large profit margins have attracted the attention of revenue
authorities.
In 2000, when the predecessor of Glaxo (GlaxoWellcome) merged with SmithKline

Beecham to form Glaxo, the merger triggered a transfer pricing audit in the United
States. Glaxo also faced transfer pricing audit adjustments in Canada and Japan.
Glaxo's sales of drugs in the United States generated almost $30 billion in revenues
from 1989 to 1999. During this period, Glaxo paid about $1.3 billion in U.S. taxes.
Glaxo claimed that the United Kingdom had already taxed the MNE Group's
profits under dispute with the IRS, arguing that any reallocation by the United
States would result in double taxation of Glaxo.
Approximately seventy-five percent of Glaxo's income in the United States was

attributable to Zantac.
The drug had been patented in the UK and hence, the US subsidiary was acting as
distributor for the US market. However, the IRS argued that the US subsidiary of
Glaxo overpaid its UK parent for the patent it held. The IRS also argued that
marketing efforts by the US subsidiary were the determining factor in the success of
Zantac. Also, as the US was the largest market for the drug, which was also
manufactured in the US, the economic ownership of the IP was challenged. The
IRS demanded about $8 billion in tax adjustments and penalties.
Glaxo tried to reach settlement with the IRS by referring the dispute to a
competent authority under the MAP procedure. The governmental discussions did
not reach common ground and the IRS took Glaxo to court to preserve evidence
in preparation for the anticipated trial.
In settling the Glaxo case, IRS Commissioner Mark Everson stated that transfer
pricing issues “are one of the most significant challenges” tax agencies face.

1.10 KHO:2010:73
A Finnish company replaced its external borrowings, on which it was paying

interest of a little over 3%, with an internal loan from a Swedish member of the
same group, on which the interest rate was 9.5%, reflecting the cost of external
funding of the group. The court confirmed that the price of external financing for
the group was not a relevant basis for determining the interest rate that should be
paid by the Finnish company, when, on a stand-alone basis, the borrower would
have received significantly better terms given its own credit rating and other
circumstances. The borrower's financial position had not deteriorated and the
Swedish lender was not providing any additional services that would have justified
a higher rate.
1.11 Kwiat v Commissioner 64 TCM (CCH) 327
In this 1992 case a purported lease with reciprocal put/call options was
recharacterised as a secured loan. This was not a transfer pricing case as such
because the parties to the transaction were not associated enterprises. However,
it serves as a contextual reminder of the need to consider all possible legal tools at
the disposal of the tax authority which might ultimately result in the disregard or
recharacterisation of a transaction. In the Kwiat case, the appellant taxpayers
leased shelving equipment to another party. There was a put option permitting the
taxpayers to sell the equipment at a projected profit to the taxpayers.
The Tax Court held that the rights and responsibilities of ownership of the shelving
had passed to the purported lessee: the lease was in substance a sale and the
taxpayer was denied tax depreciation in respect of the assets in question.
1.12 Lankhorst Hohorst C-324/00
This case looks at thin capitalisation rules and compatibility with EU law. The case
involved payment of interest from a German company to a non resident (Dutch)
grandparent company. Thin cap rules applied to limit the deduction in the
German company where the company was thinly capitalised and the loan was
not on arm's length terms. However these rules only applied where the interest was
paid to a non resident (and certain non-CT paying domestic entities), interest
payments to other German companies were not caught by the rules. The ECJ held
that such rules were contrary to the freedom of establishment, as they
discriminated against shareholder companies based in other EU States. However,
the tax authorities put forward various justifications. The tax avoidance justification
did not work, as the rules were too broadly drafted and did not target wholly
artificial arrangements.
1.13 LG Electronics India Pvt. Limited v ACIT (2013)
LG India manufactures and distributes LG Korea’s products under license, for

which it paid a royalty. The Indian tax authorities successfully deemed LG India’s
marketing expenses to be excessive and something that should be recharged to
LG Korea with a mark up using the cost plus method at arm’s length given the
license arrangement and allocation of risk between the companies. This
effectively imputed another transaction – for brand building – which had not been
captured in the transfer pricing method. It also confirmed the acceptance of the
‘brightline’ test, as there was no increase to taxpayer income or profits from the
additional marketing spending.

1.14 Maruti Suzuki India v ACIT
Maruti Suzuki India Limited (“Maruti”) manufactures passenger cars and spare
parts in India. Suzuki Motor Corporation, Japan (“Suzuki”) holds majority shares in
Maruti. The trade mark/logo “M” is the registered trade mark of Maruti. In 1992
Suzuki entered into an agreement under which Suzuki agreed to grant a license to
Maruti for manufacturing and sale of specified models of cars. Under the said
agreement, Maruti was obligated to use the trade mark “Maruti Suzuki” on all the
products and parts manufactured pursuant to this agreement. Further, since 1993,
Maruti replaced the logo “M”, logo of Maruti by “S”, logo of Suzuki on the front of
the cars manufactured and sold by it. At the same time it started using the
“Maruti” mark along with the word “Suzuki” on the rear side of the vehicles.
Maruti made payments to Suzuki for the use of their brand. The Indian tax
authorities said that Maruti should receive payments for using the Suzuki brand as
they were effectively giving the Maruti brand to Suzuki. The Maruti brand was
stronger than the Suzuki Brand in India at the time. Secondly the authorities said
that as Suzuki were penetrating the Indian market by “piggybacking” on to the
Maruti brand, they thought that Maruti should receive something like a royalty fee
as a result. Thirdly it also held that the advertisement expenses incurred by Maruti
had gone to benefit Suzuki.
Maruti contended that at no time had there been a transfer of the Maruti brand to
Suzuki. Suzuki did not have a right to use the trademark, and the trademark could
be transferred only by a written instrument of assignment.
Further, Maruti asserted that it had received a large benefit from Suzuki while
Suzuki had received no benefit, and that because it had a right to use the Suzuki
trademark in the future, Maruti received the benefit of its advertising.
The case talks a lot about the approach taken by the government official, the TPO
(transfer pricing officer). The court found that the the TPO can reject the price
computed by the assessment person only if he finds that the data used by the
assessment person is unreliable, incorrect or inappropriate or he finds evidence,
which discredits the data used and/or the methodology applied by the
assessment person; further the Transfer Pricing Officer (TPO)/Assessing officer (AO)
is obliged to give the assessment person an opportunity to produce evidence in
support of the arm's length price and before making adjustments, he is obliged to
convey to the assessment person the grounds on which the adjustment is
proposed to be made and give the assessment person an opportunity to
controvert the grounds on which the adjustment is proposed.
In considering payments made for using the S logo on the products the court
stated that it is important to consider whether the use of the trademark was
discretionary or mandatory. All factors of the agreement needed to be taken in to
account including the value of marketing intangibles.
Turning to the expenditure incurred by a domestic Associate Enterprise on

advertising of its products using a foreign trademark, this does not require any
payment or compensation by the owner of the foreign trademark/logo to the
domestic entity on account of use of the foreign trademark/logo in the advertising
undertaken by it, so long as the expenses incurred by the domestic entity do not
exceed the expenses which a similarly situated and comparable independent
domestic entity would have incurred. Where they exceed this amount all factors
need to be taken into account to determine the ALP. In this regard the TPO needs
to identify comparables and make the required adjustments.

1.15 Mentor Graphics (India) Private Limited
This case looked at the selection of appropriate comparables and related

analysis.
The taxpayer, a company incorporated under the Indian Companies Act, is the
wholly owned subsidiary of IKOS Systems Inc., a company incorporated in USA and
engaged in the business of software development and also rendering marketing
systems services to the parent company. The taxpayer filed its return of income for
the year under consideration on October 31, 2002 declaring total income at INR
3,99,080/- for the F.A.2001-02. The income disclosed included profit from export of
computer software to its parent company for which deduction was claimed.
Software is developed only as instructed by its parent (associated enterprise (AE)).

It does not create/develop/sell software products and packages. The software
developed by the appellant is used by the parent AE in-house for integrating the
same with other software components developed by the parent AE itself. The
whole software in turn supports the hardware manufactured by the parent, and is
sold as a package in the open market by the parent AE. Therefore the appellant's
business is limited to providing services of software development support.
The taxpayer selected TNMM as the most appropriate TP method. The Indian
authorities stated that the amount for export of software development services
was not arms length; they were happy with the amounts for export of marketing
support services.
The taxpayer searched public databases as required by law and carried out
quantative analysis narrowing the selection to 16 companies. As the NCP (Profit
Margins) of above companies as per average arithmetic mean was 13.41%
against 11.07% earned by the taxpayer in the relevant assessment years, it was
claimed that taxpayer carried out international transactions at arm's length.
The Indian authorities (TPO) raised objections to the comparables chosen and the
years looked at as comparables.
The Delhi branch of the Indian tribunal system rejected the adjustments that the
TPO tried to make to the figures submitted by the tax payer.
Emphasis was placed on selection of comparable companies based on

comparison of economically significant activities and responsibilities of the
independent enterprises vis-à-vis the taxpayer. The Tribunal emphasised the
importance of comparability adjustments with specific reference to adjustments
for differences in working capital, risk and R & D. Further, the Tribunal observed that
as long as the taxpayer is within the arm's length range, the onus to prove an
otherwise scenario rests with the Revenue. In the Tribunal's view, it is not necessary
for the taxpayer to satisfy all points in the range; even if one point is satisfied, the
taxpayer has established its case.
Commentators have noted that by ignoring high profit and high loss making
companies in the comparable set, the Tribunal's observation on the arm's length
range is commensurate with use of an inter-quartile range as prevalent in other
jurisdictions.
1.16 Microsoft Corp v Office of Tax and Revenue
In this case the IRS contract auditor applied a CPM analysis comparing profit-to-
cost ratio of Microsoft with the profit-to-cost ratio of businesses chosen as

comparables. However, the auditor aggregated both controlled and uncontrolled

transactions of Microsoft. Columbia Judge found that there was no justification for
such aggregation which rendered the analysis “arbitrary, capricious and
unreasonable.”
1.17 National Semiconductor (NSC) and consolidated subsidiaries v IRS
NSC was engaged in the manufacture of a variety of electronic products for use
by consumers, industry, and Government. Those products included IC's, discrete
devices, hybrid circuits, electronic displays, module components, calculators,
digital watches, and other similar products.
During the late 1970s, the management of NSC decided that NSC needed to
enter the large-die market in order to continue growing. Large amounts were
spent on R&D.
NSC and other U.S. semiconductor manufacturers began moving their

semiconductor packaging operations to subsidiaries in Asia in the late 1960s. This
allowed them to take advantage of lower-cost labour and overheads and of the
tax and other investment incentives provided by local Asian governments. It was
essential for NSC to achieve labour cost savings by locating its packaging
operations in Southeast Asia, and the Asian subsidiaries were dependent on NSC
for a secure source of semiconductor dies to justify their substantial investment in
assembly equipment, packaging methods, and personnel.
The Asian subsidiaries performed semiconductor packaging and associated

activities at several plants in Malaysia, Singapore, Hong Kong, Thailand, Indonesia,
and the Philippines. Unaffiliated IDM's performed a small amount of packaging for
NSC.
The Asian subsidiaries were responsible for packaging some of the products.
Several of the Asian subsidiaries held dies (used in the packaging) and finished
goods inventory. The Indian Subsidiaries financed inventories, held by them, of the
dies and sometimes of the finished goods. In addition, the Asian subsidiaries bore
the cost of shipping finished devices. On the whole, the Asian subsidiaries had
successful digital and linear lines and were efficient cost-competitive packagers.
The Asian subsidiaries increased the efficiency of the packaging through process
improvements, which, among other things, improved output per operator.
Like most organisations that produce a large number of individual products using
processes that are both complex and relatively standardised, NSC used a
standard cost system for product costing. It assigned a specified cost to each
material component and labour operation that was required to complete each
stage in the production process. A standard amount of manufacturing overhead
costs was also applied.
The total standard cost was computed as the sum of the material, labour, and
overhead costs when the product was completed. “Overhead” costs were those
indirect costs that were most directly identifiable with the manufacturing activities
and were allocated to production on a unit-by-unit basis. Indirect costs that were
related to manufacturing activities, but not identifiable with specific units of
production, were classified as “manufacturing period” expenses. The balance of
indirect costs were commonly classified as nonmanufacturing period expenses,
engineering, R&D, selling, and general and administrative expenses. Any
difference that was identified as a result of comparing the standard cost of
producing a specific quantity of a product with the actual cost of producing that

quantity was called a variance. Variances had two potential causes: either the
standard cost was not accurate or production process irregularities resulted in
changed actual costs of production. To determine which was the cause required
a detailed investigation.
For financial and tax reporting purposes, NSC treated as sales (1) the transfer of
semiconductor dies in wafer form and associated materials to the Asian
subsidiaries (outbound sales) and (2) the transfer of assembled devices from the
Asian subsidiaries back to sales and marketing affiliates in the United States
(inbound sales) or to affiliates in third countries.
The issue presented to the Court was whether the transfer prices that were
charged between NSC and its Asian subsidiaries met the arm's length standard of
section 482.NSC claimed to have proven that the determinations made by the IRS
were unacceptable and to have presented comparable transactions between
unrelated parties and industry data which proved that its transfer prices satisfied
the arm's length standard.
The IRS claimed that NSC had not presented comparable uncontrolled prices to
prove that its transfer pricing system should be upheld.
Before trial, NSC filed a memorandum requesting that the burden of proof be
shifted to the IRS with regard to certain allegations in the IRS's amendments to
answer, pertaining to methods of allocation based on outbound sales prices,
because they were beyond the scope of the notices of deficiency.
Both sides called on expert witnesses who gave detailed calculations and
explanations of how the transfer price should be calculated.
The court ruled that because evidence presented by each side demonstrated
that the notices were unreasonable, the determinations in the notices were
arbitrary, capricious, or unreasonable.
With regards to the expert witnesses the court said:
“Because proper income allocations cannot be determined from the

transaction evidence presented by the parties, we must look to opinions of
their experts. As we have frequently stated, “we are not bound by the opinion
of any expert witness. We may accept an expert's opinion or we may reject
testimony that is contrary to our own judgment”. See, e.g., Estate of Hall v.
Commissioner, 92T.C. 312, 338 (1989). Further, “We are not restricted to
choosing the opinion of one expert over another, but may extract relevant
findings from each in drawing our own conclusions.” Bausch & Lomb, Inc. v.
Commissioner, 92 T.C. 525, 597(1989), affd. 933 F.2d 1084 (2d Cir. 1991).”
The court allowed some amendments to the transfer price; however the majority
of the location savings were allowed to remain in Asia.
1.18 Philip Morris case
One of the best known cases on PEs heard before a European Tax court is the
Phillip Morris case heard by the Italian Supreme Court (L Ministry of Finance (Tax
Office) v Phillip Morris GMBH Corte Suprema di Cassazione 7682/02 25th May 2002).
Phillip Morris GMBH, a company tax resident in Germany, received royalties from
the Italian Tobacco Administration for a license to produce and sell tobacco
products using the Phillip Morris trademark. The execution of the agreement was

supervised by Interba SPA, a group company resident in Italy. The company

performed agency and promotional activities for Phillip Morris in duty free zones. Its
other main activity was the manufacture and distribution of cigarette filters.
The Italian tax authorities argued that Interba Spa was a PE of the group as it
participated in the royalty agreement negotiations as well as other group business
activities with no remuneration. Accordingly the royalty income should be
allocated to a PE of Phillip Morris Gmbh. They also argued that the Italian
subsidiary had been formed to avoid a PE.
The Italian Supreme court found a PE existed. The activity could not be considered
auxiliary for the purposes of Article 5 of the German/Italian tax treaty (similar
provisions are contained in the model tax treaty). It was found that participating in
contract negotiations can be construed as an authority to conclude contracts. A
PE will also be established where a principal entrusts some of its business operations
to a subsidiary.
1.19 Ranbaxy Laboratories Ltd (Delhi tribunal) 110 IRTD 428
This case looked at the transfer pricing analysis conducted by the taxpayer, such
as selection of tested party, aggregation of transactions, selection of overseas
comparables, etc. The Tribunal also made comments on the disclosure norms in
the accountant's report and the inadequate disclosures made by the taxpayer.
Ranbaxy Laboratories Limited is a company registered in India engaged in the

business of manufacture and sale of pharmaceutical products. During the
financial year (FY) 2003-04, the taxpayer exported goods and services to its
associated enterprises (AEs). The prices charged by the taxpayer from its AEs were
determined to be at arm's length by using the Transactional Net Margin Method
(TNMM) with the profit level indicator (PLI) of operating profit margin on sales
(OPM)
The case involved transactions with some 17 AEs in various countries including
Malaysia, Africa, Brazil, Germany and Ireland. The transactions included sale of
products and payments for technical knowhow. The company looked for
comparable transactions and eight comparables were selected including
comparables from the USA, Europe and Malaysia. The average ‘net profit margin
on sales’ of these comparable companies was higher than the average net profit
margin earned by the 17 AEs.
The Indian tax authorities questioned the company's return on two issues:
1. The determination of the arm's length price (ALP) was not referred by the
Assessing Officer (AO) to the Transfer Pricing Officer (TPO) as required by the
law; and
2. TNMM was used as the most appropriate method and the PLI of the AEs were
tested instead of the PLI of the taxpayer.
On the second point Ranbaxy contended that the AEs were the less complex
party and as a result it was correct that they be the tested party. The tribunal
disagreed as reliable data on the AEs was not made available to allow
benchmark analysis to be undertaken.
The tribunal also stated that it was not correct to aggregate the 17 AEs and treat
them as one tested party. The tribunal agreed that the least complex part should
be the tested party but stated that if comparable data was available relating to

the other party, in this case the Indian tax payer Ranbaxy, then that should be
used. Note that in India there is publically available data on pharmaceutical
companies and the tribunal thought this should be used in preference to foreign
data.
The tribunal also commentated that the OECD Guidelines should not be referred
to on a selective basis as this would be against the spirit of the Guidelines.
1.20 Roche Products Pty Ltd v FC of T 2008 ATC
The case is notable for being the first decision in a court room on a substantive
transfer pricing issue under Australian law.
This case involved the judges in looking at the testimony of expert witnesses who
do not agree with each other.
Roche Australia is a subsidiary of Roche Holdings Ltd of Basel, Switzerland. Globally,

the Roche Group carries on the business of producing, selling and supplying
pharmaceutical and diagnostic products. Roche Australia comprised three
operating divisions over the audit period which was 11 years up to 2002.
The Australian Tax Office (ATO) questioned the transfer pricing methodology used
by the company.
The court disagreed with the evidence put forward by the ATO criticising a number
of “presumptions” made by a number of the expert economists. The court thought
the economists were too US-focused in their approach and as a result they did not
provide analysis that specifically addressed Australia's transfer pricing provisions.
The key points made in the case included the following:
• that arm's length prices be determined for each separate year under
consideration, rather than a multiple-year average.
• questions were raised about whether Australia's double taxation treaties be

applied by the ATO to effect transfer pricing adjustments (independent of the
“domestic” transfer pricing provisions set out in Div 13 of ITAA 1936).
• the ruling acknowledges the difficulty in finding available comparable data,

and uses a uniform gross margin to price the transfers of all pharmaceutical
products; a preference was expressed for transactional methods over profit
methods, such as the profit-based transactional net margin method (TNMM).
Following the case the ATO released as a statement that in their view Roche is
confined to “to the facts of the case” and that “all things considered [Roche] is
seen as having limited significance for the administration of transfer pricing laws
generally”
1.21 Sunstrand Corporation v Commissioner (1991). Bausch & Lomb Inc. v.

Comm'r, 92 T.C. 525 (1989)
We will look at these two cases together as they are similar
Sundstrand Corporation, a component manufacturer, set up a subsidiary (Sunpac)

in Singapore to manufacture constant speed drives (CSDs). Sunpac was treated as
a full cost manufacture. The TP was calculated in a way that left all the location
savings in Singapore.

The IRS challenged this saying that Sunpac was a “machine shop” or a “contract
manufacturer”.
The Court determined that Sunpac was not, in fact, a contract manufacturer
because it operated under a licence from the parent company.
Sundstrand argued that Sunpac should retain any location savings because the
licence agreement gave it a “monopolistic position” with respect to CSD spare
parts. This monopolistic position would, Sundstrand argued, have led Sunpac to
price in a way that caused all the location savings to remain in Sunpac. The Court
agreed with this argument. The court accepted that Sunpac has market power as
a result of the IP it owned.
In the case of Bausch & Lomb (B&L), B&L,a manufacturer of contact lenses,
developed and patented the spin cast method for manufacturing soft contact
lenses, which enabled production costs of approximately $1.50 per lens, while
alternative methods used by competitors cost at least $3.00 per lens. B&L
subsequently licensed the technology to wholly-owned Irish subsidiary B&L Ireland.
B&L Ireland manufactured the lenses at a cost of approximately $1.50 per lens and
then sold them to B&L for $7.50 per lens. The TP price was challenged by the IRS.
The IRS contended that the Irish company was a contract manufacturer because
sale of its total production was assured. Because it did not bear the risks of an
independent manufacturer, B&L Ireland is only entitled to cost plus a comparable
contract manufacturer mark-up.
The court found that CUP was the correct method. This was partly because B&L
Ireland was not contractually bound to sell the lenses it produced to B&L.
Therefore, it bore the risks of an independent producer, and it was entitled to the
market prices commanded by analogous independent producers. If B&L
committed to purchase the entire production, it would need to be compensated
for taking on that additional risk in the form of a discounted unit price.
Some writers have criticised this decision as the cost savings had been developed
in the US via development of the technology.
1.22 Thin Cap GLO C-524/04
This ECJ case considered the UK thin cap rules and held that whilst they were a
restriction on the freedom of establishment, such rules would be acceptable so
long as: they were aimed at purely artificial arrangements (identified using
objective and verifiable elements); they allowed taxpayers to produce evidence
of commercial justification for the transaction; and any disallowance only applied
to the interest which exceeded the arm's length amount.
1.23 VERITAS Software Corp., 133 TC No. 14,Dec. 58,016 (Dec. 10, 2009)
This was a US case looking at “buy in” costs for a cost contribution arrangement.
The IRS argued that what had taken place was akin to a sale or spinoff of Veritas
operations hence the sum to be paid should be valued on this basis.
Veritas Software, which is in the business of developing, manufacturing, marketing,

and selling software products, went through several corporate changes a few
years back; mostly notably, it was purchased by Symantec Corp. on July 2, 2005.
Prior to that, on November 3, 1999, Veritas Software assigned all its existing sales
agreements with its European-based sales subsidiaries to a new corporation –

Veritas Ireland. In addition, on the same date, Veritas Software and Veritas Ireland
entered into a research and development agreement, as well as a technology
license agreement.
Based on the licensing agreement, Veritas Software granted Veritas Ireland the
right to use certain “covered intangibles,” as well as the right to use Veritas
Software's trademarks, trade names, and service marks. In exchange for the rights
granted by licensing agreement, Veritas Ireland agreed to pay royalties, as well as
a “prepayment amount.”
In 2000 Veritas Ireland made a $166 million “lump sum buy-in payment” to Veritas
Software. This amount was later adjusted downward to $118 million. At issue, from
a tax perspective, is whether the buy-in payment was “arm's length.”
The court rejected the IRS approach agreeing with Veritas that the amount to be
paid should be based on comparable uncontrolled royalties payable over the life
of the agreement. Further the court said that the IRS determination was arbitrary,
capricious, and altogether unreasonable.
Veritas used agreements between Veritas Software and certain original

equipment manufacturers (OEMs) as comparables. The IRS contended that the
OEM agreements involve substantially different intangibles. But the court
disagreed: it concluded that, collectively, the more than 90 “unbundled” OEM
agreements the parties stipulated were sufficiently comparable to the controlled
transaction.
In noting the comparability, the court also pointed out the following:
(1) Veritas Ireland and the OEMs undertook similar activities and employed similar
resources in conjunction with such activities, (2) there were no significant
differences in contractual terms, (3) the parties to the controlled and uncontrolled
transactions bore similar market risks and other risks, and (4) there were no
significant differences in property or services provided,
therefore, the court was happy that the unbundled OEM agreements were
sufficiently comparable to the transaction they were looking at thus giving the
result that comparable uncontrolled transaction method (CUT) (as set down in the
US regulations) was the best method to determine the appropriate buy-in price.
The buy-in payment charged met the arm's length standard and the IRS's
contention was rejected.
1.24 Waterloo plc and others v CIR
In 2001, the Special Commissioners heard a case relating to loans made by a

parent company to a related trust to enable the trustee to purchase shares and
grant share options to employees of subsidiary companies. While the findings in
Waterloo plc and others v CIR (SPC301) related to a period prior to 1998, the point
at which transfer pricing regulations were introduced in the UK, and have
therefore to a certain degree been trumped by contemporaneous legislation,
there were a couple of particular points raised during the case that continue to be
of application.
On a general note, this case included analysis of precisely what constituted

‘business facilities’, an area which has been raised in following cases, and which to
a degree informed the wording of subsequent UK TP legislation – while the phrase
‘business facility’ is no longer included in the regulations, the regulations now
require analysis of any series of linked transactions. It was specifically noted in

Waterloo that ‘the phrase ‘business facility’ is a commercial not a legal term,
and…that where a commercial term is used in legislation, the test of ordinary
business might require an aggregation of transactions which transcended their
juristic individuality’. HMRC's stated position is now that it does not matter that
business facilities had been given and received, by way of a complex provision,
rather than being sold and bought, by way of a straightforward transaction.
Therefore there is no need to specifically identify a transaction between the
parent and the subsidiary, the relevant share scheme merely needs to provide a
defined, valuable and quantifiable benefit to the subsidiary employing the
relevant employees.
Secondly, Waterloo gave some guidance on the complex and frequently

contentious area of tax treatment and allocation of employee share option costs.
HMRC now considers that a facility is being provided no matter how the
arrangements are set up for administering and delivering a Group employee share
plan, and transfer pricing rules will subsequently apply – under Waterloo, that
facility should be priced accordingly, with the provider receiving or imputing
receipts that reflect the full value of the facility it is providing. Detailed
commentary based in part on the Waterloo findings now form part of HMRC's
guidance on the pricing of share plans under IFRS accounting rules that apply to
accounting periods commencing on or after 1 January 2005.
1.25 XILINX Inc. & Consolidated Subsidiaries v The IRS 2009
This case looked at whether related companies engaged in a joint venture to

develop intangible property must include the value of certain stock option
compensation one participant gives to its employees in the pool of costs to be
shared under a cost sharing agreement, even when companies operating at arm's
length would not do so. The tax court found related companies are not required to
share such costs and ruled that the Commissioner of Internal Revenue's attempt to
allocate such costs was arbitrary and capricious.
Xilinx, Inc. (“Xilinx”) researches, develops, manufactures, markets and sells

integrated circuit devices and related development software systems. Xilinix set up
Xilinx Ireland (XI).
Xilinx and XI entered into a Cost and Risk Sharing Agreement (“the Agreement”),
which provided that all right, title and interest in new technology developed by
either Xilinx or XI would be jointly owned. Under the Agreement, each party was
required to pay a percentage of the total R&D costs in proportion to the
anticipated benefits to each from the new technology that was expected to be
created. Specifically, the Agreement required the parties to share:
1. direct costs, defined as costs directly related to the R&D of new technology,
including, but not limited to, salaries, bonuses and other payroll costs and
benefits;
2. indirect costs, defined as costs incurred by departments not involved in R&D

that generally benefit R&D, including, but not limited to, administrative, legal,
accounting and insurance costs; and
3. costs incurred to acquire products or intellectual property rights necessary to

conduct R&D. The Agreement did not specifically address whether employee
stock options (ESOs) were a cost to be shared.

The IRS contended that ESOs issued to its employees involved in or supporting R&D
activities were costs that should have been shared between Xilinx and XI under
the Agreement.
The relevant sections of the US tax code apply the arm's length standard, the latter
stating: “… the standard to be applied in every case is that of a taxpayer dealing
at arm's length with an uncontrolled taxpayer.” (italics added)
Contrast that regulation with the regulation dealing with cost sharing agreements
which provides that participants in a cost sharing arrangement are to allocate all
costs of developing the intangible.
The parties agreed (and the Tax Court found as a fact) that unrelated persons
entering into a cost sharing arrangement would not include the cost of employee
stock options as a “cost.” Since the arm's length principle would require related
parties to only share costs that unrelated parties would share, that principle
dictates that ESOs should not be included as a shared cost.
Therefore, as stated above, there is a risk that the existing US cost-sharing

regulations, which require stock-based compensation to be included in the pool of
costs to be shared between the parties, are not in line with the arm's length
standard as set out by the OECD Guidelines.
1.26 Zimmer case
Zimmer SAS, a former distributor in France for Zimmer Ltd products, was converted
in 1995 into a commissionaire. The French tax authorities then assessed Zimmer Ltd
to French corporate income tax for the years 1995 and 1996 on the grounds that it
had a PE, contending that the UK Company carried out a business through a
dependent agent (i.e., the French company Zimmer SAS) under Art. 4(5) of the
France-UK tax treaty.
The Paris Administrative Court of Appeal decided in February 2007 that the French
commissionaire of the UK principal constituted a French PE of that company.
Zimmer Ltd appealed against this decision before the French Supreme
Administrative.
The Supreme Court made its decision on a pure legal analysis of the provisions of
the French Commercial Code, according to which a French commissionaire has
no legal authority to conclude a contract in the name of its principal.
The Supreme Court referred to Article 94 of the former Commercial Code (L 132-1
of the new Code) which states that a commissionaire acts in its own name on
behalf of its principal. Contracts concluded by a commissionaire, even on behalf
of its principal, cannot directly bind the principal to the co-contracting parties of
the commissionaire. The Court concluded that a commissionaire cannot create a
PE simply as a result of the commission agreement with the principal.
However, that there may be exceptions to this rule, such as where the terms of the
commission agreement or other aspects of the instructions demonstrate that,
despite the qualification of the contract given by parties, the principal is bound by
contracts entered into by the commissionaire with third parties.
Key points arising from the case:
• Where the wording of the commissionaire agreement follows the legal nature
of a commissionaire, in accordance with French civil and commercial

regulations, it cannot be recharacterised by the tax authorities as a

contractual arrangement of a different nature.
• A commissionaire agreement can grant sufficient flexibility to the

commissionaire for carrying out its daily activities without constituting a PE of its
principal.
• The decision is based on legal principles and does not look at what is actually
happening in the business and how it actually operates.

APPENDIX 2
CONVENTION on the elimination of double taxation in connection with the

adjustment of profits of associated enterprises (90/436/EEC)
THE HIGH CONTRACTING PARTIES TO THE TREATY ESTABLISHING THE EUROPEAN

ECONOMIC COMMUNITY,
DESIRING to give effect to Article 220 of that Treaty, by virtue of which they have
undertaken to enter into negotiations with one another with a view to securing for
the benefit of their nationals the elimination of double taxation,
CONSIDERING the importance attached to the elimination of double taxation in

connection with the adjustment of profits of associated enterprises,
HAVE DECIDED to conclude this Convention, and to this end have designated as
their Plenipotentiaries:
HIS MAJESTY THE KING OF THE BELGIANS:
Philippe de SCHOUTHEETE de TERVARENT,
Ambassador Extraordinary and Plenipotentiary;
HER MAJESTY THE QUEEN OF DENMARK:
Niels HELVEG PETERSEN,
Minister for Economic Affairs;
THE PRESIDENT OF THE FEDERAL REPUBLIC OF GERMANY:
Theo WAIGEL,
Federal Minister for Finance;
Juergen TRUMPF,
THE PRESIDENT OF THE HELLENIC REPUBLIC:
Ioannis PALAIOKRASSAS,
Minister for Finance;
HIS MAJESTY THE KING OF SPAIN:
Carlos SOLCHAGA CATALÁN,
Minister for Economic Affairs and Finance;
THE PRESIDENT OF THE FRENCH REPUBLIC:
Jean VIDAL,

THE PRESIDENT OF IRELAND:
Albert REYNOLDS,
THE PRESIDENT OF THE ITALIAN REPUBLIC:
Stefano DE LUCA,
State Secretary for Finance;
HIS ROYAL HIGHNESS THE GRAND DUKE OF LUXEMBOURG:
Jean-Claude JUNCKER,
Minister for the Budget, Minister for Finance, Minister for Labour;
HER MAJESTY THE QUEEN OF THE NETHERLANDS:
P.C. NIEMAN,
THE PRESIDENT OF THE PORTUGUESE REPUBLIC:
Miguel BELEZA,
HER MAJESTY THE QUEEN OF THE UNITED KINGDOM OF GREAT BRITAIN AND
NORTHERN IRELAND:
David H.A. HANNAY KCMG,
WHO, meeting within the Council and having exchanged their Full Powers, found
in good and due form,
HAVE AGREED AS FOLLOWS:
CHAPTER I SCOPE OF THE CONVENTION
Article 1
1. This Convention shall apply where, for the purposes of taxation, profits which are
included in the profits of an enterprise of a Contracting State are also included or
are also likely to be included in the profits of an enterprise of another Contracting
State on the grounds that the principles set out in Article 4 and applied either
directly or in corresponding provisions of the law of the State concerned have not
been observed.
2. For the purposes of this Convention, the permanent establishment of an

enterprise of an Contracting State situated in another Contracting State shall be
deemed to be an enterprise of the State in which it is situated.

3. Paragraph 1 shall also apply where any of the enterprises concerned have
made losses rather than profits.
Article 2
1. This Convention shall apply to taxes on income.
2. The existing taxes to which this Convention shall apply are, in particular the
following:
a. in Belguim:
– impôt des personnes physiques/personenbelasting,
– impôt des sociétés/vennootschapsbelasting,
– impôt des personnes morales/rechtspersonenbelasting,
– impôt des non-résidents/belasting der niet-verblijfhouders,
– taxe communale et la taxe d'agglomération additionnelles à l'impôt des

personnes physiques/ aanvullende gemeentebelasting en
agglomeratiebelasting op de personenbelasting;
b. in Denmark:
– selskabsskat,
– indkomstskat til staten,
– kommunale indkomstskat,
– amtskommunal indkomstskat,
– saerlig indkomstskat,
– kirkeskat,
– udbytteskat,
– renteskat,
– royaltyskat,
– frigoerelsesafgift;
c. in the Federal Republic of Germany:
– Einkommensteuer,
– Koerperschaftsteuer,
– Gewerbesteuer, in so far as this tax is based on trading profits;

d. in Greece:
– foros eisodimatos fysikon prosopon,
– foros eisodimatos nomikon prosopon,
– eisfora yper ton epicheiriseon ydrefsis kai apochetefsis;
e. in Spain:
– impuesto sobre la renta de las personas fisicas,
– impuesto sobre sociedades;
f. in France:
– impôt sur le revenu,
– impôt sur les sociétés;
g. in Ireland:
– Income Tax,
– Corporation Tax;
h. in Italy:
– imposta sul reddito delle persone fisiche,
– imposta sul reddito delle persone giuridiche,
– imposta locale sui redditi;
i. in Luxembourg:
– impôt sur le revenu des personnes physiques,
– impôt sur le revenu des collectivités,
– impôt commercial, in so far as this tax is based on trading profits;
j. in the Netherlands
– inkomstenbelasting,
– vennootschapsbelasting;
k. in Portugal:
– imposto sobre o rendimento das pessoas singulares,
– imposto sobre o rendimento das pessoas colectivas,
– derrama para os municípios sobre o imposto sobre o rendimento das pessoas

colectivas;

l. in the United Kingdom:
– Income Tax,
– Corporation Tax.
3. The Convention shall also apply to any identical or similar taxes which are
imposed after the date of signature thereof in addition to, or in place of existing
taxes. The competent authorities of the Contracting States shall inform each other
of any changes made in the respective domestic laws.
CHAPTER II GENERAL PROVISIONS
Section I Definitions
Article 3
1. For the purposes of this Convention: ‘competent authority’ shall mean:
– in Belgium:
De Minister van Financiën or an authorized representative,
Le Ministre des Finances or an authorized representative,
– in Denmark:
Skatteministeren or an authorized representative,
– in the Federal Republic of Germany:
Der Bundesminister der Finanzen or an authorized representative,
– in Greece:
O Ypoyrgos ton Oikonomikon or an authorized representative,
– in Spain:
El Ministro de Economía y Hacienda or an authorized representative,
– in France:
Le Ministre chargé du budget or an authorized representative,
– in Ireland:
The Revenue Commissioners or an authorized representative,
– in Italy:
Il Ministro delle Finanze or an authorized representative,
– in Luxembourg:
Le Ministre des Finances or an authorized representative,

– in the Netherlands:
De Minister van Financiën or an authorized representative,
– in Portugal:
O Ministro das Finanças or an authorized representative,
– in the United Kingdom:
The Commissioners of Inland Revenue or an authorized representative.
2. Any term not defined in this Convention shall, unless the context otherwise
requires, have the meaning which it has under the double taxation convention
between the States concerned.
Section II
Principles applying to the adjustment of profits of associated enterprises and to the

attribution of profits to permanent establishments
Article 4
The following principles shall be observed in the application of this Convention:
1. Where:
a. an enterprise of a Contracting State participates directly or indirectly in

the management, control
or capital of an enterprise of another Contracting State,
or
b. the same persons participate directly or indirectly in the management,

control or capital of an enterprise of one Contracting State and an
enterprise of another Contracting State, and in either case conditions are
made or imposed between the two enterprises in their commercial or
financial relations which differ form 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. Where an enterprise of a Contracting State carries on business in another

Contracting State through a permanent establishment situated therein, there
shall be attributed to that permanent establishment the profits which it might
be expected to make if it were a distinct and separate enterprise engaged in
the same or similar activities under the same or similar conditions and dealing
wholly independently with the enterprise of which it is a permanent
establishment.

Article 5
Where a Contracting State intends to adjust the profits of an enterprise in

accordance with the principles set out in Article 4, it shall inform the enterprise of
the intended action in due time and give it the opportunity to inform the other
enterprise so as to give that other enterprise the opportunity to inform in turn the
other Contracting State.
However, the Contracting State providing such information shall not be prevented
from making the proposed adjustment.
If after such information has been given the two enterprises and the other
Contracting State agree to the adjustment, Articles 6 and 7 shall not apply.
Section III Mutual agreement and arbitration procedure
Article 6
1. Where an enterprise considers that, in any case to which this Convention

applies, the principles set out in Article 4 have not been observed, it may,
irrespective of the remedies provided by the domestic law of the Contracting
States concerned, present its case to the competent authority of the Contracting
State of which it is an enterprise or in which its permanent establishment is situated.
The case must be presented within three years of the first notification of the action
which results or is likely to result in double taxation within the meaning of Article 1.
The enterprise shall at the same time notify the competent authority if other
Contracting States may be concerned in the case. The competent authority shall
then without delay notify the competent authorities of those other Contracting
States.
2. If the complaint appears to it to be well-founded and if it is not itself able to

arrive at a satisfactory solution, the competent authority shall endeavour to resolve
the case by mutual agreement with the competent authority of any other
Contracting State concerned, with a view to the elimination of double taxation on
the basis of the principles set out in Article 4. Any mutual agreement reached shall
be implemented irrespective of any time limits prescribed by the domestic laws of
the Contracting States concerned.
Article 7
1. If the competent authorities concerned fail to reach an agreement that

eliminates the double taxation referred to in Article 6 within two years of the date
on which the case was first submitted to one of the competent authorities in
accordance with Article 6 (1), they shall set up an advisory commission charged
with delivering its opinion on the elimination of the double taxation in question.
Enterprises may have recourse to the remedies available to them under the
domestic law of the Contracting States concerned; however, where the case has
so been submitted to a court or tribunal, the term of two years referred to in the
first subparagraph shall be computed from the date on which the judgment of the
final court of appeal was given.
2. The submission of the case to the advisory commission shall not prevent a
Contracting State from initiating or continuing judicial proceedings or proceedings
for administrative penalties in relation to the same matters.

3. Where the domestic law of a Contracting State does not permit the competent
authorities of that State to derogate from the decisions of their judicial bodies,
paragraph 1 shall not apply unless the associated enterprise of that State has
allowed the time provided for appeal to expire, or has withdrawn any such appeal
before a decision has been delivered. This provision shall not affect the appeal if
and in so far as it relates to matters other than those referred to in Article 6.
4. The competent authorities may by mutual agreement and with the agreement
of the associated enterprises concerned waive the time limits referred to in
paragraph 1.
5. In so far as the provisions of paragraphs 1 to 4 are not applied, the rights of each
of the associated enterprises, as laid down in Article 6, shall be unaffected.
Article 8
1. The competent authority of a Contracting State shall not be obliged to initiate

the mutual agreement procedure or to set up the advisory commission referred to
in Article 7 where legal or administrative proceedings have resulted in a final ruling
that by actions giving rise to an adjustment of transfers of profits under Article 4
one of the enterprises concerned is liable to a serious penalty.
2. Where judicial or administrative proceedings, initiated with a view to a ruling

that by actions giving rise to an adjustment of profits under Article 4 one of the
enterprises concerned was liable to a serious penalty, are being conducted
simultaneously with any of the proceedings referred to in Articles 6 and 7, the
competent authorities may stay the latter proceedings until the judicial or
administrative proceedings have been concluded.
Article 9
1. The advisory commission referred to in Article 7 (1) shall consist of, in addition to
its Chairman:
– two representatives of each competent authority concerned; this number

may be reduced to one by agreement between the competent authorities,
– an even number of independent persons of standing to be appointed by

mutual agreement from the list of persons referred to in paragraph 4 or, in the
absence of agreement, by the drawing of lots by the competent authorities
concerned.
2. When the independent persons of standing are appointed an alternate shall be

appointed for each of them according to the rules for the appointment of the
independent persons in case the independent persons are prevented from
carrying out their duties.
3. Where lots are drawn, each of the competent authorities may object to the
appointment of any particular independent person of standing in any
circumstance agreed in advance between the competent authorities concerned
or in one of the following situations:
– where that person belongs to or is working on behalf of one of the tax

administrations concerned,
– where that person has, or has had, a large holding in or is or has been an
employee of or adviser to one or each of the associated enterprises,

– where that person does not offer a sufficient guarantee of objectivity for the
settlement of the case or cases to be decided.
4. The list of independent persons of standing shall consist of all the independent
persons nominated by the Contracting States. For this purpose each Contracting
State shall nominate five persons and shall inform the Secretary-General of the
Council of the European Communities thereof.
Such persons must be nationals of a Contracting State and resident within the
territory to which this Convention applies. They must be competent and
independent.
The Contracting States may make alterations to the list referred to in the first
subparagraph; they shall inform the Secretary-General of the Council of the
European Communities thereof without delay.
5. The representatives and independent persons of standing appointed in

accordance with paragraph 1 shall elect a Chairman from among those persons
of standing on the list referred to in paragraph 4, without prejudice to the right of
each competent authority concerned to object to the appointment of the person
of standing thus chosen in one of the situations referred to in paragraph 3.
The Chairman must possess the qualifications required for appointment to the
highest judicial offices in his country or be a jurisconsult of recognized
competence.
6. The members of the advisory commission shall keep secret all matters which
they learn as a result of the proceedings. The Contracting States shall adopt
appropriate provisions to penalize any breach of secrecy obligations. They shall,
without delay inform the Commission of the European Communities of the
measures taken. The Commission of the European Comunities shall inform the
other Contracting States.
7. The Contracting States shall take all necessary steps to ensure that the advisory
commission meets without delay once cases are referred to it.
Article 10
1. For the purposes of the procedure referred to in Article 7, the associated

enterprises concerned may provide any information, evidence or documents
which seem to them likely to be of use to the advisory commission in reaching a
decision. The enterprises and the competent authorities of the Contracting States
concerned shall give effect to any request made by the advisory commission to
provide information, evidence or documents. However, the competent authorities
of any such Contracting State shall not be under any obligation:
a. to carry out administrative measures at variance with its domestic law or its
normal administrative practice;
b. to supply information which is not obtainable under its domestic law or in its
normal administrative practice;
or

c. to supply information which would disclose any trade, business, industrial or

professional secret or trade process, or information the disclosure of which
would be contrary to public policy (ordre public).
2. Each of the associated enterprises may, at its request, appear or be represented

before the advisory commission. If the advisory commission so requests, each of
the associated enterprises shall appear or be represented before it.
Article 11
1. The advisory commission referred to in Article 7 shall deliver its opinion not more
than six months from the date on which the matter was referred to it.
The advisory commission must base its opinion on Article 4.
2. The advisory commission shall adopt its opinion by a simple majority of its
members. The competent authorities concerned may agree on additional rules of
procedure.
3. The costs of the advisory commission procedure, other than those incurred by
the associated enterprises, shall be shared equally by the Contracting States
concerned.
Article 12
1. The competent authorities party to the procedure referred to in Article 7 shall,

acting by common consent on the basis of Article 4, take a decision which will
eliminate the double taxation within six months of the date on which the advisory
commission delivered its opinion.
The competent authorities may take a decision which deviates from the advisory
commission's opinion. If they fail to reach agreement, they shall be obliged to act
in accordance with that opinion.
2. The competent authorities may agree to publish the decision referred to in

paragraph 1, subject to the consent of the enterprises concerned.
Article 13
The fact that the decisions taken by the Contracting States, concerning the
taxation of profits resulting from a transaction between associated enterprises,
have become final shall not prevent recourse to the procedures set out in Articles
6 and 7.
Article 14
For the purposes of this Convention, the double taxation of profits shall be
regarded as eliminated if either:
a. the profits are included in the computation of taxable profits in one State only;
or
b. the tax chargeable on those profits in one State is reduced by an amount

equal to the tax chargeable on them in the other.

CHAPTER III FINAL PROVISIONS
Article 15
Nothing in this Convention shall affect the fulfilment of wider obligations with
respect to the elimination of double taxation in the case of an adjustment of
profits of associated enterprises resulting either from other conventions to which
the Contracting States are or will become parties or from the domestic law of the
Contracting States.
Article 16
1. The territorial scope of this Convention shall be that defined in Article 227 (1) of
the Treaty establishing the European Economic Community, without prejudice to
paragraph 2 of this Article.
2. This Convention shall not apply to:
– the French territories referred to in Annex IV to the Treaty establishing the

European Economic Community,
– the Faroe Islands and Greenland.
Article 17
This Convention will be ratified by the Contracting States. The instruments of

ratification will be deposited at the office of the Secretary-General of the Council
of the European Communities.
Article 18
This Convention shall enter into force on the first day of the third month following
that in which the instrument of ratification is deposited by the last signatory State to
take that step. The Convention shall apply to proceedings referred to in Article 6
(1) which are initiated after its entry into force.
Article 19
The Secretary-General of the Council of the European Communities shall inform

the Contracting States of:
a. the deposit of each instrument of ratification;
b. the date on which this Convention will enter into force;
c. the list of independent persons of standing appointed by the Contracting

States and any alterations thereto in accordance with Article 9 (4).
Article 20
This Convention is concluded for a period of five years. Six months before the
expiry of that period, the Contracting
States will meet to decide on the extension of this Convention and any other
relevant measure.

Article 21
Each Contracting State may, at any time, ask for a revision of this Convention. In
that event, a conference to revise the Convention will be convened by the
President of the Council of the European Communities.
Article 22
This Convention, drawn up in a single original in the Danish, Dutch, English, French,
German, Greek, Irish, Italian, Portuguese and Spanish languages, all 10 texts being
equally authentic, shall be deposited in the archives of the General Secretariat of
the Council of the European Communities. The Secretary-General shall transmit a
certified copy to the Government of each Signatory State.
FINAL ACT
THE PLENIPOTENTIARIES OF THE HIGH CONTRACTING PARTIES,
meeting at Brussels, on the twenty-third day of July nineteen hundred and ninety,
for the signature of the Convention on the elimination of double taxation in
connection with the adjustment of profits of associated enterprises,
have, on the occasion of signing the said Convention:
a. adopted the following joint Declarations attached to the Final Act:
– Declaration on Article 4 (1),
– Declaration on Article 9 (6),
– Declaration on Article 13;
b. taken note of the following unilateral Declarations attached to this Final Act:
– Declaration of France and the United Kingdom on Article 7,
– Individual Declarations of the Contracting States on Article 8,
– Declaration of the Federal Republic of Germany on Article 16.
En fe de lo cual, los abajo firmantes suscriben la presente Acta Final.
Til bekraeftelse heraf har undertegnede underskrevet denne slutakt.
Zu Urkund dessen haben die Unterzeichneten ihre Unterschrift unter diese

Schlussakte gesetzt.
Se pistosi ton anotero, oi ypografontes plirexoysioi ethesan tin ypografi toys kato
apo tin paroysa teliki praxi.
In witness whereof, the undersigned have signed this Final Act.
En foi de quoi, les soussignés ont apposé leurs signatures au bas du présent acte
final.
Dá fhianú sin, chuir na daoine thíos-sínithe a lámh leis an Ionstraim

Chríochnaitheach seo.

In fede di che, i sottoscritti hanno apposto le loro firme in calce al presente atto
finale.
Ten blijke waarvan de ondergetekenden hun handtekening onder deze Slotakte

hebben gesteld.
Em fé do que os abaixo assinados apuseram as suas assinaturas no final do

presente Acto Final.
Hecho en Bruselas, el veintitrés de julio de mil novecientos noventa.
Udfaerdiget i Bruxelles, den treogtyvende juli nitten hundrede og halvfems.
Geschehen zu Bruessel am dreiundzwanzigsten Juli neunzehnhundertneunzig.
iEgine stis Vryxelles, stis eikosi treis Ioylioy chilia enniakosia eneninta.
Done at Brussels on the twenty-third day of July in the year one thousand nine
hundred and ninety.
Fait à Bruxelles, le vingt-trois juillet mil neuf cent quatre-vingt-dix.
Arna dhéanamh sa Bhruiséil, an tríú lá fichead de Iúil, míle naoi gcéad nócha.
Fatto a Bruxelles, addì ventitré luglio millenovecentonovanta.
Gedaan te Brussel, de drieëntwintigste juli negentienhonderd negentig.
Feito em Bruxelas, em vinte e três de Julho de mil novecentos e noventa.
Pour Sa Majesté le Roi des Belges
Voor Zijne Majesteit de Koning der Belgen
For Hendes Majestaet Danmarks Dronning
Fuer den Praesidenten der Bundesrepublik Deutschland
Gia ton Proedro tis Ellinikis Dimokratias
Por Su Majestad el Rey de España
Pour le président de la République française
For the President of Ireland
Thar ceann Uachtarán na hÉireann
Per il presidente della Repubblica italiana
Pour Son Altesse Royale le Grand-Duc de Luxembourg
Voor Hare Majesteit de Koningin der Nederlanden
Pelo Presidente da República Portuguesa
For Her Majesty the Queen of the United Kingdom of Great Britain and Northern
Ireland

JOINT DECLARATIONS
Declaration on Article 4 (1)
The provisions of Article 4 (1) shall cover both cases where a transaction is carried
out directly between two legally distinct enterprises as well as cases where a
transaction is carried out between one of the enterprises and the permanent
establishment of the other enterprise situated in a third country.
Declaration on Article 9 (6)
The Member States shall be entirely free as regards the nature and scope of the
appropriate provisions they adopt for penalizing any breach of secrecy
obligations.
Declaration on Article 13
Where, in one or more of the Contracting States concerned, the decisions

regarding the taxation giving rise to the procedures referred to in Articles 6 and 7
have been altered after the procedure referred to in Article 6 has been
concluded or after the decision referred to in Article 12 has been taken and where
double taxation within the meaning of Article 1 results, account being taken of the
application of the outcome of that procedure or that decision, Articles 6 and 7
shall apply.
UNILATERAL DECLARATIONS
Declaration on Article 7
France and the United Kingdom declare that they will apply Article 7 (3).
Individual Declarations of the Contracting States on Article 8
Belgium
The term ‘serious penalty’ means a criminal or administrative penalty in cases:
– either of a common law offence committed with the aim of tax evasion,
– or infringements of the provisions of the Code of income tax or of decisions

taken in implementation thereof, committed with fraudulent intention or with
the intention of causing injury.
Denmark
The concept of ‘serious penalty’ means a penalty for the intentional infringement
of provisions of the Criminal Law or of special legislation in cases which cannot be
regulated by administrative means.
Cases of infringement of provisions of tax law may, as a general rule, be regulated

by administrative means where it is considered that the infringement will not entail
a punishment greater than a fine.
Germany
An infringement of the tax laws punishable by a ‘serious penalty’ is constituted by

any infringement of the tax laws penalized by detention, criminal or administrative
fines.

Greece
Under Greek legislation governing taxation, an undertaking is liable to ‘severe

penalties’:
1. if it fails to submit declarations, or submits incorrect declarations, in respect of

taxes, charges or contributions which must be withheld and paid to the State
under existing provisions, or in respect of value added tax, turnover tax or the
special tax on luxury goods, in so far as the total amount of the above taxes,
charges and contributions which should have been declared and paid to the
State as a result of trade or other activities carried out over a period of six
months exceeds an amount of six hundred thousand (600 000) Greek
drachmas or one million (1 000 000) Greek drachmas over a period of one
calendar year;
2. if it fails to submit a declaration of income tax, in so far as the tax due in

respect of the income not declared is more than three hundred thousand (300
000) Greek drachmas;
3. if it fails to supply the taxation details laid down in the Code on Taxation Data;
4. if it supplies details as referred to under the previous case 3, which are

incorrect as regards quantity or unit price or value, in so far as the inaccuracy
results in a discrepancy which exceeds ten per cent (10 %) of the total amount
or of the total value of the goods, the provision of services or the trade
generally;
5. if it fails to keep accurately the books and records required by the Code on
Taxation Data, in so far as that inaccuracy has been noted in the course of a
regular check, the findings of which have been confirmed either by
administrative resolution of the discrepancy or because the period allowed for
an appeal has expired or as a result of a definitive decision by an
administrative tribunal, provided that during the management period
checked the discrepancy between gross income and the income declared is
more than twenty per cent (20 %) and in any case not less than one million (1
000 000) Greek drachmas;
6. if it fails to observe the obligation to keep books and records as laid down in
the relevant provisions of the Code on Taxation Data;
7. if it issues false or fictitious - or itself falsifies - invoices for the sale of goods or the
supply of services or any other taxation details as referred to in case 3 above.
A taxation document is regarded as false if it has been perforated or stamped

in any way without the proper authentication having been entered in the
relevant books of the competent tax authority, in so far as failure to make such
an entry has occurred in the knowledge that such authentication is required
for the taxation document. A taxation document is also regarded as false if
the content and other details of the original or the copy differ from those
which are recorded on the counterfoil of that document.
A taxation document is regarded as fictitious if it has been issued for a

transaction or part of a transaction, transfer or any other reason not recorded
in the total or for a transaction carried out by persons different from those
recorded in the taxation document;

8. if it is aware of the intention of the action taken and collaborates in any way in
the production of false taxation documents or is aware that the documents
are false or fictitious and collaborates in any way in their issue or accepts the
false, fictitious or falsified taxation documents with the intention of concealing
material relevant to taxation.
Spain
The term ‘serious penalties’ includes administrative penalties for serious tax
infringements, as well as criminal penalties for offences committed with respect to
the taxation authorities.
France
The term ‘serious penalties’ includes criminal penalties and tax penalties such as
penalties for failure to make a tax return after receiving a summons, for lack of
good faith, for fraudulent practices, for opposition to tax inspection, for secret
payments or distribution, or for abuse of rights.
Ireland
‘Serious penalties’ shall include penalties for:
a. failing to make a return;
b. fraudulently or negligently making an incorrect return;
c. failing to keep proper records;
d. failing to make documents and records available for inspection;
e. obstructing persons exercising statutory powers;
f. failing to notify chargeability to tax;
g. making a false statement to obtain an allowance.
The legislative provisions governing these offences, as at 3 July 1990, are as follows:
– Part XXXV of the Income Tax Act, 1967,
– Section 6 of the Finance Act, 1968,
– Part XIV of the Corporation Tax Act, 1976,
– Section 94 of the Finance Act, 1983.
Any subsequent provisions replacing, amending or updating the penalty code

would also be comprehended.
Italy
The term ‘serious penalties’ means penalties laid down for illicit acts, within the
meaning of the domestic law, constituting a tax offence.

Luxembourg
Luxembourg considers to be a ‘serious penalty’ what the other Contracting State

considers to be so for the purposes of Article 8.
Netherlands
The term ‘serious penalty’ means a penalty imposed by a judge for any action,
committed intentionally, which is mentioned in Article 68 of the General Law on
taxation.
Portugal
The terms ‘serious penalties’ include criminal penalties as well as the further tax
penalties applicable to infringements committed with intent to defraud or in which
the fine applicable is of an amount exceeding 1 000 000 (one million) Portuguese
escudos.
United Kingdom
The United Kingdom will interpret the term ‘serious penalty’ as comprising criminal
sanctions and administrative sanctions in respect of the fraudulent or negligent
delivery of incorrect accounts, claims or returns for tax purposes.
Declaration by the Federal Republic of Germany on Article 16
The Government of the Federal Republic of Germany reserves the right to declare,
when lodging its instrument of ratification that the Convention also applies to Land
of Berlin.

30.12.2009 EN Official Journal of the European Union C 322/1
II
(Information)
INFORMATION FROM EUROPEAN UNION INSTITUTIONS AND BODIES
COUNCIL
Revised Code of Conduct for the effective implementation of the Convention on the elimination of
double taxation in connection with the adjustment of profits of associated enterprises
(2009/C 322/01)
THE COUNCIL OF THE EUROPEAN UNION AND THE REPRESENTATIVES OF THE GOVERNMENTS OF THE MEMBER
STATES, MEETING WITHIN THE COUNCIL,
HAVING REGARD to the Convention of 23 July 1990 on the elimination of double taxation in connection
with the adjustment of profits of associated enterprises (the ‘Arbitration Convention’),
ACKNOWLEDGING the need both for Member States, as Contracting States to the Arbitration Convention,
and for taxpayers to have more detailed rules to implement efficiently the Arbitration Convention,
NOTING the Commission Communication of 14 September 2009 on the work of the EU Joint Transfer
Pricing Forum (JTPF) in the period March 2007 to March 2009, based on the reports of the JTPF on
penalties and transfer pricing, and on the interpretation of some provisions of the Arbitration Convention,
EMPHASISING that this Code of Conduct is a political commitment and does not affect the Member States'
rights and obligations or the respective spheres of competence of the Member States and the European
Union resulting from the Treaty on European Union and the Treaty on the Functioning of the European
Union,
ACKNOWLEDGING that the implementation of this Code of Conduct should not hamper solutions at a more
global level,
TAKING NOTE of the conclusions of the JTPF report on penalties,
HEREBY ADOPT THE FOLLOWING REVISED CODE OF CONDUCT:
Without prejudice to the respective spheres of competence of the Member States and the European Union,
this revised Code of Conduct concerns the implementation of the Arbitration Convention and certain
related issues concerning mutual agreement procedures under double taxation treaties between Member
States.
1. Scope of the Arbitration Convention

1.1. EU triangular transfer pricing cases
(a) For the purpose of this Code of Conduct, a EU triangular case is a case where, in the first stage of the
Arbitration Convention procedure, two EU competent authorities cannot fully resolve any double
C 322/2 EN Official Journal of the European Union 30.12.2009
taxation arising in a transfer pricing case when applying the arm's length principle because an associated
enterprise situated in (an)other Member State(s) and identified by both EU competent authorities
(evidence based on a comparability analysis including a functional analysis and other related factual
elements) had a significant influence in contributing to a non-arm's length result in a chain of relevant
transactions or commercial/financial relations and is recognised as such by the taxpayer suffering the
double taxation and having requested the application of the provisions of the Arbitration Convention.
(b) The scope of the Arbitration Convention includes all EU transactions involved in triangular cases among
Member States.
1.2. Thin capitalisation (1)

The Arbitration Convention makes clear reference to profits arising from commercial and financial relations
but does not seek to differentiate between these specific profit types. Therefore, profit adjustments arising
from financial relations, including a loan and its terms, and based on the arm's length principle are to be
considered within the scope of the Arbitration Convention.
(1) Reservations: Bulgaria holds the view that profit adjustments arising from an adjustment to the price of a loan (i.e. the
interest rate) fall within the scope of the Arbitration Convention. On the contrary, Bulgaria considers that the
Arbitration Convention does not cover cases of profit adjustments based on adjustments to the amount of financing.
In principle the grounds for such adjustments lay in the domestic legislation of Member States. The operation of
varying national rules and the absence of an internationally recognized arms' length set of guidelines to be applied to
a business' capital structure, to a great extent challenge the arms' length character of profit adjustments based on
adjustments to the amount of a loan.
The Czech Republic shall not apply the mutual agreement procedure under the Arbitration Convention in case that is
a subject to the anti-abuse rules under the domestic law.
The Netherlands endorses the view that an adjustment of the interest rate (pricing of the loan) which is based on
national legislation based on the arm's length principle falls within the scope of the Arbitration Convention.
Adjustments of the amount of the loan as well as adjustments of the deductibility of the interest based on a thin
capitalization approach under the arm's length principle or adjustments based on anti-abuse legislation based on the
arm's length principle are considered to fall outside the scope of the Arbitration Convention. The Netherlands will
preserve its reservation until there is guidance from the OECD on how to apply the arm's length principle to thin
capitalization of associated enterprises.
Greece considers that adjustments which fall within the scope of Arbitration Convention are those of the interest rate
of a loan. Adjustments concerning the amount of a loan and the deductibility of accrued interest related to a loan
should not apply to Arbitration Convention, due to domestic legislation limitations in force.
Hungary considers only those cases fall within the scope of the AC where double taxation is due to the adjustment of
the interest rate of the loan and the adjustment is based on the ALP.
Italy considers that the Arbitration Convention may be invoked in case of double taxation due to a price adjustment
of a financial transaction not in accordance with the arm's length principle. Conversely, it cannot be invoked to solve
double taxation arising from adjustments to the amount of loans, or double taxation occurred because of the
differences in domestic rules on the allowed amount of financing or on interest deductibility.
Latvia's understanding is that the Arbitration Convention cannot be invoked in case of double taxation arising as a
result of application of general national legislation on adjustments of the amount of a loan or on deductibility of
interest payments, that is not based on the arm's length principle provided for in Article 4 of the Arbitration
Convention.
Therefore, Latvia considers that only adjustments of interest deductions performed under national legislation based on
the arm's length principle are within the scope of the Arbitration Convention.
Poland considers that procedure stipulated by Arbitration Convention may be applicable only in the case of interest
adjustments. While adjustments concerning amount of a loan should not be covered by the Convention. In our
opinion it is quite impossible to define how capital structure should look in practice in order to be in line with arm's
length principle.
Portugal considers that the Arbitration Convention cannot be invoked to resolve cases of double taxation caused by
adjustments to profits arising either from corrections to the amount of a loan contracted between associated
companies or to interest payments based on domestic anti-abuse measures. Nevertheless, Portugal admits to review
its position once consensus is reached at international level, namely through guidance from the OECD, on the
application of the arm's length principle to the amount of debts (involving thin capitalisation situations) between
associated companies.
Slovakia is of the opinion that an adjustment of the interest rate which is based on national legislation based on the
arm's length principle should fall within the scope of the Arbitration Convention but the adjustments to profits arising
as a result of the application of anti-abuse rules under domestic legislation should fall outside the scope of the
Arbitration Convention.
2. Admissibility of a case
On the basis of Article 18 of the Arbitration Convention, Member States are recommended to consider that
a case is covered by the Arbitration Convention when the request is presented in due time after the date of
entry into force of accession by new Member States to the Arbitration Convention, even if the adjustment
applies to earlier fiscal years.
3. Serious penalties
As Article 8(1) provides for flexibility in refusing to give access to the Arbitration Convention due to the
imposition of a serious penalty, and considering the practical experience acquired since 1995, Member
States are recommended to clarify or revise their unilateral declarations in the Annex to the Arbitration
Convention in order to better reflect that a serious penalty should only be applied in exceptional cases like
fraud.
4. The starting point of the three-year period (deadline for submitting the request according to
Article 6(1) of the Arbitration Convention)
The date of the ‘first tax assessment notice or equivalent which results or is likely to result in double
taxation within the meaning of Article 1 of the Arbitration Convention, e.g. due to a transfer pricing
adjustment’ (1), is considered as the starting point for the three-year period.
As far as transfer pricing cases are concerned, Member States are recommended to apply this definition also
to the determination of the three-year period as provided for in Article 25.1 of the OECD Model Tax
Convention on Income and on Capital and implemented in the double taxation treaties between Member
States.
5. The starting point of the two-year period (Article 7(1) of the Arbitration Convention)
(a) For the purpose of Article 7(1) of the Arbitration Convention, a case will be regarded as having been
submitted according to Article 6(1) when the taxpayer provides the following:
(i) identification (such as name, address, tax identification number) of the enterprise of the Member
State that presents its request and of the other parties to the relevant transactions;
(ii) details of the relevant facts and circumstances of the case (including details of the relations
between the enterprise and the other parties to the relevant transactions);
(iii) identification of the tax periods concerned;
(iv) copies of the tax assessment notices, tax audit report or equivalent leading to the alleged double
taxation;
(v) details of any appeals and litigation procedures initiated by the enterprise or the other parties to
the relevant transactions and any court decisions concerning the case;
(vi) an explanation by the enterprise of why it considers that the principles set out in Article 4 of the
Arbitration Convention have not been observed;
(vii) an undertaking that the enterprise shall respond as completely and quickly as possible to all
reasonable and appropriate requests made by a competent authority and have documentation at
the disposal of the competent authorities; and
(1) Reservation: The tax authority Member from Italy considers ‘the date of the first tax assessment notice or equivalent
reflecting a transfer pricing adjustment which results or is likely to result in double taxation within the meaning of
Article 1’ as the starting point of the three-year period, since the application of the existing Arbitration Convention
should be limited to those cases where there is a transfer pricing ‘adjustment’.
(viii) any specific additional information requested by the competent authority within two months upon
receipt of the taxpayer's request.
(b) The two-year period starts on the latest of the following dates:
(i) the date of the tax assessment notice, i.e. a final decision of the tax administration on the additional
income, or equivalent;
(ii) the date on which the competent authority receives the request and the minimum information as
stated under point (a).
6. Mutual agreement procedures under the Arbitration Convention

6.1. General provisions
(a) The arm's length principle will be applied, as advocated by the OECD, without regard to the immediate
tax consequences for any particular Member State.
(b) Cases will be resolved as quickly as possible having regard to the complexity of the issues in the
particular case in question.
(c) Any appropriate means for reaching a mutual agreement as expeditiously as possible, including face-to-
face meetings, will be considered. Where appropriate, the enterprise will be invited to make a presen
tation to its competent authority.
(d) Taking into account the provisions of this Code of Conduct, a mutual agreement should be reached
within two years of the date on which the case was first submitted to one of the competent authorities
in accordance with point 5(b) of this Code of Conduct. However, it is recognised that in some situations
(e.g. imminent resolution of the case or particularly complex transactions, or triangular cases), it may be
appropriate to apply Article 7(4) of the Arbitration Convention (providing for time limits to be
extended) to agree a short extension.
(e) The mutual agreement procedure should not impose any inappropriate or excessive compliance costs on
the person requesting it, or on any other person involved in the case.
6.2. EU triangular transfer pricing cases

(a) As soon as the competent authorities of the Member States have agreed that the case under discussion is
to be considered a EU triangular case, they should immediately invite the other EU competent
authority(ies) to take part in the proceedings and discussions as (an) observer(s) or as (an) active
stakeholder(s) and decide together which is their favoured approach. Accordingly, all information
should be shared with the other EU competent authority(ies) through for example exchanges of
information. The other competent authority(ies) should be invited to acknowledge the actual or
possible involvement of ‘their’ taxpayer(s).
(b) One of the following approaches may be adopted by the competent authorities involved to resolve
double taxation arising from EU triangular cases under the Arbitration Convention:
(i) the competent authorities can decide to take a multilateral approach (immediate and full partici
pation of all the competent authorities concerned); or
(ii) the competent authorities can decide to start a bilateral procedure, whereby the two parties to the
bilateral procedure are the competent authorities that identified (based on a comparability analysis
including a functional analysis and other related factual elements) the associated enterprise situated
in another Member State that had a significant influence in contributing to a non-arm's length result
in the chain of relevant transactions or commercial/financial relations, and should invite the other
EU competent authority(ies) to participate as (an) observer(s) in the mutual agreement procedure
discussions; or
(iii) the competent authorities can decide to start more than one bilateral procedure in parallel and
should invite the other EU competent authority(ies) to participate as (an) observer(s) in the
respective mutual agreement procedure discussions.
Member States are recommended to apply a multilateral procedure to resolve such double taxation cases.
However this should always be agreed by all the competent authorities, based on the specific facts and
circumstances of the case. If a multilateral approach is not possible and a two or more parallel bilateral
procedures are started, all relevant competent authorities should be involved in the first stage of the
Arbitration Convention procedure either as Contracting States in the initial Arbitration Convention
application or as observers.
(c) The status of observer may change to that of stakeholder depending on the development of the
discussions and evidence presented. If the other competent authority(ies) want(s) to participate in the
second stage (arbitration), it (they) has (have) to become (a) stakeholder(s).
The fact that the other EU competent authority(ies) remain(s) throughout as (a) party(ies) to the
discussions as (an) observer(s) only has no consequences for the application of the provisions of the
Arbitration Convention (e.g. timing issues and procedural issues).
Participation as (an) observer(s) does not bind the other competent authority(ies) to the final outcome of
the Arbitration Convention procedure.
In the procedure, any exchange of information must comply with the normal legal and administrative
requirements and procedures.
(d) The taxpayer(s) should, as soon as possible, inform the tax administration(s) involved that (an)other
party(ies), in (an)other Member State(s), could be involved in the case. That notification should be
followed in a timely manner by the presentation of all relevant facts and supporting documentation.
Such an approach will not only lead to quicker resolution but also guard against the failure to resolve
double taxation issues due to differing procedural deadlines in the Member States.
6.3. Practical functioning and transparency

(a) In order to minimise costs and delays caused by translation, the mutual agreement procedure, in
particular the exchange of position papers, should be conducted in a common working language, or
in a manner having the same effect, if the competent authorities can reach agreement on a bilateral (or
multilateral) basis.
(b) The enterprise requesting the mutual agreement procedure will be kept informed by the competent
authority to which it made the request of all significant developments that affect it during the course of
the procedure.
(c) The confidentiality of information relating to any person that is protected under a bilateral tax
convention or under the law of a Member State will be ensured.
(d) The competent authority will acknowledge receipt of a taxpayer's request to initiate a mutual agreement
procedure within one month from the receipt of the request and at the same time inform the competent
authority(ies) of the other Member State(s) involved in the case attaching a copy of the taxpayer's
request.
(e) If the competent authority believes that the enterprise has not submitted the minimum information
necessary for the initiation of a mutual agreement procedure as stated under point 5(a), it will invite the
enterprise, within two months upon receipt of the request, to provide it with the specific additional
information it needs.
(f) Member States undertake that the competent authority will respond to the enterprise making the request
in one of the following forms:
(i) if the competent authority does not believe that profits of the enterprise are included, or are likely
to be included, in the profits of an enterprise of another Member State, it will inform the enterprise
of its doubts and invite it to make any further comments;
(ii) if the request appears to the competent authority to be well-founded and it can itself arrive at a
satisfactory solution, it will inform the enterprise accordingly and make as quickly as possible such
adjustments or allow such reliefs as are justified;
(iii) if the request appears to the competent authority to be well-founded but it is not itself able to arrive
at a satisfactory solution, it will inform the enterprise that it will endeavour to resolve the case by
mutual agreement with the competent authority of any other Member State concerned.
(g) If a competent authority considers a case to be well-founded, it should initiate a mutual agreement
procedure by informing the competent authority(ies) of the other Member State(s) of its decision and
attach a copy of the information as specified under point 5(a) of this Code of Conduct. At the same time
it will inform the person invoking the Arbitration Convention that it has initiated the mutual agreement
procedure. The competent authority initiating the mutual agreement procedure will also inform — on
the basis of information available to it — the competent authority(ies) of the other Member State(s) and
the person making the request whether the case was presented within the time limits provided for in
Article 6(1) of the Arbitration Convention and of the starting point for the two-year period of
Article 7(1) of the Arbitration Convention.
6.4. Exchange of position papers

(a) Member States undertake that when a mutual agreement procedure has been initiated, the competent
authority of the country in which a tax assessment, i.e. a final decision of the tax administration on the
income, or equivalent has been made, or is intended to be made, which contains an adjustment that
results, or is likely to result, in double taxation within the meaning of Article 1 of the Arbitration
Convention, will send a position paper to the competent authority(ies) of the other Member State(s)
involved in the case setting out:
(i) the case made by the person making the request;
(ii) its view of the merits of the case, e.g. why it believes that double taxation has occurred or is likely
to occur;
(iii) how the case might be resolved with a view to the elimination of double taxation together with a
full explanation of the proposal.
(b) The position paper will contain a full justification of the assessment or adjustment and will be accom
panied by basic documentation supporting the competent authority's position and a list of all other
documents used for the adjustment.
(c) The position paper will be sent to the competent authority(ies) of the other Member State(s) involved in
the case as quickly as possible taking account of the complexity of the particular case and no later than
four months from the latest of the following dates:
(i) the date of the tax assessment notice, i.e. final decision of the tax administration on the additional
income, or equivalent;
(ii) the date on which the competent authority receives the request and the minimum information as
stated under point 5(a).
(d) Member States undertake that, where a competent authority of a country in which no tax assessment or
equivalent has been made, or is not intended to be made, which results, or is likely to result, in double
taxation within the meaning of Article 1 of the Arbitration Convention, e.g. due to a transfer pricing
adjustment, receives a position paper from another competent authority, it will respond as quickly as
possible taking account of the complexity of the particular case and no later than six months after
receipt of the position paper.
(e) The response should take one of the following two forms:
(i) if the competent authority believes that double taxation has occurred, or is likely to occur, and
agrees with the remedy proposed in the position paper, it will inform the other competent
authority(ies) accordingly and make such adjustments or allow such relief as quickly as possible;
(ii) if the competent authority does not believe that double taxation has occurred, or is likely to occur,
or does not agree with the remedy proposed in the position paper, it will send a responding position
paper to the other competent authority(ies) setting out its reasons and proposing an indicative time
scale for dealing with the case taking into account its complexity. The proposal will include,
whenever appropriate, a date for a face-to-face meeting, which should take place no later than
18 months from the latest of the following dates:
(aa) the date of the tax assessment notice, i.e. final decision of the tax administration on the
additional income, or equivalent;
(bb) the date on which the competent authority receives the request and the minimum information
as stated under point 5(a).
(f) Member States will further undertake any appropriate steps to speed up all procedures wherever
possible. In this respect, Member States should envisage to organise regularly, and at least once a
year, face-to-face-meetings between their competent authorities to discuss pending mutual agreement
procedures (provided that the number of cases justifies such regular meetings).
6.5. Double taxation treaties between Member States

As far as transfer pricing cases are concerned, Member States are recommended to apply the provisions of
points 1, 2 and 3 also to mutual agreement procedures initiated in accordance with Article 25(1) of the
OECD Model Convention on Income and on Capital, implemented in the double taxation treaties between
Member States.
7. Proceedings during the second phase of the Arbitration Convention

7.1. List of independent persons
(a) Member States commit themselves to inform without any further delay the Secretary-General of the
Council of the names of the five independent persons of standing, eligible to become a member of the
advisory commission as referred to in Article 7(1) of the Arbitration Convention and inform, under the
same conditions, of any alteration of the list.
(b) When transmitting the names of their independent persons of standing to the Secretary-General of the
Council, Member States will join a curriculum vitae of those persons, which should, among other things,
describe their legal, tax and especially transfer pricing experience.
(c) Member States may also indicate on their list those independent persons of standing who fulfil the
requirements to be elected as Chairman.
(d) The Secretary General of the Council will address every year a request to Member States to confirm the
names of their independent persons of standing or give the names of their replacements.
(e) The aggregate list of all independent persons of standing will be published on the Council's website.
(f) Independent persons of standing do not have to be nationals of or resident in the nominating State, but
do have to be nationals of a Member State and resident within the territory to which the Arbitration
Convention applies.
(g) Competent authorities are recommended to draw up an agreed declaration of acceptance and a
statement of independence for the particular case, to be signed by the selected independent persons
of standing.
7.2. Establishment of the advisory commission

(a) Unless otherwise agreed between the Member States concerned, the Member State that issued the first
tax assessment notice, i.e. final decision of the tax administration on the additional income, or equivalent
which results, or is likely to result, in double taxation within the meaning of Article 1 of the Arbitration
Convention, takes the initiative for the establishment of the advisory commission and arranges for its
meetings, in agreement with the other Member State(s).
(b) Competent authorities should establish the advisory commission no later than six months following
expiry of the period referred to in Article 7 of the Arbitration Convention. Where one competent
authority does not do this, another competent authority involved is entitled to take the initiative.
(c) The advisory commission will normally consist of two independent persons of standing in addition to
its Chairman and the representatives of the competent authorities. For triangular cases, where an
advisory commission is to be set up under the multilateral approach, Member States will have regard
to the requirements of Article 11(2) of the Arbitration Convention, introducing as necessary additional
rules of procedure, to ensure that the advisory commission, including its Chairman, is able to adopt its
opinion by a simple majority of its members.
(d) The advisory commission will be assisted by a secretariat for which the facilities will be provided by the
Member State that initiated the establishment of the advisory commission unless otherwise agreed by the
Member States concerned. For reasons of independence, this secretariat will function under the super
vision of the Chairman of the advisory commission. Members of the secretariat will be bound by the
secrecy provisions as stated in Article 9(6) of the Arbitration Convention.
(e) The place where the advisory commission meets and the place where its opinion is to be delivered may
be determined in advance by the competent authorities of the Member States concerned.
(f) Member States will provide the advisory commission before its first meeting, with all relevant docu
mentation and information and in particular all documents, reports, correspondence and conclusions
used during the mutual agreement procedure.
7.3. Functioning of the advisory commission

(a) A case is considered to be referred to the advisory commission on the date when the Chairman confirms
that its members have received all relevant documentation and information as specified in point 7.2(f).
(b) The proceedings of the advisory commission will be conducted in the official language or languages of
the Member States involved, unless the competent authorities decide otherwise by mutual agreement,
taking into account the wishes of the advisory commission.
(c) The advisory commission may request from the party from which a statement or document emanates to
arrange for a translation into the language or languages in which the proceedings are conducted.
(d) Whilst respecting Article 10 of the Arbitration Convention, the advisory commission may request
Member States and in particular the Member State that issued the first tax assessment notice, i.e.
final decision of the tax administration on the additional income, or equivalent, which resulted, or
may result, in double taxation within the meaning of Article 1 of the Arbitration Convention, to appear
before the advisory commission.
(e) The costs of the advisory commission procedure, which will be shared equally by the Member States
concerned, will be the administrative costs of the advisory commission and the fees and expenses of the
independent persons of standing.
(f) Unless the competent authorities of the Member States concerned agree otherwise:
(i) the reimbursement of the expenses of the independent persons of standing will be limited to the
reimbursement usual for high ranking civil servants of the Member State which has taken the
initiative to establish the advisory commission;
(ii) the fees of the independent persons of standing will be fixed at EUR 1 000 per person per meeting
day of the advisory commission, and the Chairman will receive a fee higher by 10 % than that of the
other independent persons of standing.
(g) Actual payment of the costs of the advisory commission procedure will be made by the Member State
which has taken the initiative to establish the advisory commission, unless the competent authorities of
the Member States concerned decide otherwise.
7.4. Opinion of the advisory commission

Member States would expect the opinion to contain:
(a) the names of the members of the advisory commission;
(b) the request; the request contains:
(i) the names and addresses of the enterprises involved;
(ii) the competent authorities involved;
(iii) a description of the facts and circumstances of the dispute;
(iv) a clear statement of what is claimed;
(c) a short summary of the proceedings;
(d) the arguments and methods on which the decision in the opinion is based;
(e) the opinion;
(f) the place where the opinion is delivered;
(g) the date on which the opinion is delivered;
(h) the signatures of the members of the advisory commission.
The decision of the competent authorities and the opinion of the advisory commission will be
communicated as follows:
(i) Once the decision has been taken, the competent authority to which the case was presented will send a
copy of the decision of the competent authorities and the opinion of the advisory commission to each
of the enterprises involved.
(ii) The competent authorities of the Member States can agree that the decision and the opinion may be
published in full. They can also agree to publish the decision and the opinion without mentioning the
names of the enterprises involved and with deletion of any further details that might disclose the
identity of the enterprises involved. In both cases, the enterprises' consent is required and prior to any
publication the enterprises involved must have communicated in writing to the competent authority to
which the case was presented that they do not have objections to publication of the decision and the
opinion.
(iii) The opinion of the advisory commission will be drafted in three (or more in the case of triangular
cases) original copies, one to be sent to each competent authority of the Member States involved and
one to be transmitted to the Secretariat-General of the Council for archiving. If there is agreement on
the publication of the opinion, the latter will be rendered public in the original language(s) on the
website of the Commission.
8. Tax collection and interest charges during cross-border dispute resolution procedures
(a) Member States are recommended to take all necessary measures to ensure that the suspension of tax
collection during cross-border dispute resolution procedures under the Arbitration Convention can be
obtained by enterprises engaged in such procedures under the same conditions as those engaged in a
domestic appeals or litigation procedure although these measures may imply legislative changes in some
Member States. It would be appropriate for Member States to extend these measures to the cross-border
dispute resolution procedures under double taxation treaties between Member States.
(b) Considering that, during mutual agreement procedure negotiations, a taxpayer should not be adversely
affected by the existence of different approaches to interest charges and refunds during the time it takes
to complete the mutual agreement procedure, Member States are recommended to apply one of the
following approaches:
(i) tax to be released for collection and repaid without attracting any interest; or
(ii) tax to be released for collection and repaid with interest; or
(iii) each case to be dealt with on its merits in terms of charging or repaying interest (possibly during
the mutual agreement procedure).
9. Accession of new Member States to the Arbitration Convention

Member States will endeavour to sign and ratify the conventions on accession of new Member States to the
Arbitration Convention as soon as possible and in any event no later than two years after their accession to
the EU.
10. Final provisions

In order to ensure the even and effective application of this Code of Conduct, Member States are invited to
report to the Commission on its practical functioning every two years. On the basis of these reports, the
Commission intends to report to the Council and may propose a review of the provisions of this Code of
Conduct.
(Information)
COUNCIL
Resolution of the Council and of the representatives of the governments of the Member States,
meeting within the Council, of 27 June 2006 on a code of conduct on transfer pricing documenta-
tion for associated enterprises in the European Union (EU TPD)
(2006/C 176/01)
THE COUNCIL OF THE EUROPEAN UNION AND THE REPRESENTA- instrument for the implementation of standardised and partially
TIVES OF THE GOVERNMENTS OF THE MEMBER STATES, MEETING centralised transfer pricing documentation in the European
WITHIN THE COUNCIL, Union, with the aim of simplifying transfer pricing require-
ments for cross-border activities,
Having regard to the Commission's study entitled ‘Company
Taxation in the Internal Market’ (1),
Considering that acceptance by Member States of standardised
and partially centralised transfer pricing documentation to
Having regard to the proposal made by the Commission, in its support transfer pricing on an arm's length basis could help
Communication of 23 October 2001 entitled ‘Towards an businesses to benefit more from the internal market,
internal market without obstacles — A strategy for providing
companies with a consolidated corporate tax base for their EU-
wide activities (2)’, for the establishment of an EU Joint Transfer Considering that transfer pricing documentation in the Euro-
Pricing Forum, pean Union needs to be viewed in the framework of the OECD
Transfer Pricing Guidelines,
Having regard to the Council conclusions of 11 March 2002
welcoming this move and the establishment of the Joint
Transfer Pricing Forum in June 2002, Considering that standardised and partially centralised docu-
mentation should be implemented flexibly and should recog-
nise the particular circumstances of the business concerned,
Considering that the internal market comprises an area without
frontiers in which the free movement of goods, persons,
services and capital is guaranteed, Considering that a Member State may decide not to have
transfer pricing documentation rules at all or to require less
transfer pricing documentation than that referred to in the
Considering that in an internal market having the characteris- Code of Conduct contained in this Resolution,
tics of a domestic market, transactions between associated
enterprises from different Member States should not be subject
to conditions less favourable than those applicable to the same Acknowledging that a common approach in the European
transactions carried out between associated enterprises from Union with respect to documentation requirements is beneficial
the same Member State, both for taxpayers, in particular in terms of reducing compli-
ance costs and exposure to documentation-related penalties,
and for tax administrations owing to enhanced transparency
Considering that in the interest of the proper functioning of
and consistency,
the internal market, it is of major importance to reduce the
compliance costs as regards transfer pricing documentation for
associated enterprises,
Welcoming the Commission Communication of 7 November
2005 (3) on the work of the EU Joint Transfer Pricing Forum in
Considering that the Code of Conduct contained in this Resolu- the field of business taxation and on a Code of Conduct on
tion provides Member States and taxpayers with a valuable transfer pricing documentation for associated enterprises in the
European Union,
(1) SEC(2001) 1681, 23.10.2001.
(2) COM(2001) 582 final, 23.10.2001. (3) COM(2005) 543 final, 7.11.2005.
Emphasising that the Code of Conduct is a political commit- permanent establishment as apply to transfer pricing docu-
ment and does not affect the Member States' rights and obliga- mentation.
tions or the respective spheres of competence of the Member
States and the Community resulting from the Treaty estab- 4. Member States will, wherever necessary, take duly into
lishing the European Community, account and be guided by the general principles and require-
ments referred to in the Annex.
Acknowledging that the implementation of the Code of
Conduct contained in this Resolution should not hamper solu- 5. Member States undertake not to require smaller and less
tions at a more global level, complex enterprises (including small and medium-sized
enterprises) to produce the amount or complexity of docu-
mentation that might be expected from larger and more
HEREBY AGREE TO THE FOLLOWING CODE OF CONDUCT: complex enterprises.
Code of conduct on transfer pricing documentation for 6. Member States should:

associated enterprises in the European Union (EU TPD) (a) not impose unreasonable compliance costs or adminis-
Without prejudice to the respective spheres of competence of trative burden on enterprises in requesting documenta-
the Member States and the Community, this Code of Conduct tion to be created or obtained;
concerns the implementation of standardised and partially (b) not request documentation that has no bearing on trans-
centralised transfer pricing documentation for associated enter- actions under review;
prises in the European Union. It is addressed to Member States
but is also intended to encourage multinational enterprises to (c) ensure that there is no public disclosure of confidential
apply the EU TPD approach. information contained in documentation.
7. Member States should not impose a documentation-related
1. Member States will accept standardised and partially centra-
penalty where taxpayers comply in good faith, in a reason-
lised transfer pricing documentation for associated enter-
able manner and within a reasonable time with standardised
prises in the European Union (EU TPD), as set out in the
and consistent documentation as described in the Annex or
Annex, and consider it as a basic set of information for the
with a Member State's domestic documentation require-
assessment of a multinational enterprise group's transfer
ments, and apply their documentation properly to deter-
prices.
mine their arm's length transfer prices.
2. The use of the EU TPD will be optional for a multinational
enterprise group. 8. In order to ensure the even and effective application of this
Code, Member States should report annually to the Commis-
3. Member States will apply similar considerations to docu- sion on any measures they have taken further to this Code
mentation requirements for the attribution of profits to a and its practical functioning.
ANNEX
TO THE CODE OF CONDUCT ON TRANSFER PRICING DOCUMENTATION FOR ASSOCIATED ENTER-

PRISES IN THE EUROPEAN UNION (EU TPD)
SECTION 1
CONTENT OF THE EU TPD
1. A multinational enterprise (MNE) group's standardised and consistent EU TPD consists of two main parts:
(i) one set of documentation containing common standardised information relevant for all EU group members (the
‘masterfile’), and
(ii) several sets of standardised documentation each containing country-specific information (‘country-specific docu-
mentation’).
The EU TPD should contain enough details to allow the tax administration to make a risk assessment for case selec-
tion purposes or at the beginning of a tax audit, ask relevant and precise questions regarding the MNE's transfer
pricing and assess the transfer prices of the inter-company transactions. Subject to paragraph 31, the company would
produce one single file for each Member State concerned, i.e. one common masterfile to be used in all Member States
concerned and a different set of country-specific documentation for each Member State.
2. Each of the items of the EU TPD listed below should be completed, taking into account the complexity of the enter-
prise and the transactions. As far as possible, information should be used that is already in existence within the
group (e.g. for management purposes). However, an MNE might be required to produce documentation for this
purpose that otherwise would not have been in existence.
3. The EU TPD covers all group entities resident in the EU including controlled transactions between enterprises resident
outside the EU and group entities resident in the EU.
4. The masterfile
4.1. The masterfile should follow the economic reality of the business and provide a ‘blueprint’ of the MNE group and
its transfer pricing system that would be relevant and available to all EU Member States concerned.
4.2. The masterfile should contain the following items:
(a) a general description of the business and business strategy, including changes in the business strategy compared
to the previous tax year;
(b) a general description of the MNE group's organisational, legal and operational structure (including an organisa-
tion chart, a list of group members and a description of the participation of the parent company in the subsidi-
aries);
(c) the general identification of the associated enterprises engaged in controlled transactions involving enterprises
in the EU;
(d) a general description of the controlled transactions involving associated enterprises in the EU, i.e. a general
description of:
(i) flows of transactions (tangible and intangible assets, services, financial),
(ii) invoice flows, and
(iii) amounts of transaction flows;
(e) a general description of functions performed, risks assumed and a description of changes in functions and risks
compared to the previous tax year, e.g. change from a fully fledged distributor to a commissionaire;
(f) the ownership of intangibles (patents, trademarks, brand names, know-how, etc.) and royalties paid or received;
(g) the MNE group's inter-company transfer pricing policy or a description of the group's transfer pricing system
that explains the arm's length nature of the company's transfer prices;
(h) a list of cost contribution agreements, Advance Pricing Agreements and rulings covering transfer pricing
aspects as far as group members in the EU are affected; and
(i) an undertaking by each domestic taxpayer to provide supplementary information upon request and within a
reasonable time frame in accordance with national rules.
5. Country-specific documentation
5.1. The content of the country-specific documentation supplements the masterfile. Together the two constitute the
documentation file for the relevant EU Member State. The country-specific documentation would be available to
those tax administrations with a legitimate interest in the appropriate tax treatment of the transactions covered by
the documentation.
5.2. Country-specific documentation should contain, in addition to the content of the masterfile, the following items:
(a) a detailed description of the business and business strategy, including changes in the business strategy 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, and
(iii) 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, and
(v) specific business strategies;
(d) an explanation of 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; and
(f) a description of the implementation and application of the group's inter-company transfer pricing policy.
6. An MNE should have the possibility of including items in the masterfile instead of the country-specific documenta-
tion, keeping, however, the same level of detail as in the country-specific documentation. The country-specific
documentation should be prepared in a language prescribed by the Member State concerned, even if the MNE has
opted to keep the country-specific documentation in the masterfile.
7. Any country-specific information and documents that relate to a controlled transaction involving one or more
Member States must be contained either in the country-specific documentation of all the Member States concerned
or in the common masterfile.
8. MNEs should be allowed to prepare the country-specific documentation in one set of documentation (containing
information about all businesses in that country) or in separate files for each business or group of activities in that
country.
9. The country-specific documentation should be prepared in a language prescribed by the Member State concerned.
SECTION 2
GENERAL APPLICATION RULES AND REQUIREMENTS FOR MNEs
10. Use of the EU TPD is optional for MNE groups. However, an MNE group should not arbitrarily opt in and out of
the EU Transfer Pricing Documentation approach for its documentation purposes but should apply the EU TPD in a
way that is consistent throughout the EU and from year to year.
11. An MNE group that opts for the EU TPD should generally apply this approach collectively to all associated enter-
prises engaged in controlled transactions involving enterprises in the EU to which transfer pricing rules apply.
Subject to paragraph 31, an MNE group opting for the EU TPD would, therefore, need to keep the documentation
specified in Section 1 in respect of all its enterprises in the Member State concerned, including permanent establish-
ments.
12. Where an MNE group has opted for the EU TPD for a given fiscal year, each member of the MNE group should
inform its tax administration accordingly.
13. MNEs should undertake to prepare the masterfile in time to comply with any legitimate request originating from
one of the tax administrations involved.
14. The taxpayer in a given Member State should make its EU TPD available, upon request by a tax administration,
within a reasonable time depending on the complexity of the transactions.
15. The taxpayer responsible for making documentation available to the tax administration is the taxpayer that would
be required to make the tax return and that would be liable to a penalty if adequate documentation were not made
available. This is the case even if the documentation is prepared and stored by one enterprise within a group on
behalf of another. The decision of an MNE group to apply the EU TPD implies a commitment towards all associated
enterprises in the EU to make the masterfile and the respective country-specific documentation available to its
national tax administration.
16. Where in its tax return, a taxpayer makes an adjustment to its accounts profit resulting from the application of the
arm's length principle, documentation demonstrating how the adjustment was calculated should be available.
17. The aggregation of transactions must be applied consistently, be transparent to the tax administration and be in
accordance with paragraph 1.42 of the OECD Transfer Pricing Guidelines (which allow aggregation of transactions
that are so closely linked or continuous that they cannot be evaluated adequately on a separate basis). These rules
should be applied in a reasonable manner, taking into account in particular the number and complexity of the
transactions.
SECTION 3
GENERAL APPLICATION RULES AND REQUIREMENTS FOR MEMBER STATES
18. Since the EU TPD is a basic set of information for the assessment of the MNE group's transfer prices a Member
State would be entitled in its domestic law to require more and different information and documents, by specific
request or during a tax audit, than would be contained in the EU TPD.
19. The period for providing additional information and documents upon specific request referred to in paragraph 18
should be determined on a case-by-case basis taking into account the amount and detail of the information and
documents requested. Depending on specific local regulations, the timing should give the taxpayer a reasonable
time (which can vary depending on the complexity of the transaction) to prepare the additional information.
20. Taxpayers avoid cooperation-related penalties where they have agreed to adopt the EU TPD approach and provide,
upon specific request or during a tax audit, in a reasonable manner and within a reasonable time, additional infor-
mation and documents going beyond the EU TPD referred to in paragraph 18.
21. Taxpayers should be required to submit their 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.
22. Where a Member State requires a taxpayer to submit information about transfer pricing with its tax return, that
information should be no more than a short questionnaire or an appropriate risk assessment form.
23. It may not always be necessary for documents to be translated into a local language. In order to minimise costs and
delays caused by translation, Member States should accept documents in a foreign language as far as possible. As far
as the EU Transfer Pricing Documentation is concerned, tax administrations should be prepared to accept the
masterfile in a commonly understood language in the Member States concerned. Translations of the masterfile
should be made available only if strictly necessary and upon specific request.
24. Member States should not oblige taxpayers to retain documentation beyond a reasonable period consistent with the
requirements of the domestic laws where the taxpayer is liable to tax regardless of where the documentation, or any
part of it, is situated.
25. Member States should evaluate domestic or non-domestic comparables with respect to the specific facts and circum-
stances of the case. For example, comparables found in pan-European databases should not be rejected automati-
cally. The use of non-domestic comparables by itself should not subject the taxpayer to penalties for non-compli-
ance.
SECTION 4
GENERAL APPLICATION RULES AND REQUIREMENTS APPLICABLE TO MNEs AND MEMBER STATES
26. Where documentation produced for one period remains relevant for subsequent periods and continues to provide
evidence of arm's length pricing, it may be appropriate for the documentation for subsequent periods to refer to
earlier documentation rather than to repeat it.
27. Documentation does not need to replicate the documentation that might be found in negotiations between enter-
prises acting at arm's length (for example, in agreeing to a borrowing facility or a large contract) as long as it
includes adequate information to assess whether arm's length pricing has been applied.
28. The sort of documentation that needs to be produced by an enterprise that is a subsidiary enterprise in a group
may be different from that needed to be produced by a parent company, i.e. a subsidiary company would not need
to produce information about all of the cross-border relationships and transactions between associated enterprises
within the MNE group but only about relationships and transactions relevant to the subsidiary in question.
29. It should be irrelevant for tax administrations where a taxpayer prepares and stores its documentation as long as the
documentation is sufficient and made available in a timely manner to the tax administrations involved upon
request. Taxpayers should, therefore, be free to keep their documentation, including their EU TPD, either in a
centralised or in a decentralised manner.
30. The way that documentation is stored — whether on paper, in electronic form or in any other way — should be at
the discretion of the taxpayer, provided that it can be made available to the tax administration in a reasonable way.
31. In well justified cases, e.g. where an MNE group has a decentralised organisational, legal or operational structure or
consists of several large divisions with completely different product lines and transfer pricing policies or no inter-
company transactions, and in the case of a recently acquired enterprise, an MNE group should be allowed to
produce more than one masterfile or to exempt specific group members from the EU TPD.
SECTION 5
GLOSSARY
MULTINATIONAL ENTERPRISE (MNE) AND MNE GROUP
According to the OECD Transfer Pricing Guidelines:
— an MNE is a company that is part of an MNE group,
— an MNE group is a group of associated companies with business establishments in two or more countries.
STANDARDISED DOCUMENTATION
A uniform, EU-wide set of rules for documentation requirements according to which all enterprises in Member States
prepare separate and unique documentation packages. This more prescriptive approach aims at arriving at a decentra-
lised but standardised set of documentation, i.e. each entity in a multinational group prepares its own documentation,
but according to the same rules.
CENTRALISED (INTEGRATED GLOBAL) DOCUMENTATION

A single documentation package (core documentation) on a global or regional basis that is prepared by the parent
company or headquarters of a group of companies in a EU-wide standardised and consistent form. This documentation
package can serve as the basis for preparing local country documentation from both local and central sources.
EU TRANSFER PRICING DOCUMENTATION (EU TPD)

The EU Transfer Pricing Documentation (EU TPD) approach combines aspects of the standardised and of the centralised
(integrated global) documentation approach. A multinational group would prepare one set of standardised and consistent
transfer pricing documentation that would consist of two main parts:
(i) one uniform set of documentation containing common standardised information relevant for all EU group members
(the ‘masterfile’), and
(ii) several sets of standardised documentation each containing country-specific information (‘country-specific documen-
tation’).
The documentation set for a given country would consist of the common masterfile supplemented by the standardised
country-specific documentation for that country.
DOCUMENTATION-RELATED PENALTY
An administrative (or civil) penalty imposed for failure to comply with the EU TPD or the domestic documentation
requirements of a Member State (depending on which requirements the MNE has chosen to comply with) at the time
the EU TPD or the domestic documentation required by a Member State was due to be submitted to the tax administra-
tion.
COOPERATION-RELATED PENALTY
An administrative (or civil) penalty imposed for failure to comply in a timely manner with a specific request of a tax
administration to submit additional information or documents going beyond the EU TPD or the domestic documenta-
tion requirements of a Member State (depending on which requirements the MNE has chosen to comply with).
ADJUSTMENT-RELATED PENALTY
A penalty imposed for failure to comply with the arm's length principle usually levied in the form of a surcharge at a
fixed amount or a certain percentage of the transfer pricing adjustment or the tax understatement.

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Tolley Exam Training

TRANSFER PRICING OPTION

ADIT Paper IIIF TP examines Principles of Corporate and International Taxation –

What do I have here?

After this introduction you will find:

• the study manual chapters.

Kees Van Raad

We recommend that you obtain a copy as soon as possible.

© Reed Elsevier UK Ltd 2013 I 2014 Sittings

Additional material was provided by:

David Abrehart (Chapter 24)

© Reed Elsevier UK Ltd 2013 II 2014 Sittings

3 The Arm’s Length Principle & Comparability

4 Transfer Pricing Methods

6 Analysis of Functions, Assets & Risk

7 Relating Functional Analysis to Selection of TP Method

9 Comparability Analysis: OECD Proposed Process

10 Comparability Analysis: Aggregation and Use of Third Party non-

11 Comparability Adjustment including Practical Issues

12 Specific Transactions: Intra Group Services

13 Specific Transactions: Loans and Other Financial Transactions

14 Specific Transactions: Intangible Property

15 Specific Transactions: Business Restructuring

18 Attribution of Profits to PEs

19 PE: Attribution of Profits to Financial Institutions & Financial Instruments

21 Avoiding Double Taxation and Dispute Resolution I

22 Avoiding Double Taxation and Dispute Resolution II

23 Role of Strategic & Managerial Transfer Pricing

24 Latest developments in Transfer Pricing

© Reed Elsevier UK Ltd 2013 III 2014 Sittings

Appendix 1 Case Law

Appendix 2 EU Arbitration Convention © European Union, http://eur-lex.europa.eu/

EUJTP Code of Conduct on transfer pricing documentation for associated

© Reed Elsevier UK Ltd 2013 IV 2014 Sittings

In this chapter we will look at:

1.1 Management accounting origins

To a management accountant, transfer pricing is a fundamental process required

To take a simple scenario where entity 1 produces a product and it is sold to an

© Reed Elsevier UK Ltd 2013 1 2014 Sittings

1.2 Taxation context

Production cost Transfer price

© Reed Elsevier UK Ltd 2013 2 2014 Sittings

1.3 Origin of the arm's length principle

© Reed Elsevier UK Ltd 2013 3 2014 Sittings

1.4 The OECD Guidelines

1.5 Fundamental source: OECD Guidelines

© Reed Elsevier UK Ltd 2013 4 2014 Sittings

It is therefore important to be clear which version of the OECD Guidelines is

1.6 Fundamental source: OECD Model Tax Convention

Article 9 Associated Enterprises

© Reed Elsevier UK Ltd 2013 5 2014 Sittings

The article reads as follows:

a. an enterprise of a Contracting State participates directly or indirectly in the

b. the same persons participate directly or indirectly in the management, control

2. Where a Contracting State includes in the profits of an enterprise of that State –

Broadly speaking, paragraph 1 authorises a country that is a signatory to the tax

It should be noted that it is generally accepted that Article 9 is intended to be

© Reed Elsevier UK Ltd 2013 6 2014 Sittings

Paragraph 2 relates to what are known as corresponding adjustments, although

Country B is not automatically obliged to give a downward adjustment merely

3. The provisions of paragraph 2 shall not apply where judicial, administrative or

In other words, where a transfer pricing adjustment arises because of a failed

Article 7 Business Profits