In the early 2000s the IRS issued a “APA study guide” where guidance is provided in relation to various practical issues in the area of transfer pricing. The study guide is part of a large collection of IRS practices and statistics from working with MAP and APA that can be accessed via this link.

OECD Transfer Pricing Guidelines 2017 – New version The OECD Transfer Pricing Guidelines for Multinational Enterprise and Tax Administrations provide guidance on the application of the “arm’s length principle”, which is the international consensus on transfer pricing, i.e. on the valuation for tax purposes of cross-border transactions between associated enterprises. In a global economy where multinational enterprises (MNEs) play a prominent role, transfer pricing continues to be high on the agenda of tax administrations and taxpayers alike. Governments need to ensure that the taxable profits of MNEs are not artificially shifted out of their jurisdiction and that the tax base reported by MNEs in their country reflects the economic activity undertaken therein. For taxpayers, it is essential to limit the risks of economic double taxation that may result from a dispute between two countries on the determination of the arm’s length remuneration for their cross-border transactions with associated enterprises.

Italien legislation on transfer pricing is contained in Article 110, paragraph 7 of the Consolidated Income Tax Act, where the first sentence states that “the components of income deriving from transactions with companies not resident in the territory of the State, which directly or indirectly control the company, are controlled by it or are controlled by the same company that controls the company, are determined by reference to the terms and prices that would have been agreed between independent parties operating in conditions of free competition and in comparable circumstances, if an increase in income is the result”. The rule was last amended by Article 59 of Decree-Law No. 50/2017 which, as far as it is of interest, replaced the reference to “normal value” with the “arm’s length principle”, referred to in the aforementioned Article 9 of the OECD Model Convention, in determining the value of transactions between associated enterprises operating in different States. At the level of secondary legislation, the Ministerial Decree of 14 May 2018, published in the Official Gazette no. 118/2018, contains the guidelines for the application of the provisions contained in paragraph 7 of Article 110 on transfer pricing. Click here for unofficial English translation

June 2018 the OECD released revised guidance on the profit split method. The new guidance will be incorporated into the OECD Transfer Pricing Guidelines, replacing the previous text on the transactional profit split method in Chapter II. The revised guidance retains the basic premise that the profit split method should be applied where it is found to be the most appropriate method to the case at hand, but it significantly expands the guidance available to help determine when that may be the case. It also contains more guidance on how to apply the method, as well as numerous examples.

“Think international – act international – audit international“. Multinational enterprises (MNEs) primarily engage in cross-border activities and invest internationally while the competences of national tax jurisdictions remain limited to the national territory as a matter of principle. To face up to the challenges of globalisation and address the business models that have been developed to match the new economic realities, tax administrations need to strengthen their cooperation and be open to experiment with new forms of collaboration that deepen the exchange of information. In this context, a coordinated approach to transfer pricing controls would contribute to a better functioning of the internal market on two fronts: it would offer tax administrations a transparent and efficient tool to facilitate the allocation of taxing rights and also prevent the occurrence of double taxation and double non taxation. In the EU legal order there is a framework that provides Member States’ tax administrations with the tools for cross-border/administrative cooperation. It is important to use all available tools for administrative cooperation in the best possible way, including bi- and multilateral transfer pricing controls and to consider their improvement where necessary1. In the Report on Transfer Pricing Risk Management of the Joint Transfer Pricing Forum (JTPF), it is recommended to take simultaneous controls or joint audits into consideration in appropriate cases while it is recognized that especially at the beginning of this practice, the capacity and experience of one or both tax administrations involved may be limited.2 For this reason the current work programme of the JTPF3 includes the assignment of summarizing Member States’ practices and experiences in the context of simultaneous controls and joint audits as well as providing practical guidance on how to cooperate bi- or multilaterally in transfer pricing controls. OBJECTIVE  The objective of this paper is to establish a coordinated approach to transfer pricing controls within the EU, in order to avoid double taxation or non-taxation. Furthermore, it serves as a starting point for analysing which tools, and how, can be improved based on the current EU legal framework. PART 1 THE FRAMEWORK FOR A COOPERATIVE APPROACH TO TRANSFER PRICING CONTROLS IN THE EU 1.1. PRINCIPLES A fair corporate tax system ensures that profits are allocated where the value is generated and that these profits are not taxed twice. Transfer pricing rules based on the arm’s length principle serve to allocate income earned by a multinational enterprise among those countries in which the company does business. Transfer pricing is highly fact-specific as, generally, the price of each transaction needs to be determined by reference to a comparable transaction. This determination requires the exercise of judgement on the part of both the tax administration and the taxpayer and a review of the transfer pricing methods at several points in the process of a comparability analysis4. Therefore, transfer pricing is potentially more subjective than other areas of direct and indirect taxation and, for this reason, sensitive to disputes. Given this nature of transfer pricing, it is key to develop administrative cooperation at two levels: (i) between the relevant tax administrations; and (ii) between tax administrations and taxpayers. Cooperation between tax administrations When the tax authorities of a Member State decide to audit an MNE with taxable activity that extends beyond their taxing jurisdiction (and possibly, beyond the EU), close and transparent cooperation between the relevant Member States’ tax authorities throughout the auditing process could decisively contribute to a successful audit, i.e. an audit that is effective (concluding the review of a case without the need for further procedural steps, e.g. a MAP) and efficient (achieving this aim with a minimum of resources and time). To this end, tax administrations are encouraged to exchange all foreseeably relevant information in a timely manner and to cooperate for building a common analysis and understanding of the same facts and circumstances of a specific case. In fact, even a common risk assessment and analysis of the functions, risks and assets related to the cross-border transactions under scrutiny should facilitate a common interpretation of the arm’s length principle. “Recommendation 1: Exchange of information and cooperation between tax administrations should be used where they are expected to assist in the identification of transfer pricing risks and to contribute to an efficient audit.” Cooperation between tax administrations and taxpayers Taking into consideration the recommendations that feature in the JTPF report on transfer pricing risk management and the principles laid out in the Guidelines for a Model European Taxpayers’ Code5, the taxpayer, without prejudice to national provisions, should have the right to be kept up-to- date with the milestone developments of the audit. At the same time, the taxpayer should be transparent and share – in a timely manner – the relevant information with each of the tax administrations involved in the bi-or multilateral control. “Recommendation 2: It is preferable to take a cooperative approach based on dialogue and trust. A cooperative approach  is inter alia characterised by communication between tax administrations and taxpayers. The taxpayer should be actively involved in the actual auditing activities and have the right to communicate and be heard in accordance with the national provisions. The taxpayer should be timely informed of the steps taken by the tax administrations during the audit.6 At the same time, the taxpayer should be transparent and share in a timely manner the relevant information with each of the tax administrations involved.” 1.2 CURRENT CONCEPTS AND TERMS Various terms are used in the practice of tax administrations and in tax literature to refer to tax- related ‘examinations’ with a cross-border operational dimension. Presences in administrative offices and participation in administrative enquiries (PAOE) According to article 11 of Directive 2011/16/EU (the DAC), PAOEs consist in one Member State requesting to be present in another Member States’ offices and/or during administrative enquiries carried out in the territory of the requested Member State. In addition to being present, Member States’ officials may interview individuals and examine records during administrative enquiries – but under the condition that this is permitted under the legislation of the

28 December 2022 Brazil published draft legislation on implementation of the arm’s length principle as described in the OECD Transfer Pricing Guidelines. The new provisions came into effect on the date of publication and must be converted into law by the National Congress. The new transfer pricing regime will be optional for taxpayers for 2023 and mandatory as of 2024. Unofficial English Translation

17 January 2023 the South African Revenue Service (SARS) released an interpretation note titled “DETERMINATION OF THE TAXABLE INCOME OF CERTAIN PERSONS FROM INTERNATIONAL TRANSACTIONS: INTRA-GROUP LOANS” which provides guidance on how SARS will determine arm’s length pricing for intra-group loans. The Note also provides guidance on the consequences for a taxpayer if the amount of debt, the cost of debt or both are not arm’s length. According to the note an intra-group loan would be incorrectly priced if the amount of debt funding, the cost of the debt or both are excessive compared to what is arm’s length.

3 February 2023 the Inland Revenue of New Zealand issued an interpretation statement explaining the Commissioner’s view of the law on tax avoidance in New Zealand. It sets out the approach the Commissioner will take to the general anti-avoidance provisions in the Income Tax Act 2007 – ss BG 1 and s GA 1. Where s BG 1 applies, s GA 1 enables the Commissioner to make an adjustment to counteract a tax advantage obtained from or under a tax avoidance arrangement. The Supreme Court in Ben Nevis considered it desirable to settle the approach to the relationship between s BG 1 and the specific provisions in the rest of the Act. This approach is referred to as the Parliamentary contemplation test. The Parliamentary contemplation test was confirmed as the proper and authoritative approach to applying s BG 1 by the Supreme Court in Penny and Frucor. The statement is based on and reflects the view of the Supreme Court as set out in Ben Nevis, and applied in Penny and Frucor.

On 27 March 2024, new paragraphs (3d) and (3e) were added to the German Foreign Tax Act (Außensteuergesetz – AStG) regarding intragroup financing. Paragraph (3d) concerns the determination of arm’s length interest rates, group vs. stand-alone rating and whether capital is treated as a loan or equity. Paragraph (3e) concerns the treatment of financing arrangements, i.e. cash pools, hedging, etc.

12 December 2024, the German Federal Ministry of Finance published updated administrative principles on transfer pricing 2024 (VWG VP 2024). The updates mainly concern the chapter on financial transactions, where paragraphs 3d and 3e have recently been added to the AStG. Paragraph 3d concerns the determination of arm’s length interest rates, group or stand-alone rating and whether capital should be treated as a loan or equity, and paragraph 3e concerns the treatment of financing arrangements, i.e. cash pools, hedging, etc. New guidance is also provided on the application of OECD Pillar 1 – Amount B. Click here for an unofficial English Translation

14 August 2024, the Federal Ministry of Finance sent revised administrative principles for transfer prices 2023 dated 6 June 2023 regarding the topic of intra-group financing, which, among other things, takes into account new paragraphs 3d and 3e in the German TP provisions. An opportunity to comment on the draft will be available until 6 September 2024. Paragraphs 3d and 3e were recently added to the German Foreign Tax Act (AStG). Paragraph 3d concerns the determination of arm’s length interest rates, group or stand-alone rating and whether capital should be treated as a loan or equity and paragraph 3e concerns the treatment of financing arrangements, i.e. cash pools, hedging, etc. Click here for an unofficial English Translation

This paper addresses the first stage and aims at clarifying certain concepts in applying the PSM: (i) when to use the PSM (i.e. in which circumstances it may be considered the most appropriate transfer pricing method) and (ii) how to split the profit based on the concepts described in the revised OECD Guidelines as well as by providing an inventory of recurrent splitting factors. For the avoidance of doubt this report should be regarded as complementary to, and supportive of, the text of the OECD Revised Guidelines on the application of the Transactional Profit Split Method issued in June 2018. The paper is structured as follows: section 2 provides a short description of the profit split method; section 3 seeks to clarify some key concepts related to the use of the profit split method also touching upon some challenging points; and section 4 describes a number of potential splitting factors listed in the Annex.

In March 2017 the JTPF agreed the Report on the Use of Comparables in the EU. The report establishes best practices and pragmatic solutions by issuing various recommendations for both taxpayers and tax administrations in the EU and aims at increasing in practice the objectivity and transparency of comparable searches for transfer pricing. JTPF-comparables-October-2016

EU REPORT ON THE USE OF COMPARABLES IN THE EU Background The EU Joint Transfer Pricing Forum (JTPF), as part of its work programme for 2015- 2019 (“Tools for the rules”), addresses the use of comparables in the EU (section 2.2 doc. JTPF/005/2015). Non-Governmental Members and Member States were asked to provide contributions as part of the preparation of the two meetings of 18 February 2016 and 23 June 2016. Those led to issuing two working documents (respectively, (doc. JTPF/009/2016/EN and JTPF/013/2016/EN) and were considered in the preparation of an overview on the current state of play, issues and possible solutions. A draft discussion paper on “Comparables in the EU” was prepared and discussed at the JTPF meeting in February 2016 (doc. JTPF/001/2016/EN). The present report also reflects the outcome of this discussion. Contents Background………………………………………………………………………………………………………………. 3 Introduction: context and scope……………………………………………………………………………….. 3 Comparable search…………………………………………………………………………………………………… 4 General aspects……………………………………………………………………………………………………. 4 Search strategy proposal………………………………………………………………………………………. 5 Specific aspects dealing with internal comparables……………………………………………………. 6 Selecting internal comparables……………………………………………………………………………… 6 Using internal comparables…………………………………………………………………………………… 7 Specific aspects dealing with external comparables……………………………………………………. 8 Sources of information in the EU……………………………………………………………………………. 8 Selecting external comparables……………………………………………………………………………… 9 Processing and interpreting external comparables……………………………………………….. 11 Specific aspects of comparability adjustments…………………………………………………………… 13 Observation in practice:………………………………………………………………………………………… 13 General aspects to be considered for comparability adjustments…………………………. 13 State of play and way forward on pan-European comparables………………………………….. 14 Assessing the reliability of the comparability analysis………………………………………………… 16 2. Introduction: context and scope 2. The 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 parties (‘comparability analysis’). The OECD Transfer Pricing Guidelines (‘TPG’)1 describe two key aspects of the comparability analysis (i) to identify the commercial and financial relations between the associated enterprises, the conditions and economically relevant circumstances attaching to these relations in order that the controlled transaction is accurately delineated; (ii) the search for comparables, described as “compar(ing) the conditions and the economically relevant circumstances of the controlled transaction as accurately delineated with the conditions and the economically relevant circumstances of comparable transactions between independent enterprises“2. These two components are part of the typical process of a comparability analysis3, whereas the delineation is part of step 3 and the comparable search is addressed in steps 4 to 9. 3. Delineating the transaction (see component (i) above) and drawing conclusions from the risk analytical framework4 is the first step and separate from the search for comparables. The delineation has significant consequences on the result of the comparability analysis. The search for comparables therefore needs to be systematically positioned vis-à-vis the delineation of the transaction. It is the delineated transaction, which governs the comparables search and not vice versa. 4. This report focusses on the second component described above, i.e. the search for comparables. It contains various recommendations for both taxpayers and tax administrations and aims at increasing in practice the objectivity and transparency of comparable searches in the EU. The purpose here is to make progress towards best practices and to find pragmatic solutions for companies doing business in the while sections 3 and 4 apply to search for comparable data in general, Sections 5 and 6 are mainly related to the search for data on potential comparable companies (‘comparable company search’). 3.   Comparable search 3.1   General aspects 5. A comparable search should be put in context of the following general aspects. The search for comparable data is part of the comparability analysis. As such, it is inter-linked with the delineation of the transaction and directly based on the facts and circumstances of each individual case. Most Member States have set out legislation and practical guidance on how a comparability analysis should be performed5, which broadly reflect the guidance given in Chapter III of the OECD Transfer Pricing Guidelines. This Chapter has not been revised further to the recent Report on BEPS Actions 8-10 Aligning Transfer Pricing Outcomes with Value Creation and is confirmed as setting out the process of “making comparisons between the controlled transactions and the uncontrolled transactions in order to determine an Arm’s length price for the controlled transaction”. There is also more and more case law available on the use of comparables in EU Member States and in third countries6, which is of growing interest. Finding acceptable comparable data is regarded as a challenge in the practical application of transfer pricing. It is recognised that complete elimination of judgments from the selection of comparable data would not be feasible, but also that much can be done to increase objectivity and ensure transparency in the application of subjective judgements7 . A balance has to be found between (i) care, thought, analysis and judgment, on the one hand, and, (ii) ensuring consistency and maximizing objectivity, on the other hand. The first (i) attributes need to be exercised when searching for comparables but the second term (ii) is crucial in the context of the EU to ensure a proper implementation of the TPG and best practice and therefore to prevent tax disputes “Recommendation 1:  a) Both taxpayers and tax administrations should apply a principle of transparency when they respectively conduct or control a comparable search. This means that taxpayers should justify and document the steps of the searches vis-à-vis the tax administration, and, symmetrically, that the tax administration should provide the relevant information for these steps to the taxpayer, when preparing or challenging such searches. b) The burden on both taxpayers and administrations as regards comparable searches execution and review should be proportionate. Additionally, the emphasis should be placed on quality, transparency and consistency of the analysis when conducting a comparable search. Consistency here refers to the application of a coherent approach at each step from the start of the search until its last step (e.g. the adjustment phase), but also considering each step in relation with the others and, overall, the comparable search in correlation with the delineation of the transaction. Consistency over time is a good practice: once an approach is taken, it should be consistently applied, unless valid reasons are put

The Study on the Application of Economic Valuation Techniques for Determining Transfer Prices of Cross Border Transactions between Members of Multinational Enterprise Groups in the EU provides an overview on how valuation techniques can practically and most efficiently be used for transfer pricing purposes in the EU, particularly for transactions involving intangibles. It investigates the differences between valuations for transfer pricing purposes and valuations for other purposes, and the state of play in terms of experience gathered by EU Member States and trade partners.

In April 2015 the Forum agreed on a Report on Improving the Functioning of the Arbitration Convention including a revised Code of Conduct for the effective implementation of the Arbitration Convention. The report and the revised Code of Conduct are the result of a monitoring exercise carried out by the JTPF and provide clarification inter alia on the following topics: Application of the AC in certain cases (absence of tax payment, changes in the status of the taxpayer) Transparency in cases when access to the AC is denied Implications of the new Article 7 OECD Model Tax Convention (2010) Functioning of the AC (e.g. as regards the 3 year period under Article 6 (1) AC) Serious penalties, tax collection and interest charges.

In October 2024, the Department of Inland Revenue in Nepal issued local Guidelines on Transfer Pricing. Section 33 of the Nepalese Income Tax Act, 2058, includes provisions related to transfer pricing and other arrangements between related parties. Under this section, the Inland Revenue Department may, in determining income, adjust or allocate amounts by including or excluding certain transactions to calculate taxable income and tax based on the arm’s length principle. The department also has the authority to recharacterize distributions, allocations, or allocations of income between related parties. The provisions under section 33 apply to the transactions between related parties based on the transfer pricing methods determined by the department. The guidelines applies for the fiscal year 2024/2025 and forward. The content is devided into the following sections 1 Introduction 2 Definitions 3 Transfer Pricing Determination and Arm’s Length Principle 4 Comparability Analysis 5 Arm’s Length Pricing Methods 6 Documentation Related to Transfer Pricing Determination 7 Administration of Transfer Pricing Determination Annex 1 – List of Documents to be Maintained by the Taxpayer Related to Transfer Pricing Determination Annex 2 – Certified Details Submitted by the Auditor in the Income Return Form

Kenya’s Double Taxation Agreements (DTAs) contain an Article on Mutual Agreement Procedure (MAP), typically Article 25, which allows two Contracting States to interact with each other with the intent of resolving international tax disputes. These disputes arise from situations where a taxpayer is of the view that they have been subjected to taxation contrary to the provisions of the DTA or from inconsistencies in the interpretation and application of the DTA. The Article also allows for consultation on the elimination of double taxation in cases not provided for in the DTA. The purpose of the Guidance is to set out the MAP process through which taxpayers can request assistance from the Kenyan Competent Authority to resolve disputes arising from taxation that they consider not to be in accordance with the provisions of the relevant DTA.

On 22 July 2010 a new report on the attribution of profits to permanent establishments was published. The 2008 Report will serve as background guidance to the 2008 revised Commentary‘s interpretation of the pre-2010 Article 7 for as long as bilateral tax treaties that are based on the text of that version of Article 7 are in force. However, because the 2008 Report included a number of references to the text of the pre-2010 Article 7, and because the Committee revised the text of Article 7 in the 2010 update to the Model Tax Convention, the Committee believed it would be advisable to prepare a modified version of the 2008 Report which would delete obsolete references to the text of the pre-2010 Article 7 and which would align the Report‘s wording with the wording of the new Article 7, thus making the modified Report available as a future reference for guidance on the interpretation of future treaties based on the new Article 7. The Committee decided to prepare this modified version of the 2008 Report for publication simultaneously with the 2010 update to the Model Tax Convention. The 2010 Report does not change the conclusions of the 2008 Report and has been prepared simply to avoid difficulties that might arise in trying to use the 2008 Report for the interpretation of the new Article 7.

On 17 July 2008, the OECD Council approved the release the Report on the Attribution of Profits to Permanent Establishments. The Report includes a preface and four Parts. Part I sets out general considerations for attributing profits to permanent establishments, regardless of the business sector in which they operate. Part II describes the application of the approach to enterprises carrying on a banking business through a permanent establishment. Part III addresses the situation of permanent establishments of enterprises carrying on global trading in financial instruments. Part IV deals with the application of the approach to PE of enterprises carrying on insurance activities.

A.1. INTRODUCTION A.1.1.                 This chapter provides background material on Multinational Enterprises (MNEs); MNEs are a key aspect of globalization as they have integrated cross-border business operations. The chapter describes the factors that gave rise to MNEs and shows how an MNE is able to exploit integration opportunities in the cross-border production of goods and provision of services through a value chain (or value-added chain). A.1.2.                 MNEs are groups of companies and generally operate worldwide through locally incorporated subsidiaries or permanent establishments; they may also use other structures such as joint ventures and partnerships. At the operational level, an MNE’s business operations may be organized in several different ways such as a functional structure, a divisional structure or a matrix structure. This chapter outlines the legal structures that may be used by MNEs, and considers the differences between them. A.1.3.                 This chapter then uses a “value chain analysis” (see Paragraphs A.2.5 and A.3.5 below) as a measure for testing the performance of an MNE. It considers the management of the transfer pricing function in an MNE to minimize the risk of transfer pricing adjustments and to avoid double taxation. While MNEs test the performance of their business operations, for tax and company law purposes they are required to report the performance of associated entities in the countries in which they operate. An MNE’s transfer pricing policy should provide guidance on: transfer pricing documentation requirements; reporting for transfer pricing purposes; dealing with audits; and appropriate measures for dispute resolution with a tax authority.

A.2. Theory of the Firm and Development of Multinational Enterprises A.2.1.                 In economic theory, firms are organizations that arrange the production of goods and the provision of services. The aim of a firm is to produce goods and provide services to maximize profits. In the absence of MNEs, production would be carried out through a series of arm’s length transactions between independent parties.7 These transactions would require contracts between the independent producers but a significant part of these resources would be used in the process of making contracts. A.2.2.                 The expenses of making contracts are called “transaction costs” since expenses are incurred by individuals in finding other persons with whom to contract, as well as in negotiating and finalizing the contracts. As contracts cannot cover every possible issue that may arise between the contracting parties, there is a risk of disputes being created by unforeseen contingencies. When disputes occur between contracting parties they may incur considerable costs in resolving these disputes including negotiation costs, legal expenses, and litigation and mediation expenses. As transactions and associated costs would be significant in an economy without firms, it is rational for firms to be created to produce goods and services, provided that the firms’ costs of production are less than the costs of outsourcing the production. A.2.3.                 Within a firm, contracts between the various factors of production are eliminated and replaced with administrative arrangements. Usually, the administrative costs of organizing production within a firm are less than the cost of the alternative, which is outsourcing market transactions. The theoretical limit to the expansion of a firm is the point at which its costs of organizing transactions are equal to the costs of carrying out the transactions through the market. A.2.4.                A firm will internalize the costs of production to the extent that it can achieve economies of scale in production and distribution and establish coordination economies. The United Nations Conference on Trade and Development (UNCTAD) in its 1993 World Investment Report: Transnational Corporations and Integrated Production noted that in many industries the expansion of internalized activities within multinational enterprises indicates that there are significant efficiency gains that may be achieved. A.2.5.                 A firm’s functions in providing goods and services are collectively called its supply chain, through which the firm converts inputs into goods and services. Most firms begin by operating in their home market and rely on their competitive advantages to enter markets abroad. The term “supply chain” is defined as “the chain of processes involved in the production and distribution of a commodity.” In this chapter the term “supply chain” is used for the provision of both goods and services by MNEs. The term “value chain” is defined in this Manual as “the process or activities by which a company adds value to an article, including production, marketing, and the provision of after-sales service.” A.2.6.                 MNEs create organizational structures and develop strategies to arrange the cross-border production of goods and services in locations around the world and to determine the level of intra-entity or intra-group integration. UNCTAD considered that there was a trend in many MNEs across a broad range of industries to use structures and strategies with high levels of integration in their operations. The integration included structures giving an associated enterprise control over a group-wide function or the sharing of group-wide functions between two or more enterprises. A.2.7.                Successful MNEs use their location and internalization advantages to maximize their share of global markets and growth opportunities. Thus, multinational enterprises are able to minimize their costs through their integration economies, which are not available to domestic firms. A.2.8.                 The key feature of MNEs is that they are integrated (global) businesses. Globalization has made it possible for an MNE to achieve high levels of integration and the ability to have control centralized in one location. Modern information and communications systems also provide increased horizontal communications across geographic and functional business lines. This has resulted in many MNEs providing services such as advisory, research and development (R&D), legal, accounting, financial management, and data processing from one or several regional centres to group companies. Also, management teams of an MNE can be based in different locations, leading the MNE from several locations. A.2.9.                 In order to optimize the value chain, MNEs may establish new business operations in a developing country. These investments often happen in stages, with the initial stage involving the establishment of infrastructure, improvement of the education of individuals and accordingly, provision of economic benefits to the country. A.2.10.               MNEs have common control, common goals and common resources, and the units of the enterprise — parent company, subsidiaries and branches — are located in more than one country. Thus, many MNEs are fully integrated businesses that plan and implement global strategies. UNCTAD has noted that integration of production by MNEs creates challenges for policy-makers in adapting the methods for allocating the income and costs of MNEs between jurisdictions for tax purposes. A.2.11.               In Multinational Enterprises and the Global Economy (2008) the authors argue that the history of MNEs was shaped by political, social and cultural events that influenced the ownership, organization and location of international production of their goods and services. The authors claim that MNE groups integrated their operations until the late 1980s and then more recently chose to outsource some activities in which they do not have competitive advantages. A.2.12.               For most of the twentieth century, MNE groups and international enterprises operating through branches or subsidiaries tended to expand the range of their value adding activities and by the late 1980s firms had integrated their production and marketing functions. Up to the 1960s and 1970s, MNEs had engaged in limited or no outsourcing of operations and they became large integrated conglomerates. But the authors argue that from the late 1980s MNEs began outsourcing many activities that were previously performed by the firms themselves. From the early 1990s, MNEs began restructuring to specialize in the areas in which they had competitive advantages, such as unique firm-specific assets, in particular high value intangible

A.3. Legal Structure   A.3.1.       General Principles of Company Law A.3.1.1.              The legal systems used by countries include the common law and civil law systems. The common law system originates in the UK and is used in countries such as Australia, Canada, India, Malaysia, New Zealand and the USA. The common law is based on judgments in court cases. A judgment of a superior court is binding on lower courts in future cases. The civil law system has its origins in Roman law and operates in Europe, South America and Japan. Under a civil law system, law is enacted and codified by parliament. Companies are recognized under both systems as artificial legal persons with perpetual life and limited liability. The domestic law treatment of a partnership varies in common law and civil law countries. A.3.1.2.              Most countries treat partnerships as fiscally transparent entities with flow-through treatment under which the partnership is ignored and tax is imposed on the partners according to their respective shares of partnership income. Other countries treat partnerships as taxable units subject to taxation as entities, including company treatment. Some countries such as the USA have limited liability companies which provide the benefit of limited liability and allow the entity to choose either flow-through treatment or treatment as a taxable unit. This is called the “check the box” system and the entities are referred to as “hybrids”. A feature of common law countries is the “trust” concept which is an obligation in relation to property which allows for concurrent legal and beneficial ownership of the trust property. A trustee will be the legal owner of property but holds the property on trust for the beneficiaries which may include both income and capital beneficiaries. While business operations may be carried on in some common law countries using a trust structure, MNEs would not normally use trusts to carry on business operations. A.3.1.3.              One of the key decisions facing any MNE when expanding its operations to another country is the type of legal structure it will use to operate in that jurisdiction. The alternatives for an MNE are to operate abroad through locally incorporated subsidiary companies (associated enterprises) or operate abroad using permanent establishments (branches). Foreign subsidiaries may be either fully-owned by the parent company or partly-owned. A.3.1.4.              An MNE is a group of companies or other entities and under the company law of the country in which each company is incorporated it is a legal entity. This choice of legal structure will be affected by a number of factors, apart from the tax implications, including: Legal liability; Risk and control; and Administrative and regulatory obligations and costs. A.3.1.5.              Other factors which may affect the choice of the legal form of the enterprise include: Exchange controls; Requirements for minimum shareholding by local persons or entities; Administrative costs; Extraction of profits; and Capital requirements. A.3.1.6.              MNEs may also carry on business abroad through a partnership or joint venture. In most jurisdictions partnerships are not legal entities and are fiscally transparent. For a partnership to exist, an MNE would require other entities to be partners such as independent entities or subsidiaries. Joint ventures involve independent companies working together on a specific project and a joint venture party may include a government or a government authority. The business structures used by an MNE may change over time such as, for example, commencing operations in a jurisdiction using a joint venture structure and then buying out the joint venture partner and operating in that jurisdiction through an associated enterprise. An MNE may also operate abroad using an agent, which may be an independent agent, a dependent agent or a commissionaire. A.3.2.       Companies and Permanent Establishments A.3.2.1.              In an MNE group, the parent company and subsidiary companies are separate legal entities and they may enter into intra-group transactions. On the other hand, an international enterprise with a head office in the country of residence and permanent establishments abroad is one legal entity and a permanent establishment cannot legally enter into transactions with other parts of the enterprise because transactions require at least two legal entities. In the context of the Business Profits article of some tax treaties, notional transactions within an international enterprise (either between a head office and its permanent establishment or between permanent establishments) may be recognized provided they comply with the arm’s length principle. In addition, for accounting and management purposes, the head office of an international enterprise and a branch may be treated as “transacting” with each other. Whether or not dealings between a head office and its branch are subject to transfer pricing rules would depend on the scope of a country’s domestic legislation and its tax treaties. A.3.2.2.              Operational structures used by MNEs vary and evolve over time. There are many types of structures or hybrids which an organization can choose to adopt, but an organization’s primary aim should be to adopt an operational structure that will most effectively support and help it to achieve its business objectives. MNE operational structures usually differ from the legal structures and as a result, employees generally operate beyond and across the boundaries of legal entities and countries. Examples of the types of modern operational structures an MNE may adopt include a functional structure, a divisional structure or a matrix structure as outlined below. A.3.3.       Types of Organizational Structures A.3.3.1.              In a functional structure an MNE’s functions are performed by the employees within the functional divisions. These functions are usually specialized tasks, for instance the information technology engineering department would be staffed with software engineers. As a whole, a functional organization is best suited to a producer of standardized goods and services at large volume and low cost to exploit economies of scale. Coordination and specialization of tasks are centralized in a functional structure, which makes producing a limited amount of products or services efficient and predictable. A.3.3.2.              Under a divisional structure, each organizational function is grouped into a division with each division containing all the necessary resources and functions within it, such

A.4. Managing the Transfer Pricing Function in a Multinational Enterprise A.4.1.           MNEs face challenges in managing their transfer pricing function. While transfer pricing may be used in some MNEs for management control, MNEs nevertheless are required to comply with the transfer pricing rules for tax purposes in the countries in which they operate. The determination of the transfer price affects the allocation of taxable income among the associated enterprises of an MNE group. A.4.2.           Entities in an MNE group conduct global business that gives rise to opportunities to optimize the value chain of goods or services and therefore look for synergies. A challenge facing an MNE conducting a global business with associated enterprises is whether the transfer pricing method used for internal transactions is acceptable to the tax authorities in the countries in which the MNE operates. The transfer pricing challenge becomes even greater when the MNE has multiple global businesses with different business models and multiple cost centres. The size of the MNE adds to the complexity. A.4.3.          Financial reporting for MNEs is informed by two decision trees. On the one hand, corporate and tax law require an associated enterprise to determine its taxable income derived from a specific jurisdiction. On the other hand, an MNE will usually need to determine for management purposes the income and costs of its businesses lines, which, as the previous discussion shows, can operate across several jurisdictions. In other words, while tax authorities focus on an associated enterprise’s taxable income, an MNE’s managers focus on income from their business lines. MNEs, particularly those where the parent is listed on a stock exchange, are more likely to aim to meet their tax obligations in the countries in which they operate provided that they are not subject to double taxation. Consequently, MNEs should develop and publicize within the enterprise a global transfer pricing policy to help minimize the risk of transfer pricing adjustments which may result in double taxation. A.4.4.           The following is an illustrative example of the two different decision trees within an MNE: Figure A.2: Multinational Enterprise Decision Trees A.4.5.           The allocation of profits and costs to the various legal structures is based on the functions performed, risks assumed and assets employed. Since MNEs consist of numerous associated enterprises it is very difficult to allocate the profits and costs to all the separate legal entities due to the absence of market forces. It is a complex exercise to come up with a consistent global policy for allocating results to the legal structures. A.4.6.           The arm’s length principle allows national tax authorities to make an adjustment to the profits of one enterprise where the terms of transactions between associated enterprises differ from terms that would be agreed between unrelated enterprises in similar circumstances. A tax authority should only disregard a controlled transaction in exceptional circumstances. If the terms of a transaction between associated enterprises differ from those between unrelated parties and comparisons are difficult to make, an MNE bears the risk of transfer pricing adjustments. If the income of an associated enterprise within Country A is increased as a result of a transfer pricing adjustment, it would be reasonable to expect that there would be a corresponding transfer pricing adjustment resulting in a proportionate reduction in the income of the other associated enterprise in Country B, provided a consistent transfer pricing method is used by both countries. A.4.7.           But Country B may use different transfer pricing methods. Consequently, if transfer prices are adjusted by a tax authority in one country, double taxation will occur if the tax authority in the other country does not use the same transfer pricing method and allows a corresponding transfer pricing adjustment. It is the task of the transfer pricing function within an MNE to limit the risk of transfer pricing adjustments and the risk of double taxation. See the illustration of double taxation below in Figure A.3. A.4.8.           In principle, designing, implementing and documenting an appropriate transfer pricing policy should not be viewed solely as a compliance issue for MNEs. The main goal should be to develop a consistent global policy which cannot be altered to exploit tax laws. A well-developed and consistently applied transfer pricing policy should reduce an MNE’s risk of transfer pricing adjustments and the potential for double taxation, thereby increasing profitability by minimizing transfer pricing costs. Moreover, a global transfer pricing policy may be used as evidence in negotiations with tax authorities when transfer pricing disputes occur. A.4.9.           An MNE’s transfer pricing policy should ideally reduce the risk of transfer pricing adjustments and the risks of double taxation of cross-border transactions. A comprehensive transfer pricing policy should cover four key areas as shown in Figure A.4. Ø Advisory; Ø Reporting; Ø Documentation; and Ø Audit support/Dispute resolution. Figure A.3: Global Effect of Transfer Pricing Adjustments (before adjustment)     Global Business 2   Global Business 1   Global Business 3 DT DT       Figure A.4: Aspects of Transfer Pricing Policy A.4.10.          Advising requires a thorough knowledge of an MNE’s business operations. It is a misconception that the tax department makes the key business decisions within an MNE. In practice, the business units of an MNE will identify business opportunities and a decision may be taken to exploit the opportunity if it fits into the MNE’s global business strategy. Advice can be provided to minimize the risk of transfer pricing adjustments and therefore optimize the business opportunity if the tax department is involved in an MNE’s decision-making. A.4.11.          In today’s environment there is an increasing level of detail required to meet each country’s transfer pricing documentation requirements. Most MNEs therefore prepare global and regional documentation (master files) of the various global businesses. Subsequently, global and regional reports are prepared for local purposes based on the identified risks for each country in which the MNE operates. A.4.12.          Tax authorities around the world are increasingly focused on transfer pricing and on expanding their transfer pricing capabilities. MNEs have to find a way to deal with the

B.1. INTRODUCTION TO TRANSFER PRICING   B .1 .1 . What is Transfer Pricing? B.1.1.1.              This introductory chapter gives a brief outline of the subject of transfer pricing and addresses the practical issues and concerns surrounding it, especially the issues faced and approaches taken by developing countries. These are then dealt with in greater detail in later chapters. B.1.1.2.              Rapid advances in technology, transportation and communication have given rise to a large number of multinational enterprises (MNEs) which have the flexibility to place their enterprises and activities anywhere in the world, as outlined in Part A of this Manual. B.1.1.3.              A significant volume of global trade consists of international transfers of goods and services, capital (such as money) and intangibles (such as intellectual property) within an MNE group; such transfers are called “intra-group transactions”. There is evidence that intra-group trade has been growing steadily since the mid-20th century and arguably accounts for more than 30% of all international transactions. B.1.1.4.              In addition, transactions involving intangibles and multi-tiered services constitute a rapidly growing proportion of an MNE’s commercial transactions and have greatly increased the complexities involved in analyzing and understanding such transactions. B.1.1.5.              The structure of transactions within an MNE group is determined by a combination of the market and group driven forces which can differ from the open market conditions operating between independent entities. A large and growing number of international transactions are therefore not governed entirely by market forces, but driven by the common interests of the entities of a group. B.1.1.6.              In such a situation, it becomes important to establish the appropriate price, called the “transfer price”, for intra-group, cross-border transfers of goods, intangibles and services. “Transfer pricing” is the general term for the pricing of cross-border, intra-firm transactions between related parties. Transfer pricing therefore refers to the setting of prices18 for transactions between associated enterprises involving the transfer of property or services. These transactions are also referred to as “controlled” transactions, as distinct from “uncontrolled” transactions between companies that are not associated and can be assumed to operate independently (“on an arm’s length basis”) in setting terms for such transactions. B.1.1.7.              Transfer pricing thus does not necessarily involve tax avoidance, as the need to set such prices is a normal aspect of how MNEs must operate. Where the pricing does not accord with internationally applicable norms or with the arm’s length principle under domestic law, the tax administration may consider this to be “mis-pricing”, “incorrect pricing”, “unjustified pricing” or non-arm’s length pricing, and issues of tax avoidance and evasion may potentially arise. Two examples illustrate these points: Example: Solid State Drive Manufacturer In the first example, a profitable computer group in Country A buys “solid state drives” from its own subsidiary in Country The price the parent company in Country A pays its subsidiary company in Country B (the “transfer price”) will determine how much profit the Country B unit reports and how much local tax it pays. If the parent pays the subsidiary a price that is lower than the appropriate arm’s length price, the Country B unit may appear to be in financial difficulty, even if the group as a whole shows a reasonable profit margin when the completed computer is sold. From the perspective of the tax authorities, Country A’s tax authorities might agree with the profit reported at their end by the computer group in Country A, but their Country B counterparts may not agree they may not have the expected profit to tax on their side of the If the computer company in Country A bought its drives from an independent company in Country B under comparable circumstances, it would pay the market price, and the supplier would pay taxes on its own profits in the normal way. This approach gives scope for the parent or subsidiary, whichever is in a low-tax jurisdiction, to be shown as making a higher profit by fixing the transfer price to that effect and thereby minimizing its tax incidence. Accordingly, when the various parts of the organization are under some form of common control, it may mean that transfer prices are not subject to the full play of market forces and the correct arm’s length price, or at least an “arm’s length range” of prices needs to be arrived Example: Luxury Watch Manufacturer In a second example, a luxury watch manufacturer in Country A distributes its watches through a subsidiary in Country It is assumed that the watch costs $1400 to make and it costs the Country B subsidiary $100 to distribute it. The company in Country A sets a transfer price of $1500 and the subsidiary in Country B retails the watch at $1600 in Country B. Overall, the company has thus made $100 in profit, on which it is expected to pay tax. However, when the company in Country B is audited by Country B’s tax administration they notice that the distributor itself does not earn a profit: the $1500 transfer price plus the Country B unit’s $100 distribution costs are exactly equal to the $1600 retail price. Country B’s tax administration considers that the transfer price should be set at $1400 so that Country B’s unit shows the group’s $100 profit that would be liable for tax. This poses a problem for the parent company, as it is already paying tax in Country A on the $100 profit per watch shown in its Since it is a multinational group it is liable for tax in the countries where it operates and in dealing with two different tax authorities it is generally not possible to just cancel one out against the other. So the MNE can end up suffering double taxation on the same profits where there are differences about what constitutes the appropriate transfer B.1.1.8.              A possible reason for associated entities charging transfer prices for intra-group trade is to measure the performance of the individual entities in a multinational group. The individual entities within a multinational group may be separate profit centres and transfer

B.2. COMPARABILITY ANALYSIS  B .2 .1 .       Rationale for Comparability Analysis B.2.1.1.              The term “comparability analysis” is used to designate two distinct but related analytical steps: 1)     An understanding of The economically significant characteristics and circumstances of the controlled transaction, i.e. the transaction between associated enterprises, and The respective roles and responsibilities of the parties to the controlled transaction. This is generally performed through an examination of five “comparability factors”, see further para. B.2.1.6. 2)     A comparison between the conditions of the controlled transaction (as established in step 1 immediately above) and those in uncontrolled transactions (i.e. transactions between independent enterprises) taking place in comparable circumstances. The latter are often referred to as “comparable uncontrolled transactions” or “comparables”. B.2.1.2.              This concept of comparability analysis is used in the selection of the most appropriate transfer pricing method, as well as in applying the selected method to arrive at an arm’s length price or financial indicator (or range of prices or financial indicators). It thus plays a central role in the overall application of the arm’s length principle. B.2.1.3.              A practical difficulty in applying the arm’s length principle is that associated enterprises may engage in transactions that independent enterprises would not undertake. Where independent enterprises do not 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, or is not, arm’s length. B.2.1.4.              It should be kept in mind that the lack of a comparable for a taxpayer’s controlled transaction does not imply that the arm’s length principle is inapplicable to that transaction. Nor does it imply anything about whether that transaction is or is not, in fact, at arm’s length. In a number of instances, it will be possible to use “imperfect” comparables, e.g. comparables from another country with comparable economic conditions or comparables from another industry sector. Such a comparable would possibly need to be adjusted to eliminate or reduce the differences between that transaction and the controlled transaction as discussed in Paragraph B.2.1.5 below. In other instances, where no comparables are found for a controlled transaction between associated enterprises, it may become necessary to use approaches not depending directly on comparables to find an arm’s length price35 (see further Chapter B.3.). It may also be necessary to examine the economic substance of the controlled transaction to determine whether its conditions are such that it might be expected to have been agreed between independent parties in similar circumstances — in the absence of evidence of what independent parties have actually done in similar circumstances. B.2.1.5.              A controlled and an uncontrolled transaction are regarded as comparable if the economically relevant characteristics of the two transactions and the circumstances surrounding them are sufficiently similar to provide a reliable measure of an arm’s length result. It is recognized that in reality two transactions are seldom completely alike and in this imperfect world, perfect comparables are often not available. It is therefore necessary to use a practical approach to establish the degree of comparability between controlled and uncontrolled transactions. To be comparable does not mean that the two transactions are necessarily identical, but instead means that either none of the differences between them could materially affect the arm’s length price or profit or, where such material differences exist, that reasonably accurate adjustments can be made to eliminate their effect. Thus, in determining a reasonable degree of comparability, adjustments may need to be made to account for certain material differences between the controlled and uncontrolled transactions. These adjustments (which are referred to as “comparability adjustments”) are to be made only if the effect of the material differences on price or profits can be ascertained with sufficient accuracy to improve the reliability of the results. B.2.1.6.              The aforesaid degree of comparability between controlled and uncontrolled transactions is typically determined on the basis of a number of attributes of the transactions or parties that could materially affect prices or profits and the adjustment that can be made to account for differences. An examination of these attributes is therefore necessary to both steps of the comparability analysis. These attributes, which are usually referred to as the five comparability factors, include: Ø Characteristics of the property or service transferred; Ø Functions performed by the parties taking into account assets employed and risks assumed, in short referred to as the “functional analysis”; Ø Contractual terms; Ø Economic circumstances; and Ø Business strategies pursued. B.2.1.7.              Obviously, as the degree of comparability increases, the number and extent of potential differences that could render the analysis inaccurate necessarily decreases. Also, in general, while adjustments can and must be made when evaluating these factors so as to increase comparability, the number, magnitude and the reliability of such adjustments may affect the reliability of the overall comparability analysis. B.2.1.8.              The type and attributes of available comparables in a given situation also needs to be considered in determining the most appropriate transfer pricing method. For further information, see Chapter B.1, Paragraph B.1.5 and Chapter B.3. In general, closely comparable products or services are required if the Comparable Uncontrolled Price Method is used for arm’s length pricing; the Resale Price Method, Cost Plus Method and Transactional Net Margin Method, may also be appropriate where only functional comparables are available, i.e. where the functions performed, assets employed and risks assumed by the parties to the controlled transaction are sufficiently comparable to the functions performed, assets employed and risks assumed by the parties to the uncontrolled transaction so that the comparison makes economic sense. An example would be two comparable distributors of consumer goods of the same industry segment, where the goods distributed may not be exactly the same, but the functional analyzes of the two distributors would be comparable. See further Chapter B.3. B.2.1.9.       Practical guidance is needed for cases without sufficient

B.3. METHODS B .3 .1 .       Introduction to Transfer Pricing Methods B.3.1.1.                         This part of the chapter describes several transfer pricing methods that can be used to determine an arm’s length price and describes how to apply these methods in practice. Transfer pricing methods (or “methodologies”) are used to calculate or test the arm’s length nature of prices or profits. Transfer pricing methods are ways of establishing arm’s length prices or profits from transactions between associated enterprises. The transaction between related enterprises for which an arm’s length price is to be established is referred to as the “controlled transaction”. The application of transfer pricing methods helps assure that transactions conform to the arm’s length standard. It is important to note that although the term “profit margin” is used, companies may also have legitimate reasons to report losses at arm’s length. Furthermore, transfer pricing methods are not determinative in and of themselves. If an associated enterprise reports an arm’s length amount of income, without the explicit use of one of the recognized transfer pricing methods, this does not mean that its pricing should automatically be regarded as not being at arm’s length and there may be no reason to impose adjustments. B.3.1.2.           Selection of Methods (How, Why and Use of Methods) B.3.1.2.1.            The selection of a transfer pricing method serves to find the most appropriate method for a particular case. Considerations involved in selecting a method can include: the respective strengths and weaknesses of each method; the nature of the controlled transaction; the availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method; and the degree of comparability between the controlled and uncontrolled transactions. B.3.1.2.2.            The starting point in selecting a method is an understanding of the controlled transaction (inbound or outbound), in particular based on the functional analysis which is necessary regardless of which transfer pricing method is selected. The functional analysis is a major part of selecting the transfer pricing method as it helps: To identify and understand the intra-group transactions; To identify the characteristics that would make a particular transaction or function suitable for use as a comparable; To determine any necessary adjustments to the comparables; To check the relative reliability of the method selected; and Over time, to determine if modification of the method is appropriate because the transaction, function, allocation of risks or allocation of assets have been modified. B.3.1.2.3.            The major components of a functional analysis are analyzes of the functions, assets and risks. The functional analysis is described and discussed in detail in Chapter B.2, at Paragraph B.2.3.2.7. Appendix I provides examples of a functional analysis for a manufacturing business and a distribution business. A summary is provided here for context in the case of selection of appropriate methods. B.3.1.2.4.            The functions performed: The functional analysis describes the activities performed such as design, purchasing, inbound logistics, manufacturing, research and development (R&D), assembling, inventory management, outbound logistics, marketing and sales activities, after sale services, supporting activities, services, advertising, financing and management, etc. The functional analysis must specify which party performs each activity and in case both parties are involved in performing an activity it should provide for the relevant differences; for example if both have inventories but Company A holds inventories for a period of up to two years whereas Company B holds inventories for a period of one month. The activities that add most value must be identified and should be discussed in more detail. B.3.1.2.5.            The risks undertaken: The functional analysis should identify risks undertaken. Examples are: financial risk (currency, interest rate, funding risks etc.) credit and collection risk (trading credit risk, commercial credit risk), operational risk (systems failure risk), commodity price risk, inventory risk and carrying costs, R&D risk, environmental and other regulatory risks, market risk (country political risk, reliability of customers, fluctuation in demand and prices) and product risk (product liability risk, warranty risk and costs and contract enforceability). A risk-bearing party would expect to have higher earnings than a non-risk bearing party, and will incur the expenses and perhaps related loss if and when risk materializes. B.3.1.2.6.  The assets used or contributed: The functional analysis must identify and distinguish between tangible and intangible assets. Tangible assets such as property, plant and equipment have to be financed and an investment in such capital assets would usually be expected to earn a long term return based on the use and risk level  of the investment. Intangible assets are very important as substantial competitive advantage is often achieved by the use of intangible assets. Some intangibles have legal protection (e.g. patents, trademarks, trade names) but other intangibles with less legal protection may be equally important and valuable (e.g. know-how, trade secrets, marketing intangibles, etc.). B.3.1.2.7.            Interplay of above factors: Today, in a multinational group, operations tend to be more integrated across jurisdictional boundaries and the functions, risks and assets are often shared between entities in different jurisdictions. This makes functional analyzes both more difficult and more necessary. The functional analysis can help identify which functions, risks and assets are attributable to the various related parties. For example, the functional analysis may reveal that one company performs one particular function but the cost of this  is borne by the other party to the transaction. The functional analysis could highlight that situation and consider the legal allocation of risk and the economic substance of the transaction. Another example would be where a company performs one particular function and bears the cost thereof but the benefit also accrues to the other party to the transaction. The functional analysis could emphasize that situation and consider which party bears the risk in legal terms and which party bears the risk according to the economic substance of the transaction. The functional analysis typically includes a discussion of the industry in which the tested party operates, the contractual terms of the transaction at issue, the economic circumstances of the parties and the business strategies they employ. The functional analysis helps to identify

B.4. INTRA-GROUP SERVICES   B .4 .1 .       Introduction B.4.1.1.              This chapter considers the transfer prices for intra-group services within an MNE group. Firstly, it considers the tests for determining whether chargeable services have been provided by one or more members of an MNE group to one or more associated enterprises for transfer pricing purposes. Secondly, if chargeable intra-group services have been provided, it considers the methods for determining arm’s length consideration for the services. The chapter also considers the circumstances in which tax authorities may provide taxpayers with the option of using a safe harbour for low value-adding services or for minor expenses. B.4.1.2.              Under the arm’s length principle, if a chargeable intra-group service has been provided to associated enterprises, arm’s length transfer prices should be charged to group members receiving or expected to receive an economic benefit from the services. The term “associated enterprises” is defined at Article 9(1) of the United Nations Model Double Taxation Convention between Developed and Developing Countries. It includes a parent company and its direct and indirect subsidiary companies. The test for determining whether chargeable intra-group services have been provided between associated enterprises is whether one or more associated enterprises have received or are expected to receive an economic benefit from the activity. Such an economic benefit exists if an independent entity in the same or similar circumstances would be willing to pay for the services or perform the activity itself. This principle is referred to in this chapter as the “benefit test” and is considered in more detail below (paras. B.4.2.3 – B.4.2.6). B.4.1.3.              A transfer pricing analysis of intra-group services should be considered from both the perspective of the service-provider and of the associated enterprise receiving the services. Tax authorities may view the provision of intra-group services from either the perspective of a service provider or of a recipient of services. The tax authority of the service provider would seek to ensure that if chargeable intra-group services have been provided, the associated enterprise benefitting from the service is paying an arm’s length price for such services. The tax authority of the service-provider would be concerned if there were no payments for the intra-group cross-border services or if the charges for such services were below arm’s length prices. It would also be concerned if the service provider incurred costs for the benefit of foreign associated enterprises without reimbursement or arm’s length consideration if the benefits test has been satisfied. B.4.1.4.              On the other hand, the tax authority of the recipient would be seeking to ensure that the services in question satisfy the benefit test and that the recipient was being charged arm’s length prices for the intra-group services. A tax authority of the service recipient would consider making an adjustment if it considered that the services provided a benefit to the recipient but that the service charges were excessive. Given the scale of business operations of an MNE group, service costs incurred and service charges may reflect significant amounts and any misallocation of service costs or charges within an MNE will affect the profit or loss allocations among group members. B.4.1.5.              It should be noted that the requirement that chargeable services be paid for on an arm’s length basis is distinct from the question whether such arm’s length payments are deductible under the domestic law of the associated enterprise receiving the service. Transfer pricing rules require the payment of arm’s length transfer prices for chargeable services. Principles of domestic law are then applied to determine if such payments may be deducted by the associated enterprise making the payment in determining its taxable income. In some countries, although an expense may satisfy the arm’s length principle, the deduction may be denied, in full or in part, by domestic rules restricting deductions. B.4.1.6.              MNE groups in a globalized economy may have highly integrated business operations. The associated enterprises comprising such groups may seek business advantages from exploiting information, technology and communications systems and other assets on a combined basis. Intra-group services may play an important role in MNE groups as they seek to obtain services at the lowest price to maintain or improve their competitive position. Transfer pricing analyzes of such service relationships should recognize that MNE groups seek to maximize their profitability and competitive positions and they do not generally incur costs without a business purpose. B.4.1.7.              Many of the services that MNE groups require may either be performed within the group or acquired by the group from one or more independent service providers. Many types of services are not within the company’s core business but are nonetheless necessary for the MNE’s business operations. The performance of service activities required by members of the group may be centralized in one group member or dispersed among many group members. In some cases MNE groups may outsource services to independent enterprises and then charge out the cost of the services on a pass-through basis to those associated enterprises receiving a benefit. B.4.1.8.              Most intra-group services are easily identifiable such as human resources services. In some situations a service may be connected with the provision of goods. For example, an associated enterprise might be provided with goods and it might also receive services to assist in the use of the goods. In other cases intra-group services may also be provided in conjunction with or embedded in intangibles or other assets. B .4 .2 . Analysis of Intra-Group Services Types of intra-group services B.4.2.1.                         Many types of intra-group services may be provided between the associated enterprises comprising an MNE group. UNCTAD has noted in its World Investment Report 2004: The Shift towards Services, that it is “difficult to formulate a clear-cut definition of services. No commonly accepted definition exists.” A detailed list at the end of this chapter (drawn up by the European Commission) sets out some of the types of intra-group services. The list is intended to be illustrative and is not comprehensive. Activities can generally be divided into chargeable services and non-chargeable activities. Chargeable services can

B.5. TRANSFER PRICING CONSIDERATIONS FOR INTANGIBLE PROPERTY   B .5 .1 .       Introduction B.5.1.1.              Intangibles affect nearly every aspect of economic activity in the twenty-first century. Intangibles have become a major source of sustainable competitive advantage for many firms. The importance of intangibles in the economy has been growing for decades in a number of sectors. The information and communication technology (ICT) revolution has made some technologies cheaper and more powerful, enabling improvement of business processes and boosting innovation across virtually all sectors of the economy. This technological evolution has made intangibles increasingly important profit drivers in many individual businesses. It is therefore necessary to give careful consideration to intangibles when conducting a transfer pricing analysis. B.5.1.2.              Transfer pricing issues can arise when MNEs develop, acquire, exploit or transfer intangibles. Various entities within an MNE group may participate in intangibles development through functions like research, development and marketing, providing funding for acquisition and development of intangibles, and exploiting intangibles in a wide range of business activities. These activities should be rewarded on an arm’s length basis. The business operations of one member of an MNE group may require the use of intangibles developed or owned by other group members. Use by one member of the MNE group of intangibles belonging to or developed by other group members should be compensated on an arm’s length basis. B.5.1.3.              Transfer pricing issues relating to intangibles should be resolved using the fundamental transfer pricing principles contained in Chapters B.1, B.2 and B.8 of this Manual. However, as intangibles may be unique, may be difficult to value and may be very important to the successful operation of the MNE group’s business, transfer pricing issues related to intangibles can be very challenging for both tax administrations and taxpayers in developed and developing countries. This Chapter therefore supplements the general principles contained in earlier Chapters to provide special practical guidance on transfer pricing matters related to intangibles. B.5.1.4.              In carrying out a transfer pricing analysis involving intangibles it is necessary to consider: (i) the identification of the specific intangibles involved, (ii) the ownership of intangibles within the MNE group, (iii) the value of the identified intangibles, (iv) how the intangibles contribute to the creation of value by the MNE group, and (v) the identity of the members of the MNE group that contribute to intangible value and how they should be rewarded. This framework for analyzing transfer pricing issues related to intangibles is discussed in the following sections. B .5 .2 .       Identifying Intangibles Definition of intangibles B.5.2.1.              Article 9 of the UN Model Tax Convention is concerned with the conditions of transactions between associated enterprises, not with assigning labels to such transactions. The key consideration is whether a transaction conveys economic value from one associated enterprise to another, whether that benefit derives from tangible property, intangibles, services or other activities. As is the case with other transfer pricing matters the analysis of cases involving the use or transfer of intangibles should begin with a thorough identification of the commercial and financial relations entered into by the associated enterprises and the economically relevant characteristics attached to those relations. Such an approach is pursued in order to accurately delineate the actual transaction involving the use or transfer of intangibles. However, whether a particular item falls within the definition of intangibles or not will have little consequence for the analysis, since the principles in Chapters B.1, B.2 and B.8 will apply in any event. The following definition is provided primarily to aid in discussion rather than to create a substantive difference between cases involving intangibles and those that do not. B.5.2.2.              Difficulties can arise in a transfer pricing analysis as a result of definitions of the term intangibles that are either too narrow or too broad. If an overly narrow definition of the term intangible is applied either taxpayers or governments may argue, incorrectly, that certain items fall outside the definition and may therefore be transferred or used without separate compensation, even though such use or transfer would give rise to compensation in transactions between independent enterprises. If too broad a definition is applied, either taxpayers or governments may argue, again incorrectly, that the use or transfer of an item in transactions between associated enterprises should require compensation in circumstances where no such compensation would be provided in transactions between independent enterprises. B.5.2.3.              For the purposes of this chapter the term “intangible” encompasses something which is neither a physical nor a financial asset, which is capable of being owned or controlled for commercial purposes, whose use or transfer would be compensated had it occurred between independent enterprises in comparable circumstances. Whether something is recognized as an intangible for legal or accounting purposes is an informative starting point but not determinative. It is not the case that all valuable intangibles are legally protected, registered or recognized for accounting purposes. B.5.2.4.              It is recognized that some countries use a different definition in their domestic law. However, irrespective of whether an item is characterized as an intangible under domestic law, the transfer pricing analysis will be based on the definition above. Of course, other elements may need to be taken into account if they would affect pricing between unrelated parties. See for example the items discussed in section B.5.2.20. below. Common categories of intangibles B.5.2.5.              Notwithstanding the above, it is sometimes the case that labels, such as those described in paragraph B.5.2.7., are commonly applied to certain intangibles, often those with a legal status. While such categorization may be helpful in identifying intangibles as a starting point of the analysis, the approach contained in this chapter for determining arm’s length prices in cases involving intangibles does not rely on any categorization. As a result, no attempt is made to delineate with precision various classes or categories of intangibles or to prescribe outcomes that turn on such categories. The categories of intangibles described below are ones often considered in transfer pricing analyzes involving intangibles. They are illustrative and not intended to be comprehensive. B.5.2.6.             

B.6. COST CONTRIBUTION ARRANGEMENTS   B .6 .1 .       Introduction B.6.1.1.                         This chapter provides guidance on the use of cost contribution arrangements (CCAs) and the application of the arm’s length principle to CCAs for transfer pricing purposes. CCAs are contractual agreements between associated enterprises in an MNE group in which the participants share certain costs and risks in return for having a proportionate interest in the expected outcomes arising from the CCA. CCAs may also include independent parties. CCAs may be used for a broad range of purposes such as acquiring or creating tangible assets, acquiring or creating intangibles, and providing intra-group services. In relation to intangibles, the CCA will set out the interest of each participant in the intangibles to be developed. For services, the CCA will set out the services that each participant is entitled to receive. For CCAs involving tangible assets, the CCA will set out the interest of each participant in the tangible assets. B.6.1.2.                         A CCA will satisfy the arm’s length principle if a participant’s share of contributions to the CCA is in proportion to its share of expected benefits under the CCA. B.6.1.3.                         CCAs offer significant administrative advantages. As associated enterprises perform intra-group services for other group members and also benefit from intra-group services provided by other group members, a CCA can provide a mechanism for replacing a web of separate intra-group arm’s length payments with streamlined net payments based on aggregated benefits and aggregated costs associated with the services. Similarly, a CCA for sharing in intangibles development can eliminate the need for complicated cross-licensing payments and replace it with a more streamlined sharing of contributions and risks, effectively achieving joint ownership of the resulting intangible. B.6.1.4.                         CCAs are used to develop future benefits such as tangible assets or intangibles, or to provide intra-group services. MNE groups use CCAs to share the costs and risks of developing intangibles. These activities involve risk as the expected benefits may not be realized. For example, it is uncertain whether research and development will result in the creation of an intangible which can be exploited by the participants. Given the degree of risk involved, the sharing of costs and expected benefits may be a preferred approach. Moreover, a single associated enterprise may not have the resources or the capacity to individually carry out the development by itself. Another advantage of a CCA is the flexibility to make contributions in the form of tangible assets, intangibles and services. A CCA may provide that the participants are allowed the exclusive right to exploit the intangible in specific countries or regions. A participant in a CCA must be able to use its interest in the intangibles and thus the participants cannot be required to pay royalties for the use of intangibles developed under the CCA. B.6.1.5.                         Broadly, there are two distinct categories of CCAs: arrangements for sharing in the costs and benefits of intercompany services (service sharing arrangements), and arrangements established for the development, production, or obtaining of intangibles or tangible assets (development arrangements, most typically intangibles development arrangements). Both types of arrangements involve the sharing of contributions and the sharing of anticipated benefits. Contributions may be in the form of cash, tangible assets, intangibles, and services. While both types of CCAs derive from the same underlying frame work of sharing relative contributions in proportion to relative benefits, the motivation for these arrangements and some of the practical issues of implementing the arrangements may not be the same. B.6.1.6.                         In service sharing arrangements, for example, an MNE may decide to centralize its human resources operations or information technology (IT) function in an associated enterprise so the participants will share the costs of providing these services. The advantage of intra-group service CCAs is that they provide for economies of scale to the participants, resulting in a lower proportional cost for these services than if each participant were providing the services in-house. For example, an MNE group may decide to have its IT services provided by a participant in a low cost country which has an established history of being an international leader in IT. The centralization of IT provides the group with access to high quality IT services provided at a lower cost through economies of scale and potential location savings. B.6.1.7.                         Some of the savings from centralizing functions may arise from preventing unnecessary duplication of functions within an MNE group. The savings that arise from centralizing services provided in an associated enterprise will usually be immediate. The services that may be the subject of a CCA include management, administrative and technical services, marketing and purchasing of raw materials or products. B.6.1.8.                         On the other hand, for example in an intangibles development CCA, participants within an MNE may decide to share in the costs, risks and potential benefits from undertaking a project to develop a new product such as a pharmaceutical product. Contributions may include patents and other existing intangibles relevant to the development, research and development services, and use of laboratories. Potential benefits might include the exclusive rights for each of the participants to exploit the intangible in its own market. There may be a significant time lag between development activities and the creation and exploitation of intangibles. B .6 .2 .       CCA features B.6.2.1.              The key characteristic of CCAs is that the participants agree to share the proportionate costs of creating or acquiring tangible assets, creating or acquiring intangibles or providing services. They accordingly agree to have corresponding proportionate interests in the tangible assets, intangibles, or services created by the CCA. Participants should thus share the benefits in a way that is consistent with their contributions to the CCA. The predictability of the bene fits of participating in CCAs varies. In some CCAs the benefits may be predictable at the outset but in other cases there may be uncertainty about the outcome. For example, it may be highly uncertain whether research and development will result in the creation of intangibles such as patents, know-how or IT software. In relation to services,

B.7. TRANSFER PRICING ASPECTS OF BUSINESS RESTRUCTURINGS   B .7 .1 .       Setting the framework and definition issues General B.7.1.1.                   In recent years the tax aspects of business restructurings undertaken by multinational enterprises (MNEs) have attracted much attention from tax authorities all around the globe. From a transfer pricing standpoint such reorganizations require consideration of how to apply the arm´s length principle to a sound cross-border redeployment of functions, assets and risks within the same group. B.7.1.2.                   There is no legal or universally accepted definition of “business restructurings”. In a transfer pricing scenario these transactions are defined as the cross-border redeployment of functions, assets (tangible and/or intangible) and risks to which a profit/loss potential may be attached. In this respect business restructurings undertaken by MNEs need not be confused with the ordinary acquisition of a business or an ongoing concern. However, it may be common to proceed with a business restructuring of the supply chain operations of an MNE group following an acquisition, divestiture of a business, or in response to the changing business environment. B.7.1.3.                   Common examples of business restructurings are reorganizations involving conversions of the manufacturing and/or distribution layer of an MNE such as (i) conversion of a buy-sell distributor into a commissionaire or (ii) conversion of a fully-fledged manufacturer into a provider of manufacturing services. Business restructurings may also involve the transfer of the ownership and management of intangible property rights such as patents, trademarks, brand names etc. B.7.1.4.                   As a general rule businesses are entitled to organize their activities in the way they see fit. Business restructuring undertaken in a manner consistent with the arm’s length principle is entirely appropriate. However, there may be situations in which business restructurings facilitate inappropriate income shifting through non-arm’s length pricing or through commercially irrational structures. The guidance in this Manual, including this Chapter, applies to business restructurings to ensure that they are consistent with the arm’s length principle. B.7.1.5.                   The application of Article 9 of the United Nations Model Double Taxation Convention to business restructurings requires that the arm’s length consideration for a supply, acquisition or transfer of property is that which might reasonably be expected to be made under an agreement between independent parties dealing at arm’s length. As a result, a business restructuring generally involves the determination of whether at arm’s length a payment would be warranted for the transfer of something of value, or for the termination or substantial renegotiation of commercial arrangements between associated enterprises, and if so what the amounts of such arm’s length consideration would be. Business Restructurings: Considerations regarding Developing Countries B.7.1.6.                   The changes triggered by the implementation of a business restructuring can have significant effects on the allocation of profits (or losses) between the countries in which the entities operate, regardless of whether or not tax savings are a driver. When a multinational group changes its business model, the tax and legal structure of the group would generally require an alignment with the new business model. B.7.1.7.                   Business restructurings increasingly affect developing countries. In recent years a number of large MNEs have either (i) transferred their manufacturing facilities into low-cost countries, e.g. where the cost of labor of a skilled workforce is lower and/or (ii) similarly moved certain distribution functions and/or (iii) similarly moved valuable intangible property out of the jurisdiction where they were acquired, developed or exploited. This Chapter discusses how to determine, on a case by case basis, whether or not the conditions of such restructurings comply with the arm’s length principle. B.7.1.8.                   In a business restructuring context, the arm’s length principle entails a comparison of the conditions (including the pricing) of a transaction or arrangement between associated enterprises and those which would have been agreed between independent enterprises dealing at arm’s length in similar circumstances. Where a particular transaction is a part of a broader arrangement in respect of a business restructuring, setting (as well as testing) the arm’s length consideration for that transaction requires that all the circumstances relevant to the broader arrangement are taken into account in evaluating the comparability factors that might reasonably apply under an agreement between independent parties dealing at arm’s length. B.7.1.9.                   In the absence of reliable uncontrolled comparable data, an assessment has to be made of the consistency of the conditions  of the controlled transaction with those that might reasonably be expected under an agreement between independent parties dealing at arm’s length. B.7.1.10.                The above mentioned process with respect to the implementation of the arm’s length principle highlights the need for authorities in developing countries to be alert to business restructurings and their potential consequences. As already stated in other parts of this Manual, while it is for each country to determine its own tax system, the desire to avoid double taxation has been an important factor in the very broad acceptance of the arm’s length principle internationally. Process for setting or testing the arm’s length principle in business restructuring operations B.7.1.11.                This paragraph describes a typical process which may be followed when setting or reviewing transfer prices in the context of a business restructuring. This process is neither prescriptive nor exhaustive B.7.1.12.                As a first step, it is important to characterize the transactions entered into by the associated enterprises, taking into account the business environment in which the MNE group is operating. This entails carrying out the following activities: Ø identifying the scope, type (e.g. supply of goods, provision of services, licensing arrangements) and economic nature of the arrangements between the associated enterprises involved in the business restructuring; Ø performing a functional analysis of the pre and post-business restructuring activities of associated enterprises affected by the restructuring. Such an analysis requires as a starting point reference to any relevant contract, including those entered into to implement the business restructuring (e.g. contracts transferring the legal ownership of certain intangible property and those evidencing the terms and conditions of the pre and post-restructuring arrangements for the business activities affected by the restructuring) as well as an examination of risks assumed and functions performed

B.8. GENERAL LEGAL ENVIRONMENT   B .8 .1 .       Introduction B.8.1.1.              Transfer pricing rules were introduced in domestic legislation by the United Kingdom in 1915 and by the United States in 1917. Transfer pricing was not an issue of great concern, however, until the late 1960s when international commercial transactions expanded greatly in volume. The development of transfer pricing legislation was historically led by developed countries; in recent years, however, with the growth and complexity of international “transfers” within MNEs, both developed and developing countries are introducing legislation to address transfer pricing issues. See Chapter B.1., para. B.1.3. for more on the evolution of transfer pricing rules. B.8.1.2.              Domestic transfer pricing legislation worldwide shows some harmonisation in basic principles, in accordance with the arm’s length standard, even if the application is not identical across jurisdictions. The introduction of transfer pricing rules has taken place within different legislative traditions, and in the context of the sovereign right of countries to address taxation matters. The reasons why there has been a great deal of consistency in approach include: Ø The broad acceptance of the arm’s length principle as the best current alternative for dealing with transfer pricing issues; Ø Many countries have adopted the UN or OECD forms of Article 9 in their bilateral tax treaties, and have therefore already committed to it; and Ø The benefits of similar approaches between countries in terms of avoiding double taxation or double non-taxation. B.8.1.3.              With the increase in cases where tax authorities have made adjustments to transfer prices set by related entities, taxpayers increasingly seek practical dispute resolution mechanisms to avoid double taxation. As a result, mutual agreement procedure (MAP) discussions as set out in bilateral treaties have been made more effective through supplementary domestic regulations, as well as practice regarding the conduct of the MAP. B.8.1.4.              Many countries have implemented advance pricing agreements (APAs) in their legal or administrative procedures as a bilateral resolution mechanism to avoid double taxation. Other countries have introduced an arbitration procedure to give certainty that a dispute will be resolved. The advantages and disadvantages of these solutions are dealt with in Chapter C.4.; however, the application of these solutions will be influenced by the legal environment of each country, and thus will take place in a variety of ways. B.8.1.5.              This chapter reviews the legal environment of transfer pricing legislation in a global context and seeks to identify the key practical issues from the perspective of developing countries. It should be emphasized that there is no “template” or model legislation that works in every situation. New legislation has to be appropriate to the needs of a particular developing country. This means that any legislation of another country which is examined as a source of ideas should be considered closely as to why it has worked or has not worked in  its original context, including ease of practical administration of and compliance with the rules it contains. Those reasons and the “environment” of the legislation should be compared with those in the country developing transfer pricing rules. This analysis will help indicate what adaptation, if any, of the legislation is needed for it to work effectively in the conditions of a particular country. B.8.1.6.              It is important that drafters of transfer pricing legislation take into account the outcomes of the BEPS Project, especially regarding Actions 8, 9, 10 and 13 (8 — Intangibles; 9 — Risks and capital; 10 — Other high-risk transactions, and 13 — Transfer pricing documentation).71 These issues tend to have a more harmonized legal approach in a post-BEPS Project era. B .8 .2 .       Domestic Transfer Pricing Legislation: Structural Overview B.8.2.1.              As already noted in Chapter B.1 “transfer pricing” is essentially a neutral concept. However, the term is sometimes used, incorrectly and in a pejorative sense, to mean the shifting of taxable income from one company within an MNE, located in a high-tax jurisdiction, to another company of the same group, in a low-tax jurisdiction, through incorrect transfer prices. The aim of such practices is to reduce the overall tax burden of the group. This involves a transfer price, but is more accurately referred to in this Manual as a type of transfer mis-pricing; the issue is not that there has been a “transfer price” set (as there must be in such a transaction, however legitimate) but that the price set is not an arm’s length price. See Chapter B.1., at para. B.1.1.7., for examples. B.8.2.2.              Many countries have introduced specific domestic tax rules to prevent possible tax base erosion through mis-pricing of transactions between related parties. As noted above, this legislation is almost invariably proposed as being in accordance with the arm’s length principle. The arm’s length principle is generally accepted as the guiding principle for allocating income not only among related entities (group companies) but also among cross-border units of a single entity. Under the arm’s length principle, it is in principle necessary to conduct a comparability analysis of third party transactions. However, when the taxpayer fails to provide the tax authorities with the required data to compute an arm’s length price in particular circumstances some countries have adopted a presumptive taxation method (discussed at para. B.8.7. below). This is normally subject to rebuttal by a taxpayer, who may present counter-evidence to show the results as being at arm’s length. B.8.2.3.              Another approach to transfer pricing income allocation is referred to as global formulary apportionment (GFA), see Chapter B.1., para. B.1.4.14. for further information. However, such a system cannot operate at a global level, in a way that fully avoids double taxation, without prior agreement on a suitable uniform formula, which is yet to be achieved. Before joining the OECD, the Republic of Korea used to apply the GFA method on the grounds that this method provided more certainty and also reduced compliance costs for taxpayers. However, around the mid-1990s, the tax authorities of the Republic of Korea revoked some of their own guidelines based upon GFA acknowledging that GFA is not consistent with

C.1. ESTABLISHING AND UPDATING TRANSFER PRICING REGIMES   C .1 .1 .       Introduction C.1.1.1.     Overview of Part C C.1.1.1.1.            Part C of this Manual addresses the practical implementation of transfer pricing rules in a particular jurisdiction guided by the legislative design considerations outlined in Chapter B.8. This Chapter, C.1., provides guidance on Ø How the considerations and the substantive issues raised in Part B can be implemented in a national transfer pricing regime through laws and subsidiary regulations; Ø How national transfer pricing regimes relate to domestic tax laws; Ø The position of transfer pricing rules within the overall framework of international tax rules within that domestic regime; and Ø How to keep the newly implemented transfer pricing regime updated, and administer it on a daily basis. C.1.1.1.2.            The Chapters that follow in Part C then deal in depth with specific areas of implementation and administration. Chapter C.2. covers the documentation requirements central to a transfer pricing regime, transparency issues and exchange of information, in an increasingly complex business environment discussed in detail at Part A. Chapter C.3. discusses transfer pricing audits and provides guidance on approaches to managing audit programmes and capacity. Chapter C.4. provides detail and approaches to dispute resolution techniques, including how to access dispute resolution systems. C.1.1.1.3. Chapter C.5 then brings together these issues for a tax administration in a developing country to provide approaches to build capacity within the tax administration. Part C thus aims to provide a set of approaches by which a tax administration in a developing country can introduce and sustain a transfer pricing regime that meets international standards. C.1.1.2.     Key considerations in the design of the transfer pricing regime C.1.1.2.1.            Two different approaches are broadly discussed at B.8.2.4, to implement the arm’s length standard with respect to related party transactions, namely: Ø Incorporate the arm’s length principle, as well as other guiding transfer pricing principles into the income tax legislation, with the detailed transfer pricing guidelines expressed as Regulations, Rules or other subsidiary legislation. Ø Incorporate the full transfer pricing regime into the income tax system. A typical approach may see the transfer pricing regime being incorporated in a Supplementary law, regulated in Law and further explained in an Administrative ordinance. All features of the regime are thus legal in nature. Irrespective of which approach is taken in policy design, the measures need have the full force of domestic tax law. C.1.1.2.2.            As a policy choice, governments should decide when, how and in what format they want to receive transfer pricing information. The form should be the most convenient format for the tax administration to process and respond to the information received, if required. C.1.1.2.3.            Disclosure requirements included in legislation may be voluntary, as part of the regular submission of annual returns, at the end of accounting/assessment periods, or be required as a result of the conclusion of a transaction. In these cases, taxpayers are required to voluntarily inform the tax administration of the existence of a related party transaction, and to provide the details of that transaction. C.1.1.2.4.            On the other hand, the legislation may require the taxpayer to retain the information and provide it upon request. In that case the taxpayer has the responsibility to have adequate documentation to prove that the transaction was effected at arm’s length if asked by the tax administration to demonstrate that. C.1.1.2.5.            An example of voluntary information requirements on transfer pricing in filing the annual income-tax return is the related party transactions reporting form. A specific example is the Australian International Dealings Schedule that has to be filed with the annual corporate income tax return. Another example is the Brazilian Corporate Income Tax Return (Declaração de Informações Econômico-Fiscais da Pessoa Jurídica, (DIPJ)) where the taxpayer is required to voluntarily report all transfer pricing transactions taking place within a period or annual basis (depending on the taxpayer’s reporting schedule). Taxpayers are required to report certain transactions with non-residents as they arise through these forms. The South African transfer pricing questionnaire, required to be submitted with the annual corporate tax return, is a good non-OECD example. C.1.1.2.6.            The voluntary disclosure of information is the most suitable option for tax administrations with capacity constraints— it may, as a result, be the preferred option for a developing country with limited resources to gather taxpayer information. Under this option, it is important for the regulation in force to make disclosure of information a function of the transfer pricing legislation so that the obligation to report derives directly from the main legislation (without any additional administrative requirements). That will provide tax administrations with taxpayer information which would allow them to better target audit procedures. Tax administrations should make sure they have human and technological resources in place to be able to audit the information, if required. C.1.1.3.     Balance to be struck between statute and subsidiary regulations C.1.1.3.1.                       As mentioned in C.1.1.1, above, some tax systems contain a general recognition of the basic aspects of a tax obligation, and then issue extensive regulations explaining how the rules would apply in practice. This essentially means recognizing the arm’s length principle and the basic principles applicable to transfer pricing through the primary legislation. C.1.1.3.2.                       This is the case in the United States, for example, where the substantive provisions are included in the Internal Revenue Code (IRC) Section 482, and then extensively regulated in the Treasury Regulation Section 1.482 –1 through Section 1.482 – 9. Legislative and procedural regulations have the weight of law in the United States, and are binding on the taxpayer. Therefore, even though the IRC only provides the foundation to the transfer pricing principle, the obligation to observe transfer pricing rules and the determination on how to observe it is mandated by the regulations. C.1.1.3.3.                       Sometimes domestic tax systems are not able to confer the appropriate weight of authority to the accompanying regulation (as  a result of the way the domestic tax system is organized or the legal system), but the bulk of the regulatory provision is, nevertheless, only included

C.2. DOCUMENTATION   C .2 .1 .       Introduction C.2.1.1.      Adequate transfer pricing documentation can serve several useful functions. Quality transfer pricing documentation will: (i)   ensure that taxpayers give appropriate consideration to transfer pricing requirements in establishing prices for transactions between associated enterprises; (ii) provide tax administrations with the information necessary to conduct an informed transfer pricing risk assessment; and (iii) provide tax administrations with useful information to use in evaluating a taxpayer’s transfer pricing positions upon audit, thereby contributing to the avoidance of many disputes and to the timely resolution of any transfer pricing disputes that may arise. C.2.1.2.      In the period from 2013 to 2015, the OECD/G20 BEPS Project has included an effort to create a more consistent and useful documentation standard for use by countries. Insofar as possible, countries should conform their transfer pricing documentation requirements to established international standards in order to limit compliance burdens imposed on taxpayers. When these international standards are followed, documentation will be characterized by (i) sufficient detail to demonstrate the taxpayer’s compliance with the arm’s length principle, and (ii) the timely delivery of such useful information to tax authorities, enabling them to assess tax risks and begin audit investigations in appropriate cases. A taxpayer should make reasonable efforts to reflect in its documentation an adequate transfer pricing analysis of its material transactions with associated enterprises in order to establish its good faith effort to apply the arm’s length principle. C.2.1.3.      This chapter first summarizes recent developments regarding the establishment of international guidelines on transfer pricing documentation. It then provides a more in-depth discussion on several topical issues that developing countries will need to addressin adapting the international standards to their own needs. The goal of the chapter is to provide practical guidance on these documentation related issues. C .2 .2 .          International Guidelines on Transfer Pricing Documentation OECD/G20 Transfer Pricing Documentation Standard C.2.2.1.                         The OECD first published guidance on transfer pricing documentation in 1995, shortly after the first individual country rules on documentation were developed. The original OECD guidelines contained general principles but did not prescribe a list of specific items to be included in transfer pricing documentation. Over the ensuing 20 years, numerous countries adopted transfer pricing documentation rules and gained experience administering those rules. Several multinational bodies also sought to develop consistent transfer pricing documentation standards. Notwithstanding these efforts by multinational bodies to encourage consistency, the various country rules differ from one another in many ways, a fact which complicates taxpayer compliance with global documentation requirements. Accordingly, in 2015, in connection with the OECD/G20 BEPS Project, the OECD guidance on transfer pricing documentation was updated to establish a uniform documentation standard. C.2.2.1.2.                       The OECD/G20 2015 guidance sets out a standardized three-tiered approach to transfer pricing documentation. It suggests that documentation should include: (i) a master file containing general information about the MNE group relevant to all MNE group members; (ii) a local file referring specifically to material transactions of the MNE group members resident in the local jurisdiction and setting out the taxpayer’s transfer pricing methodology for such material transactions; and (iii) a Country-by-Country Report (“CbC Report”) containing certain information relating to the global allocation among taxing jurisdictions of the MNE group’s income and taxes paid, together with certain general indicators of the location of economic activity within the MNE group. The Final BEPS Report also includes agreed guidance on implementing the new documentation and reporting rules. The OECD work builds on earlier work of other bodies, particularly that of the EU. C.2.2.1.3.                       Master File. The master file is intended to provide a high level overview of the MNE’s global operations. The new OECD/G20 documentation standard calls for the following information to be included in the master file: Ø A chart illustrating the MNE’s legal and ownership structure and the geographical location of operating entities. Ø A general description of the MNE’s business including: a) important drivers of business profit; b) a description (which may be in the form of a chart) of the supply chain for the group’s five largest products and / or service offerings by turnover and any other products or services amounting to more than 5% of group turnover; c) a list and brief description of important service arrangements between members of the MNE group, other than research and development (R&D) services, including a description of the principal locations providing important services and the transfer pricing policies for allocating service costs and determining prices for intragroup services; d) a description of the main geographic markets for the group’s products and services referred to in (b), above; e) a brief written functional analysis describing the principal contributions to value creation by individual entities within the group; and f) a description of important business restructuring transactions, acquisitions, and divestitures occurring during the fiscal Ø A description of the MNE’s intangibles, including: a) a general description of the MNE’s overall strategy for the development, ownership and exploitation of intangibles, including location of principal R&D facilities and location of R&D management; b) a list of intangibles of the MNE group that are important for transfer pricing purposes and which entities own them; c) a list of important agreements among identified associated enterprises related to intangibles, including cost contribution agreements, principal R&D service arrangements, and licence arrangements; d) a general description of the group’s transfer pricing policies related to R&D and intangibles; and e) a general description of transfers of interests in intangibles among associated enterprises during the fiscal year, including the entities, countries and compensation Ø A description of the MNE’s intercompany financial arrangements, including: a) a general description of how the group is financed, including important financing arrangements with unrelated lenders; b) the identification of any members of the MNE group that provide a central financing function for the group, including the country under whose laws each entity is organized and its place of effective management; and c) a general description of the MNE’s transfer pricing policies related to financing arrangements between associated enterprises. Ø The

C.3. AUDITS AND RISK ASSESSMENT   C .3 .1 .       Introduction to Audits and Risk Assessment C.3.1.1.          As discussed in Chapter B.1, the establishment of an appropriate “arm’s length” result is not an exact science and requires judgment, based on sound knowledge, experience and skill. Owing to the complexities inherent in transfer pricing, a transfer pricing enquiry is usually complicated and can become a costly exercise both for a national tax authority and a taxpayer. It should therefore not be undertaken lightly; due consideration should be given to the possible complexities and to the amount of tax at risk. C.3.1.2.          The outcome of an effective audit process has two aspects: Ø increased future compliance (which indirectly contributes to future tax revenue and protection of the tax base); and Ø increased current tax revenues (where cases are successfully audited). C.3.1.3.          Transfer pricing audits are generally time and resource intensive. An increase of “current” tax revenues resulting from such audits may refer to revenues that would be collected in a year or two. The hard work involved in a transfer pricing audit may result in significant revenue adjustments that can benefit a developing country. However, such results do not come quickly and easily;—considerable resilience is required due to the complexity and uncertainty inherent in transfer pricing issues. Transfer pricing units in both the tax administration and the private sector often come under significant scrutiny, as the returns from the resources devoted to developing transfer pricing capability tend not to be quickly achieved and are not always easily identifiable. C.3.1.4.          The success of audits depends a great deal on good case selection. It is therefore important to dedicate adequate time and resources to risk assessment and subsequent case selection, alongside he provision of appropriate resources for actual audit of a case. There are various factors that could be used to “flag” higher risk transactions and these are discussed in more detail below. C.3.1.5.          Materiality, used in isolation, is not generally a reliable basis for risk assessment, as transactions are often over or undervalued due to transfer mis-pricing. Accordingly, where materiality is used as the primary basis for case selection, an undervalued transaction may be overlooked as it appears to be immaterial. This could be a direct result of the entities charging non-arm’s length prices. C.3.1.6.          It is advisable to separate the risk assessment process for transfer pricing and thin capitalization purposes (depending on domestic legislation). Thin capitalization is generally easier to detect (particularly where a debt to equity ratio safe harbour is in place as is the case in most countries) and the auditing process may be shorter. Transfer pricing audits generally take much longer to resolve and are usually more complex. C.3.1.7.          Risk assessment should be carried out at various stages of the audit subsequent to the initial risk assessment, similar to a cost/ benefit analysis, to ensure the most efficient and effective use of time and resources. This should be built into the auditing process and incorporated into an audit programme. C .3 .2 .    Organization and Staffing of Transfer Pricing Audits C.3.2.1.     Administrative Aspects Administrative features C.3.2.1.1.            Tax administrations vary in terms of how their respective transfer pricing units are set up. The spectrum of transfer pricing work undertaken, policy regulations, geographic size, level and complexity of transfer pricing activity, quantum of the tax base, number of resources etc. may impact on how the transfer pricing division is structured within the tax administration. C.3.2.1.2.            The following functions are nevertheless likely to exist in most countries with a fair degree of transfer pricing experience: Ø audit section: transfer pricing risk assessment and audits; Ø specialist advisory function: provision of technical guidance on audits, dispute resolution (settlements) and negotiation of advance pricing agreements (APAs) etc.; Ø competent authority: mutual agreement procedures; and Ø advance pricing arrangements (APAs). C.3.2.1.3.            In contrast, tax administrations in other countries may only have some of the aforementioned functions depending on their stage of transfer pricing advancement and development. For exam ple, some countries do not have an APA programme or an established transfer pricing Competent Authority section. Administrative models C.3.2.1.4.            Generally, two types of structural models exist for organizing the transfer pricing capability; centralized and decentralized. C.3.2.1.5.            One variation that may be considered is the establishment of specialist transfer pricing capabilities separated into functional units i.e. risk assessment, audit, MAP and APA teams. There may be overlaps in the use of expertise and resources but to a large degree each functional unit will be individually staffed. C.3.2.1.6.            An alternative approach within the decentralized model involves creating a specialist function at the centre of the tax administration to advise generalist auditors and tax inspectors on how best to conduct transfer pricing audits through the provision of technical support. It is rare for these specialists to conduct audits themselves but that can happen when issues are particularly complex or contentious. C.3.2.1.7.            Both centralized and decentralized models can be applied at a national level or in regional centres throughout the country, are interchangeable and contain their own advantages and disadvantages. There is no established best practice and tax administrations should decide which option suits their needs. It may be advisable for developing countries to adopt a centralized model at the inception or during the infancy of the transfer pricing administration. This will enhance development of experience and capability, consistency and quality in audit approach and establishment of best practice. See Chapter C.5. and following for further analysis of the centralized and decentralized models. C.3.2.2.      Staffing and Resourcing C.3.2.2.1.            Transfer pricing is not an exact science and requires judgement and discretion; audits are often complex and time intensive. Owing to this, it is critical that adequate resourcing is available for such audits. Developing countries are generally more constrained in transfer pricing resources, and a tax administration can be challenged by the complexity and volume of audits. The matching of adequate and appropriate skills and resources to a transfer pricing audit is nevertheless critical to the efficient, timely and successful conclusion and

C.4. DISPUTE AVOIDANCE AND RESOLUTION   C .4 .1 .       Introduction C.4.1.1.                         Dispute avoidance and resolution procedures are essential to the effective and efficient functioning of all tax administrations. Such procedures, if properly designed and implemented, can enable fair and expeditious resolution of differences between tax administrations and taxpayers regarding interpretation and application of the relevant tax laws. They can help reduce the uncertainty, expense and delay associated with a general resort to litigation on tax matters or a failure to provide any recourse. They can also avoid integrity issues that might sometimes arise in case of an over-reliance on ad hoc (case by case) settlements. For the reasons mentioned above dispute avoidance and resolution procedures are of critical importance to taxpayers and access to effective procedures is therefore a key consideration for taxpayers. C.4.1.2.                         The goal of dispute avoidance and resolution procedures is to facilitate the efficient and equitable determination and collection of tax revenues that are properly due. Ideally, this determination and collection should be done in ways that minimize controversy, cost, uncertainty and delay for both tax administrations and taxpayers. The most efficient method of addressing disputes is to prevent them from arising. Tax administrations seeking to use their resources most efficiently should therefore probably focus in the first instance on procedures for avoiding disputes while subsequently ensuring that appropriate dispute resolution procedures are available, should they become necessary. C.4.1.3.                         In the cross-border context, dispute avoidance and resolution procedures are particularly important to avoid double taxation of the same income for a taxpayer or for associated enterprises. These procedures can also help avoid the imposition of tax not in accordance with the provisions of the applicable tax treaty, if any. When a tax treaty applies both tax administrations involved in a tax dispute ought to give effect to the provisions of that tax treaty and ought to provide rules and procedures for departing from the domestic law result where necessary to resolve disputes. C .4 .2 .       Special Considerations for Developing Countries C.4.2.1.                         The number of Mutual Agreement Procedure (MAP) disputes worldwide has been rising rapidly according to the MAP data for OECD countries and some partner economies available at the OECD website.101. However, tax administrations often face resource limitations regarding the handling of (cross-border) tax disputes and such limitations may be even greater for the tax administrations of many developing countries. Such limitations may affect staffing levels, training budgets, access to commercial databases needed for transfer pricing analyzes and other research materials, access to outside experts, travel funding and other factors. It should be recognized that such resource limitations may put tax administrations at a real (or perceived) disadvantage when dealing with better-resourced administrations. It is thus particularly important for developing countries that dispute avoidance and resolution procedures be designed to operate as efficiently as possible, to minimize the demand on tax administration resources. Efficient dispute avoidance and resolution procedures should benefit taxpayers as well. Access to properly functioning dispute avoidance and resolution procedures is particularly important for multinational enterprises as they are called on to comply with the tax laws and reporting requirements of many dozens of countries and may need to address any audits or disputes that may arise in any of the countries where they do business. C.4.2.2.                         There are various administrative procedures that could be applied to minimize transfer pricing disputes and to help resolve them when they do arise between taxpayers and their administrations, and between different tax administrations. As indicated earlier, where two or more tax administrations take different positions in determining arm’s length conditions, double taxation may occur. This means that the same income is included in the taxable base by more than one tax administration. Double taxation is undesirable and should be eliminated wherever possible, because it constitutes a potential barrier to development of international trade and stated investment flows. C.4.2.3.                         This chapter discusses several administrative approaches to resolving disputes caused by transfer pricing adjustments and for avoiding double taxation. The respective procedures all call upon domestic tax administration resources. If resource mobilization is a key concern or limiting factor for a country’s tax administration it should consider the approaches that can be realistically made available, are appropriate, and investments that may be required to expand the available dispute resolution procedures. C .4 .3 . Dispute Avoidance Procedures: Domestic C.4.3.1.     Legislation and Guidance C.4.3.1.1.            As in other areas of the law, clear guidance in advance regarding any legal transfer pricing requirements that apply can serve to reduce tax disputes. This is equally important both for tax administrations, which need such guidance to apply the law properly and equitably, and for taxpayers, which must comply with the law. Clear guidance can help avoid unexpected results and therefore help minimize controversy. C.4.3.1.2.            Guidance can serve these purposes only if it is clear and detailed enough to be properly understood by both tax administrations and taxpayers. Countries that have adopted transfer pricing legislation have struck various balances between the provision of general principles and detailed rules in that legislation and accompanying guidance. Where general principles are preferred it is often advisable, for the sake of clarity, to supplement them with examples illustrating their application. C.4.3.1.3.            Developing countries seeking to adopt transfer pricing legislation or revise existing legislation generally base such legislation on the arm’s length principle, which is adopted in both the UN and OECD Model Conventions and in most national legislation throughout the world. As long as this remains the case, departures from the arm’s length principle will create an increased risk of double or unexpected taxation, with no realistic prospect of cross-border relief. This could make the costs of doing business in the country concerned prohibitive and have the effect of discouraging cross-border trade and investment, with negative effects on sustainable development. While it is for each country to determine its own tax system the desire to avoid double taxation has been an important factor in the very broad acceptance of the arm’s length principle internationally. C.4.3.1.4.            Developing countries whose

C.5. ESTABLISHING TRANSFER PRICING CAPABILITY IN DEVELOPING COUNTRIES   C .5 .1 .       Introduction C.5.1.1.                         This Chapter addresses issues of setting up a dedicated transfer pricing unit in the tax administration. There are important opportunities as well as challenges in setting up such a unit for the first time. The design of such a unit, its vision and mission statements and the measurement of whether it has been successful will have to take into account factors widely recognized to be key features of modern tax administrations. These include factors such as: Ø the relationship between tax policy and tax administration; Ø the need to evaluate current capabilities and gaps to be filled; Ø the need for a clear vision, a mission and a culture that reflects them; Ø organizational structure; Ø approaches taken to building team capability; Ø the need for effective and efficient business processes; Ø the advantages of staged approaches to reaching long-term goals; and Ø the need for monitoring to assess effectiveness and for fine tuning. C.5.1.2.                         These points provide a useful framework when setting up a transfer pricing unit, even though there is no “template” that will be suitable for all countries in every respect. These issues will all need consideration in the context of decisions taken at a wider policy and tax administration level. C .5 .2 .       Relationship between Tax Policy and Tax Administration C.5.2.1.              The tax policy-making function generally resides with the Ministry of Finance rather than with the tax administration in most jurisdictions. The other revenue generating organs of government (e.g. the Customs Service)123 are also separate from the tax administration in many jurisdictions. There is, however, a particular need to bridge the gap between the policy making function and the tax administration in order to implement an effective transfer pricing regime, particularly due to: Ø the complexity and resource intensiveness of administering a transfer pricing regime; Ø the potential costs of compliance for taxpayers and of collection by tax administrations; and Ø the international dimension given the link to binding tax treaties through provisions based upon Article 9 of the UN and OECD Model Conventions, issues of potential double taxation and the interest of other countries; and the large amounts of money that may be at stake. C.5.2.2.              An essential first step in improving cooperation is to review and clarify exactly what each agency’s responsibilities and functions are and the mechanisms for contact and coordination. This review should be used to examine the scope for removing duplication and overlap of functions, and for streamlining and consolidating procedures. C.5.2.3.              Some factors that could improve cooperation include: Ø recognition of the need to have a “policy feedback loop” so that the policy reasons for a transfer pricing regime are properly reflected in that regime and in its administration, but also that practical lessons from the administration of the regime can be used as feedback in order to fine tune policy. Examples are:  where aspects of the policy are expensive or otherwise very resource intensive to administer, and the likely revenue return is not commensurate with these costs;  where a wider treaty framework and strong exchange of information provisions would be beneficial; or where there is a need to ensure that the framework of thresholds, deterrence mechanisms and penalties is effective and up to date; and  utilizing the experience of the administration in taxpayer service, education and enforcement, and feedback from competent authorities in improving legislation or implementing regulations; Ø cross-secondment of tax administrators and policy-makers to each other’s teams. This will help ensure that administration officials understand the policy-making process and the objectives of the legislation, and that policy-makers understand the practical issues of tax administration. Good tax policy must be able to be administered and good administration must have sound policy underpinnings; Ø broader governmental policies to ensure that all investment policies with a tax dimension must have the involvement of the tax administration. For example, tax administrators should be involved in discussions about tax incentive and tax holiday policies that may affect transfer pricing and other aspects of tax administration; and Ø recognition that policy-makers should not be limited in their training to the economic effects of investment; but tax policy should also be incorporated into the training. Conversely, tax officials should also recognize the importance of investment to development and the importance of, for example, seeking to avoid double taxation in accordance with applicable law. C .5 .3 .       Assessing Current Capabilities and Gaps to be Filled C.5.3.1.              Different tax administrations require different types of administrative arrangements when it comes to implementing their government’s transfer pricing policies. The level of development/ capability in the tax administration should be a key factor to consider when formulating policies, which is not always the case. In many cases, there is an unrealistic expectation of an increase in capability across too many areas in too short a time. C.5.3.2.              In addressing the issue of developing transfer pricing capability it is important, first of all, to determine the actual level of existing knowledge and the best organizational approach. The focus in this Manual is on countries with little or no existing experience in transfer pricing, so there are initial start-up issues. There is also a recognition that not everything can be achieved at once and that the system and the administrative capability will need to evolve over time, as part of a capability building plan—what is often termed a “life cycle approach”. A possible approach is outlined below in Figure C.5.1: Figure C.5.1: Audit Process C.5.3.3.           Factors to consider when assessing the level of development/capability of the tax administration include: Ø levels of education and expertise; Ø the legal environment or framework (as addressed in Chapter B.8) including the characteristics of the transfer pricing legislation and responsibilities for and the scope of regulations – a clear and transparent legal framework is important to the functioning of the administration as a whole,125 and perhaps especially in a difficult and legally complex area such as

D.1. BRAZIL COUNTRY PRACTICES   D .1 .1 .       Introduction: General Explanation D.1.1.1.              Brazil introduced a law on transfer pricing, through Law n. 9430/1996, in 1996.137 The bill was proposed to deal with tax evasion through transfer pricing schemes, and in line with this proposal it adopted the arm´s length principle. D.1.1.2.              The methodology introduced by the law listed the traditional transaction methods (Cost Plus Method and Resale Price Method) but denied the use of transactional profit methods (the Profit Split Method and Transactional Net Margin Method) and formulary apportionment. Regarding the CUP Method, for exports or imports, the law introduced a methodology that is similar to OECD practices; and in addition Brazil also adopted the so called Sixth Method (which is the CUP method applied specifically for commodities). However, with regard to the Cost Plus Method and Resale Price Method, instead of making use of comparable transactions, the law established fixed margins for gross profits and mark-up. D.1.1.3.              In 2012 the law was changed by adopting different margins for certain specific sectors as applicable to the Resale Price Method (RSP). The Brazilian perspective is that the conventional use of the Resale Price Method and the Cost Plus Method implies some uncertainty and juridical instability, since they are implemented by the taxpayer without previous consent or summary review by the tax authorities. This affects stability and expectations in economic and fiscal relations. D.1.1.4.              Brazil’s Resale Price Method and Cost Plus Method with fixed margins are applicable to both export and import operations. In order to make them easier to understand they are presented in the following paragraphs disregarding practical distinctions. A more detailed explanation to differentiate the application to imports and to exports and how to deal with that will be discussed separately. This is because the Brazilian transfer pricing law details the application of the two methods (RSP and CPM) for exports and imports in separate sets of rules. There are also specific methods for tradable commodities and interest that are addressed in para. D.1.8.2. and following of this Chapter. D.1.1.5.              Brazil’s Resale Price Method and Cost Plus Method with fixed margins are not “safe harbor” methods. For these purposes, safe harbours mean provisions that apply to a defined category of taxpayers or transactions that relieve eligible taxpayers, at their own option, from certain obligations in pricing controlled transactions otherwise applicable under the arm’s length standard. The Resale Price Method and Cost Plus Method with fixed margins can be applied by the taxpayers as regular methods, not as safe harbours. The fixed margins are subject to modifications authorized by the Minister of Finance, based on the taxpayer´s request or ex officio, as discussed below. D .1 .2 Resale Price Method with Fixed Margins Explanation of the methodology D.1.2.1.              The mechanism of the Resale Price Method using fixed gross profit margins is considered by Brazil to be similar to the conventional Resale Price Method with margins, except that the gross margins are set out in the rules, rather than being based on comparables (see Figure D.1.1 below). In order to determine the transfer price (deemed arm´s length price, or parameter price, as it is called in Brazilian transfer pricing laws), the resale price that the reselling company (Associated Enterprise 2) charges to an unrelated customer (Independent Enterprise) is reduced by a fixed gross profit margin. The remainder is the acceptable transfer price between the associated parties (Associated Enterprise 1 and Associated Enterprise 2), which is the parameter price. D.1.2.2.              Reference is made below to two applications of how this method could be implemented for transfer pricing of products, including cases where the product is subject to manufacturing activities (value added costs) before it is resold. D.1.2.3.              The method is based on the participation of transferred goods in the product that is resold (which is 100% in a simple resale). Then the parameter price will be the resale price participation less a profit margin, fixed by law. Therefore, this methodology is also feasible to apply when other inputs (bought from independent companies) are combined with the inputs traded between associated enterprises and the final goods, manufactured from these different sources of inputs, are resold by a Brazilian enterprise. D.1.2.4.              Resale Price (without manufacturing) If the product traded between related parties is not subject to any manufacturing modifications the formula adopted will be the same and the participation ratio will be 100%, since the price of product A1 will be equal to the resale cost of product A: Figure D.1.1: Independent Enterprise Associated Enterprise 2 Associated Enterprise 1 Resale Price Method (without manufacturing) Product A’ Product A1 (Net) Resale Price                                                       = $ 10 000 Participation Ratio (of Prod. A1 in Prod. A’)       = 100% Participation Value (of Prod. A1 in Prod. A’)       = $ 10 000 Resale price margin (20%)                                      = $ 2 000 Parameter Price                                                         = $ 8 000 Appropriate Price? Price is Given     D.1.2.5.              In this case the calculation is simple as the parameter price (deemed arm´s length price) is the resale price of the same product (charged between independent parties) reduced by: unconditional discounts granted; taxes and contributions on sales; commissions and brokerage fees paid; and a fixed profit margin of, for example, 20% (according to current Brazilian law as at September 2016). TP (parameter price) = NRP— GPM x NRP, Where: Ø TP (parameter price) = transfer price determined by Brazilian law. The maximum price on imports or the minimum price on exports; Ø NRP = net resale price; Ø GPM = gross profit margin = the value of gross profit margin ratio, as determined by law or tax regulations (20% in this simplified example); and Ø TP (parameter price) = NRP—GPM x NRP = NRP—20% x NRP = 80% NRP. Hence: Ø (Net) Resale Price                                              $ 10,000 Ø – Resale Price Margin (20%)                              $ 2,000 ¾ = A1 Transfer Price under Brazilian law =      $ 8,000 D.1.2.6.              Resale Price (with manufacturing operation) In this methodology the transfer price would be calculated having regard to the

D.2. CHINA COUNTRY PRACTICE   D .2 .1 .       Introduction D.2.1.1.              On 5 October 2015, the Organisation for Economic Co-operation and Development (OECD) published 15 final reports and an explanatory statement on the Base Erosion and Profit Shifting (BEPS) project. After an intensive two-year process, the international tax reform mandated by the G20 leaders and coordinated by the OECD has finally come to fruition. The post-BEPS era focusing on the implementation of the BEPS outcomes has been ushered in. A distinguishing factor that made this reform different from the previous ones is the involvement of many developing countries in both the early stage when the various measures were developed and the later implementation phase. The voice of developing countries has started to be heard by the global community when formulating international tax policy. This unprecedented event has provided developing countries with an opportunity to begin at the same starting line as their developed counterparts. However, the opportunity comes with challenges. Having the right to speak does not necessarily mean being ready to speak. Getting involved is still a long way from being equipped to lead. It is therefore imperative that the developing countries continue to build capacity in tax administration to enable them to become more prepared to contribute and lead. D.2.1.2.              As a G20 member, a major economy and the largest developing country, China has been actively involved with the BEPS project since 2013. The State Administration of Taxation (“SAT”) has endeavoured to attend every relevant BEPS meeting, trace the progress of the project and research on many topics such as intangibles for transfer pricing purposes and comparability analysis. In the process, the SAT has provided China’s position on various issues like location specific advantages (“LSAs”), exploitation of intangibles, and application of the profit split method. During the post-BEPS phase China has evaluated the outcomes of the BEPS project and has adopted some of them into domestic legislation. China welcomes the OECD’s effort to build an inclusive framework by inviting more jurisdictions, especially developing countries, to commit to the follow-up work including further research on specific areas, as well as implementation accompanied by review and monitoring. This will lead to enhanced coordination and cooperation across the globe. 141 By WANG Xiaoyue, Deputy Director General of the International Taxation Department of the State Administration of Taxation (People’s Republic of China), SUN Yimin, Deputy Director of the Anti-tax Avoidance Division II of the International Taxation Department of the State Administration of Taxation, and LI Hanli, Senior Staff Member of the Anti-Tax Avoidance Division II of the International Taxation Department of the State Administration of Taxation. D.2.1.3.              On the other hand, China calls for more respect for jurisdictions’ sovereignty during the review and monitoring process. Given the nature of developing countries, more flexibility is also essential for them to play on a level field with developed countries. A fair and equitable international tax system that benefits all the participants can only be built if the jurisdictions remain autonomous and informed even though they are subject to review. As the G20 leaders’ communiqué at the Hangzhou summit of 2016 points out, all the members “will continue the support for international tax cooperation to achieve a globally fair and modern international tax system and to foster growth”. D.2.1.4.              Transfer pricing is a weighty component of the international tax reform as 10 of the 15 actions of the BEPS action plan relate to it in some way. The BEPS project was initiated to tackle the situation arising where profits are left untaxed because multinational enterprises (“MNEs”) have managed to shift the income to no-tax or low-tax jurisdictions. Historically, transfer pricing administration has focused on dealing with how to allocate taxing rights between jurisdictions and preventing/eliminating double taxation under the mutual agreement procedure (“MAP”). The priority of the ongoing international tax reform, however, has been to address double non-taxation where MNEs have paid no taxes or less than their fair share of taxes in jurisdictions with well-established corporate income tax regimes. The support shown by more than 100 countries and regions for the BEPS project suggests that this common goal was able to rally interested tax jurisdictions including both developed and developing countries to work together. D.2.1.5.              However, some important questions remain unanswered. For example, has the project resolved all the differences between developed and developing countries in transfer pricing issues? Also, have the international tax rules become fairer and less biased as a result of the reform? Thanks to the concerted efforts of the developed and developing countries in combating tax avoidance, the reform now needs to reconsider the classic transfer pricing question of how to allocate profits retrieved from tax havens. The rules need to be fair and clear on who creates value and how the profits should be allocated between countries. The general principle of the BEPS project that the profits should be taxed where economic activities occur and value is created has guided jurisdictions to develop measures to counter tax avoidance using tax havens. That being said, developing countries need more specific rules and practical guidance on important issues such as how to determine the location of economic activity and value creation; how to allocate the profits retrieved from tax havens between countries with well-established corporate income tax regimes; how to divide the pie between countries that are the location of economic activity and value creation; and above all, how to apply the arm’s length principle in transfer pricing legislation and practice. This is where the United Nations Practical Manual on Transfer Pricing for Developing Countries (hereafter referred to as “UN Practical Manual on Transfer Pricing”) can be helpful. D.2.1.6.              The Chinese tax administration has been exploring ways to improve transfer pricing administration ever since China introduced a transfer pricing tax regime in 1991. Significant developments have been seen in the past two decades. First, China has established a relatively sound legal framework composed of transfer pricing legislation and specific rules. Second, China has intensified efforts in transfer pricing audits. Third, China has

D .3. TRANSFER PRICING PRACTICES AND CHALLENGES IN INDIA   D .3 .1 .       Introduction D.3.1.1.              Transfer pricing provisions were introduced in the Indian Income-tax Act in 2001. The provisions were broadly aligned with the OECD guidelines on transfer pricing. Over the last 15 years, transfer pricing audits in India have thrown up a number of issues and challenges. Administration of the transfer pricing law has also resulted in a number of disputes and protracted litigation. With a view to reducing transfer pricing disputes, a number of initiatives have been introduced by the tax administration in the recent past. Some of the initiatives have included the introduction of an Advance Pricing Agreement (APA) Scheme, inclusion of Safe Harbour provisions, utilization of the MAP provision in bilateral tax treaties to resolve TP disputes, migration from a quantum of transaction based selection to risk-based selection of TP cases for audit, and issuance of various Circulars and Instructions on transfer pricing matters to provide clarity on TP issues, etc. D.3.1.2.               Owing to these initiatives, there has been an impact on the number of cases under audit as well as the number of disputes arising from such audits which have both shown a downward trend. Transfer pricing tax administration can now focus on high risk cases and at the same time provide a reasonable degree of certainty to low risk taxpayers. The new approach is expected to raise the quality of transfer pricing audits without creating an environment of tax uncertainty and protracted litigation. D.3.1.3.               India, as a member of the G20, has participated in the Base Erosion and Profit Shifting (BEPS) Project on an equal footing with the OECD and other non-OECD member countries and is a party to the consensus developed under the various Action Points of the BEPS Project. The final reports of all the 15 Action Points of the BEPS Project have been endorsed at the highest political level by all G20 countries, including India. Accordingly, India is committed to implementing all the recommendations contained in the BEPS reports including those on transfer pricing. D.3.1.4.               Various aspects pertaining to the transfer pricing regime in India and the outstanding issues that continue to pose challenges to the transfer pricing administration are discussed in the subsequent paragraphs of this Chapter. D .3 .2 . Transfer Pricing Regulations in India D.3.2.1.              The Indian Transfer Pricing Regulations are based on the arm’s length principle. The regulations came into effect from 1 April 2001. The regulations provide that any income arising from an international transaction between associated enterprises shall be computed having regard to the arm’s length price (ALP). The concept of associated enterprises has been defined in detail in the regulations. D.3.2.2.              The ALP is to be determined by any of the prescribed methods. The methods prescribed for the determination of an arm’s length price are: Comparable Uncontrolled Price Method, Resale Price Method, Cost Plus Method, Transactional Net Margin Method, Profit Split Method and a residual method known as “any other method” to determine the arm’s length price under the statute. The regulations do not provide any hierarchy of the methods and support the concept of the “most appropriate method” which provides the most reliable measure of an arm’s length result under a particular set of facts and circumstances. D.3.2.3.              The regulations prescribe mandatory annual filing requirements as well as maintenance of contemporaneous documentation by taxpayers if international transactions between associated enterprises cross a threshold, and they contain penalty implications in case of non-compliance. The primary onus of proving the arm’s length price of a transaction lies with the taxpayer. In most cases, the Indian entity is taken as the tested party and Indian comparables are used. If the foreign associated enterprise is the less complex entity, it is taken as the tested party. D.3.2.4.              In order to provide uniformity in the application of transfer pricing law, there are specialised Commissionerates under the supervision of a Principal Chief Commissioner of Income-tax (International Taxation) at Delhi and two Chief Commissioners of Income-tax (International Taxation) stationed at Mumbai and Bengaluru. Transfer Pricing Officers (TPO) are vested with powers of inspection, discovery, enforcing attendance, examining a person under oath, on-the-spot enquiry/verification and compelling the production of books of account and other relevant documents during the course of a transfer pricing audit. The mechanism of the dispute resolution panel (DRP) is also available to taxpayers to resolve disputes relating to transfer pricing. D.3.2.5.       The government of India has a dedicated website which contains comprehensive information about the latest provisions of tax law and related rules, Circulars and Instructions including on transfer pricing. The website has a user friendly interface. It can be accessed at http://www.incometaxindia.gov.in D .3 .3 . Transfer Pricing Issues in India D .3 .3 .1 . Comparability Analysis Comparability analysis is the key to determining the arm’s length price of an international transaction. However, increased market volatility and increased complexity in international transactions have thrown open serious challenges to comparability analysis and determination of the arm’s length price. Some of these challenges and the responses of the Indian transfer pricing administration in dealing with these challenges are analyzed below. D.3.3.2.          Use of contemporaneous data: Use of contemporaneous data of comparable companies provides a more accurate arm’s length price in a particular year. Accordingly, the Indian transfer pricing rules gave primacy to the data of the current year, i.e., the year under audit. D.3.3.3.          Application of data rules: As stated above, the Indian transfer pricing regulations stipulated that data to be used in analyzing the comparability of the uncontrolled transaction with an international transaction should be the data relating to the financial year in which the international transactions have been entered into. However, the rule also provided an exception and permitted the use of data for the preceding two years if it was proved that such data could have an influence on the determination of the arm’s length price. This exception resulted in numerous disputes and protracted litigation between taxpayers and the tax authorities. To put an

D .4 . MEXICO COUNTRY PRACTICES   D .4 .1 .       Introduction D.4.1.1.              Mexico introduced transfer pricing rules in 1997 by including the arm’s length principle in the Mexican Income Tax Law (MITL). Since fiscal year 2014 the transfer pricing rules are found in Articles 76-IX, 76-X, 76-XII, 179, 180; 181 and 182. The Transfer Pricing Guidelines for Multinational Companies and Tax Administrations as approved by the Council of the OECD are referred to as applica ble in the MITL, for interpretation of the provisions in transfer pricing matters. D.4.1.2.              Tax audits in Mexico may be conducted through on-site inspection of taxpayers to review their accounting, goods and merchandise, or through desk reviews, in which the tax authorities may require that taxpayers submit their accounting records, data and other required documents and information at the offices of the tax authorities. In practice, most audits are conducted through desk reviews. D .4 .2 .       Related party definition D.4.2.1.              In Mexico two or more individuals or legal entities are deemed as related parties when one of them has a direct or indirect participation in the management, control, or capital of the other, or when a person or a group of persons participate directly or indirectly in the management, control, or capital of such persons. There is no specific threshold for the entities to be considered related parties. D.4.2.2.              In addition, since 2002 members of joint ventures, as well as permanent establishments with regard to their central office or other permanent establishments, are considered related parties. This is in accordance with the provisions of Article 179 of the MITL. D .4 .3 . Deemed related party definition D.4.3.1. It is assumed that any transaction conducted with companies residing in preferred tax regimes will be considered to be carried out between related companies at values other than market values. In addition, it is established that the payments made to residents in such regimes are not deductible; unless it can be proven that the price or consideration amount was settled at market value. D .4 .4 . Specific documentation requirements D.4.4.1.                         The law in force requires all taxpayers to prepare and keep documentation that proves that all the transactions carried out with related parties are conducted pursuant to the arm’s length principle. The transfer pricing documentation must be prepared for each tax year and should have an evaluation per type of transaction and per related party. Mexican related parties are required to provide specific information in the transfer pricing documentation that includes the arm’s length intra-group transactions. D.4.4.2.                            In addition, taxpayers must also disclose information regarding the conclusions of the transfer pricing documentation studies as part of the appendices of the statutory tax audit report, when this report is applicable. The transfer pricing documentation must contain: 1)      Name or firm name of the related company residing abroad; 2)      Information relating to assets, functions, and risks per type of transaction; 3)      Information and documentation with the detail of each transaction with related parties and their amounts per type of transaction; and 4)      Transfer pricing method applied, as well as the documentation of comparable companies or transactions per type of transaction. It is worth mentioning that the range of results obtained from comparable transactions/companies must be the interquartile range. D.4.4.3.                         Taxpayers whose income for the immediately preceding tax year was under 13 million pesos in entrepreneurial activities, or 3 million in the provision of services have no obligation to keep and maintain the documentation referred to in the law. This benefit does not apply in the case of transactions with companies residing in preferred tax regimes, or in the case of a transfer pricing information tax return. D.4.4.4.                         The same law establishes that such documentation should be recorded in account books, specifying that the transactions were conducted with related parties residing abroad. D.4.4.5.                         The Mexican Income Tax Law in force establishes that when using financial information to demonstrate that intercompany prices were agreed at market prices, the taxpayer must prepare such information in accordance with the accounting standard in order to calculate the income, cost, gross profit, net income, expenses and operating profit, as well as assets and liabilities. D.4.4.6.                         Through an informative return (DIM 9), taxpayers are also required to submit information regarding transactions with foreign-resident related parties during the immediately preceding year. D.4.4.7.                         In addition, companies that are required to file a statutory tax audit report (due on June 30th) must also submit the following appendices with regard to transfer pricing: Ø type and amount of intra-group transactions by related party, transfer pricing method used, whether the intra-group transaction is at arm’s length, and amount of the adjustment if so applied to comply with the arm’s length principle; Ø business activity of the taxpayer, ownership of intangible assets used, date on which the informative return was submitted and whether the taxpayer has supporting documentation of the arm’s length nature of intra-group transactions, Advance Pricing Agreements (APAs) under negotiation, Tax ID of transfer pricing advisors, interest deemed to be dividends, pro rata expenses, financial derivative transactions with related parties, thin capitalization issues, corresponding adjustments, etc.; and Ø the external auditors of the Mexican taxpayer filing the statutory tax audit report will also have to complete a transfer pricing questionnaire confirming that all transactions were at arm’s length and that documentation requirements were met. D.4.4.8.                         The documentation substantiating transfer pricing matters must be prepared every year not later than the date when the annual tax return is filed. In the case of an informative tax return, it has to be filed not later than the date when the statutory tax report is filed. D.4.4.9.                         The Mexican tax authorities conduct audits based on information provided by the taxpayer and other data, including information from international databases. A key issue is that this information must be reproducible for purposes of the review. D.4.4.10.                       Failing to keep documentary support will result in the external auditor’s mentioning of such failure in his report and, in case of an audit, the authority may

D.5. SOUTH AFRICA—COUNTRY PERSPECTIVE   D.5.1.             Introduction D.5.1.1.              Transfer pricing has been and still is a strategic focus area for the South African Revenue Service (SARS) over the last few years, forming an integral part of SARS’s Compliance Programme. International developments around the transfer pricing practices of large multinationals that have been made public, together with the G20/OECD BEPS Project, have resulted in transfer pricing having a heightened focus not only for SARS and South Africa’s National Treasury but also at the highest levels of government. Labour unrest in the extractive sector saw NGOs and civil society, together with some political parties, attributing the inability of corporates to pay higher wages to be the direct result of transfer mispricing and profit shifting. D.5.2.             South African Transfer Pricing Law D.5.2.1.                South Africa’s transfer pricing legislation is set out in section 31 of Income Tax Act, 1962, and came into effect on 1 July 1995. This was followed by Practice Note 2 (published on 14 May 1996) and Practice Note 7 (published on 6 August 1999) which serves to provide taxpayers with guidance on how SARS interprets the legislation. Practice Note 2 covered thin capitalisation whilst Practice Note 7 deals with transfer pricing. Several legislative amendments to the transfer pricing rules became effective with effect from 1 April 2012. D.5.2.2.              The fundamental principle underpinning South African transfer pricing legislation, since inception, is the arm’s length principle as set out in Article 9 of both the United Nations Model Double Taxation Convention between Developed and Developing Countries and the OECD Model Tax Convention on Income and on Capital. The principle is reinforced by the UN Practical Manual on Transfer Pricing for Developing Countries and the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Transfer Pricing Guidelines). It is the stated intention of SARS to review Practice Note 2 and Practice Note 7 to take into account the legislative amendments mentioned above. D.5.2.3.              Given the strategic importance of transfer pricing to SARS, there has been significant progress in refining and improving the administration of transfer pricing and the application of the arm’s length principle. Whilst resourcing and skills challenges remain, active measures are being taken by SARS to build capacity in its transfer pricing unit. This country experience is not an affirmation of SARS’s approach to all transactions as this remains circumstance and fact specific. D.5.3.             Recent Transfer Pricing Developments in South Africa D.5.3.1.              South Africa’s Minister of Finance announced in February 2013 that the government would initiate a tax review to assess South Africa’s tax policy framework and its role in supporting the objectives of inclusive growth, employment, development and fiscal sustainability. A nine member committee known as the “Davis Tax Committee” (DTC) was inaugurated and the Committee’s Terms of Reference were announced in July 2013. D.5.3.2.              The G20/OECD BEPS Project was launched in September 2013 with South Africa participating as an equal partner. As a result, the DTC set up a BEPS Sub-Committee to address its concerns around base erosion and profit shifting and formulate the DTC’s position in this regard. The DTC consulted with various stakeholders from business representatives, trade unions, civil society organisations, tax practitioners, SARS, National Treasury, the South African Reserve Bank, members of international bodies and academics, in releasing its “BEPS First Interim Report” on 23 December 2014 for public comment by 31 March 2015. D.5.3.3.              In this release, the DTC made recommendations for South Africa regarding transfer pricing in general and recommendations in relation to Actions 8 and 13 of the G20/OECD BEPS Project around intangibles and documentation. D.5.3.4.              The general recommendations included the following: Ø Formal adoption of the OECD Transfer Pricing Guidelines through a Binding General Ruling, as provided for in section 89 of the Tax Administration Act, 2011; Ø the suggested Binding General Ruling should include a set of principles reflecting the South African reality; Ø SARS must increase its enforcement capability within the transfer pricing unit; and Ø SARS must ensure that there is sufficient transfer pricing training and capacity building in its transfer pricing unit. D.5.3.5.              With regard to Action 8 – Intangibles, the recommendations of the DTC focussed on: Ø The transfer pricing implications associated with foreign owned intellectual property (IP) which is licensed to South African related parties; and Ø the transfer pricing implications associated with South African owned IP that is made available to foreign related parties. D.5.3.6.              The DTC acknowledged the role of the South African Exchange Control rules (governing sales and transfers of South African owned and developed IP and outbound royalty payments), the Department of Trade and Industry (which regulates royalty rates for IP associated with a process of manufacture) and the South African Reserve Bank (governing all other royalty payments). The DTC also analysed situations involving IP that, despite governance, controls and specific anti-avoidance regulations, could nonetheless lead to base erosion and profit shifting through business restructurings, treaties and artificial creation of substance. D.5.3.7.              Against this backdrop the DTC made the following observations/recommendations: Ø No immediate need for South Africa to enact legislation to prevent transfer pricing of intangibles since the current exchange controls restrict the outbound movement of intangibles and royalty payments; and Ø careful consideration should be given in the event of any future developments or relaxation of the exchange control rules for IP. The DTC suggested that any policy development in this area should be informed by tax and specifically the transfer pricing considerations. D.5.3.8.               Given that South African developed IP cannot be readily exported without the necessary regulatory approvals, the DTC recommended that: Ø The South African CFC rules exclude intangibles from the CFC exemption benefits; Ø the transfer pricing rules or even the general anti-avoidance provisions of the Income Tax Act could be applied to challenge the limited remuneration of a South African entity involved in the IP development process; Ø use should be made of section 23I of the Income Tax Act (an anti-avoidance provision), which prohibits the claiming of an income tax deduction in respect of

Anti Tax Avoidance measures are now beeing implemented across the EU with effect as of 1 January 2019. The EU Anti Tax Avoidance Package (ATAP) was issued by the European Commission in 2016 to counter tax avoidance behavior of MNEs in the EU and to align tax payments with value creation. The package includes the Anti-Tax Avoidance Directive, an amending Directive as regards hybrid mismatches with third countries, and four Other measures. ATAD I The Anti-Tax Avoidance Directive (ATAD), COUNCIL DIRECTIVE (EU) 2016/1164 of 12 July 2016, introduces five anti-abuse measures, against tax avoidance practices that directly affect the functioning of the internal market. 1) Interest Limitation Rule  – Reduce profitshifting via exessive interest payments (Article 4) 2) Exit Taxation – Prevent tax motivated movement of valuable business assets (eg. intangibles) across borders (Article 5) 3) General Anti-Avoidance Rule (GAAR) – Discourage Artificial Arrangements (Article 6) 4) Controlled Foreign Company (CFC) – Reduce profits shifting to low tax jurisdictions (Article 7, 8) 5) Hybrid Mismatch Rule – Reduce Hybrid Mismatch Possibilities (Article 9 + ATAD II) The first measure, interest limitation rule aims to prevent profitshifting activities that take place via exessive interest payments . This rule restricts deductibility of interest expenses and similar payments from the tax base. The second measure, exit taxation, deals with cases where the tax base (eg. valuable intangible assets) is moved across borders. The third measure is the general antiavoidance rule (GAAR) which allows countries to tackle artificial tax arrangements not govened by rational economic reasons. The fourth measure is the controlled foreign company (CFC) rule, which is designed to deter profit-shifting to low-tax countries. The fifth measure, the rule on hybrid mismatches, aims to limit cases of double non-taxation and assymetric deductions resulting from discrepancies between different tax systems. ATAD II ATAD II, COUNCIL DIRECTIVE (EU) 2017/952) of 29 May 2017, an amending Directive as regards hybrid mismatches with third countries, contains a set of additional rules to neutralize hybrid mismatches where at least one of the parties is a corporate taxpayer in an EU Member State, thus expanding the application to Non-EU countries. The second directive also addresses hybrid permanent establishment (PE) mismatches, hybrid transfers, imported mismatches, reverse hybrid mismatches and dual resident mismatches. (Article 9, 9a and 9b) Other Measures Other measures included in the Anti Tax Avoidance Package Package are mainly aimed at sharing information and improving knowledge among EU Member States. 1) Country-by-Country Reporting (CbCR) – Improve Transparency (EU Directives on Administrative cooporation in the field of taxation) 2) Recommendation on Tax Treaties – Address Treaty Abuses 3) External Strategy – More Coherent Dealing with Third Countries 4) Study on Aggressive Tax Planning – Improve Knowledge (2015 Report on Structures of Aggressive Tax Planning and Indicators and 2017 Report on Aggressive Tax Planning Indicators)   The Country-by-Country Reporting (CbCR) requirement introduces a reporting requirement on global income allocations of MNEs to increase transparency and provide Member States with information to detect and prevent tax avoidance schemes. The Recommendation on Tax Treaties provides Member States with information on how to design their tax treaties in order to minimise aggressive tax-planning in ways that are in line with EU laws. The External Strategy provides a coherent way for EU Member States to work with third countries, for instance by creating a common EU black list of Low Tax Jurisdictions . The Study on Aggressive Tax Planning investigates corporate tax rules in Member States that are or may be used in aggressive tax-planning strategies. Implementation and Effect Most of the measures introduced in ATAD I are now implemented and in effect as of 1 January 2019. ATAD II, addressing hybrid mismatches with Non-EU countries, is also being implemented and will be in effect as of 1 January 2020. A Non official version of the 2016 EU Anti Tax Avoidance Directive with the 2017 Amendments

The Australian Taxation Office has issued new guidance for multinational groups using offshore marketing- and procurment hubs for tax avoidance purposes. The guidance adresses tax schemes where MNEs uses offshore hubs to shift profits and thereby avoid Australian taxes. Offshore hub arrangements are catagorised by the ATO as white, green, blue, yellow, amber, or red – based on the risk assesment for tax purposes of the transfer pricing setup. The new guidance is a result of recent Australian investigations and hearings into tax avoidance schemes used by Multinational Groups. Tax avoidance in Australia Australian Senate Hearings into Tax Avoidance The overall framework for Australian risk assessment for tax purposes of MNE’s offshore marketing- and procurement hubs is shown below:

The OECD has released additional guidance on the attribution of profits to permanent establishments. This additional guidance sets out high-level general principles for the attribution of profits to permanent establishments arising under Article 5(5), in accordance with applicable treaty provisions, and includes examples of a commissionnaire structure for the sale of goods, an online advertising sales structure, and a procurement structure. It also includes additional guidance related to permanent establishments created as a result of the changes to Article 5(4), and provides an example on the attribution of profits to permanent establishments arising from the anti-fragmentation rule included in Article 5(4.1). See also the 2008 Guidance and 2010 Guidance.

The Study on the Application of Economic Valuation Techniques for Determining Transfer Prices of Cross Border Transactions between Members of Multinational Enterprise Groups in the EU provides an overview on how valuation techniques can practically and most efficiently be used for transfer pricing purposes in the EU, particularly for transactions involving intangibles. It investigates the differences between valuations for transfer pricing purposes and valuations for other purposes, and the state of play in terms of experience gathered by EU Member States and trade partners.

The purpose of section 482 is to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the avoidance of taxes with respect to such transactions. Section 482 places a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer. This section sets forth general principles and guidelines to be followed under section 482. Section 1.482-2 provides rules for the determination of the true taxable income of controlled taxpayers in specific situations, including controlled transactions involving loans or advances or the use of tangible property. Sections 1.482-3 through 1.482-6 provide rules for the determination of the true taxable income of controlled taxpayers in cases involving the transfer of property. Section 1.482-7T sets forth the cost sharing provisions applicable to taxable years beginning on or after January 5, 2009. Section 1.482-8 provides examples illustrating the application of the best method rule. Finally, § 1.482-9 provides rules for the determination of the true taxable income of controlled taxpayers in cases involving the performance of services.

The district director may make allocations between or among the members of a controlled group if a controlled taxpayer has not reported its true taxable income. In such case, the district director may allocate income, deductions, credits, allowances, basis, or any other item or element affecting taxable income (referred to as allocations). The appropriate allocation may take the form of an increase or decrease in any relevant amount.

If necessary to reflect an arm’s length result, a controlled taxpayer may report on a timely filed U.S. income tax return (including extensions) the results of its controlled transactions based upon prices different from those actually charged. Except as provided in this paragraph, section 482 grants no other right to a controlled taxpayer to apply the provisions of section 482 at will or to compel the district director to apply such provisions. Therefore, no untimely or amended returns will be permitted to decrease taxable income based on allocations or other adjustments with respect to controlled transactions. See § 1.6662-6T(a)(2) or successor regulations.

In determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s length result). However, because identical transactions can rarely be located, whether a transaction produces an arm’s length result generally will be determined by reference to the results of comparable transactions under comparable circumstances. See § 1.482-1(d)(2) (Standard of comparability). Evaluation of whether a controlled transaction produces an arm’s length result is made pursuant to a method selected under the best method rule described in § 1.482-1(c).

Sections 1.482-2 through 1.482-7 and 1.482-9 provide specific methods to be used to evaluate whether transactions between or among members of the controlled group satisfy the arm’s length standard, and if they do not, to determine the arm’s length result. This section provides general principles applicable in determining arm’s length results of such controlled transactions, but do not provide methods, for which reference must be made to those other sections in accordance with paragraphs (b)(2)(ii) and (iii) of this section. Section 1.482-7 provides the specific methods to be used to evaluate whether a cost sharing arrangement as defined in § 1.482-7 produces results consistent with an arm’s length result.

The methods listed in § 1.482-2 apply to different types of transactions, such as transfers of property, services, loans or advances, and rentals. Accordingly, the method or methods most appropriate to the calculation of arm’s length results for controlled transactions must be selected, and different methods may be applied to interrelated transactions if such transactions are most reliably evaluated on a separate basis. For example, if services are provided in connection with the transfer of property, it may be appropriate to separately apply the methods applicable to services and property in order to determine an arm’s length result. But see § 1.482-1(f)(2)(i) (Aggregation of transactions). In addition, other applicable provisions of the Code may affect the characterization of a transaction, and therefore affect the methods applicable under section 482. See for example section 467.

Section 1.482-7 provides the specific methods to be used to determine arm’s length results of controlled transactions in connection with a cost sharing arrangement as defined in § 1.482-7. Sections 1.482-4 and 1.482-9, as appropriate, provide the specific methods to be used to determine arm’s length results of arrangements, including partnerships, for sharing the costs and risks of developing intangibles, other than a cost sharing arrangement covered by § 1.482-7. See also §§ 1.482-4(g) (Coordination with rules governing cost sharing arrangements) and 1.482-9(m)(3) (Coordination with rules governing cost sharing arrangements).

The arm’s length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result. Thus, there is no strict priority of methods, and no method will invariably be considered to be more reliable than others. An arm’s length result may be determined under any method without establishing the inapplicability of another method, but if another method subsequently is shown to produce a more reliable measure of an arm’s length result, such other method must be used. Similarly, if two or more applications of a single method provide inconsistent results, the arm’s length result must be determined under the application that, under the facts and circumstances, provides the most reliable measure of an arm’s length result. See § 1.482-8 for examples of the application of the best method rule. See § 1.482-7 for the applicable methods in the case of a cost sharing arrangement.

Data based on the results of transactions between unrelated parties provides the most objective basis for determining whether the results of a controlled transaction are arm’s length. Thus, in determining which of two or more available methods (or applications of a single method) provides the most reliable measure of an arm’s length result, the two primary factors to take into account are the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables, and the quality of the data and assumptions used in the analysis. In addition, in certain circumstances, it also may be relevant to consider whether the results of an analysis are consistent with the results of an analysis under another method. These factors are explained in paragraphs (c)(2)(i), (ii), and (iii) of this section.

The relative reliability of a method based on the results of transactions between unrelated parties depends on the degree of comparability between the controlled transaction or taxpayers and the uncontrolled comparables, taking into account the factors described in § 1.482-1(d)(3) (Factors for determining comparability), and after making adjustments for differences, as described in § 1.482-1(d)(2) (Standard of comparability). As the degree of comparability increases, the number and extent of potential differences that could render the analysis inaccurate is reduced. In addition, if adjustments are made to increase the degree of comparability, the number, magnitude, and reliability of those adjustments will affect the reliability of the results of the analysis. Thus, an analysis under the comparable uncontrolled price method will generally be more reliable than analyses obtained under other methods if the analysis is based on closely comparable uncontrolled transactions, because such an analysis can be expected to achieve a higher degree of comparability and be susceptible to fewer differences than analyses under other methods. See § 1.482-3(b)(2)(ii)(A). An analysis will be relatively less reliable, however, as the uncontrolled transactions become less comparable to the controlled transaction.

Whether a method provides the most reliable measure of an arm’s length result also depends upon the completeness and accuracy of the underlying data, the reliability of the assumptions, and the sensitivity of the results to possible deficiencies in the data and assumptions. Such factors are particularly relevant in evaluating the degree of comparability between the controlled and uncontrolled transactions. These factors are discussed in paragraphs (c)(2)(ii) (A), (B), and (C) of this section.

The completeness and accuracy of the data affects the ability to identify and quantify those factors that would affect the result under any particular method. For example, the completeness and accuracy of data will determine the extent to which it is possible to identify differences between the controlled and uncontrolled transactions, and the reliability of adjustments that are made to account for such differences. An analysis will be relatively more reliable as the completeness and accuracy of the data increases.

All methods rely on certain assumptions. The reliability of the results derived from a method depends on the soundness of such assumptions. Some assumptions are relatively reliable. For example, adjustments for differences in payment terms between controlled and uncontrolled transactions may be based on the assumption that at arm’s length such differences would lead to price differences that reflect the time value of money. Although selection of the appropriate interest rate to use in making such adjustments involves some judgement, the economic analysis on which the assumption is based is relatively sound. Other assumptions may be less reliable. For example, the residual profit split method may be based on the assumption that capitalized intangible development expenses reflect the relative value of the intangible property contributed by each party. Because the costs of developing an intangible may not be related to its market value, the soundness of this assumption will affect the reliability of the results derived from this method.

Deficiencies in the data used or assumptions made may have a greater effect on some methods than others. In particular, the reliability of some methods is heavily dependent on the similarity of property or services involved in the controlled and uncontrolled transaction. For certain other methods, such as the resale price method, the analysis of the extent to which controlled and uncontrolled taxpayers undertake the same or similar functions, employ similar resources, and bear similar risks is particularly important. Finally, under other methods, such as the profit split method, defining the relevant business activity and appropriate allocation of costs, income, and assets may be of particular importance. Therefore, a difference between the controlled and uncontrolled transactions for which an accurate adjustment cannot be made may have a greater effect on the reliability of the results derived under one method than the results derived under another method. For example, differences in management efficiency may have a greater effect on a comparable profits method analysis than on a comparable uncontrolled price method analysis, while differences in product characteristics will ordinarily have a greater effect on a comparable uncontrolled price method analysis than on a comparable profits method analysis.

If two or more methods produce inconsistent results, the best method rule will be applied to select the method that provides the most reliable measure of an arm’s length result. If the best method rule does not clearly indicate which method should be selected, an additional factor that may be taken into account in selecting a method is whether any of the competing methods produce results that are consistent with the results obtained from the appropriate application of another method. Further, in evaluating different applications of the same method, the fact that a second method (or another application of the first method) produces results that are consistent with one of the competing applications may be taken into account.

Deficiencies in the data used or assumptions made may have a greater effect on some methods than others. In particular, the reliability of some methods is heavily dependent on the similarity of property or services involved in the controlled and uncontrolled transaction. For certain other methods, such as the resale price method, the analysis of the extent to which controlled and uncontrolled taxpayers undertake the same or similar functions, employ similar resources, and bear similar risks is particularly important. Finally, under other methods, such as the profit split method, defining the relevant business activity and appropriate allocation of costs, income, and assets may be of particular importance. Therefore, a difference between the controlled and uncontrolled transactions for which an accurate adjustment cannot be made may have a greater effect on the reliability of the results derived under one method than the results derived under another method. For example, differences in management efficiency may have a greater effect on a comparable profits method analysis than on a comparable uncontrolled price method analysis, while differences in product characteristics will ordinarily have a greater effect on a comparable uncontrolled price method analysis than on a comparable profits method analysis.

Whether a controlled transaction produces an arm’s length result is generally evaluated by comparing the results of that transaction to results realized by uncontrolled taxpayers engaged in comparable transactions under comparable circumstances. For this purpose, the comparability of transactions and circumstances must be evaluated considering all factors that could affect prices or profits in arm’s length dealings (comparability factors). While a specific comparability factor may be of particular importance in applying a method, each method requires analysis of all of the factors that affect comparability under that method. Such factors include the following – (i) Functions; (ii) Contractual terms; (iii) Risks; (iv) Economic conditions; and (v) Property or services.

In order to be considered comparable to a controlled transaction, an uncontrolled transaction need not be identical to the controlled transaction, but must be sufficiently similar that it provides a reliable measure of an arm’s length result. If there are material differences between the controlled and uncontrolled transactions, adjustments must be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results. For purposes of this section, a material difference is one that would materially affect the measure of an arm’s length result under the method being applied. If adjustments for material differences cannot be made, the uncontrolled transaction may be used as a measure of an arm’s length result, but the reliability of the analysis will be reduced. Generally, such adjustments must be made to the results of the uncontrolled comparable and must be based on commercial practices, economic principles, or statistical analyses. The extent and reliability of any adjustments will affect the relative reliability of the analysis. See § 1.482-1(c)(1) (Best method rule). In any event, unadjusted industry average returns themselves cannot establish arm’s length results.

The comparability factors listed in § 1.482-1(d)(1) are discussed in this section. Each of these factors must be considered in determining the degree of comparability between transactions or taxpayers and the extent to which comparability adjustments may be necessary. In addition, in certain cases involving special circumstances, the rules under paragraph (d)(4) of this section must be considered.

Determining the degree of comparability between controlled and uncontrolled transactions requires a comparison of the functions performed, and associated resources employed, by the taxpayers in each transaction. This comparison is based on a functional analysis that identifies and compares the economically significant activities undertaken, or to be undertaken, by the taxpayers in both controlled and uncontrolled transactions. A functional analysis should also include consideration of the resources that are employed, or to be employed, in conjunction with the activities undertaken, including consideration of the type of assets used, such as plant and equipment, or the use of valuable intangibles. A functional analysis is not a pricing method and does not itself determine the arm’s length result for the controlled transaction under review. Functions that may need to be accounted for in determining the comparability of two transactions include – (A) Research and development; (B) Product design and engineering; (C) Manufacturing, production and process engineering; (D) Product fabrication, extraction, and assembly; (E) Purchasing and materials management; (F) Marketing and distribution functions, including inventory management, warranty administration, and advertising activities; (G) Transportation and warehousing; and (H) Managerial, legal, accounting and finance, credit and collection, training, and personnel management services.

Determining the degree of comparability between the controlled and uncontrolled transactions requires a comparison of the significant contractual terms that could affect the results of the two transactions. These terms include – (1) The form of consideration charged or paid; (2) Sales or purchase volume; (3) The scope and terms of warranties provided; (4) Rights to updates, revisions or modifications; (5) The duration of relevant license, contract or other agreements, and termination or renegotiation rights; (6) Collateral transactions or ongoing business relationships between the buyer and the seller, including arrangements for the provision of ancillary or subsidiary services; and (7) Extension of credit and payment terms. Thus, for example, if the time for payment of the amount charged in a controlled transaction differs from the time for payment of the amount charged in an uncontrolled transaction, an adjustment to reflect the difference in payment terms should be made if such difference would have a material effect on price. Such comparability adjustment is required even if no interest would be allocated or imputed under § 1.482-2(a) or other applicable provisions of the Internal Revenue Code or regulations.

The contractual terms, including the consequent allocation of risks, that are agreed to in writing before the transactions are entered into will be respected if such terms are consistent with the economic substance of the underlying transactions. In evaluating economic substance, greatest weight will be given to the actual conduct of the parties, and the respective legal rights of the parties (see, for example, § 1.482-4(f)(3) (Ownership of intangible property)). If the contractual terms are inconsistent with the economic substance of the underlying transaction, the district director may disregard such terms and impute terms that are consistent with the economic substance of the transaction.

In the absence of a written agreement, the district director may impute a contractual agreement between the controlled taxpayers consistent with the economic substance of the transaction. In determining the economic substance of the transaction, greatest weight will be given to the actual conduct of the parties and their respective legal rights (see, for example, § 1.482-4(f)(3) (Ownership of intangible property)). For example, if, without a written agreement, a controlled taxpayer operates at full capacity and regularly sells all of its output to another member of its controlled group, the district director may impute a purchasing contract from the course of conduct of the controlled taxpayers, and determine that the producer bears little risk that the buyer will fail to purchase its full output. Further, if an established industry convention or usage of trade assigns a risk or resolves an issue, that convention or usage will be followed if the conduct of the taxpayers is consistent with it. See UCC 1-205. For example, unless otherwise agreed, payment generally is due at the time and place at which the buyer is to receive goods. See UCC 2-310.

The following examples illustrate this paragraph (d)(3)(ii).

Differences in volume. USP, a United States agricultural exporter, regularly buys transportation services from FSub, its foreign subsidiary, to ship its products from the United States to overseas markets. Although FSub occasionally provides transportation services to URA, an unrelated domestic corporation, URA accounts for only 10% of the gross revenues of FSub, and the remaining 90% of FSub’s gross revenues are attributable to FSub’s transactions with USP. In determining the degree of comparability between FSub’s uncontrolled transaction with URA and its controlled transaction with USP, the difference in volumes involved in the two transactions and the regularity with which these services are provided must be taken into account if such difference would have a material effect on the price charged. Inability to make reliable adjustments for these differences would affect the reliability of the results derived from the uncontrolled transaction as a measure of the arm’s length result.

Reliability of adjustment for differences in volume. (i) FS manufactures product XX and sells that product to its parent corporation, P. FS also sells product XX to uncontrolled taxpayers at a price of $100 per unit. Except for the volume of each transaction, the sales to P and to uncontrolled taxpayers take place under substantially the same economic conditions and contractual terms. In uncontrolled transactions, FS offers a 2% discount for quantities of 20 per order, and a 5% discount for quantities of 100 per order. If P purchases product XX in quantities of 60 per order, in the absence of other reliable information, it may reasonably be concluded that the arm’s length price to P would be $100, less a discount of 3.5%. (ii) If P purchases product XX in quantities of 1,000 per order, a reliable estimate of the appropriate volume discount must be based on proper economic or statistical analysis, not necessarily a linear extrapolation from the 2% and 5% catalog discounts applicable to sales of 20 and 100 units, respectively.

Contractual terms imputed from economic substance. (i) FP, a foreign producer of wristwatches, is the registered holder of the YY trademark in the United States and in other countries worldwide. In year 1, FP enters the United States market by selling YY wristwatches to its newly organized United States subsidiary, USSub, for distribution in the United States market. USSub pays FP a fixed price per wristwatch. USSub and FP undertake, without separate compensation, marketing activities to establish the YY trademark in the United States market. Unrelated foreign producers of trademarked wristwatches and their authorized United States distributors respectively undertake similar marketing activities in independent arrangements involving distribution of trademarked wristwatches in the United States market. In years 1 through 6, USSub markets and sells YY wristwatches in the United States. Further, in years 1 through 6, USSub undertakes incremental marketing activities in addition to the activities similar to those observed in the independent distribution transactions in the United States market. FP does not directly or indirectly compensate USSub for performing these incremental activities during years 1 through 6. Assume that, aside from these incremental activities, and after any adjustments are made to improve the reliability of the comparison, the price paid per wristwatch by the independent, authorized distributors of wristwatches would provide the most reliable measure of the arm’s length price paid per YY wristwatch by USSub. (ii) By year 7, the wristwatches with the YY trademark generate a premium return in the United States market, as compared to wristwatches marketed by the independent distributors. In year 7, substantially all the premium return from the YY trademark in the United States market is attributed to FP, for example through an increase in the price paid per watch by USSub, or by some other means. (iii) In determining whether an allocation of income is appropriate in year 7, the Commissioner may consider the economic substance of the arrangements between USSub and FP, and the parties’ course of conduct throughout their relationship. Based on this analysis, the Commissioner determines that it is unlikely that, ex ante, an uncontrolled taxpayer operating at arm’s length would engage in the incremental marketing activities to develop or enhance intangible property owned by another party unless it received contemporaneous compensation or otherwise had a reasonable anticipation of receiving a future benefit from those activities. In this case, USSub’s undertaking the incremental marketing activities in years 1 through 6 is a course of conduct that is inconsistent with the parties’ attribution to FP in year 7 of substantially all the premium return from the enhanced YY trademark in the United States market. Therefore, the Commissioner may impute one or more agreements between USSub and FP, consistent with the economic substance of their course of conduct, which would afford USSub an appropriate portion of the premium return from the YY trademark wristwatches. For example, the Commissioner may impute a separate services agreement that affords USSub contingent-payment compensation for its incremental marketing activities in years 1 through 6, which benefited FP by contributing to the value of the trademark owned by FP. In the alternative, the Commissioner may impute a long-term, exclusive agreement to exploit the YY trademark in the United States that allows USSub to benefit from the incremental marketing activities it performed. As another alternative, the Commissioner may require FP to compensate USSub for terminating USSub’s imputed long-term, exclusive agreement to exploit the YY trademark in the United States, an agreement that USSub made more valuable at its own expense and risk. The taxpayer may present additional facts that could indicate which of these or other alternative agreements best reflects the economic substance of the underlying transactions, consistent with the parties’ course of conduct in the particular case.

Contractual terms imputed from economic substance. (i) FP, a foreign producer of athletic gear, is the registered holder of the AA trademark in the United States and in other countries worldwide. In year 1, FP enters into a licensing agreement that affords its newly organized United States subsidiary, USSub, exclusive rights to certain manufacturing and marketing intangible property (including the AA trademark) for purposes of manufacturing and marketing athletic gear in the United States under the AA trademark. The contractual terms of this agreement obligate USSub to pay FP a royalty based on sales, and also obligate both FP and USSub to undertake without separate compensation specified types and levels of marketing activities. Unrelated foreign businesses license independent United States businesses to manufacture and market athletic gear in the United States, using trademarks owned by the unrelated foreign businesses. The contractual terms of these uncontrolled transactions require the licensees to pay royalties based on sales of the merchandise, and obligate the licensors and licensees to undertake without separate compensation specified types and levels of marketing activities. In years 1 through 6, USSub manufactures and sells athletic gear under the AA trademark in the United States. Assume that, after adjustments are made to improve the reliability of the comparison for any material differences relating to marketing activities, manufacturing or marketing intangible property, and other comparability factors, the royalties paid by independent licensees would provide the most reliable measure of the arm’s length royalty owed by USSub to FP, apart from the additional facts in paragraph (ii) of this Example 4. (ii) In years 1 through 6, USSub performs incremental marketing activities with respect to the AA trademark athletic gear, in addition to the activities required under the terms of the license agreement with FP, that are also incremental as compared to those observed in the comparables. FP does not directly or indirectly compensate USSub for performing these incremental activities during years 1 through 6. By year 7, AA trademark athletic gear generates a premium return in the United States, as compared to similar athletic gear marketed by independent licensees. In year 7, USSub and FP enter into a separate services agreement under which FP agrees to compensate USSub on a cost basis for the incremental marketing activities that USSub performed during years 1 through 6, and to compensate USSub on a cost basis for any incremental marketing activities it may perform in year 7 and subsequent years. In addition, the parties revise the license agreement executed in year 1, and increase the royalty to a level that attributes to FP substantially all the premium return from sales of the AA trademark athletic gear in the United States. (iii) In determining whether an allocation of income is appropriate in year 7, the Commissioner may consider the economic substance of the arrangements between USSub and FP and the parties’ course of conduct throughout their relationship. Based on this analysis, the Commissioner determines that it is unlikely that, ex ante, an uncontrolled taxpayer operating at arm’s length would engage in the incremental marketing activities to develop or enhance intangible property owned by another party unless it received contemporaneous compensation or otherwise had a reasonable anticipation of a future benefit. In this case, USSub’s undertaking the incremental marketing activities in years 1 through 6 is a course of conduct that is inconsistent with the parties’ adoption in year 7 of contractual terms by which FP compensates USSub on a cost basis for the incremental marketing activities that it performed. Therefore, the Commissioner may impute one or more agreements between USSub and FP, consistent with the economic substance of their course of conduct, which would afford USSub an appropriate portion of the premium return from the AA trademark athletic gear. For example, the Commissioner may impute a separate services agreement that affords USSub contingent-payment compensation for the incremental activities it performed during years 1 through 6, which benefited FP by contributing to the value of the trademark owned by FP. In the alternative, the Commissioner may impute a long-term, exclusive United States license agreement that allows USSub to benefit from the incremental activities. As another alternative, the Commissioner may require FP to compensate USSub for terminating USSub’s imputed long-term United States license agreement, a license that USSub made more valuable at its own expense and risk. The taxpayer may present additional facts that could indicate which of these or other alternative agreements best reflects the economic substance of the underlying transactions, consistent with the parties’ course of conduct in this particular case.

Non-arm’s length compensation. (i) The facts are the same as in paragraph (i) of Example 4. As in Example 4, assume that, after adjustments are made to improve the reliability of the comparison for any material differences relating to marketing activities, manufacturing or marketing intangible property, and other comparability factors, the royalties paid by independent licensees would provide the most reliable measure of the arm’s length royalty owed by USSub to FP, apart from the additional facts described in paragraph (ii) of this Example 5. (ii) In years 1 through 4, USSub performs certain incremental marketing activities with respect to the AA trademark athletic gear, in addition to the activities required under the terms of the basic license agreement, that are also incremental as compared with those activities observed in the comparables. At the start of year 1, FP enters into a separate services agreement with USSub, which states that FP will compensate USSub quarterly, in an amount equal to specified costs plus X%, for these incremental marketing functions. Further, these written agreements reflect the intent of the parties that USSub receive such compensation from FP throughout the term of the agreement, without regard to the success or failure of the promotional activities. During years 1 through 4, USSub performs marketing activities pursuant to the separate services agreement and in each year USSub receives the specified compensation from FP on a cost of services plus basis. (iii) In evaluating year 4, the Commissioner performs an analysis of independent parties that perform promotional activities comparable to those performed by USSub and that receive separately-stated compensation on a current basis without contingency. The Commissioner determines that the magnitude of the specified cost plus X% is outside the arm’s length range in each of years 1 through 4. Based on an evaluation of all the facts and circumstances, the Commissioner makes an allocation to require payment of compensation to USSub for the promotional activities performed in year 4, based on the median of the interquartile range of the arm’s length markups charged by the uncontrolled comparables described in paragraph (e)(3) of this section. (iv) Given that based on facts and circumstances, the terms agreed by the controlled parties were that FP would bear all risks associated with the promotional activities performed by USSub to promote the AA trademark product in the United States market, and given that the parties’ conduct during the years examined was consistent with this allocation of risk, the fact that the cost of services plus markup on USSub’s services was outside the arm’s length range does not, without more, support imputation of additional contractual terms based on alternative views of the economic substance of the transaction, such as terms indicating that USSub, rather than FP, bore the risk associated with these activities.

Contractual terms imputed from economic substance. (i) Company X is a member of a controlled group that has been in operation in the pharmaceutical sector for many years. In years 1 through 4, Company X undertakes research and development activities. As a result of those activities, Company X developed a compound that may be more effective than existing medications in the treatment of certain conditions. (ii) Company Y is acquired in year 4 by the controlled group that includes Company X. Once Company Y is acquired, Company X makes available to Company Y a large amount of technical data concerning the new compound, which Company Y uses to register patent rights with respect to the compound in several jurisdictions, making Company Y the legal owner of such patents. Company Y then enters into licensing agreements with group members that afford Company Y 100% of the premium return attributable to use of the intangible property by its subsidiaries. (iii) In determining whether an allocation is appropriate in year 4, the Commissioner may consider the economic substance of the arrangements between Company X and Company Y, and the parties’ course of conduct throughout their relationship. Based on this analysis, the Commissioner determines that it is unlikely that an uncontrolled taxpayer operating at arm’s length would make available the results of its research and development or perform services that resulted in transfer of valuable know how to another party unless it received contemporaneous compensation or otherwise had a reasonable anticipation of receiving a future benefit from those activities. In this case, Company X’s undertaking the research and development activities and then providing technical data and know-how to Company Y in year 4 is inconsistent with the registration and subsequent exploitation of the patent by Company Y. Therefore, the Commissioner may impute one or more agreements between Company X and Company Y consistent with the economic substance of their course of conduct, which would afford Company X an appropriate portion of the premium return from the patent rights. For example, the Commissioner may impute a separate services agreement that affords Company X contingent-payment compensation for its services in year 4 for the benefit of Company Y, consisting of making available to Company Y technical data, know-how, and other fruits of research and development conducted in previous years. These services benefited Company Y by giving rise to and contributing to the value of the patent rights that were ultimately registered by Company Y. In the alternative, the Commissioner may impute a transfer of patentable intangible property rights from Company X to Company Y immediately preceding the registration of patent rights by Company Y. The taxpayer may present additional facts that could indicate which of these or other alternative agreements best reflects the economic substance of the underlying transactions, consistent with the parties’ course of conduct in the particular case.

Determining the degree of comparability between controlled and uncontrolled transactions requires a comparison of the significant risks that could affect the prices that would be charged or paid, or the profit that would be earned, in the two transactions. Relevant risks to consider include – (1) Market risks, including fluctuations in cost, demand, pricing, and inventory levels; (2) Risks associated with the success or failure of research and development activities; (3) Financial risks, including fluctuations in foreign currency rates of exchange and interest rates; (4) Credit and collection risks; (5) Product liability risks; and (6) General business risks related to the ownership of property, plant, and equipment.

In general, the determination of which controlled taxpayer bears a particular risk will be made in accordance with the provisions of § 1.482-1(d)(3)(ii)(B) (Identifying contractual terms). Thus, the allocation of risks specified or implied by the taxpayer’s contractual terms will generally be respected if it is consistent with the economic substance of the transaction. An allocation of risk between controlled taxpayers after the outcome of such risk is known or reasonably knowable lacks economic substance. In considering the economic substance of the transaction, the following facts are relevant – (1) Whether the pattern of the controlled taxpayer’s conduct over time is consistent with the purported allocation of risk between the controlled taxpayers; or where the pattern is changed, whether the relevant contractual arrangements have been modified accordingly; (2) Whether a controlled taxpayer has the financial capacity to fund losses that might be expected to occur as the result of the assumption of a risk, or whether, at arm’s length, another party to the controlled transaction would ultimately suffer the consequences of such losses; and (3) The extent to which each controlled taxpayer exercises managerial or operational control over the business activities that directly influence the amount of income or loss realized. In arm’s length dealings, parties ordinarily bear a greater share of those risks over which they have relatively more control.

The following examples illustrate this paragraph (d)(3)(iii).

FD, the wholly-owned foreign distributor of USM, a U.S. manufacturer, buys widgets from USM under a written contract. Widgets are a generic electronic appliance. Under the terms of the contract, FD must buy and take title to 20,000 widgets for each of the five years of the contract at a price of $10 per widget. The widgets will be sold under FD’s label, and FD must finance any marketing strategies to promote sales in the foreign market. There are no rebate or buy back provisions. FD has adequate financial capacity to fund its obligations under the contract under any circumstances that could reasonably be expected to arise. In Years 1, 2 and 3, FD sold only 10,000 widgets at a price of $11 per unit. In Year 4, FD sold its entire inventory of widgets at a price of $25 per unit. Since the contractual terms allocating market risk were agreed to before the outcome of such risk was known or reasonably knowable, FD had the financial capacity to bear the market risk that it would be unable to sell all of the widgets it purchased currently, and its conduct was consistent over time, FD will be deemed to bear the risk.

The facts are the same as in Example 1, except that in Year 1 FD had only $100,000 in total capital, including loans. In subsequent years USM makes no additional contributions to the capital of FD, and FD is unable to obtain any capital through loans from an unrelated party. Nonetheless, USM continues to sell 20,000 widgets annually to FD under the terms of the contract, and USM extends credit to FD to enable it to finance the purchase. FD does not have the financial capacity in Years 1, 2 and 3 to finance the purchase of the widgets given that it could not sell most of the widgets it purchased during those years. Thus, notwithstanding the terms of the contract, USM and not FD assumed the market risk that a substantial portion of the widgets could not be sold, since in that event FD would not be able to pay USM for all of the widgets it purchased.

S, a Country X corporation, manufactures small motors that it sells to P, its U.S. parent. P incorporates the motors into various products and sells those products to uncontrolled customers in the United States. The contract price for the motors is expressed in U.S. dollars, effectively allocating the currency risk for these transactions to S for any currency fluctuations between the time the contract is signed and payment is made. As long as S has adequate financial capacity to bear this currency risk (including by hedging all or part of the risk) and the conduct of S and P is consistent with the terms of the contract (i.e., the contract price is not adjusted to reflect exchange rate movements), the agreement of the parties to allocate the exchange risk to S will be respected.

USSub is the wholly-owned U.S. subsidiary of FP, a foreign manufacturer. USSub acts as a distributor of goods manufactured by FP. FP and USSub execute an agreement providing that FP will bear any ordinary product liability costs arising from defects in the goods manufactured by FP. In practice, however, when ordinary product liability claims are sustained against USSub and FP, USSub pays the resulting damages. Therefore, the district director disregards the contractual arrangement regarding product liability costs between FP and USSub, and treats the risk as having been assumed by USSub.

Determining the degree of comparability between controlled and uncontrolled transactions requires a comparison of the significant economic conditions that could affect the prices that would be charged or paid, or the profit that would be earned in each of the transactions. These factors include – (A) The similarity of geographic markets; (B) The relative size of each market, and the extent of the overall economic development in each market; (C) The level of the market (e.g., wholesale, retail, etc.); (D) The relevant market shares for the products, properties, or services transferred or provided; (E) The location-specific costs of the factors of production and distribution; (F) The extent of competition in each market with regard to the property or services under review; (G) The economic condition of the particular industry, including whether the market is in contraction or expansion; and (H) The alternatives realistically available to the buyer and seller.

Evaluating the degree of comparability between controlled and uncontrolled transactions requires a comparison of the property or services transferred in the transactions. This comparison may include any intangible property that is embedded in tangible property or services being transferred (embedded intangibles). The comparability of the embedded intangibles will be analyzed using the factors listed in § 1.482-4(c)(2)(iii)(B)(1) (comparable intangible property). The relevance of product comparability in evaluating the relative reliability of the results will depend on the method applied. For guidance concerning the specific comparability considerations applicable to transfers of tangible and intangible property and performance of services, see §§ 1.482-3 through 1.482-6 and § 1.482-9; see also §§ 1.482-3(f), 1.482-4(f)(4), and 1.482-9(m), dealing with the coordination of intangible and tangible property and performance of services rules.

In certain circumstances, taxpayers may adopt strategies to enter new markets or to increase a product’s share of an existing market (market share strategy). Such a strategy would be reflected by temporarily increased market development expenses or resale prices that are temporarily lower than the prices charged for comparable products in the same market. Whether or not the strategy is reflected in the transfer price depends on which party to the controlled transaction bears the costs of the pricing strategy. In any case, the effect of a market share strategy on a controlled transaction will be taken into account only if it can be shown that an uncontrolled taxpayer engaged in a comparable strategy under comparable circumstances for a comparable period of time, and the taxpayer provides documentation that substantiates the following – (A) The costs incurred to implement the market share strategy are borne by the controlled taxpayer that would obtain the future profits that result from the strategy, and there is a reasonable likelihood that the strategy will result in future profits that reflect an appropriate return in relation to the costs incurred to implement it; (B) The market share strategy is pursued only for a period of time that is reasonable, taking into consideration the industry and product in question; and (C) The market share strategy, the related costs and expected returns, and any agreement between the controlled taxpayers to share the related costs, were established before the strategy was implemented.

Uncontrolled comparables ordinarily should be derived from the geographic market in which the controlled taxpayer operates, because there may be significant differences in economic conditions in different markets. If information from the same market is not available, an uncontrolled comparable derived from a different geographic market may be considered if adjustments are made to account for differences between the two markets. If information permitting adjustments for such differences is not available, then information derived from uncontrolled comparables in the most similar market for which reliable data is available may be used, but the extent of such differences may affect the reliability of the method for purposes of the best method rule. For this purpose, a geographic market is any geographic area in which the economic conditions for the relevant product or service are substantially the same, and may include multiple countries, depending on the economic conditions.

The following example illustrates this paragraph (d)(4)(ii).

Manuco, a wholly-owned foreign subsidiary of P, a U.S. corporation, manufactures products in Country Z for sale to P. No uncontrolled transactions are located that would provide a reliable measure of the arm’s length result under the comparable uncontrolled price method. The district director considers applying the cost plus method or the comparable profits method. Information on uncontrolled taxpayers performing comparable functions under comparable circumstances in the same geographic market is not available. Therefore, adjusted data from uncontrolled manufacturers in other markets may be considered in order to apply the cost plus method. In this case, comparable uncontrolled manufacturers are found in the United States. Accordingly, data from the comparable U.S. uncontrolled manufacturers, as adjusted to account for differences between the United States and Country Z’s geographic market, is used to test the arm’s length price paid by P to Manuco. However, the use of such data may affect the reliability of the results for purposes of the best method rule. See § 1.482-1(c).

If an uncontrolled taxpayer operates in a different geographic market than the controlled taxpayer, adjustments may be necessary to account for significant differences in costs attributable to the geographic markets. These adjustments must be based on the effect such differences would have on the consideration charged or paid in the controlled transaction given the relative competitive positions of buyers and sellers in each market. Thus, for example, the fact that the total costs of operating in a controlled manufacturer’s geographic market are less than the total costs of operating in other markets ordinarily justifies higher profits to the manufacturer only if the cost differences would increase the profits of comparable uncontrolled manufacturers operating at arm’s length, given the competitive positions of buyers and sellers in that market.

The following example illustrates the principles of this paragraph (d)(4)(ii)(C).

Couture, a U.S. apparel design corporation, contracts with Sewco, its wholly owned Country Y subsidiary, to manufacture its clothes. Costs of operating in Country Y are significantly lower than the operating costs in the United States. Although clothes with the Couture label sell for a premium price, the actual production of the clothes does not require significant specialized knowledge that could not be acquired by actual or potential competitors to Sewco at reasonable cost. Thus, Sewco’s functions could be performed by several actual or potential competitors to Sewco in geographic markets that are similar to Country Y. Thus, the fact that production is less costly in Country Y will not, in and of itself, justify additional profits derived from lower operating costs in Country Y inuring to Sewco, because the competitive positions of the other actual or potential producers in similar geographic markets capable of performing the same functions at the same low costs indicate that at arm’s length such profits would not be retained by Sewco.

Transactions ordinarily will not constitute reliable measures of an arm’s length result for purposes of this section if – (1) They are not made in the ordinary course of business; or (2) One of the principal purposes of the uncontrolled transaction was to establish an arm’s length result with respect to the controlled transaction.

The following examples illustrate the principle of this paragraph (d)(4)(iii).

Not in the ordinary course of business. USP, a United States manufacturer of computer software, sells its products to FSub, its foreign distributor in country X. Compco, a United States competitor of USP, also sells its products in X through unrelated distributors. However, in the year under review, Compco is forced into bankruptcy, and Compco liquidates its inventory by selling all of its products to unrelated distributors in X for a liquidation price. Because the sale of its entire inventory was not a sale in the ordinary course of business, Compco’s sale cannot be used as an uncontrolled comparable to determine USP’s arm’s length result from its controlled transaction.

USP, a United States manufacturer of farm machinery, sells its products to FSub, its wholly-owned distributor in Country Y. USP, operating at nearly full capacity, sells 95% of its inventory to FSub. To make use of its excess capacity, and also to establish a comparable uncontrolled price for its transfer price to FSub, USP increases its production to full capacity. USP sells its excess inventory to Compco, an unrelated foreign distributor in Country X. Country X has approximately the same economic conditions as that of Country Y. Because one of the principal purposes of selling to Compco was to establish an arm’s length price for its controlled transactions with FSub, USP’s sale to Compco cannot be used as an uncontrolled comparable to determine USP’s arm’s length result from its controlled transaction.

In some cases, application of a pricing method will produce a single result that is the most reliable measure of an arm’s length result. In other cases, application of a method may produce a number of results from which a range of reliable results may be derived. A taxpayer will not be subject to adjustment if its results fall within such range (arm’s length range).

The arm’s length range is ordinarily determined by applying a single pricing method selected under the best method rule to two or more uncontrolled transactions of similar comparability and reliability. Use of more than one method may be appropriate for the purposes described in paragraph (c)(2)(iii) of this section (Best method rule).

Uncontrolled comparables must be selected based upon the comparability criteria relevant to the method applied and must be sufficiently similar to the controlled transaction that they provide a reliable measure of an arm’s length result. If material differences exist between the controlled and uncontrolled transactions, adjustments must be made to the results of the uncontrolled transaction if the effect of such differences on price or profits can be ascertained with sufficient accuracy to improve the reliability of the results. See § 1.482-1(d)(2) (Standard of comparability). The arm’s length range will be derived only from those uncontrolled comparables that have, or through adjustments can be brought to, a similar level of comparability and reliability, and uncontrolled comparables that have a significantly lower level of comparability and reliability will not be used in establishing the arm’s length range.

The arm’s length range will consist of the results of all of the uncontrolled comparables that meet the following conditions: the information on the controlled transaction and the uncontrolled comparables is sufficiently complete that it is likely that all material differences have been identified, each such difference has a definite and reasonably ascertainable effect on price or profit, and an adjustment is made to eliminate the effect of each such difference.

If there are no uncontrolled comparables described in paragraph (e)(2)(iii)(A) of this section, the arm’s length range is derived from the results of all the uncontrolled comparables, selected pursuant to paragraph (e)(2)(ii) of this section, that achieve a similar level of comparability and reliability. In such cases the reliability of the analysis must be increased, where it is possible to do so, by adjusting the range through application of a valid statistical method to the results of all of the uncontrolled comparables so selected. The reliability of the analysis is increased when statistical methods are used to establish a range of results in which the limits of the range will be determined such that there is a 75 percent probability of a result falling above the lower end of the range and a 75 percent probability of a result falling below the upper end of the range. The interquartile range ordinarily provides an acceptable measure of this range; however a different statistical method may be applied if it provides a more reliable measure.

For purposes of this section, the interquartile range is the range from the 25th to the 75th percentile of the results derived from the uncontrolled comparables. For this purpose, the 25th percentile is the lowest result derived from an uncontrolled comparable such that at least 25 percent of the results are at or below the value of that result. However, if exactly 25 percent of the results are at or below a result, then the 25th percentile is equal to the average of that result and the next higher result derived from the uncontrolled comparables. The 75th percentile is determined analogously.

If the results of a controlled transaction fall outside the arm’s length range, the district director may make allocations that adjust the controlled taxpayer’s result to any point within the arm’s length range. If the interquartile range is used to determine the arm’s length range, such adjustment will ordinarily be to the median of all the results. The median is the 50th percentile of the results, which is determined in a manner analogous to that described in paragraph (e)(2)(iii)(C) of this section (Interquartile range). In other cases, an adjustment normally will be made to the arithmetic mean of all the results. See § 1.482-1(f)(2)(iii)(D) for determination of an adjustment when a controlled taxpayer’s result for a multiple year period falls outside an arm’s length range consisting of the average results of uncontrolled comparables over the same period.

The rules of this paragraph (e) do not require that the district director establish an arm’s length range prior to making an allocation under section 482. Thus, for example, the district director may properly propose an allocation on the basis of a single comparable uncontrolled price if the comparable uncontrolled price method, as described in § 1.482-3(b), has been properly applied. However, if the taxpayer subsequently demonstrates that the results claimed on its income tax return are within the range established by additional equally reliable comparable uncontrolled prices in a manner consistent with the requirements set forth in § 1.482-1(e)(2)(iii), then no allocation will be made.

The following examples illustrate the principles of this paragraph (e).

Selection of comparables. (i) To evaluate the arm’s length result of a controlled transaction between USSub, the United States taxpayer under review, and FP, its foreign parent, the district director considers applying the resale price method. The district director identifies ten potential uncontrolled transactions. The distributors in all ten uncontrolled transactions purchase and resell similar products and perform similar functions to those of USSub. (ii) Data with respect to three of the uncontrolled transactions is very limited, and although some material differences can be identified and adjusted for, the level of comparability of these three uncontrolled comparables is significantly lower than that of the other seven. Further, of those seven, adjustments for the identified material differences can be reliably made for only four of the uncontrolled transactions. Therefore, pursuant to § 1.482-1(e)(2)(ii) only these four uncontrolled comparables may be used to establish an arm’s length range.

Arm’s length range consists of all the results. (i) The facts are the same as in Example 1. Applying the resale price method to the four uncontrolled comparables, and making adjustments to the uncontrolled comparables pursuant to § 1.482-1(d)(2), the district director derives the following results: Comparable Result (price) 1 $44.00 2 45.00 3 45.00 4 45.50 (ii) The district director determines that data regarding the four uncontrolled transactions is sufficiently complete and accurate so that it is likely that all material differences between the controlled and uncontrolled transactions have been identified, such differences have a definite and reasonably ascertainable effect, and appropriate adjustments were made for such differences. Accordingly, if the resale price method is determined to be the best method pursuant to § 1.482-1(c), the arm’s length range for the controlled transaction will consist of the results of all of the uncontrolled comparables, pursuant to paragraph (e)(2)(iii)(A) of this section. Thus, the arm’s length range in this case would be the range from $44 to $45.50.

Arm’s length range limited to interquartile range. (i) The facts are the same as in Example 2, except in this case there are some product and functional differences between the four uncontrolled comparables and USSub. However, the data is insufficiently complete to determine the effect of the differences. Applying the resale price method to the four uncontrolled comparables, and making adjustments to the uncontrolled comparables pursuant to § 1.482-1(d)(2), the district director derives the following results: Uncontrolled comparable Result (price) 1 $42.00 2 44.00 3 45.00 4 47.50 (ii) It cannot be established in this case that all material differences are likely to have been identified and reliable adjustments made for those differences. Accordingly, if the resale price method is determined to be the best method pursuant to § 1.482-1(c), the arm’s length range for the controlled transaction must be established pursuant to paragraph (e)(2)(iii)(B) of this section. In this case, the district director uses the interquartile range to determine the arm’s length range, which is the range from $43 to $46.25. If USSub’s price falls outside this range, the district director may make an allocation. In this case that allocation would be to the median of the results, or $44.50.

Arm’s length range limited to interquartile range. (i) To evaluate the arm’s length result of controlled transactions between USP, a United States manufacturing company, and FSub, its foreign subsidiary, the district director considers applying the comparable profits method. The district director identifies 50 uncontrolled taxpayers within the same industry that potentially could be used to apply the method. (ii) Further review indicates that only 20 of the uncontrolled manufacturers engage in activities requiring similar capital investments and technical know-how. Data with respect to five of the uncontrolled manufacturers is very limited, and although some material differences can be identified and adjusted for, the level of comparability of these five uncontrolled comparables is significantly lower than that of the other 15. In addition, for those five uncontrolled comparables it is not possible to accurately allocate costs between the business activity associated with the relevant transactions and other business activities. Therefore, pursuant to § 1.482-1(e)(2)(ii) only the other fifteen uncontrolled comparables may be used to establish an arm’s length range. (iii) Although the data for the fifteen remaining uncontrolled comparables is relatively complete and accurate, there is a significant possibility that some material differences may remain. The district director has determined, for example, that it is likely that there are material differences in the level of technical expertise or in management efficiency. Accordingly, if the comparable profits method is determined to be the best method pursuant to § 1.482-1(c), the arm’s length range for the controlled transaction may be established only pursuant to paragraph (e)(2)(iii)(B) of this section.

The authority to determine true taxable income extends to any case in which either by inadvertence or design the taxable income, in whole or in part, of a controlled taxpayer is other than it would have been had the taxpayer, in the conduct of its affairs, been dealing at arm’s length with an uncontrolled taxpayer.

In making allocations under section 482, the district director is not restricted to the case of improper accounting, to the case of a fraudulent, colorable, or sham transaction, or to the case of a device designed to reduce or avoid tax by shifting or distorting income, deductions, credits, or allowances.

The district director may make an allocation under section 482 even if the income ultimately anticipated from a series of transactions has not been or is never realized. For example, if a controlled taxpayer sells a product at less than an arm’s length price to a related taxpayer in one taxable year and the second controlled taxpayer resells the product to an unrelated party in the next taxable year, the district director may make an appropriate allocation to reflect an arm’s length price for the sale of the product in the first taxable year, even though the second controlled taxpayer had not realized any gross income from the resale of the product in the first year. Similarly, if a controlled taxpayer lends money to a related taxpayer in a taxable year, the district director may make an appropriate allocation to reflect an arm’s length charge for interest during such taxable year even if the second controlled taxpayer does not realize income during such year. Finally, even if two controlled taxpayers realize an overall loss that is attributable to a particular controlled transaction, an allocation under section 482 is not precluded.

The following example illustrates this paragraph (f)(1)(ii).

USSub is a U.S. subsidiary of FP, a foreign corporation. Parent manufactures product X and sells it to USSub. USSub functions as a distributor of product X to unrelated customers in the United States. The fact that FP may incur a loss on the manufacture and sale of product X does not by itself establish that USSub, dealing with FP at arm’s length, also would incur a loss. An independent distributor acting at arm’s length with its supplier would in many circumstances be expected to earn a profit without regard to the level of profit earned by the supplier.

If necessary to prevent the avoidance of taxes or to clearly reflect income, the district director may make an allocation under section 482 with respect to transactions that otherwise qualify for nonrecognition of gain or loss under applicable provisions of the Internal Revenue Code (such as section 351 or 1031).

The following example illustrates this paragraph (f)(1)(iii).

(i) In Year 1 USP, a United States corporation, bought 100 shares of UR, an unrelated corporation, for $100,000. In Year 2, when the value of the UR stock had decreased to $40,000, USP contributed all 100 shares of UR stock to its wholly-owned subsidiary in exchange for subsidiary’s capital stock. In Year 3, the subsidiary sold all of the UR stock for $40,000 to an unrelated buyer, and on its U.S. income tax return, claimed a loss of $60,000 attributable to the sale of the UR stock. USP and its subsidiary do not file a consolidated return. (ii) In determining the true taxable income of the subsidiary, the district director may disallow the loss of $60,000 on the ground that the loss was incurred by USP. National Securities Corp. v Commissioner, 137 F.2d 600 (3rd Cir. 1943), cert. denied, 320 U.S. 794 (1943).

Section 482 and the regulations thereunder apply to all controlled taxpayers, whether the controlled taxpayer files a separate or consolidated U.S. income tax return. If a controlled taxpayer files a separate return, its true separate taxable income will be determined. If a controlled taxpayer is a party to a consolidated return, the true consolidated taxable income of the affiliated group and the true separate taxable income of the controlled taxpayer must be determined consistently with the principles of a consolidated return.

The following rules must be taken into account in determining the true taxable income of a controlled taxpayer.

For further guidance see § 1.482-1T(f)(2)(i)(A) through (E).

The Commissioner will evaluate the results of a transaction as actually structured by the taxpayer unless its structure lacks economic substance. However, the Commissioner may consider the alternatives available to the taxpayer in determining whether the terms of the controlled transaction would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under comparable circumstances. In such cases the Commissioner may adjust the consideration charged in the controlled transaction based on the cost or profit of an alternative as adjusted to account for material differences between the alternative and the controlled transaction, but will not restructure the transaction as if the alternative had been adopted by the taxpayer. See paragraph (d)(3) of this section (factors for determining comparability; contractual terms and risk); §§ 1.482-3(e), 1.482-4(d), and 1.482-9(h) (unspecified methods).

For further guidance see § 1.482-1T(f)(2)(ii)(B).

The results of a controlled transaction ordinarily will be compared with the results of uncontrolled comparables occurring in the taxable year under review. It may be appropriate, however, to consider data relating to the uncontrolled comparables or the controlled taxpayer for one or more years before or after the year under review. If data relating to uncontrolled comparables from multiple years is used, data relating to the controlled taxpayer for the same years ordinarily must be considered. However, if such data is not available, reliable data from other years, as adjusted under paragraph (d)(2) (Standard of comparability) of this section may be used.

The extent to which it is appropriate to consider multiple year data depends on the method being applied and the issue being addressed. Circumstances that may warrant consideration of data from multiple years include the extent to which complete and accurate data are available for the taxable year under review, the effect of business cycles in the controlled taxpayer’s industry, or the effects of life cycles of the product or intangible property being examined. Data from one or more years before or after the taxable year under review must ordinarily be considered for purposes of applying the provisions of paragraph (d)(3)(iii) of this section (risk), paragraph (d)(4)(i) of this section (market share strategy), § 1.482-4(f)(2) (periodic adjustments), § 1.482-5 (comparable profits method), § 1.482-9(f) (comparable profits method for services), and § 1.482-9(i) (contingent-payment contractual terms for services). On the other hand, multiple year data ordinarily will not be considered for purposes of applying the comparable uncontrolled price method of § 1.482-3(b) or the comparable uncontrolled services price method of § 1.482-9(c) (except to the extent that risk or market share strategy issues are present).

Data from multiple years may be considered to determine whether the same economic conditions that caused the controlled taxpayer’s results had a comparable effect over a comparable period of time on the uncontrolled comparables that establish the arm’s length range. For example, given that uncontrolled taxpayers enter into transactions with the ultimate expectation of earning a profit, persistent losses among controlled taxpayers may be an indication of non-arm’s length dealings. Thus, if a controlled taxpayer that realizes a loss with respect to a controlled transaction seeks to demonstrate that the loss is within the arm’s length range, the district director may take into account data from taxable years other than the taxable year of the transaction to determine whether the loss was attributable to arm’s length dealings. The rule of this paragraph (f)(2)(iii)(C) is illustrated by Example 3 of paragraph (f)(2)(iii)(E) of this section.

If a comparison of a controlled taxpayer’s average result over a multiple year period with the average results of uncontrolled comparables over the same period would reduce the effect of short-term variations that may be unrelated to transfer pricing, it may be appropriate to establish a range derived from the average results of uncontrolled comparables over a multiple year period to determine if an adjustment should be made. In such a case the district director may make an adjustment if the controlled taxpayer’s average result for the multiple year period is not within such range. Such a range must be determined in accordance with § 1.482-1(e) (Arm’s length range). An adjustment in such a case ordinarily will be equal to the difference, if any, between the controlled taxpayer’s result for the taxable year and the mid-point of the uncontrolled comparables’ results for that year. If the interquartile range is used to determine the range of average results for the multiple year period, such adjustment will ordinarily be made to the median of all the results of the uncontrolled comparables for the taxable year. See Example 2 of § 1.482-5(e). In other cases, the adjustment normally will be made to the arithmetic mean of all the results of the uncontrolled comparables for the taxable year. However, an adjustment will be made only to the extent that it would move the controlled taxpayer’s multiple year average closer to the arm’s length range for the multiple year period or to any point within such range. In determining a controlled taxpayer’s average result for a multiple year period, adjustments made under this section for prior years will be taken into account only if such adjustments have been finally determined, as described in § 1.482-1(g)(2)(iii). See Example 3 of § 1.482-5(e).

The following examples, in which S and P are controlled taxpayers, illustrate this paragraph (f)(2)(iii). Examples 1 and 4 also illustrate the principle of the arm’s length range of paragraph (e) of this section.

P sold product Z to S for $60 per unit in 1995. Applying the resale price method to data from uncontrolled comparables for the same year establishes an arm’s length range of prices for the controlled transaction from $52 to $59 per unit. Since the price charged in the controlled transaction falls outside the range, the district director would ordinarily make an allocation under section 482. However, in this case there are cyclical factors that affect the results of the uncontrolled comparables (and that of the controlled transaction) that cannot be adequately accounted for by specific adjustments to the data for 1995. Therefore, the district director considers results over multiple years to account for these factors. Under these circumstances, it is appropriate to average the results of the uncontrolled comparables over the years 1993, 1994, and 1995 to determine an arm’s length range. The averaged results establish an arm’s length range of $56 to $58 per unit. For consistency, the results of the controlled taxpayers must also be averaged over the same years. The average price in the controlled transaction over the three years is $57. Because the controlled transfer price of product Z falls within the arm’s length range, the district director makes no allocation.

(i) FP, a Country X corporation, designs and manufactures machinery in Country X. FP’s costs are incurred in Country X currency. USSub is the exclusive distributor of FP’s machinery in the United States. The price of the machinery sold by FP to USSub is expressed in Country X currency. Thus, USSub bears all of the currency risk associated with fluctuations in the exchange rate between the time the contract is signed and the payment is made. The prices charged by FP to USSub for 1995 are under examination. In that year, the value of the dollar depreciated against the currency of Country X, and as a result, USSub’s gross margin was only 8%. (ii) UD is an uncontrolled distributor of similar machinery that performs distribution functions substantially the same as those performed by USSub, except that UD purchases and resells machinery in transactions where both the purchase and resale prices are denominated in U.S. dollars. Thus, UD had no currency exchange risk. UD’s gross margin in 1995 was 10%. UD’s average gross margin for the period 1990 to 1998 has been 12%. (iii) In determining whether the price charged by FP to USSub in 1995 was arm’s length, the district director may consider USSub’s average gross margin for an appropriate period before and after 1995 to determine whether USSub’s average gross margin during the period was sufficiently greater than UD’s average gross margin during the same period such that USSub was sufficiently compensated for the currency risk it bore throughout the period. See § 1.482– 1(d)(3)(iii) (Risk).

FP manufactures product X in Country M and sells it to USSub, which distributes X in the United States. USSub realizes losses with respect to the controlled transactions in each of five consecutive taxable years. In each of the five consecutive years a different uncontrolled comparable realized a loss with respect to comparable transactions equal to or greater than USSub’s loss. Pursuant to paragraph (f)(3)(iii)(C) of this section, the district director examines whether the uncontrolled comparables realized similar losses over a comparable period of time, and finds that each of the five comparables realized losses in only one of the five years, and their average result over the five-year period was a profit. Based on this data, the district director may conclude that the controlled taxpayer’s results are not within the arm’s length range over the five year period, since the economic conditions that resulted in the controlled taxpayer’s loss did not have a comparable effect over a comparable period of time on the uncontrolled comparables.

(i) USP, a U.S. corporation, manufactures product Y in the United States and sells it to FSub, which acts as USP’s exclusive distributor of product Y in Country N. The resale price method described in § 1.482-3(c) is used to evaluate whether the transfer price charged by USP to FSub for the 1994 taxable year for product Y was arm’s length. For the period 1992 through 1994, FSub had a gross profit margin for each year of 13%. A, B, C and D are uncontrolled distributors of products that compete directly with product Y in country N. After making appropriate adjustments in accordance with §§ 1.482-1(d)(2) and 1.482-3(c), the gross profit margins for A, B, C, and D are as follows: 1992 1993 1994 Average A 13 3 8 8.00 B 11 13 2 8.67 7C 4 7 13 8.00 7D 7 9 6 7.33 (ii) Applying the provisions of § 1.482-1(e), the district director determines that the arm’s length range of the average gross profit margins is between 7.33 and 8.67. The district director concludes that FSub’s average gross margin of 13% is not within the arm’s length range, despite the fact that C’s gross profit margin for 1994 was also 13%, since the economic conditions that caused S’s result did not have a comparable effect over a comparable period of time on the results of C or the other uncontrolled comparables. In this case, the district director makes an allocation equivalent to adjusting FSub’s gross profit margin for 1994 from 13% to the mean of the uncontrolled comparables’ results for 1994 (7.25%).

The methods described in §§ 1.482-2 through 1.482-6 are generally stated in terms of individual transactions. However, because a taxpayer may have controlled transactions involving many different products, or many separate transactions involving the same product, it may be impractical to analyze every individual transaction to determine its arm’s length price. In such cases, it is permissible to evaluate the arm’s length results by applying the appropriate methods to the overall results for product lines or other groupings. In addition, the arm’s length results of all related party transactions entered into by a controlled taxpayer may be evaluated by employing sampling and other valid statistical techniques.

In evaluating whether the result of a controlled transaction is arm’s length, it is not necessary for the district director to determine whether the method or procedure that a controlled taxpayer employs to set the terms for its controlled transactions corresponds to the method or procedure that might have been used by a taxpayer dealing at arm’s length with an uncontrolled taxpayer. Rather, the district director will evaluate the result achieved rather than the method the taxpayer used to determine its prices.

The following example illustrates this paragraph (f)(2)(v).

(i) FS is a foreign subsidiary of P, a U.S. corporation. P manufactures and sells household appliances. FS operates as P’s exclusive distributor in Europe. P annually establishes the price for each of its appliances sold to FS as part of its annual budgeting, production allocation and scheduling, and performance evaluation processes. FS’s aggregate gross margin earned in its distribution business is 18%. (ii) ED is an uncontrolled European distributor of competing household appliances. After adjusting for minor differences in the level of inventory, volume of sales, and warranty programs conducted by FS and ED, ED’s aggregate gross margin is also 18%. Thus, the district director may conclude that the aggregate prices charged by P for its appliances sold to FS are arm’s length, without determining whether the budgeting, production, and performance evaluation processes of P are similar to such processes used by ED.

The district director will take into account appropriate collateral adjustments with respect to allocations under section 482. Appropriate collateral adjustments may include correlative allocations, conforming adjustments, and setoffs, as described in this paragraph (g).

When the district director makes an allocation under section 482 (referred to in this paragraph (g)(2) as the primary allocation), appropriate correlative allocations will also be made with respect to any other member of the group affected by the allocation. Thus, if the district director makes an allocation of income, the district director will not only increase the income of one member of the group, but correspondingly decrease the income of the other member. In addition, where appropriate, the district director may make such further correlative allocations as may be required by the initial correlative allocation.

The district director will furnish to the taxpayer with respect to which the primary allocation is made a written statement of the amount and nature of the correlative allocation. The correlative allocation must be reflected in the documentation of the other member of the group that is maintained for U.S. tax purposes, without regard to whether it affects the U.S. income tax liability of the other member for any open year. In some circumstances the allocation will have an immediate U.S. tax effect, by changing the taxable income computation of the other member (or the taxable income computation of a shareholder of the other member, for example, under the provisions of subpart F of the Internal Revenue Code). Alternatively, the correlative allocation may not be reflected on any U.S. tax return until a later year, for example when a dividend is paid.

For purposes of this paragraph (g)(2), a primary allocation will not be considered to have been made (and therefore, correlative allocations are not required to be made) until the date of a final determination with respect to the allocation under section 482. For this purpose, a final determination includes – (A) Assessment of tax following execution by the taxpayer of a Form 870 (Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment) with respect to such allocation; (B) Acceptance of a Form 870-AD (Offer of Waiver of Restriction on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment); (C) Payment of the deficiency; (D) Stipulation in the Tax Court of the United States; or (E) Final determination of tax liability by offer-in-compromise, closing agreement, or final resolution (determined under the principles of section 7481) of a judicial proceeding.

The following examples illustrate this paragraph (g)(2). In each example, X and Y are members of the same group of controlled taxpayers and each regularly computes its income on a calendar year basis.

(i) In 1996, Y, a U.S. corporation, rents a building owned by X, also a U.S. corporation. In 1998 the district director determines that Y did not pay an arm’s length rental charge. The district director proposes to increase X’s income to reflect an arm’s length rental charge. X consents to the assessment reflecting such adjustment by executing Form 870, a Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment. The assessment of the tax with respect to the adjustment is made in 1998. Thus, the primary allocation, as defined in paragraph (g)(2)(i) of this section, is considered to have been made in 1998. (ii) The adjustment made to X’s income under section 482 requires a correlative allocation with respect to Y’s income. The district director notifies X in writing of the amount and nature of the adjustment made with respect to Y. Y had net operating losses in 1993, 1994, 1995, 1996, and 1997. Although a correlative adjustment will not have an effect on Y’s U.S. income tax liability for 1996, an adjustment increasing Y’s net operating loss for 1996 will be made for purposes of determining Y’s U.S. income tax liability for 1998 or a later taxable year to which the increased net operating loss may be carried.

(i) In 1995, X, a U.S. construction company, provided engineering services to Y, a U.S. corporation, in the construction of Y’s factory. In 1997, the district director determines that the fees paid by Y to X for its services were not arm’s length and proposes to make an adjustment to the income of X. X consents to an assessment reflecting such adjustment by executing Form 870. An assessment of the tax with respect to such adjustment is made in 1997. The district director notifies X in writing of the amount and nature of the adjustment to be made with respect to Y. (ii) The fees paid by Y for X’s engineering services properly constitute a capital expenditure. Y does not place the factory into service until 1998. Therefore, a correlative adjustment increasing Y’s basis in the factory does not affect Y’s U.S. income tax liability for 1997. However, the correlative adjustment must be made in the books and records maintained by Y for its U.S. income tax purposes and such adjustment will be taken into account in computing Y’s allowable depreciation or gain or loss on a subsequent disposition of the factory.

In 1995, X, a U.S. corporation, makes a loan to Y, its foreign subsidiary not engaged in a U.S. trade or business. In 1997, the district director, upon determining that the interest charged on the loan was not arm’s length, proposes to adjust X’s income to reflect an arm’s length interest rate. X consents to an assessment reflecting such allocation by executing Form 870, and an assessment of the tax with respect to the section 482 allocation is made in 1997. The district director notifies X in writing of the amount and nature of the correlative allocation to be made with respect to Y. Although the correlative adjustment does not have an effect on Y’s U.S. income tax liability, the adjustment must be reflected in the documentation of Y that is maintained for U.S. tax purposes. Thus, the adjustment must be reflected in the determination of the amount of Y’s earnings and profits for 1995 and subsequent years, and the adjustment must be made to the extent it has an effect on any person’s U.S. income tax liability for any taxable year.

Appropriate adjustments must be made to conform a taxpayer’s accounts to reflect allocations made under section 482. Such adjustments may include the treatment of an allocated amount as a dividend or a capital contribution (as appropriate), or, in appropriate cases, pursuant to such applicable revenue procedures as may be provided by the Commissioner (see § 601.601(d)(2) of this chapter), repayment of the allocated amount without further income tax consequences.

The following example illustrates the principles of this paragraph (g)(3).

Conforming cash accounts. (i) USD, a United States corporation, buys Product from its foreign parent, FP. In reviewing USD’s income tax return, the district director determines that the arm’s length price would have increased USD’s taxable income by $5 million. The district director accordingly adjusts USD’s income to reflect its true taxable income. (ii) To conform its cash accounts to reflect the section 482 allocation made by the district director, USD applies for relief under Rev. Proc. 65-17, 1965-1 C.B. 833 (see § 601.601(d)(2)(ii)(b) of this chapter), to treat the $5 million adjustment as an account receivable from FP, due as of the last day of the year of the transaction, with interest accruing therefrom.

If an allocation is made under section 482 with respect to a transaction between controlled taxpayers, the Commissioner will take into account the effect of any other non-arm’s length transaction between the same controlled taxpayers in the same taxable year which will result in a setoff against the original section 482 allocation. Such setoff, however, will be taken into account only if the requirements of paragraph (g)(4)(ii) of this section are satisfied. If the effect of the setoff is to change the characterization or source of the income or deductions, or otherwise distort taxable income, in such a manner as to affect the U.S. tax liability of any member, adjustments will be made to reflect the correct amount of each category of income or deductions. For purposes of this setoff provision, the term arm’s length refers to the amount defined in paragraph (b) of this section (arm’s length standard), without regard to the rules in § 1.482-2(a) that treat certain interest rates as arm’s length rates of interest.

The district director will take a setoff into account only if the taxpayer – (A) Establishes that the transaction that is the basis of the setoff was not at arm’s length and the amount of the appropriate arm’s length charge; (B) Documents, pursuant to paragraph (g)(2) of this section, all correlative adjustments resulting from the proposed setoff; and (C) Notifies the district director of the basis of any claimed setoff within 30 days after the earlier of the date of a letter by which the district director transmits an examination report notifying the taxpayer of proposed adjustments or the date of the issuance of the notice of deficiency.

The following examples illustrate this paragraph (g)(4).

P, a U.S. corporation, renders construction services to S, its foreign subsidiary in Country Y, in connection with the construction of S’s factory. An arm’s length charge for such services determined under § 1.482-9 would be $100,000. During the same taxable year P makes available to S the use of a machine to be used in the construction of the factory, and the arm’s length rental value of the machine is $25,000. P bills S $125,000 for the services, but does not charge S for the use of the machine. No allocation will be made with respect to the undercharge for the machine if P notifies the district director of the basis of the claimed setoff within 30 days after the date of the letter from the district director transmitting the examination report notifying P of the proposed adjustment, establishes that the excess amount charged for services was equal to an arm’s length charge for the use of the machine and that the taxable income and income tax liabilities of P are not distorted, and documents the correlative allocations resulting from the proposed setoff.

The facts are the same as in Example 1, except that, if P had reported $25,000 as rental income and $25,000 less as service income, it would have been subject to the tax on personal holding companies. Allocations will be made to reflect the correct amounts of rental income and service income.

The district director will take into account the effect of a foreign legal restriction to the extent that such restriction affects the results of transactions at arm’s length. Thus, a foreign legal restriction will be taken into account only to the extent that it is shown that the restriction affected an uncontrolled taxpayer under comparable circumstances for a comparable period of time. In the absence of evidence indicating the effect of the foreign legal restriction on uncontrolled taxpayers, the restriction will be taken into account only to the extent provided in paragraphs (h)(2) (iii) and (iv) of this section (Deferred income method of accounting).

Foreign legal restrictions (whether temporary or permanent) will be taken into account for purposes of this paragraph (h)(2) only if, and so long as, the conditions set forth in paragraphs (h)(2)(ii) (A) through (D) of this section are met. (A) The restrictions are publicly promulgated, generally applicable to all similarly situated persons (both controlled and uncontrolled), and not imposed as part of a commercial transaction between the taxpayer and the foreign sovereign; (B) The taxpayer (or other member of the controlled group with respect to which the restrictions apply) has exhausted all remedies prescribed by foreign law or practice for obtaining a waiver of such restrictions (other than remedies that would have a negligible prospect of success if pursued); (C) The restrictions expressly prevented the payment or receipt, in any form, of part or all of the arm’s length amount that would otherwise be required under section 482 (for example, a restriction that applies only to the deductibility of an expense for tax purposes is not a restriction on payment or receipt for this purpose); and (D) The related parties subject to the restriction did not engage in any arrangement with controlled or uncontrolled parties that had the effect of circumventing the restriction, and have not otherwise violated the restriction in any material respect.

If a foreign legal restriction prevents the payment or receipt of part or all of the arm’s length amount that is due with respect to a controlled transaction, the restricted amount may be treated as deferrable if the following requirements are met – (A) The controlled taxpayer establishes to the satisfaction of the district director that the payment or receipt of the arm’s length amount was prevented because of a foreign legal restriction and circumstances described in paragraph (h)(2)(ii) of this section; and (B) The controlled taxpayer whose U.S. tax liability may be affected by the foreign legal restriction elects the deferred income method of accounting, as described in paragraph (h)(2)(iv) of this section, on a written statement attached to a timely U.S. income tax return (or an amended return) filed before the IRS first contacts any member of the controlled group concerning an examination of the return for the taxable year to which the foreign legal restriction applies. A written statement furnished by a taxpayer subject to the Coordinated Examination Program will be considered an amended return for purposes of this paragraph (h)(2)(iii)(B) if it satisfies the requirements of a qualified amended return for purposes of § 1.6664-2(c)(3) as set forth in those regulations or as the Commissioner may prescribe by applicable revenue procedures. The election statement must identify the affected transactions, the parties to the transactions, and the applicable foreign legal restrictions.

If the requirements of paragraph (h)(2)(ii) of this section are satisfied, any portion of the arm’s length amount, the payment or receipt of which is prevented because of applicable foreign legal restrictions, will be treated as deferrable until payment or receipt of the relevant item ceases to be prevented by the foreign legal restriction. For purposes of the deferred income method of accounting under this paragraph (h)(2)(iv), deductions (including the cost or other basis of inventory and other assets sold or exchanged) and credits properly chargeable against any amount so deferred, are subject to deferral under the provisions of § 1.461– 1(a)(4). In addition, income is deferrable under this deferred income method of accounting only to the extent that it exceeds the related deductions already claimed in open taxable years to which the foreign legal restriction applied.

The following examples, in which Sub is a Country FC subsidiary of U.S. corporation, Parent, illustrate this paragraph (h)(2).

Parent licenses an intangible to Sub. FC law generally prohibits payments by any person within FC to recipients outside the country. The FC law meets the requirements of paragraph (h)(2)(ii) of this section. There is no evidence of unrelated parties entering into transactions under comparable circumstances for a comparable period of time, and the foreign legal restrictions will not be taken into account in determining the arm’s length amount. The arm’s length royalty rate for the use of the intangible property in the absence of the foreign restriction is 10% of Sub’s sales in country FC. However, because the requirements of paragraph (h)(2)(ii) of this section are satisfied, Parent can elect the deferred income method of accounting by attaching to its timely filed U.S. income tax return a written statement that satisfies the requirements of paragraph (h)(2)(iii)(B) of this section.

(i) The facts are the same as in Example 1, except that Sub, although it makes no royalty payment to Parent, arranges with an unrelated intermediary to make payments equal to an arm’s length amount on its behalf to Parent. (ii) The district director makes an allocation of royalty income to Parent, based on the arm’s length royalty rate of 10%. Further, the district director determines that because the arrangement with the third party had the effect of circumventing the FC law, the requirements of paragraph (h)(2)(ii)(D) of this section are not satisfied. Thus, Parent could not validly elect the deferred income method of accounting, and the allocation of royalty income cannot be treated as deferrable. In appropriate circumstances, the district director may permit the amount of the distribution to be treated as payment by Sub of the royalty allocated to Parent, under the provisions of § 1.482-1(g) (Collateral adjustments).

The facts are the same as in Example 1, except that the laws of FC do not prevent distributions from corporations to their shareholders. Sub distributes an amount equal to 8% of its sales in country FC. Because the laws of FC did not expressly prevent all forms of payment from Sub to Parent, Parent cannot validly elect the deferred income method of accounting with respect to any of the arm’s length royalty amount. In appropriate circumstances, the district director may permit the 8% that was distributed to be treated as payment by Sub of the royalty allocated to Parent, under the provisions of § 1.482-1(g) (Collateral adjustments).

The facts are the same as in Example 1, except that Country FC law permits the payment of a royalty, but limits the amount to 5% of sales, and Sub pays the 5% royalty to Parent. Parent demonstrates the existence of a comparable uncontrolled transaction for purposes of the comparable uncontrolled transaction method in which an uncontrolled party accepted a royalty rate of 5%. Given the evidence of the comparable uncontrolled transaction, the 5% royalty rate is determined to be the arm’s length royalty rate.

If a possessions corporation makes an election under section 936(h)(5)(C)(i)(I), the corporation must make a section 936 cost sharing payment that is at least equal to the payment that would be required under section 482 if the electing corporation were a foreign corporation. In determining the payment that would be required under section 482 for this purpose, the provisions of §§ 1.482-1 and 1.482-4 will be applied, and to the extent relevant to the valuation of intangibles, §§ 1.482-5 and 1.482-6 will be applied. The provisions of section 936(h)(5)(C)(i)(II) (Effect of Election – electing corporation treated as owner of intangible property) do not apply until the payment that would be required under section 482 has been determined.

A cost sharing payment, for the purposes of section 936(h)(5)(C)(i)(I), is calculated using the provisions of section 936 and the regulations thereunder and the provisions of this paragraph (h)(3). The provisions relating to cost sharing under section 482 do not apply to payments made pursuant to an election under section 936(h)(5)(C)(i)(I). Similarly, a profit split payment, for the purposes of section 936(h)(5)(C)(ii)(I), is calculated using the provisions of section 936 and the regulations thereunder, not section 482 and the regulations thereunder.

The definitions set forth in paragraphs (i)(1) through (i)(10) of this section apply to this section and §§ 1.482-2 through 1.482-9. (1) Organization includes an organization of any kind, whether a sole proprietorship, a partnership, a trust, an estate, an association, or a corporation (as each is defined or understood in the Internal Revenue Code or the regulations thereunder), irrespective of the place of organization, operation, or conduct of the trade or business, and regardless of whether it is a domestic or foreign organization, whether it is an exempt organization, or whether it is a member of an affiliated group that files a consolidated U.S. income tax return, or a member of an affiliated group that does not file a consolidated U.S. income tax return. (2) Trade or business includes a trade or business activity of any kind, regardless of whether or where organized, whether owned individually or otherwise, and regardless of the place of operation. Employment for compensation will constitute a separate trade or business from the employing trade or business. (3) Taxpayer means any person, organization, trade or business, whether or not subject to any internal revenue tax. (4) Controlled includes any kind of control, direct or indirect, whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. It is the reality of the control that is decisive, not its form or the mode of its exercise. A presumption of control arises if income or deductions have been arbitrarily shifted. (5) Controlled taxpayer means any one of two or more taxpayers owned or controlled directly or indirectly by the same interests, and includes the taxpayer that owns or controls the other taxpayers. Uncontrolled taxpayer means any one of two or more taxpayers not owned or controlled directly or indirectly by the same interests. (6) Group, controlled group, and group of controlled taxpayers mean the taxpayers owned or controlled directly or indirectly by the same interests. (7) Transaction means any sale, assignment, lease, license, loan, advance, contribution, or any other transfer of any interest in or a right to use any property (whether tangible or intangible, real or personal) or money, however such transaction is effected, and whether or not the terms of such transaction are formally documented. A transaction also includes the performance of any services for the benefit of, or on behalf of, another taxpayer. (8) Controlled transaction or controlled transfer means any transaction or transfer between two or more members of the same group of controlled taxpayers. The term uncontrolled transaction means any transaction between two or more taxpayers that are not members of the same group of controlled taxpayers. (9) True taxable income means, in the case of a controlled taxpayer, the taxable income that would have resulted had it dealt with the other member or members of the group at arm’s length. It does not mean the taxable income resulting to the controlled taxpayer by reason of the particular contract, transaction, or arrangement the controlled taxpayer chose to make (even though such contract, transaction, or arrangement is legally binding upon the parties thereto). (10) Uncontrolled comparable means the uncontrolled transaction or uncontrolled taxpayer that is compared with a controlled transaction or taxpayer under any applicable pricing methodology. Thus, for example, under the comparable profits method, an uncontrolled comparable is any uncontrolled taxpayer from which data is used to establish a comparable operating profit.

(1) The regulations in this are generally effective for taxable years beginning after October 6, 1994. (2) Taxpayers may elect to apply retroactively all of the provisions of these regulations for any open taxable year. Such election will be effective for the year of the election and all subsequent taxable years. (3) Although these regulations are generally effective for taxable years as stated, the final sentence of section 482 (requiring that the income with respect to transfers or licenses of intangible property be commensurate with the income attributable to the intangible) is generally effective for taxable years beginning after December 31, 1986. For the period prior to the effective date of these regulations, the final sentence of section 482 must be applied using any reasonable method not inconsistent with the statute. The IRS considers a method that applies these regulations or their general principles to be a reasonable method. (4) These regulations will not apply with respect to transfers made or licenses granted to foreign persons before November 17, 1985, or before August 17, 1986, for transfers or licenses to others. Nevertheless, they will apply with respect to transfers or licenses before such dates if, with respect to property transferred pursuant to an earlier and continuing transfer agreement, such property was not in existence or owned by the taxpayer on such date. (5) The last sentences of paragraphs (b)(2)(i) and (c)(1) of this section and of paragraph (c)(2)(iv) of § 1.482-5 apply for taxable years beginning on or after August 26, 2003. (6) (i) The provisions of paragraphs (a)(1), (d)(3)(ii)(C) Example 3, Example 4, Example 5, and Example 6, (d)(3)(v), (f)(2)(ii)(A), (f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii), and (i) of this section are generally applicable for taxable years beginning after July 31, 2009. The provision of paragraph (b)(2)(iii) of this section is generally applicable on January 5, 2009. (ii) A person may elect to apply the provisions of paragraphs (a)(1), (b)(2)(i), (d)(3)(ii)(C) Example 3, Example 4, Example 5, and Example 6, (d)(3)(v), (f)(2)(ii)(A), (f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii), and (i) of this section to earlier taxable years in accordance with the rules set forth in § 1.482-9(n)(2). (7) [Reserved]. For further guidance see § 1.482-1T(j)(7).

(a) through (f) (2) [Reserved]. For further guidance see § 1.482-1(a) through (f)(2).

All value provided between controlled taxpayers in a controlled transaction requires an arm’s length amount of compensation determined under the best method rule of § 1.482-1(c). Such amount must be consistent with, and must account for all of, the value provided between the parties in the transaction, without regard to the form or character of the transaction. For this purpose, it is necessary to consider the entire arrangement between the parties, as determined by the contractual terms, whether written or imputed in accordance with the economic substance of the arrangement, in light of the actual conduct of the parties. See, e.g., § 1.482-1(d)(3)(ii)(B) (identifying contractual terms) and (f)(2)(ii)(A) (regarding reference to realistic alternatives).

The combined effect of two or more separate transactions (whether before, during, or after the year under review), including for purposes of an analysis under multiple provisions of the Code or regulations, may be considered if the transactions, taken as a whole, are so interrelated that an aggregate analysis of the transactions provides the most reliable measure of an arm’s length result determined under the best method rule of § 1.482-1(c). Whether two or more transactions are evaluated separately or in the aggregate depends on the extent to which the transactions are economically interrelated and on the relative reliability of the measure of an arm’s length result provided by an aggregate analysis of the transactions as compared to a separate analysis of each transaction. For example, consideration of the combined effect of two or more transactions may be appropriate to determine whether the overall compensation in the transactions is consistent with the value provided, including any synergies among items and services provided.

Consistent with the principles of paragraphs (f)(2)(i)(A) and (B) of this section, a coordinated best method analysis and evaluation of two or more controlled transactions to which one or more provisions of the Code or regulations apply may be necessary to ensure that the overall value provided, including any synergies, is properly taken into account. A coordinated best method analysis would include a consistent consideration of the facts and circumstances of the functions performed, resources employed, and risks assumed in the relevant transactions, and a consistent measure of the arm’s length results, for purposes of all relevant statutory and regulatory provisions.

In some cases, it may be necessary to allocate one or more portions of the arm’s length result that was properly determined under a coordinated best method analysis described in paragraph (f)(2)(i)(C) of this section. Any such allocation of the arm’s length result determined under the coordinated best method analysis must be made using the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result for each allocated amount. For example, if the full value of compensation due in controlled transactions whose tax treatment is governed by multiple provisions of the Code or regulations has been most reliably determined on an aggregate basis, then that full value must be allocated in a manner that provides the most reliable measure of each allocated amount.

The following examples illustrate the provisions of this paragraph (f)(2)(i). For purposes of the examples in this paragraph (E), P is a domestic corporation, and S1, S2, and S3 are foreign corporations that are wholly owned by P.

Aggregation of interrelated licensing, manufacturing, and selling activities. P enters into a license agreement with S1 that permits S1 to use a proprietary manufacturing process and to sell the output from this process throughout a specified region. S1 uses the manufacturing process and sells its output to S2, which in turn resells the output to uncontrolled parties in the specified region. In evaluating whether the royalty paid by S1 to P is an arm’s length amount, it may be appropriate to evaluate the royalty in combination with the transfer prices charged by S1 to S2 and the aggregate profits earned by S1 and S2 from the use of the manufacturing process and the sale to uncontrolled parties of the products produced by S1.

Aggregation of interrelated manufacturing, marketing, and services activities. S1 is the exclusive Country Z distributor of computers manufactured by P. S2 provides marketing services in connection with sales of P computers in Country Z and in this regard uses significant marketing intangibles provided by P. S3 administers the warranty program with respect to P computers in Country Z, including maintenance and repair services. In evaluating whether the transfer prices paid by S1 to P, the fees paid by S2 to P for the use of P marketing intangibles, and the service fees earned by S2 and S3 are arm’s length amounts, it would be appropriate to perform an aggregate analysis that considers the combined effects of these interrelated transactions if they are most reliably analyzed on an aggregated basis.

Aggregation and reliability of comparable uncontrolled transactions. The facts are the same as in Example 2. In addition, U1, U2, and U3 are uncontrolled taxpayers that carry out functions comparable to those of S1, S2, and S3, respectively, with respect to computers produced by unrelated manufacturers. R1, R2, and R3 constitute a controlled group of taxpayers (unrelated to the P controlled group) that carry out functions comparable to those of S1, S2, and S3 with respect to computers produced by their common parent. Prices charged to uncontrolled customers of the R group differ from the prices charged to customers of U1, U2, and U3. In determining whether the transactions of U1, U2, and U3, or the transactions of R1, R2, and R3, would provide a more reliable measure of the arm’s length result, it is determined that the interrelated R group transactions are more reliable than the wholly independent transactions of U1, U2, and U3, given the interrelationship of the P group transactions.

Non-aggregation of transactions that are not interrelated. P enters into a license agreement with S1 that permits S1 to use a proprietary process for manufacturing product X and to sell product X to uncontrolled parties throughout a specified region. P also sells to S1 product Y, which is manufactured by P in the United States and unrelated to product X. Product Y is resold by S1 to uncontrolled parties in the specified region. There is no connection between product X and product Y other than the fact that they are both sold in the same specified region. In evaluating whether the royalty paid by S1 to P for the use of the manufacturing process for product X and the transfer prices charged for unrelated product Y are arm’s length amounts, it would not be appropriate to consider the combined effects of these separate and unrelated transactions.

Aggregation of interrelated patents. P owns 10 individual patents that, in combination, can be used to manufacture and sell a successful product. P anticipates that it could earn profits of $25x from the patents based on a discounted cash flow analysis that provides a more reliable measure of the value of the patents exploited as a bundle rather than separately. P licenses all 10 patents to S1 to be exploited as a bundle. Evidence of uncontrolled licenses of similar individual patents indicates that, exploited separately, each license of each patent would warrant a price of $1x, implying a total price for the patents of $10x. Under paragraph (f)(2)(i)(B) of this section, in determining the arm’s length royalty for the license of the bundle of patents, it would not be appropriate to use the uncontrolled licenses as comparables for the license of the bundle of patents, because, unlike the discounted cash flow analysis, the uncontrolled licenses considered separately do not reliably reflect the enhancement to value resulting from the interrelatedness of the 10 patents exploited as a bundle.

Consideration of entire arrangement, including imputed contractual terms – (i) P conducts a business (“Business”) from the United States, with a worldwide clientele, but until Date X has no foreign operations. The success of Business significantly depends on intangibles (including marketing, manufacturing, technological, and goodwill or going concern value intangibles, collectively the “IP”), as well as ongoing support activities performed by P (including related research and development, central marketing, manufacturing process enhancement, and oversight activities, collectively “Support”), to maintain and improve the IP and otherwise maximize the profitability of Business. (ii) On Date X, Year 1, P contributes the foreign rights to conduct Business, including the foreign rights to the IP, to newly incorporated S1. S1, utilizing the IP of which it is now the owner, commences foreign operations consisting of local marketing, manufacturing, and back office activities in order to conduct and expand Business in the foreign market. (iii) Later, on Date Y, Year 1, P and S1 enter into a cost sharing arrangement (“CSA”) to develop and exploit the rights to conduct the Business. Under the CSA, P is entitled to the U.S. rights to conduct the Business, and S1 is entitled to the rest-of-the-world (“ROW”) rights to conduct the Business. P continues after Date Y to perform the Support, employing resources, capabilities, and rights that as a factual matter were not contributed to S1 in the Date X transaction, for the benefit of the Business worldwide. Pursuant to the CSA, P and S1 share the costs of P’s Support in proportion to their reasonably anticipated benefit shares from their respective rights to the Business. (iv) P treats the Date X transaction as a transfer described in section 351 that is subject to 367 and treats the Date Y transaction as the commencement of a CSA subject to section 482 and § 1.482-7. P takes the position that the only platform contribution transactions (“PCTs”) in connection with the Date Y CSA consist of P’s contribution of the U.S. Business IP rights and S1’s contribution of the ROW Business IP rights of which S1 had become the owner on account of the prior Date X transaction. (v) Pursuant to paragraph (f)(2)(i)(A) of this section, in determining whether an allocation of income is appropriate in Year 1 or subsequent years, the Commissioner may consider the economic substance of the entire arrangement between P and S1, including the parties’ actual conduct throughout their relationship, regardless of the form or character of the contractual arrangement the parties have expressly adopted. The Commissioner determines that the parties’ formal arrangement fails to reflect the full scope of the value provided between the parties in accordance with the economic substance of their arrangement. Therefore, the Commissioner may impute one or more agreements between P and S1, consistent with the economic substance of their arrangement, that fully reflect their respective reasonably anticipated commitments in terms of functions performed, resources employed, and risks assumed over time. For example, because P continues after Date Y to perform the Support, employing resources, capabilities, and rights not contributed to S1, for the benefit of the Business worldwide, the Commissioner may impute another PCT on Date Y pursuant to which P commits to so continuing the Support. See § 1.482-7(b)(1)(ii). The taxpayer may present additional facts that could indicate whether this or another alternative agreement best reflects the economic substance of the underlying transactions and course of conduct, provided that the taxpayer’s position fully reflects the value of the entire arrangement consistent with the realistic alternatives principle.

Distinguishing provision of value from characterization – (i) P developed a collection of resources, capabilities, and rights (“Collection”) that it uses on an interrelated basis in ongoing research and development of computer code that is used to create a successful line of software products. P can continue to use the Collection on such interrelated basis in the future to further develop computer code and, thus, further build on its successful line of software products. Under § 1.482-7(g)(2)(ix), P determines that the interquartile range of the net present value of its own use of the Collection in future research and development and software product marketing is between $1000x and $1100x, and this range provides the most reliable measure of the value to P of continuing to use the Collection on an interrelated basis in future research, development, and exploitation. Instead, P enters into an exchange described in section 351 in which it transfers certain intangible property related to the Collection to S1 for use in future research, development, and exploitation but continues to perform the same development functions that it did prior to the exchange, now on behalf of S1, under express or implied commitments in connection with S1’s use of the intangible property. P takes the position that a portion of the Collection, consisting of computer code and related instruction manuals and similar intangible property (Portion 1), was transferrable intangible property and was the subject of the section 351 exchange and compensable under section 367(d). P claims that another portion of the Collection consists of items that either do not constitute property for purposes of section 367 or are not transferrable (Portion 2). P then takes the position that the value of Portion 2 does not give rise to income under section 367(d) or gain under section 367(a). (ii) Under paragraphs (f)(2)(i)(A) and (C) of this section, any part of the value in Portion 2 that is not taken into account in an exchange under section 367 must nonetheless be evaluated under section 482 and the regulations thereunder to determine arm’s length compensation for any value provided to S1. Accordingly, even if P’s assertion that certain items were either not property or not capable of being transferred were correct, arm’s length compensation is nonetheless required for all of the value associated with P’s contributions under the section 482 regulations. Alternatively, the Commissioner may determine under all the facts and circumstances that P’s assertion is incorrect and that the transaction in fact constitutes an exchange of property subject to, and therefore to be taken into account under, section 367. Thus, whether any item that P identifies as being within Portion 2 is properly characterized as property under section 367 (transferable or otherwise) is irrelevant because any value in Portion 2 that is provided to S1 must be compensated by S1 in a manner consistent with the $1000x to $1100x interquartile range of the overall value.

Arm’s length compensation for equivalent provisions of intangibles under sections 351 and 482. P owns the worldwide rights to manufacturing and marketing intangibles that it uses to manufacture and market a product in the United States (“US intangibles”) and the rest of the world (“ROW intangibles”). P transfers all the ROW intangibles to S1 in an exchange described in section 351 and retains the US intangibles. Immediately after the exchange, P and S1 entered into a CSA described in § 1.482-7(b) that covers all research and development of intangibles conducted by the parties. A realistic alternative that was available to P and that would have involved the controlled parties performing similar functions, employing similar resources, and assuming similar risks as in the controlled transaction, was to transfer all ROW intangibles to S1 upon entering into the CSA in a platform contribution transaction described in § 1.482-7(c), rather than in an exchange described in section 351 immediately before entering into the CSA. Under paragraph (f)(2)(i)(A) of this section, the arm’s length compensation for the ROW intangibles must correspond to the value provided between the parties, regardless of the form of the transaction. Accordingly, the arm’s length compensation for the ROW intangibles is the same in both scenarios, and the analysis of the amount to be taken into account under section 367(d) pursuant to §§ 1.367(d)-1T(c) and 1.482-4 should include consideration of the amount that P would have charged for the realistic alternative determined under § 1.482-7(g) (and § 1.482-4, to the extent of any make-or-sell rights transferred). See §§ 1.482-1(b)(2)(iii) and 1.482-4(g).

Aggregation of interrelated manufacturing and marketing intangibles governed by different statutes and regulations. The facts are the same as in Example 8 except that P transfers only the ROW intangibles related to manufacturing to S1 in an exchange described in section 351 and, upon entering into the CSA, then transfers the ROW intangibles related to marketing to S1 in a platform contribution transaction described in § 1.482-7(c) (rather than transferring all ROW intangibles only upon entering into the CSA or only in a prior exchange described in section 351). The value of the ROW intangibles that P transferred in the two transactions is greater in the aggregate, due to synergies among the different types of ROW intangibles, than if valued as two separate transactions. Under paragraph (f)(2)(i)(B) of this section, the arm’s length standard requires these synergies to be taken into account in determining the arm’s length results for the transactions.

Services provided using intangibles. – (i) P’s worldwide group produces and markets Product X and subsequent generations of products, which result from research and development performed by P’s R&D Team. Through this collaboration with respect to P’s proprietary products, the members of the R&D Team have individually and as a group acquired specialized knowledge and expertise subject to non-disclosure agreements (collectively, “knowhow”). (ii) P arranges for the R&D Team to provide research and development services to create a new line of products, building on the Product X platform, to be owned and exploited by S1 in the overseas market. P asserts that the arm’s length charge for the services is only reimbursement to P of its associated R&D Team compensation costs. (iii) Even though P did not transfer the platform or the R&D Team to S1, P is providing value associated with the use of the platform, along with the value associated with the use of the knowhow, to S1 by way of the services performed by the R&D Team for S1 using the platform and the knowhow. The R&D Team’s use of intangible property, and any other valuable resources, in P’s provision of services (regardless of whether the service effects a transfer of intangible property or valuable resources and regardless of whether the property is relatively high or low value) must be evaluated under the section 482 regulations, including the regulations specifically applicable to controlled services transactions in § 1.482-9, to ensure that P receives arm’s length compensation for any value (attributable to such property or services) provided to S1 in a controlled transaction. See §§ 1.482-4 and 1.482-9(m). Under paragraph (f)(2)(i)(A) of this section, the arm’s length compensation for the services performed by the R&D Team for S1 must be consistent with the value provided to S1, including the value of the knowhow and any synergies with the platform. Under paragraphs (f)(2)(i)(B) and (C) of this section, the best method analysis may determine that the compensation is most reliably determined on an aggregate basis reflecting the interrelated value of the services and embedded value of the platform and knowhow. (iv) In the alternative, the facts are the same as above, except that P assigns to S1 all or a pertinent portion of the R&D Team and the relevant rights in the platform. P takes the position that, although the transferred platform rights must be compensated, the knowhow does not have substantial value independent of the services of any individual on the R&D Team and therefore is not an intangible within the meaning of § 1.482-4(b). In P’s view, S1 owes no compensation to P on account of the R&D Team, as S1 will directly bear the cost of the relevant R&D Team compensation. However, in assembling and arranging to assign the relevant R&D Team, and thereby making available the value of the knowhow to S1, rather than other employees without the knowhow, P is performing services for S1 under imputed contractual terms based on the parties’ course of conduct. Therefore, even if P’s position were correct that the knowhow is not an intangible under § 1.482-4(b), a position that the Commissioner may challenge, arm’s length compensation is required for all of the value that P provides to S1 through the interrelated provision of platform rights, knowhow, and services under paragraphs (f)(2)(i)(A), (B), and (C) of this section.

Allocating arm’s length compensation determined under an aggregate analysis – (i) P provides services to S1, which is incorporated in Country A. In connection with those services, P licenses intellectual property to S2, which is incorporated in Country B. S2 sublicenses the intellectual property to S1. (ii) Under paragraph (f)(2)(i)(B) of this section, if an aggregate analysis of the service and license transactions provides the most reliable measure of an arm’s length result, then an aggregate analysis must be performed. Under paragraph (f)(2)(i)(D) of this section, if an allocation of the value that results from such an aggregate analysis is necessary, for example, for purposes of sourcing the services income that P receives from S1 or determining deductible expenses incurred by S1, then the value determined under the aggregate analysis must be allocated using the method that provides the most reliable measure of the services income and deductible expenses.