“Caixa… S.A.” received an assessment of additional taxable income in which, among other things, the (lack of) interest on a loan granted to a subsidiary had been adjusted by the tax authorities. Caixa S.A. lodged an appeal with the Tribunal Central Administrativo Sul. Judgment of the Tribunal The Tribunal dismissed the appeal as regards the transfer pricing adjustment and upheld that part of the tax authorities’ assessment. Expert “It goes on to say that the discussion of the nature of the operation is innocuous in the context of the specific case. The fact is that “[t]here are various techniques by which practices can be employed to artificially increase interest expenses, so that they benefit from tax treatment that may be more favourable when compared to that of distributed profits. The first consists of checking the “reasonableness” of the amount of interest, refusing to deduct the excess against the objective criterion of at arm’s length interest. This is the technique used in Article 58 of the CIRC and Article 9 of the OECD Model Convention. A second technique operates at the level of the “qualification” of the underlying operation as credit or capital, given the circumstances of the specific case and is applied, for example, to “hybrid financial instruments” which have both credit and capital aspects, as is the case with profit-sharing bonds. In these circumstances, the authorities can, as part of their interpretation of treaties, laws and facts, ‘reclassify’ an apparently credit agreement as a capital contribution” [or vice versa] (9). This is what happened in this case, in which profits made by the applicant were artificially allocated to a subsidiary. The characteristic feature of indirect profit distribution is that an abnormal advantage is obtained. This presupposes, firstly, that an operation has been carried out which gives rise to an advantage and, secondly, that the advantage can be considered abnormal. “The operations do not translate into a direct, visible, apparent distribution of profits, but rather into operations that contribute to the formation of the company’s profit.” The advantage can be attributed either by the subsidiary company to another, which participates in its profits – in which case there is a hidden distribution of profits – or “be attributed, in the opposite direction, by the parent company to its subsidiary, in which case there is a hidden contribution, or it can be attributed to a third entity, linked by a triangular link”. The advantage can take two forms: it can translate into an expense or loss, or it can translate into an “unrealised gain”. The abnormal advantage of the indirect distribution of profits is “that which has no objectively equivalent counterpart”, which is measured by “comparing it with the hypothetical behaviour of two independent companies, dealing at arm’s length, i.e. with the competitive price – the open market price that would be charged, in a specific, equal or similar transaction” (10). The appellant maintains that the method adopted is not suitable for assessing transfer prices in the situation in question, given the risk involved and the specific nature of the inter-bank credit market. In this regard, it should be noted that “when analysing the transfer price of an intra-group loan, it is essential to first analyse the characteristics of the borrower in order to assess whether this entity could obtain an equal or similar level of debt from an independent creditor (e.g. bank), under the same terms and conditions as an independent entity would, given the performance of its business. In other words, the aim here is to assess and support the substance and economic rationale of the transaction, as well as its fit with the taxable person’s business purpose. Essentially, this analysis focuses on assessing the borrower’s credit risk, i.e. the risk that the borrower will not fulfil its commitments (debt) on the agreed date and whether the default requires a guarantee to be provided. // Given that credit risk is one of the main elements to be considered when determining the cost of financing (the greater the risk, the greater the cost to be borne), it may be asked to what extent a given interest rate, close to benchmarks such as Euribor, may be appropriate when there is an expectation that the debtor would not obtain that remuneration in market operations. The determination of the arm’s length remuneration for the operation in question must take into account all its specific characteristics. In particular, the date (in order to select operations with a similar context in terms of expectations and financial situation), the amount, the repayment term (longer terms imply greater uncertainty), the borrower’s credit risk (rating) and its level of indebtedness, the associated guarantees (they significantly influence credit risk), the interest rate applied (fixed or variable rate), the debtor’s sector of activity (relevant for assessing the ability to generate cash flows), the currency in which the operation was agreed and the markets involved…”. In this case, however, there is no evidence that the inspection report failed to take account of the factors in question when determining the transfer pricing method. It states that: In accordance with paragraph 199 of the 1979 OECD Committee on Fiscal Affairs Report “Transfer Pricing and Multinational Enterprises”, when determining what is meant by a comparable or similar loan, it will be necessary to take into account the following factors: the amount and duration of the loan, its nature or purpose, the currency in which it is specified, and the financial situation of the borrower. Now, as already mentioned, C…. is an eminently banking organisation, and given its importance in the national and international banking market, it is one of the financial institutions that make up the panel of institutions that contribute to setting the Euribor rate, which corresponds to the average interest rate at which European banks in the Eurozone lend funds to each other. This rate is one of the reference rates for economic agents in Europe, and is considered a risk-free rate of return, given the profile of the institutions that contribute ...

On 29 December 2023, the Office of Chief Counsel of the IRS issued a memorandum (AM 2023-008) on the effect of group membership on financial transactions. The memorandum answers the following question: “May the Service consider group membership in determining the arm’s length rate of interest chargeable for intragroup loans and making a section 482 adjustment?” The answer given in the memorandum is “Yes. Under the section 482 regulations, the arm’s length rate of interest on an intragroup loan to a controlled borrower is generally the rate at which that borrower could realistically obtain alternative financing from an unrelated party. Thus, if an unrelated lender would consider group membership in establishing financing terms available to the borrower, and such third-party financing is realistically available, then the Service may adjust the interest rate in a controlled lending transaction to reflect group membership.” The rationale in the memorandum refers to Treas. Reg. §§ 1.482-1, 1.482-2, 1.482-9, OECD TPG 7.13 and 10.76-80 and the realistic alternatives/realistically available options principle ...

In a press release dated November 7, 2022, TELE2 announced a SEK 1,8 billion win related to tax deductions for foreign exchange losses on intra-group loans, that had previously been disallowed by the Swedish tax authorities in an assessment issued back in 2019. According to the tax authorities the company would not – at arms length – have agreed to a currency conversion of certain intra-group loans which resulted in the loss. Tele2 appealed the decision to the Administrative Court where, during the proceedings, the authorities acknowledged deductions in part of the currency loss – SEK 745 millions. Hence, at issue before the Court was disallowed deductions of the remaining amount of SEK 1 billion. In January 2021 the administrative court dismissed TELE2’s appeal in regards of the remaining amount of SEK 1 billion. Tele2 then filed an appeal with the Court of Appeal. The Court of Appeal decided in favour of Tele2 and granted the full tax deduction. According to the court, a reasonable and probable explanation for the currency loss had been provided by the company. Excerpts: ” Although it may be considered somewhat remarkable that the revocation clause in the Form of Selection Note does not more clearly reflect the party intent and purpose that the company claims the clause has, the Court of Appeal considers that the company has provided a reasonable and probable explanation in this respect. … The Court of Appeal also considers that the alleged intention of the parties and the purpose of the withdrawal clause are supported by the chronology of events leading up to the buy-out of Asianet from MTS. When it became clear that the transaction would go ahead, the withdrawal clause was removed, moreover without changing the market interest rate on the loans to MTS. In addition, the Court of Appeal considers that there is some ambiguity in how the revocation clause should be read with regard to the possibility of revoking the conversion retroactively, i.e. with effect from 1 September 2015. In conclusion, the Court of Appeal considers that it is not clear that it has been a realistic option for the company to withdraw the conversion on the basis of the withdrawal clause. The fact that the company did not revoke the conversion cannot therefore be used as a basis for denying the company a deduction for the remaining exchange rate loss of SEK 1 095 764 000 after tax on the basis of the adjustment rule. … The Administrative Court of Appeal considers that the company incurred a risk of foreign exchange losses through the conversion on 1 September 2015 due to the decoupling of the KZT from the USD. However, the decoupling took place on 20 August 2015, at which time the KZT exchange rate fell by approximately 30%. Subsequently, the exchange rate recovered and at the time of the conversion, according to the company’s report, which was not challenged by the Swedish Tax Agency, it was slightly higher than at the time of the decoupling from the USD. Although there must have been a significant risk of a further fall in the exchange rate, the Court of Appeal considers that KZT could not be considered to be in free fall at the time of conversion. Nor can it be considered that it was clear that it was highly unlikely that the conversion would not result in an exchange rate loss for the company. It also appears that a functioning banking and foreign exchange market existed in Kazakhstan after the KZT was decoupled from the USD. The interest rate received by the company from MTS both before and after the conversion has been in line with market conditions. The Administrative Court of Appeal has also, as stated above, found no reason to question the company’s description of how the conditions for MTS to repay the loans to the company improved after the conversion. In conclusion, the Administrative Court of Appeal considers that the conversion cannot be used as a basis for denying the company a deduction for the remaining exchange loss of SEK 1 095 764 000 by means of after-taxation, on the basis of the correction rule. The appeal must therefore be allowed.” TELE2 Press Release dated November 7, 2022 ...

Amcan, a U.S. company, produces unique vessels for storing and transporting toxic waste, toxicans, at its U.S. production facility. Amcan agrees by contract to supply its Canadian subsidiary, Cancan, with 4000 toxicans per year to serve the Canadian market for toxicans. Prior to entering into the contract with Cancan, Amcan had received a bona fide offer from an independent Canadian waste disposal company, Cando, to serve as the Canadian distributor for toxicans and to purchase a similar number of toxicans at a price of $5,000 each. If the circumstances and terms of the Cancan supply contract are sufficiently similar to those of the Cando offer, or sufficiently reliable adjustments can be made for differences between them, then the Cando offer price of $5,000 may provide reliable information indicating that an arm’s length consideration under the Cancan contract will not be less than $5,000 per toxican ...

The following example illustrates an application of the principle of this paragraph (e) ...

Methods not specified in paragraphs (a)(1), (2), (3), (4), and (5) of this section may be used to evaluate whether the amount charged in a controlled transaction is arm’s length. Any method used under this paragraph (e) must be applied in accordance with the provisions of § 1.482-1. Consistent with the specified methods, an unspecified method should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it. For example, the comparable uncontrolled price method compares a controlled transaction to similar uncontrolled transactions to provide a direct estimate of the price to which the parties would have agreed had they resorted directly to a market alternative to the controlled transaction. Therefore, in establishing whether a controlled transaction achieved an arm’s length result, an unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction. As with any method, an unspecified method will not be applied unless it provides the most reliable measure of an arm’s length result under the principles of the best method rule. See § 1.482-1(c). Therefore, in accordance with § 1.482-1(d) (Comparability), to the extent that a method relies on internal data rather than uncontrolled comparables, its reliability will be reduced. Similarly, the reliability of a method will be affected by the reliability of the data and assumptions used to apply the method, including any projections used ...

...

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 ...

104. Pervichnyi is the parent of an MNE group organised and doing business in country X. Prior to Year 1, Pervichnyi developed patents and trademarks related to Product F. It manufactured Product F in country X and supplied the product to distribution affiliates throughout the world. For purposes of this example assume the prices charged to distribution affiliates were consistently arm’s length. 105. At the beginning of Year 1, Pervichnyi organises a wholly owned subsidiary, Company S, in country Y. In order to save costs, Pervichnyi transfers all of its production of Product F to Company S. At the time of the organisation of Company S, Pervichnyi sells the patents and trademarks related to Product F to Company S for a lump sum. Under these circumstances, Pervichnyi and Company S seek to identify an arm’s length price for the transferred intangibles by utilising a discounted cash flow valuation technique. 106. According to this valuation analysis, Pervichnyi could have generated after tax residual cash flows (after rewarding all functional activities of other members of the MNE group on an arm’s length basis) having a present value of 600 by continuing to manufacture Product F in Country X. The valuation from the buyer’s perspective shows that Company S could generate after tax residual cash flows having a present value of 1 100 if it owned the intangibles and manufactured the product in country Y. The difference in the present value of Pervichnyi’s after tax residual cash flow and the present value of Company S’s after tax residual cash flow is attributable to several factors. 107. Another option open to Pervichnyi would be for Pervichnyi to retain ownership of the intangible, and to retain Company S or an alternative supplier to manufacture products on its behalf in country Y. In this scenario, Pervichnyi calculates it would be able to generate after tax cash flow with a present value of 875. 108. In defining arm’s length compensation for the intangibles transferred by Pervichnyi to Company S, it is important to take into account the perspectives of both parties, the options realistically available to each of them, and the particular facts and circumstances of the case. Pervichnyi would certainly not sell the intangibles at a price that would yield an after tax residual cash flow with a present value lower than 600, the residual cash flow it could generate by retaining the intangible and continuing to operate in the manner it had done historically. Moreover there is no reason to believe Pervichnyi would sell the intangible for a price that would yield an after tax residual cash flow with a present value lower than 875. If Pervichnyi could capture the production cost savings by retaining another entity to manufacture on its behalf in a low cost environment, one realistically available option open to it would be to establish such a contract manufacturing operation. That realistically available option should be taken into account in determining the selling price of the intangible. 109. Company S would not be expected to pay a price that would, after taking into account all relevant facts and circumstances, leave it with an after tax return lower than it could achieve by not engaging in the transaction. According to the discounted cash flow valuation, the net present value of the after tax residual cash flow it could generate using the intangible in its business would be 1 100. A price might be negotiated that would give Pervichnyi a return equal to or greater than its other available options, and give Company S a positive return on its investment considering all of the relevant facts, including the manner in which the transaction itself would be taxed. 110. A transfer pricing analysis utilising a discounted cash flow approach would have to consider how independent enterprises dealing at arm’s length would take into account the cost savings and projected tax effects in setting a price for the intangibles. That price should, however, fall in the range between a price that would yield Pervichnyi after tax residual cash flow equivalent to that of its other options realistically available, and a price that would yield Company S a positive return to its investments and risks, considering the manner in which the transaction itself would be taxed. 111. The facts of this example and the foregoing analysis are obviously greatly oversimplified by comparison to the analysis that would be required in an actual transaction. The analysis nevertheless reflects the importance of considering all of the relevant facts and circumstances in performing a discounted cash flow analysis, evaluating the perspectives of each of the parties in such an analysis, and taking into consideration the options realistically available to each of the parties in performing the transfer pricing analysis ...

From the captive insurance’s perspective, the fact that the captive insurance is exposed to the downside outcome of the insured risk and to the possibility of significant loss could be an indicator that the insurance risk has been assumed by the captive insurance. In addition, the assumption of the insurance risk can only take place if the captive insurance has a realistic prospect of being able to satisfy claims in the event of the risk materialising, i.e. the captive insurance needs to have access to funding to bear the consequences of the playing out of the insured risk. Determining whether the captive insurance has the financial capacity to assume the risk requires consideration of the capital readily available to the captive and its options realistically available. In particular, when the captive insurance invests the premiums into the insured entities within the MNE group, the relation between the captive insurance’s capacity to satisfy the claims and the financial positions of those other MNEs would be central to Chapter I analysis ...

In that situation, the analysis under Chapter I may indicate that an independent enterprise borrowing under the same conditions as Company D would not be expected to pay a guarantee fee of 3% to Company M for the provision of the explicit guarantee since Company D is better off in the absence of the guarantee ...

Pricing under each model will be sensitive to the assumptions made in the modelling process. Whatever valuation model is used, the evaluation of cost method sets a minimum fee for the guarantee (the minimum amount that the provider of the guarantee will be willing to accept) and does not of itself necessarily reflect the outcome of a bargain made at arm’s length. The arm’s length amount should be derived from a consideration of the perspectives (taking into account options realistically available) of the borrower and guarantor ...

Determining the arm’s length interest rates for the cash pool intra-group transactions may be a difficult exercise due to the lack of comparable arrangements between unrelated parties. In this context, banking arrangements involving the cash pool leader, taking into account functional differences between the bank and the cash pool leader, and the options realistically available to the cash pool members may inform the identification of comparable interest rates in the transfer pricing analysis ...

No member of the pooling arrangement would expect to participate in the transaction if it made them any worse off than their next best option. The analysis of an MNE’s decision to participate in a cash pool arrangement should be done with reference to its options realistically available, taking into account that an MNE can obtain benefits as a member of the cash pool other than an improved interest rate (see paragraph 10.146) ...

The application of the cost of funds approach requires consideration of the options realistically available to the borrower. On prevailing facts and circumstances, a borrowing MNE would not enter into a transaction priced under the cost of funds approach if it could obtain the funding under better conditions by entering into an alternative transaction ...

Arm’s length interest rates can also be based on the return of realistic alternative transactions with comparable economic characteristics. Depending on the facts and circumstances, realistic alternatives to intra-group loans could be, for instance, bond issuances, loans which are uncontrolled transactions, deposits, convertible debentures, commercial papers, etc. In the evaluation of those alternatives as potential comparables it is important to bear in mind that, based on facts and circumstances, comparability adjustments may be required to eliminate the material effects of differences between the controlled intra-group loan and the selected alternative in terms of, for instance, liquidity, maturity, existence of collateral or currency ...

Macroeconomic circumstances may lead to changes in the financing costs in the market. In such a context, a transfer pricing analysis with regard to the possibilities of the borrower or the lender to renegotiate the terms of the loan to benefit from better conditions will be informed by the options realistically available to both the borrower and the lender ...

Borrowers seek to optimise their weighted average cost of capital and to have the right funding available to meet both short-term needs and long-term objectives. When considering the options realistically available to it, an independent business seeking funding operating in its own commercial interests will seek the most cost effective solution, with regard to the business strategy it has adopted. For example in respect of collateral, in some circumstances, assuming that the business has suitable collateral to offer, this would usually be secured funding, ahead of unsecured funding, recognising that a business’s collateral assets and its funding requirements may differ over time, e.g. because collateral is finite, the decision to pledge collateral on a particular borrowing precludes the borrower from pledging that same collateral on a subsequent borrowing. Therefore, an MNE pledging collateral would take into account its options realistically available regarding its overall financing (e.g. possible subsequent loan transactions) ...

The lender’s perspective in the decision of whether to make a loan, how much to lend, and on what terms, will involve evaluation of various factors relating to the borrower, wider economic factors affecting both the borrower and the lender, and other options realistically available to the lender for the use of the funds ...

Independent enterprises, when considering whether to enter into a particular financial transaction, will consider all other options realistically available to them, and will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objectives (see paragraph 1.38 of Chapter I). In considering the options realistically available, the perspective of each of the parties to the transaction must be considered. For instance, in the case of an entity that advances funds, other investment opportunities may be contemplated, taking account of the specific business objectives of the lender and the context in which the transaction takes place. From the borrower’s perspective, the options realistically available will include broader considerations than the entity’s ability to service its debt, for example, the funds it actually needs to meet its operational requirements. In some instances, although an entity may have the capacity to borrow and service an additional amount of debt, it may choose not to do so to avoid placing negative pressure on its credit rating and increasing its cost of capital, and jeopardising its access to capital markets and its market reputation (see comments upon “The lender’s and borrower’s perspectives” in Section C.1.1.1 of this chapter) ...

In determining which party(ies) should be attributed the location savings at arm’s length, it will be important to consider the functions, risks and assets of the parties, as well as the options realistically available to each of them. In this example, assume that there is a high demand for the type of engineering services that the company in Country X sells. Assume also that the subsidiary in Country Y is the only company operating in a lower-cost location that is able to provide such services with the required quality standard, and Company Y is able to withstand competitive pricing pressures because the technical know-how it has established acts as a barrier to competition. Furthermore, the company in Country X does not have the option of engaging qualified engineers in Country X to provide these services, as the cost of their wages would be too high compared to the hourly rate charged to clients. Considering this, the enterprise in Country X does not have many other options available to it than to use this service provider. The remuneration payable by Company X to Company Y should take into account the location savings created by Company Y, in addition to the value of its services including any intangibles used in providing those services. In some instances, the nature of the contributions made by the enterprise in Country X and its subsidiary in Country Y may meet the criteria for the use of a transactional profit split method ...

In such an example, given that the relocated activity is a highly competitive one, it is likely that the enterprise in Country A has the option realistically available to it to use either the affiliate in Country B or a third party manufacturer. As a consequence, it should be possible to find comparables data to determine the conditions in which a third party would be willing at arm’s length to manufacture the clothes for the enterprise. In such a situation, a contract manufacturer at arm’s length would generally be attributed very little, if any, part of the location savings. Doing otherwise would put the associated manufacturer in a situation different from the situation of an independent manufacturer, and would be contrary to the arm’s length principle ...

That being said, in business restructurings, before-and-after comparisons could play a role in understanding the restructuring itself and could be part of a before-and-after comparability (including functional) analysis to understand the changes that accounted for the changes in the allocation of profit/loss amongst the parties. In effect, information on the arrangements that existed prior to the restructuring and on the conditions of the restructuring itself could be essential to understand the context in which the post-restructuring arrangements were put in place and to assess whether such arrangements are arm’s length. It can also shed light on the options realistically available to the restructured entity. (See paragraphs 9.27-9.31 for a discussion of options realistically available; see also paragraphs 9.102-9.106 for a discussion of possible factual differences between situations that result from a restructuring and situations that were structured as such from the beginning and of how such differences may affect the options realistically available to the parties in negotiating the terms of the new arrangement and therefore the conditions of the restructuring and/or of the post-restructuring arrangements.) ...

Where an arrangement between associated enterprises replaces an existing arrangement (restructuring), there may be factual differences in the starting position of the restructured entity compared to the position of a newly set up operation. Sometimes, the post-restructuring arrangement is negotiated between parties that have had prior contractual and commercial relationships. In such a situation, depending on the facts and circumstances of the case and in particular on the rights and obligations derived by the parties from these prior arrangements, this may affect the options realistically available to the parties in negotiating the terms of the new arrangement and therefore the conditions of the restructuring and of the post-restructuring arrangements (see paragraphs 9.27-9.31 for a discussion of options realistically available in the context of determining the arm’s length compensation for the restructuring itself). For instance, assume a party has proved in the past to be able to perform well as a full-fledged distributor performing a whole range of marketing and selling functions, employing and developing valuable marketing intangible assets and assuming a range of risks associated with its activity such as inventory risks, bad debt risks and market risks. Assume that its distribution contract is re-negotiated and converted into a “limited risk distribution” contract whereby it will perform limited marketing activities under the supervision of a foreign associated enterprise, employ limited marketing intangibles and assume limited risks in its relationship with the foreign associated enterprise and customers. In such a situation, the restructured distributor would not be in the same position as a newly established distributor ...

The transfer pricing analysis of the arm’s length nature of the conditions of the termination or substantial renegotiation of an agreement should take account of both the perspectives of the transferor and of the transferee. Taking account of the transferee’s perspective is important both to value the amount of an arm’s length indemnification, if any, and to determine what party should bear it. It is not possible to derive a single answer for all cases and the response should be based on an examination of the facts and circumstances of the case, and in particular of the rights and other assets of the parties, of the risks assumed by the parties, of the economic rationale for the termination, of the determination of what party(ies) is (are) expected to benefit from it, and of the options realistically available to the parties. This can be illustrated as follows ...

However, in those cases where such comparables data are not found, the determination of whether the indemnification clause (or absence thereof) is arm’s length should take into account the rights and other assets of the parties at the time of entering into the arrangement and of its termination or renegotiation. This analysis might also be assisted by an examination of the options realistically available to the parties, as in some situations, it may be the case that, in comparable circumstances, an independent party would not have had any option realistically available that would be clearly more attractive to it than to accept the conditions of the termination or substantial renegotiation of the contract. The guidance in Section D of Chapter I, as well as the Guidance in Section B of this Part, are applicable ...

Once the restructuring arrangements have been accurately delineated and the options realistically available to the parties have been assessed, the following aspects should be considered: Whether commercial law supports rights to indemnification for the restructured entity under the facts of the case as accurately delineated (see Section F. 1 below); Whether the existence or absence of an indemnification clause or similar provisions (as well as the terms of such a clause where it exists) under the terms of the arrangement, as accurately delineated, is arm’s length (see Section F.2 below). Which party should ultimately bear the costs related to the indemnification of the party that suffers from the termination or re-negotiation of the agreement (see Section F.3 below) ...

There should be no presumption that all contract terminations or substantial renegotiations should give a right to indemnification at arm’s length, as this will depend on the facts and circumstances of each case. The analysis of whether an indemnification would be warranted at arm’s length should be made on the basis of the accurate delineation of the arrangements before and after the restructuring (based on the guidance in Section D. 1 of Chapter I and Section B. 1 of this Part) and the options realistically available to the parties ...

Not every case where a restructured entity experiences a reduction of its functions, assets and risks involves an actual loss of expected future profits. In some restructuring situations, the circumstances may be such that, rather than losing a “profit-making opportunity”, the restructured entity is actually being saved from the likelihood of a “loss-making opportunity”. An entity may agree to a restructuring as a better option than going out of business altogether. If the restructured entity is forecasting future losses absent the restructuring (e.g. it operates a manufacturing plant that is uneconomic due to increasing competition from low-cost imports), then there may be in fact no loss of any profit-making opportunity from restructuring rather than continuing to operate its existing business. In such circumstances, the restructuring might deliver a benefit to the restructured entity from reducing or eliminating future losses if such losses exceed the restructuring costs ...

In scenario no. 1, the distributor is surrendering a profit potential with significant uncertainties for a relatively low but stable rate of profitability. Whether an independent party would be willing to do so would depend on its anticipated return under both scenarios, on its level of risk tolerance, on its options realistically available and on possible compensation for the restructuring itself. In case scenario no. 2, it is unlikely that independent parties in the distributor’s situation would agree to relocate the risks and associated profit potential for no additional compensation if they had the option to do otherwise. Scenario no. 3 illustrates the fact that the analysis should take account of the profit potential going forward and that, where there is a significant change in the commercial or economic environment, relying on historical data alone will not be sufficient ...

There can be group-level business reasons for an MNE group to restructure. However, it is worth re-emphasising that the arm’s length principle treats the members of an MNE group as separate entities rather than as inseparable parts of a single unified business (see paragraph 1.6). As a consequence, it is not sufficient from a transfer pricing perspective that a restructuring arrangement makes commercial sense for the group as a whole: the arrangement must be arm’s length at the level of each individual taxpayer, taking account of its rights and other assets, expected benefits from the arrangement (i.e. any consideration of the post-restructuring arrangement plus, if applicable, any compensation payments for the restructuring itself), and realistically available options. Where a restructuring makes commercial sense for the group as a whole on a pre-tax basis, it is expected that an appropriate transfer price (that is, any compensation for the post-restructuring arrangement plus, if applicable, any compensation payments for the restructuring itself) would generally be available to provide arm’s length compensation for each accurately delineated transaction comprising the business restructuring for each individual group member participating in it ...

The reference to the notion of options realistically available is not intended to create a requirement for taxpayers to document all possible hypothetical options realistically available. Rather, the intention is to provide an indication that, if there is a realistically available option that is clearly more attractive, it should be considered in the analysis of the conditions of the restructuring ...

At arm’s length, there are also situations where an entity would have had one or more options realistically available to it that would clearly offer more attractive opportunities to meet their objectives than to accept the conditions of the restructuring (taking into account all the relevant conditions, including the commercial and market conditions going forward, the profit potential of the various options and any compensation or indemnification for the restructuring), including possibly the option not to enter into the restructuring transaction. In such cases, an independent party may not have agreed to the conditions of the restructuring and adjustments to the conditions made or imposed may be necessary ...

At arm’s length, there are situations where the restructured entity would have had no clearly more attractive option realistically available to it than to accept the conditions of the restructuring, e.g. a contract termination – with or without indemnification as discussed at Section F below. In longer-term contracts, this may occur by invoking an exit clause that allows for one party to prematurely exit the contract with just cause. In contracts that allow either party to opt out of the contract, the party terminating the arrangement may choose to do so because it has determined, subject to the terms of the termination clause, that it is more favourable to stop using the function, or to internalise it, or to engage a cheaper or more efficient provider or to seek more lucrative opportunities. If the restructured entity transfers rights or other assets or an ongoing concern to another party, it might however be compensated for such a transfer as discussed in Section E below ...

Thus, in applying the arm’s length principle, the tax administration should evaluate each transaction as accurately delineated under the guidance in Section D of Chapter I and consider the economically relevant characteristics taken into account by the parties in reaching the conclusion that there is no option realistically available that offers a clearly more attractive opportunity to meet their commercial objectives than the restructuring adopted (see paragraph 1.38). In making such assessment, it may be necessary or useful to assess the transactions comprising the business restructuring in the context of a broader arrangement of economically related transactions ...

The arm’s length principle is based on the notion that independent enterprises, when evaluating the terms of a potential transaction, will compare the transaction to the other options realistically available to them, and they will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objective. In other words, independent enterprises would only enter into a transaction if it does not make them worse off than their next best option. Consideration of the other options realistically available may be relevant to comparability analysis, to understand the respective positions of the parties ...

Aspects of identifying the commercial or financial relations between the parties which are particularly relevant to determining the arm’s length conditions of business restructurings, are analysed in the following sections: The accurate delineation of the transactions comprising the business restructuring and the functions, assets and risks before and after the restructuring (see Section B.1); The business reasons for and the expected benefits from the restructuring, including the role of synergies (see Section B.2); The other options realistically available to the parties (see Section B.3) ...

The application of the arm’s length principle to a business restructuring must start, as for any controlled transaction, with the identification of the commercial or financial relations between the associated enterprises involved in the business restructuring and the conditions and economically relevant circumstances attaching to those relations so that the controlled transactions comprising the business restructuring are accurately delineated. In this regard, the general guidance in Section D. 1 of Chapter I is applicable. This guidance requires the examination of the economically relevant characteristics of the commercial or financial relations between the associated enterprises, and in particular the contractual terms of the business restructuring (Section D. 1.1); the functions performed by each party to the restructuring, before and after the restructuring, taking into account assets used and risks assumed (Section D. 1.2); the economic circumstances of the parties (Section D. 1.4) and business strategies (Section D. 1.5). In addition, the analysis should be informed by a review of the business reasons for and the expected benefits from the restructuring, including the role of synergies, and the options realistically available to the parties. As stated in paragraph 1.33, these conditions and economically relevant circumstances of the accurately delineated transactions that comprise the business restructuring will then be compared with the conditions and economically relevant circumstances of comparable transactions between independent enterprises ...

Research is similarly an example of an activity that may involve intra-group services. The terms of the activity can be set out in a detailed contract with the party commissioning the service, commonly known as contract research. The activity can involve highly skilled personnel and vary considerably both in its nature and in its importance to the success of the group. The actual arrangements can take a variety of forms from the undertaking of detailed programmes laid down by the principal party, extending to agreements where the research company has discretion to work within broadly defined categories. In the latter instance, the additional functions of identifying commercially valuable areas and assessing the risk of unsuccessful research can be a critical factor in the performance of the group as a whole. It is therefore crucial to undertake a detailed functional analysis and to obtain a clear understanding of the precise nature of the research, and of how the activities are being carried out by the company, prior to consideration of the appropriate transfer pricing methodology. The consideration of options realistically available to the party commissioning the research may also prove useful in selecting the most appropriate transfer pricing method. See Section B .2 of Chapter VI ...

Where valuation techniques are utilised in a transfer pricing analysis involving the transfer of intangibles or rights in intangibles, it is necessary to apply such techniques in a manner that is consistent with the arm’s length principle and the principles of these Guidelines. In particular, due regard should be given to the principles contained in Chapters I – III. Principles related to realistically available options, economically relevant characteristics including assumption of risk (see Section D. 1 of Chapter I) and aggregation of transactions (see paragraphs 3.9 to 3.12) apply fully to situations where valuation techniques are utilised in a transfer pricing analysis. Furthermore, the rules of these Guidelines on selection of transfer pricing methods apply in determining when such techniques should be used (see paragraphs 2.1 to 2.12). The principles of Sections A, B, C, and D. 1 of this chapter also apply where use of valuation techniques is considered ...

Where information regarding reliable comparable uncontrolled transactions cannot be identified, the arm’s length principle requires use of another method to determine the price that uncontrolled parties would have agreed under comparable circumstances. In making such determinations, it is important to consider: The functions, assets and risks of the respective parties to the transaction. The business reasons for engaging in the transaction. The perspectives of and options realistically available to each of the parties to the transaction. The competitive advantages conferred by the intangibles including especially the relative profitability of products and services or potential products and services related to the intangibles. The expected future economic benefits from the transaction. Other comparability factors such as features of local markets, location savings, assembled workforce, and MNE group synergies ...

It will often be the case that a price for a transaction involving intangibles can be identified that is consistent with the realistically available options of each of the parties. The existence of such prices is consistent with the assumption that MNE groups seek to optimise resource allocations. If situations arise in which the minimum price acceptable to the transferor, based on its realistically available options, exceeds the maximum price acceptable to the transferee, based on its realistically available options, it may be necessary to consider whether the actual transaction should be disregarded under the criterion for non-recognition set out in Section D.2 of Chapter I, or whether the conditions of the transaction should otherwise be adjusted. Similarly, if situations arise in which there are assertions that either the current use of an intangible, or a proposed realistically available option (i.e. an alternative use of the intangible), does not optimise resource allocations, it may be necessary to consider whether such assertions are consistent with the true facts and circumstances of the case. This discussion highlights the importance of taking all relevant facts and circumstances into account in accurately delineating the actual transaction involving intangibles ...

While it is important to consider the perspectives of both parties to the transaction in conducting a comparability analysis, the specific business circumstances of one of the parties should not be used to dictate an outcome contrary to the realistically available options of the other party. For example, a transferor would not be expected to accept a price for the transfer of either all or part of its rights in an intangible that is less advantageous to the transferor than its other realistically available options (including making no transfer at all), merely because a particular associated enterprise transferee lacks the resources to effectively exploit the transferred rights in the intangible. Similarly, a transferee should not be expected to accept a price for a transfer of rights in one or more intangibles that would make it impossible for the transferee to anticipate earning a profit using the acquired rights in the intangible in its business. Such an outcome would be less favourable to the transferee than its realistically available option of not engaging in the transfer at all ...

In considering the options realistically available to the parties, the perspectives of each of the parties to the transaction must be considered. A comparability analysis focusing only on one side of a transaction generally does not provide a sufficient basis for evaluating a transaction involving intangibles (including in those situations for which a one-sided transfer pricing method is ultimately determined) ...

In applying the principles of the Guidelines related to the content and process of a comparability analysis to a transaction involving intangibles, a transfer pricing analysis must consider the options realistically available to each of the parties to the transaction ...

The contractual arrangements will generally determine the terms of the funding transaction, as clarified or supplemented by the economic characteristics of the transaction as reflected in the conduct of the parties. The return that would generally be expected by the funder should equal an appropriate risk-adjusted return. Such return can be determined, for example, based on the cost of capital or the return of a realistic alternative investment with comparable economic characteristics. In determining an appropriate return for the funding activities, it is important to consider the financing options realistically available to the party receiving the funds. There may be a difference between the return expected by the funder on an ex ante basis and the actual return received on an ex post basis. For example, when the funder provides a loan for a fixed amount at a fixed interest rate, the difference between the actual and expected returns will reflect the risk playing out that the borrower cannot make some or all of the payments due ...

Where associated enterprises other than the legal owner perform relevant functions that are anticipated to contribute to the value of the intangibles, they should be compensated on an arm’s length basis for the functions they perform under the principles set out in Chapters I – III. The determination of arm’s length compensation for functional contributions should consider the availability of comparable uncontrolled transactions, the importance of the functions performed to the creation of intangible value, and the realistically available options of the parties. The specific considerations described in paragraphs 6.53 to 6.58 should also be taken into account ...

Legal ownership and contractual relationships serve simply as reference points for identifying and analysing controlled transactions relating to the intangible and for determining the appropriate remuneration to members of a controlled group with respect to those transactions. Identification of legal ownership, combined with the identification and compensation of relevant functions performed, assets used, and risks assumed by all contributing members, provides the analytical framework for identifying arm’s length prices and other conditions for transactions involving intangibles. As with any other type of transaction, the analysis must take into account all of the relevant facts and circumstances present in a particular case and price determinations must reflect the realistic alternatives of the relevant group members. The principles of this paragraph are illustrated by Examples 1 to 6 in the Annex I to Chapter VI ...

This section sets out circumstances in which the transaction between the parties as accurately delineated can be disregarded for transfer pricing purposes. Because non-recognition can be contentious and a source of double taxation, every effort should be made to determine the actual nature of the transaction and apply arm’s length pricing to the accurately delineated transaction, and to ensure that non-recognition is not used simply because determining an arm’s length price is difficult. Where the same transaction can be seen between independent parties in comparable circumstances (i.e. where all economically relevant characteristics are the same as those under which the tested transaction occurs other than that the parties are associated enterprises) non-recognition would not apply. Importantly, the mere fact that the transaction may not be seen between independent parties does not mean that it should not be recognised. Associated enterprises may have the ability to enter into a much greater variety of arrangements than can independent enterprises, and may conclude transactions of a specific nature that are not encountered, or are only very rarely encountered, between independent parties, and may do so for sound business reasons. The transaction as accurately delineated may be disregarded, and if appropriate, replaced by an alternative transaction, where the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances, thereby preventing determination of a price that would be acceptable to both of the parties taking into account their respective perspectives and the options realistically available to each of them at the time of entering into the transaction. It is also a relevant pointer to consider whether the MNE group as a whole is left worse off on a pre-tax basis since this may be an indicator that the transaction viewed in its entirety lacks the commercial rationality of arrangements between unrelated parties ...

It may be possible to find a reasonable indicator of a risk-adjusted rate of return from comparable uncontrolled transactions or by considering realistically available alternative investments reflecting the same risk profile. Depending on the facts and circumstances, realistic alternatives to an intra-group loan could be bond issuances or loans which are uncontrolled transactions (see paragraph 10.93) ...

A risk-adjusted rate of return can be determined under different approaches, for example, based on the return of a realistic alternative investment with comparable economic characteristics or the cost of funds (see Section C.1.2) ...

Therefore, the process of identifying the economically relevant characteristics of the commercial or financial relations should include consideration of the capabilities of the parties, how such capabilities affect options realistically available, and whether similar capabilities are reflected in potentially comparable arm’s length arrangements ...

The actual contributions, capabilities, and other features of the parties can influence the options realistically available to them. For example, an associated enterprise provides logistics services to the group. The logistics company is required to operate warehouses with spare capacity and in several locations in order to be able to cope in the event that supply is disrupted at any one location. The option of greater efficiency through consolidation of locations and reduction in excess capacity is not available. Its functions and assets may, therefore, be different to those of an independent logistics company if that independent service provider did not offer the same capabilities to reduce the risk of disruption to supply ...

All methods that apply the arm’s length principle can be tied to the concept that independent enterprises consider the options realistically available to them and in comparing one option to another they consider any differences between the options that would significantly affect their value. For instance, before purchasing a product at a given price, independent enterprises normally would be expected to consider whether they could buy an equivalent product on otherwise comparable terms and conditions but at a lower price from another party. Therefore, as discussed in Chapter II, Part II, the comparable uncontrolled price method compares a controlled transaction to similar uncontrolled transactions to provide a direct estimate of the price the parties would have agreed to had they resorted directly to a market alternative to the controlled transaction. However, the method becomes a less reliable substitute for arm’s length transactions if not all the characteristics of these uncontrolled transactions that significantly affect the price charged between independent enterprises are comparable. Similarly, the resale price and cost plus methods compare the gross profit margin earned in the controlled transaction to gross profit margins earned in similar uncontrolled transactions. The comparison provides an estimate of the gross profit margin one of the parties could have earned had it performed the same functions for independent enterprises and therefore provides an estimate of the payment that party would have demanded, and the other party would have been willing to pay, at arm’s length for performing those functions. Other methods, as discussed in Chapter II, Part III, are based on comparisons of net profit indicators (such as profit margins) between independent and associated enterprises as a means to estimate the profits that one or each of the associated enterprises could have earned had they dealt solely with independent enterprises, and therefore the payment those enterprises would have demanded at arm’s length to compensate them for using their resources in the controlled transaction. Where there are differences between the situations being compared that could materially affect the comparison, comparability adjustments must be made, where possible, to improve the reliability of the comparison. Therefore, in no event can unadjusted industry average returns themselves establish arm’s length prices ...

Independent enterprises, when evaluating the terms of a potential transaction, will compare the transaction to the other options realistically available to them, and they will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objectives. In other words, independent enterprises would only enter into a transaction if it is not expected to make them worse off than their next best option. For example, one enterprise is unlikely to accept a price offered for its product by an independent commercial enterprise if it knows that other potential customers are willing to pay more under similar conditions, or are willing to pay the same under more beneficial conditions. Independent enterprises will generally take into account any economically relevant differences between the options realistically available to them (such as differences in the level of risk) when valuing those options. Therefore, identifying the economically relevant characteristics of the transaction is essential in accurately delineating the controlled transaction and in revealing the range of characteristics taken into account by the parties to the transaction in reaching the conclusion that there is no clearly more attractive opportunity realistically available to meet their commercial objectives than the transaction adopted. In making such an assessment, it may be necessary or useful to assess the transaction in the context of a broader arrangement of transactions, since assessment of the options realistically available to third parties is not necessarily limited to the single transaction, but may take into account a broader arrangement of economically related transactions ...

The Swedish group TELE2, one of Europe’s largest telecommunications operators, had invested in an entity in Kazakhstan, MTS, that was owned via a joint venture together with an external party. Tele2 owned 51% of the Joint venture and MTS was financed by Tele2’s financing entity, Tele2 Treasury AB, which, during 2011-2015, had issued multiple loans to MTS. In September 2015, the currency on the existing internal loans to MTS was changed from dollars to KZT. At the same time a ‘Form of Selection Note’ was signed according to which Tele2 Treasury AB could recall the currency denomination within six months. A new loan agreement denominated in KZT, replacing the existing agreements, was then signed between Tele2 Treasury AB and MTS. In the new agreement the interest rate was also changed from LIBOR + 4.6% to a fixed rate of 11.5%. As a result of these contractual changes to the loan agreements with MTS, Tele2 Treasury AB in its tax filing deducted a total currency loss of SEK 1 840 960 000 million for FY 2015. Following an audit, the Swedish tax authorities issued an assessment where the tax deduction for the full amount had been disallowed. However, during the proceedings at Court the authorities acknowledged deductions for part of the currency loss – SEK 745 196 000 – related to the period between 22 October to 31 December 2015. Hence, at issue before the Court was disallowed deductions of the remaining amount of SEK 1 095 794 000. Decision of the Court The Administrative Court ruled in favor of the tax authorities. Tele2 Treasury AB could not deduct exchange rate losses resulting from the loan arrangements with MTS related to the period between 1 September and 21 October 2015. “…there have been no reasons to assume that MTS has risked bankruptcy, and that the company’s right to interest and repayments would thus have been in jeopardy. Thus, MTS’s financial position cannot be a reason to believe that the currency conversion would have been commercially justified. With regard to commerciality, the court considers it strange that an independent lender would take great risks to secure the financing when the borrower and another external player are to carry out a merger. That the company assumed responsibility for getting MTS financing in place speak instead of that it was the financial interests of the common interests that prompted the decision to conduct currency conversion. The court thus considers that the company cannot be considered to have any significant interest in securing MTS financing. In this context, the company has stated that other companies within the Tele2 Group’s financial interests must be taken into account when assessing the current issue. However, as stated by the Administrative Court above, the relationship with any other companies in a partnership with the trader shall not be taken into account. In this context, the company has referred to the Court of Appeal in Gothenburg’s judgment of 30 September 2011 in case no. 5854-10. However, the Administrative Court cannot, based on the circumstances and reasoning in the judgment, read out any general conclusions that could provide support for the company’s view in the current cases. The Administrative Court therefore considers that the company’s reasons for the conversion cannot be considered to be any other than reasons attributable to the common interest with MTS.” According to a press release from TELE2 the decision will be appealed. Click here for translation ...

Determining whether a renegotiation of a commercial arrangement (including pricing under the arrangement going forward and any potential compensation for the renegotiation itself) represents the best interests of the parties to a transaction requires careful consideration of their options realistically available26 and the long-run effects on the profit potential of the parties.27 For example, an entity may agree to restructure a transaction if the alternative option is losing a key customer or supplier, where it considers that the restructuring will maximise its profits in the long-run. Consideration should also be given to whether the economic impact resulting from the renegotiation may require indemnification (as defined in OECD TPG paragraph 9.75) of the harmed party.28 26 It should be noted that in an uncontrolled transaction one party might attempt to force a renegotiation by threatening to violate the terms of an existing agreement, believing that the other party will not find it worthwhile to seek judicial enforcement of the agreement, whereas this course of action may not realistically be available in the context of a controlled transaction. 27 Paragraphs 9.78-9.97 of Chapter IX of the OECD TPG. 28 Paragraphs 9.78-9.97 of Chapter IX of the OECD TPG ...

WB Ambassador, took out two loans with its Luxembourg parent company and another group company, each bearing an annual interest rate of 7%. Following an audit, the tax authorities, considering that the company did not justify that the 7% interest rate of the above-mentioned intra-group loans corresponded to the rate it could have obtained from independent financial institutions or organisations under similar conditions and partially disallowed deductions of the interest incurred. Supreme Administrative Court The Supreme Administrative Court overturned the decision of the Administrative court of Appeal and ruled in favor of the WB Ambassador. It stated that the Lower Court had erred in law in ruling out the possibility that a company, in order to justify the rate it could have obtained from independent financial institutions for a loan granted under similar conditions, could rely, in order to assess that rate, on the yield of bond issues granted by undertakings in comparable economic conditions. Consequently, WB Ambassador was entitled, without needing to examine the other pleas in law of its appeal, to seek the annulment of the judgment which it is challenging. “The borrowing company, which has the burden of proving the rate it could have obtained from independent financial institutions or organisations for a loan granted under similar conditions, may provide this proof by any means. In this respect, in order to evaluate this rate, it may, where appropriate, take account of the yield on bonds issued by undertakings in comparable economic conditions, where such bonds constitute, in the circumstances under consideration, a realistic alternative to an intra-group loan.” Click here for English translation Click here for other translation ...

From the captive insurance’s perspective, the fact that the captive insurance is exposed to the downside outcome of the insured risk and to the possibility of significant loss could be an indicator that the insurance risk has been assumed by the captive insurance. In addition, the assumption of the insurance risk can only take place if the captive insurance has a realistic prospect of being able to satisfy claims in the event of the risk materialising, i.e. the captive insurance needs to have access to funding to bear the consequences of the playing out of the insured risk. Determining whether the captive insurance has the financial capacity to assume the risk requires consideration of the capital readily available to the captive and its options realistically available. In particular, when the captive insurance invests the premiums into the insured entities within the MNE group, the relation between the captive insurance’s capacity to satisfy the claims and the financial positions of those other MNEs would be central to Chapter I analysis ...

Pricing under each model will be sensitive to the assumptions made in the modelling process. Whatever valuation model is used, the evaluation of cost method sets a minimum fee for the guarantee (the minimum amount that the provider of the guarantee will be willing to accept) and does not of itself necessarily reflect the outcome of a bargain made at arm’s length. The arm’s length amount should be derived from a consideration of the perspectives (taking into account options realistically available) of the borrower and guarantor ...

Determining the arm’s length interest rates for the cash pool intra-group transactions may be a difficult exercise due to the lack of comparable arrangements between unrelated parties. In this context, banking arrangements involving the cash pool leader, taking into account functional differences between the bank and the cash pool leader, and the options realistically available to the cash pool members may inform the identification of comparable interest rates in the transfer pricing analysis ...

No member of the pooling arrangement would expect to participate in the transaction if it made them any worse off than their next best option. The analysis of an MNE’s decision to participate in a cash pool arrangement should be done with reference to its options realistically available, taking into account that an MNE can obtain benefits as a member of the cash pool other than an improved interest rate (see paragraph 10.146) ...

The application of the cost of funds approach requires consideration of the options realistically available to the borrower. On prevailing facts and circumstances, a borrowing MNE would not enter into a transaction priced under the cost of funds approach if it could obtain the funding under better conditions by entering into an alternative transaction ...

Macroeconomic circumstances may lead to changes in the financing costs in the market. In such a context, a transfer pricing analysis with regard to the possibilities of the borrower or the lender to renegotiate the terms of the loan to benefit from better conditions will be informed by the options realistically available to both the borrower and the lender ...

Borrowers seek to optimise their weighted average cost of capital and to have the right funding available to meet both short-term needs and long-term objectives. When considering the options realistically available to it, an independent business seeking funding operating in its own commercial interests will seek the most cost effective solution, with regard to the business strategy it has adopted. For example in respect of collateral, in some circumstances, assuming that the business has suitable collateral to offer, this would usually be secured funding, ahead of unsecured funding, recognising that a business’s collateral assets and its funding requirements may differ over time, e.g. because collateral is finite, the decision to pledge collateral on a particular borrowing precludes the borrower from pledging that same collateral on a subsequent borrowing. Therefore, an MNE pledging collateral would take into account its options realistically available regarding its overall financing (e.g. possible subsequent loan transactions) ...

The lender’s perspective in the decision of whether to make a loan, how much to lend, and on what terms, will involve evaluation of various factors relating to the borrower, wider economic factors affecting both the borrower and the lender, and other options realistically available to the lender for the use of the funds ...

Independent enterprises, when considering whether to enter into a particular financial transaction, will consider all other options realistically available to them, and will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objectives (see paragraph 1.38 of Chapter I). In considering the options realistically available, the perspective of each of the parties to the transaction must be considered. For instance, in the case of an entity that advances funds, other investment opportunities may be contemplated, taking account of the specific business objectives of the lender and the context in which the transaction takes place. From the borrower’s perspective, the options realistically available will include broader considerations than the entity’s ability to service its debt, for example, the funds it actually needs to meet its operational requirements. In some instances, although an entity may have the capacity to borrow and service an additional amount of debt, it may choose not to do so to avoid placing negative pressure on its credit rating and increasing its cost of capital, and jeopardising its access to capital markets and its market reputation (see comments upon “The lender’s and borrower’s perspectives” in Section C.1.1.1 of this chapter) ...

Broadcom Semiconductors Ltd is an Israeli company established in 2001 under the name Dune Semiconductors Ltd. The Company is engaged in development, production, and sale of components to routers, switches etc. The shares in Dune Semiconductors were acquired by the Broadcom Corporation (a US group) in 2009 and following the acquisition intellectual property was transferred to the new Parent for a sum of USD 17 million. The company also entered into tree agreements to provide marketing and support services to a related Broadcom affiliate under a cost+10%, to provide development services to a related Broadcom affiliate for cost+8%, and a license agreement to use Broadcom Israel’s intellectual property for royalties of approximately 14% of the affiliate’s turnover. The tax authorities argued that functions, assets, and risks had been transferred leaving only an empty shell in Israel and a tax assessment was issued based on the purchase price for the shares resulting in additional taxes of USD 29 millions. According to the company such a transfer of functions, assets, and risks would only be applicable if Broadcom Israel had been emptied of its activities which  was not the case. Following the restructuring Broadcom Israel continued as a licensor and as a service provider. The financial situation of the company also improved. The position of the company was further supported by the fact that several years following the restructuring, Broadcom Israel sold its intellectual property and was taxed for the capital gain. The District Court held in favor of the company. A business restructuring from a fully fledged principal  to a service provider on a cost-plus basis does not necessarily result in a transfer of value. Judgement of the Court In the judgement the court argues that this case is different from the prior Gteko-case where the Israeli company became an empty shell and financial results were dramatically reduced following the acquisition and restructuring of the company. Unlike the Gteko-case, Broadcom had increased its activities in Israel following the acquisition. The court also emphasized that the tax authorities did not take into consideration options realistically available to the company at the time of the restructuring. For a business restructuring to constitute a sale of functions, assets, and risks property for tax purposes, it must be demonstrated not only that the change occurred, but also that the change did not meet the arm’s length principle. The court confirmed that the OECD’s Transfer Pricing Guidelines are applicable as a reference for tax purposes in Israel. Click here for an English translation ...

An assessment was issued by the Norwegian tax authorities for years 2009 2010 and 2011 concerning the interest on a loan between Exxonmobil Production Norway Inc. (EPNI) as the lender and Exxon Mobile Delaware Holdings Inc. (EMDHI) as the borrower. Both EPNI and EMDHI are subsidiaries in the Exxon Group, where the parent company is domiciled in the United States. The loan agreement between EPNI and EMDHI was entered into in 2009. The loan had a drawing facility of NOK 20 billion. The agreed maturity was 2019, and the interest rate was fixed at 3 months NIBOR plus a margin of 30 basis points. The agreement also contained provisions on quarterly interest rate regulation and a interest adjustment clause allowing the lender to adjust the interest rate on changes in the borrower’s creditworthiness. The dispute concerns the margin of 30 basis points and the importance of the adjustment clause, also referred to as the step-up clause. The Oil Tax office and the Appeals Board for Oil Tax found that the agreed interest rate was not at arm’s length and taxable income for the three relevant years was increased by a total of NOK 95 525 000. EPNI filed an appeal to Oslo District Court. In 2016 the District Court ruled in favor of the tax authorities. EPNI then filed an appeal to the National Court of Appeal. The National Court of Appeal concluded that the interest payments had not been at arm’s length and dismissed the appeal. In the decision, reference is made to the Norwegian Supreme Court decision in the Statoil Angola case from 2007. Click here for translation ...

104. Pervichnyi is the parent of an MNE group organised and doing business in country X. Prior to Year 1, Pervichnyi developed patents and trademarks related to Product F. It manufactured Product F in country X and supplied the product to distribution affiliates throughout the world. For purposes of this example assume the prices charged to distribution affiliates were consistently arm’s length. 105. At the beginning of Year 1, Pervichnyi organises a wholly owned subsidiary, Company S, in country Y. In order to save costs, Pervichnyi transfers all of its production of Product F to Company S. At the time of the organisation of Company S, Pervichnyi sells the patents and trademarks related to Product F to Company S for a lump sum. Under these circumstances, Pervichnyi and Company S seek to identify an arm’s length price for the transferred intangibles by utilising a discounted cash flow valuation technique. 106. According to this valuation analysis, Pervichnyi could have generated after tax residual cash flows (after rewarding all functional activities of other members of the MNE group on an arm’s length basis) having a present value of 600 by continuing to manufacture Product F in Country X. The valuation from the buyer’s perspective shows that Company S could generate after tax residual cash flows having a present value of 1 100 if it owned the intangibles and manufactured the product in country Y. The difference in the present value of Pervichnyi’s after tax residual cash flow and the present value of Company S’s after tax residual cash flow is attributable to several factors. 107. Another option open to Pervichnyi would be for Pervichnyi to retain ownership of the intangible, and to retain Company S or an alternative supplier to manufacture products on its behalf in country Y. In this scenario, Pervichnyi calculates it would be able to generate after tax cash flow with a present value of 875. 108. In defining arm’s length compensation for the intangibles transferred by Pervichnyi to Company S, it is important to take into account the perspectives of both parties, the options realistically available to each of them, and the particular facts and circumstances of the case. Pervichnyi would certainly not sell the intangibles at a price that would yield an after tax residual cash flow with a present value lower than 600, the residual cash flow it could generate by retaining the intangible and continuing to operate in the manner it had done historically. Moreover there is no reason to believe Pervichnyi would sell the intangible for a price that would yield an after tax residual cash flow with a present value lower than 875. If Pervichnyi could capture the production cost savings by retaining another entity to manufacture on its behalf in a low cost environment, one realistically available option open to it would be to establish such a contract manufacturing operation. That realistically available option should be taken into account in determining the selling price of the intangible. 109. Company S would not be expected to pay a price that would, after taking into account all relevant facts and circumstances, leave it with an after tax return lower than it could achieve by not engaging in the transaction. According to the discounted cash flow valuation, the net present value of the after tax residual cash flow it could generate using the intangible in its business would be 1 100. A price might be negotiated that would give Pervichnyi a return equal to or greater than its other available options, and give Company S a positive return on its investment considering all of the relevant facts, including the manner in which the transaction itself would be taxed. 110. A transfer pricing analysis utilising a discounted cash flow approach would have to consider how independent enterprises dealing at arm’s length would take into account the cost savings and projected tax effects in setting a price for the intangibles. That price should, however, fall in the range between a price that would yield Pervichnyi after tax residual cash flow equivalent to that of its other options realistically available, and a price that would yield Company S a positive return to its investments and risks, considering the manner in which the transaction itself would be taxed. 111. The facts of this example and the foregoing analysis are obviously greatly oversimplified by comparison to the analysis that would be required in an actual transaction. The analysis nevertheless reflects the importance of considering all of the relevant facts and circumstances in performing a discounted cash flow analysis, evaluating the perspectives of each of the parties in such an analysis, and taking into consideration the options realistically available to each of the parties in performing the transfer pricing analysis ...

In determining which party(ies) should be attributed the location savings at arm’s length, it will be important to consider the functions, risks and assets of the parties, as well as the options realistically available to each of them. In this example, assume that there is a high demand for the type of engineering services that the company in Country X sells. Assume also that the subsidiary in Country Y is the only company operating in a lower-cost location that is able to provide such services with the required quality standard, and Company Y is able to withstand competitive pricing pressures because the technical know-how it has established acts as a barrier to competition. Furthermore, the company in Country X does not have the option of engaging qualified engineers in Country X to provide these services, as the cost of their wages would be too high compared to the hourly rate charged to clients. Considering this, the enterprise in Country X does not have many other options available to it than to use this service provider. The remuneration payable by Company X to Company Y should take into account the location savings created by Company Y, in addition to the value of its services including any intangibles used in providing those services. In some instances, the nature of the contributions made by the enterprise in Country X and its subsidiary in Country Y may meet the criteria for the use of a transactional profit split method ...

In such an example, given that the relocated activity is a highly competitive one, it is likely that the enterprise in Country A has the option realistically available to it to use either the affiliate in Country B or a third party manufacturer. As a consequence, it should be possible to find comparables data to determine the conditions in which a third party would be willing at arm’s length to manufacture the clothes for the enterprise. In such a situation, a contract manufacturer at arm’s length would generally be attributed very little, if any, part of the location savings. Doing otherwise would put the associated manufacturer in a situation different from the situation of an independent manufacturer, and would be contrary to the arm’s length principle ...

That being said, in business restructurings, before-and-after comparisons could play a role in understanding the restructuring itself and could be part of a before-and-after comparability (including functional) analysis to understand the changes that accounted for the changes in the allocation of profit/loss amongst the parties. In effect, information on the arrangements that existed prior to the restructuring and on the conditions of the restructuring itself could be essential to understand the context in which the post-restructuring arrangements were put in place and to assess whether such arrangements are arm’s length. It can also shed light on the options realistically available to the restructured entity. (See paragraphs 9.27-9.31 for a discussion of options realistically available; see also paragraphs 9.102-9.106 for a discussion of possible factual differences between situations that result from a restructuring and situations that were structured as such from the beginning and of how such differences may affect the options realistically available to the parties in negotiating the terms of the new arrangement and therefore the conditions of the restructuring and/or of the post-restructuring arrangements.) ...

Where an arrangement between associated enterprises replaces an existing arrangement (restructuring), there may be factual differences in the starting position of the restructured entity compared to the position of a newly set up operation. Sometimes, the post-restructuring arrangement is negotiated between parties that have had prior contractual and commercial relationships. In such a situation, depending on the facts and circumstances of the case and in particular on the rights and obligations derived by the parties from these prior arrangements, this may affect the options realistically available to the parties in negotiating the terms of the new arrangement and therefore the conditions of the restructuring and of the post-restructuring arrangements (see paragraphs 9.27-9.31 for a discussion of options realistically available in the context of determining the arm’s length compensation for the restructuring itself). For instance, assume a party has proved in the past to be able to perform well as a full-fledged distributor performing a whole range of marketing and selling functions, employing and developing valuable marketing intangible assets and assuming a range of risks associated with its activity such as inventory risks, bad debt risks and market risks. Assume that its distribution contract is re-negotiated and converted into a “limited risk distribution” contract whereby it will perform limited marketing activities under the supervision of a foreign associated enterprise, employ limited marketing intangibles and assume limited risks in its relationship with the foreign associated enterprise and customers. In such a situation, the restructured distributor would not be in the same position as a newly established distributor ...

The transfer pricing analysis of the arm’s length nature of the conditions of the termination or substantial renegotiation of an agreement should take account of both the perspectives of the transferor and of the transferee. Taking account of the transferee’s perspective is important both to value the amount of an arm’s length indemnification, if any, and to determine what party should bear it. It is not possible to derive a single answer for all cases and the response should be based on an examination of the facts and circumstances of the case, and in particular of the rights and other assets of the parties, of the risks assumed by the parties, of the economic rationale for the termination, of the determination of what party(ies) is (are) expected to benefit from it, and of the options realistically available to the parties. This can be illustrated as follows ...

However, in those cases where such comparables data are not found, the determination of whether the indemnification clause (or absence thereof) is arm’s length should take into account the rights and other assets of the parties at the time of entering into the arrangement and of its termination or renegotiation. This analysis might also be assisted by an examination of the options realistically available to the parties, as in some situations, it may be the case that, in comparable circumstances, an independent party would not have had any option realistically available that would be clearly more attractive to it than to accept the conditions of the termination or substantial renegotiation of the contract. The guidance in Section D of Chapter I, as well as the Guidance in Section B of this Part, are applicable ...

Once the restructuring arrangements have been accurately delineated and the options realistically available to the parties have been assessed, the following aspects should be considered: Whether commercial law supports rights to indemnification for the restructured entity under the facts of the case as accurately delineated (see Section F. 1 below); Whether the existence or absence of an indemnification clause or similar provisions (as well as the terms of such a clause where it exists) under the terms of the arrangement, as accurately delineated, is arm’s length (see Section F.2 below). Which party should ultimately bear the costs related to the indemnification of the party that suffers from the termination or re-negotiation of the agreement (see Section F.3 below) ...

There should be no presumption that all contract terminations or substantial renegotiations should give a right to indemnification at arm’s length, as this will depend on the facts and circumstances of each case. The analysis of whether an indemnification would be warranted at arm’s length should be made on the basis of the accurate delineation of the arrangements before and after the restructuring (based on the guidance in Section D. 1 of Chapter I and Section B. 1 of this Part) and the options realistically available to the parties ...

Not every case where a restructured entity experiences a reduction of its functions, assets and risks involves an actual loss of expected future profits. In some restructuring situations, the circumstances may be such that, rather than losing a “profit-making opportunity”, the restructured entity is actually being saved from the likelihood of a “loss-making opportunity”. An entity may agree to a restructuring as a better option than going out of business altogether. If the restructured entity is forecasting future losses absent the restructuring (e.g. it operates a manufacturing plant that is uneconomic due to increasing competition from low-cost imports), then there may be in fact no loss of any profit-making opportunity from restructuring rather than continuing to operate its existing business. In such circumstances, the restructuring might deliver a benefit to the restructured entity from reducing or eliminating future losses if such losses exceed the restructuring costs ...

In scenario no. 1, the distributor is surrendering a profit potential with significant uncertainties for a relatively low but stable rate of profitability. Whether an independent party would be willing to do so would depend on its anticipated return under both scenarios, on its level of risk tolerance, on its options realistically available and on possible compensation for the restructuring itself. In case scenario no. 2, it is unlikely that independent parties in the distributor’s situation would agree to relocate the risks and associated profit potential for no additional compensation if they had the option to do otherwise. Scenario no. 3 illustrates the fact that the analysis should take account of the profit potential going forward and that, where there is a significant change in the commercial or economic environment, relying on historical data alone will not be sufficient ...

There can be group-level business reasons for an MNE group to restructure. However, it is worth re-emphasising that the arm’s length principle treats the members of an MNE group as separate entities rather than as inseparable parts of a single unified business (see paragraph 1.6). As a consequence, it is not sufficient from a transfer pricing perspective that a restructuring arrangement makes commercial sense for the group as a whole: the arrangement must be arm’s length at the level of each individual taxpayer, taking account of its rights and other assets, expected benefits from the arrangement (i.e. any consideration of the post-restructuring arrangement plus, if applicable, any compensation payments for the restructuring itself), and realistically available options. Where a restructuring makes commercial sense for the group as a whole on a pre-tax basis, it is expected that an appropriate transfer price (that is, any compensation for the post-restructuring arrangement plus, if applicable, any compensation payments for the restructuring itself) would generally be available to provide arm’s length compensation for each accurately delineated transaction comprising the business restructuring for each individual group member participating in it ...

The reference to the notion of options realistically available is not intended to create a requirement for taxpayers to document all possible hypothetical options realistically available. Rather, the intention is to provide an indication that, if there is a realistically available option that is clearly more attractive, it should be considered in the analysis of the conditions of the restructuring ...

At arm’s length, there are also situations where an entity would have had one or more options realistically available to it that would clearly offer more attractive opportunities to meet their objectives than to accept the conditions of the restructuring (taking into account all the relevant conditions, including the commercial and market conditions going forward, the profit potential of the various options and any compensation or indemnification for the restructuring), including possibly the option not to enter into the restructuring transaction. In such cases, an independent party may not have agreed to the conditions of the restructuring and adjustments to the conditions made or imposed may be necessary ...

At arm’s length, there are situations where the restructured entity would have had no clearly more attractive option realistically available to it than to accept the conditions of the restructuring, e.g. a contract termination – with or without indemnification as discussed at Section F below. In longer-term contracts, this may occur by invoking an exit clause that allows for one party to prematurely exit the contract with just cause. In contracts that allow either party to opt out of the contract, the party terminating the arrangement may choose to do so because it has determined, subject to the terms of the termination clause, that it is more favourable to stop using the function, or to internalise it, or to engage a cheaper or more efficient provider or to seek more lucrative opportunities. If the restructured entity transfers rights or other assets or an ongoing concern to another party, it might however be compensated for such a transfer as discussed in Section E below ...

Thus, in applying the arm’s length principle, the tax administration should evaluate each transaction as accurately delineated under the guidance in Section D of Chapter I and consider the economically relevant characteristics taken into account by the parties in reaching the conclusion that there is no option realistically available that offers a clearly more attractive opportunity to meet their commercial objectives than the restructuring adopted (see paragraph 1.38). In making such assessment, it may be necessary or useful to assess the transactions comprising the business restructuring in the context of a broader arrangement of economically related transactions ...

The arm’s length principle is based on the notion that independent enterprises, when evaluating the terms of a potential transaction, will compare the transaction to the other options realistically available to them, and they will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objective. In other words, independent enterprises would only enter into a transaction if it does not make them worse off than their next best option. Consideration of the other options realistically available may be relevant to comparability analysis, to understand the respective positions of the parties ...

Aspects of identifying the commercial or financial relations between the parties which are particularly relevant to determining the arm’s length conditions of business restructurings, are analysed in the following sections: The accurate delineation of the transactions comprising the business restructuring and the functions, assets and risks before and after the restructuring (see Section B.1); The business reasons for and the expected benefits from the restructuring, including the role of synergies (see Section B.2); The other options realistically available to the parties (see Section B.3) ...

The application of the arm’s length principle to a business restructuring must start, as for any controlled transaction, with the identification of the commercial or financial relations between the associated enterprises involved in the business restructuring and the conditions and economically relevant circumstances attaching to those relations so that the controlled transactions comprising the business restructuring are accurately delineated. In this regard, the general guidance in Section D. 1 of Chapter I is applicable. This guidance requires the examination of the economically relevant characteristics of the commercial or financial relations between the associated enterprises, and in particular the contractual terms of the business restructuring (Section D. 1.1); the functions performed by each party to the restructuring, before and after the restructuring, taking into account assets used and risks assumed (Section D. 1.2); the economic circumstances of the parties (Section D. 1.4) and business strategies (Section D. 1.5). In addition, the analysis should be informed by a review of the business reasons for and the expected benefits from the restructuring, including the role of synergies, and the options realistically available to the parties. As stated in paragraph 1.33, these conditions and economically relevant circumstances of the accurately delineated transactions that comprise the business restructuring will then be compared with the conditions and economically relevant circumstances of comparable transactions between independent enterprises ...

Research is similarly an example of an activity that may involve intra-group services. The terms of the activity can be set out in a detailed contract with the party commissioning the service, commonly known as contract research. The activity can involve highly skilled personnel and vary considerably both in its nature and in its importance to the success of the group. The actual arrangements can take a variety of forms from the undertaking of detailed programmes laid down by the principal party, extending to agreements where the research company has discretion to work within broadly defined categories. In the latter instance, the additional functions of identifying commercially valuable areas and assessing the risk of unsuccessful research can be a critical factor in the performance of the group as a whole. It is therefore crucial to undertake a detailed functional analysis and to obtain a clear understanding of the precise nature of the research, and of how the activities are being carried out by the company, prior to consideration of the appropriate transfer pricing methodology. The consideration of options realistically available to the party commissioning the research may also prove useful in selecting the most appropriate transfer pricing method. See Section B .2 of Chapter VI ...

Where information regarding reliable comparable uncontrolled transactions cannot be identified, the arm’s length principle requires use of another method to determine the price that uncontrolled parties would have agreed under comparable circumstances. In making such determinations, it is important to consider: The functions, assets and risks of the respective parties to the transaction. The business reasons for engaging in the transaction. The perspectives of and options realistically available to each of the parties to the transaction. The competitive advantages conferred by the intangibles including especially the relative profitability of products and services or potential products and services related to the intangibles. The expected future economic benefits from the transaction. Other comparability factors such as features of local markets, location savings, assembled workforce, and MNE group synergies ...

It will often be the case that a price for a transaction involving intangibles can be identified that is consistent with the realistically available options of each of the parties. The existence of such prices is consistent with the assumption that MNE groups seek to optimise resource allocations. If situations arise in which the minimum price acceptable to the transferor, based on its realistically available options, exceeds the maximum price acceptable to the transferee, based on its realistically available options, it may be necessary to consider whether the actual transaction should be disregarded under the criterion for non-recognition set out in Section D.2 of Chapter I, or whether the conditions of the transaction should otherwise be adjusted. Similarly, if situations arise in which there are assertions that either the current use of an intangible, or a proposed realistically available option (i.e. an alternative use of the intangible), does not optimise resource allocations, it may be necessary to consider whether such assertions are consistent with the true facts and circumstances of the case. This discussion highlights the importance of taking all relevant facts and circumstances into account in accurately delineating the actual transaction involving intangibles ...

While it is important to consider the perspectives of both parties to the transaction in conducting a comparability analysis, the specific business circumstances of one of the parties should not be used to dictate an outcome contrary to the realistically available options of the other party. For example, a transferor would not be expected to accept a price for the transfer of either all or part of its rights in an intangible that is less advantageous to the transferor than its other realistically available options (including making no transfer at all), merely because a particular associated enterprise transferee lacks the resources to effectively exploit the transferred rights in the intangible. Similarly, a transferee should not be expected to accept a price for a transfer of rights in one or more intangibles that would make it impossible for the transferee to anticipate earning a profit using the acquired rights in the intangible in its business. Such an outcome would be less favourable to the transferee than its realistically available option of not engaging in the transfer at all ...

In considering the options realistically available to the parties, the perspectives of each of the parties to the transaction must be considered. A comparability analysis focusing only on one side of a transaction generally does not provide a sufficient basis for evaluating a transaction involving intangibles (including in those situations for which a one-sided transfer pricing method is ultimately determined) ...

In applying the principles of the Guidelines related to the content and process of a comparability analysis to a transaction involving intangibles, a transfer pricing analysis must consider the options realistically available to each of the parties to the transaction ...

The contractual arrangements will generally determine the terms of the funding transaction, as clarified or supplemented by the economic characteristics of the transaction as reflected in the conduct of the parties. The return that would generally be expected by the funder should equal an appropriate risk-adjusted return. Such return can be determined, for example, based on the cost of capital or the return of a realistic alternative investment with comparable economic characteristics. In determining an appropriate return for the funding activities, it is important to consider the financing options realistically available to the party receiving the funds. There may be a difference between the return expected by the funder on an ex ante basis and the actual return received on an ex post basis. For example, when the funder provides a loan for a fixed amount at a fixed interest rate, the difference between the actual and expected returns will reflect the risk playing out that the borrower cannot make some or all of the payments due ...

Where associated enterprises other than the legal owner perform relevant functions that are anticipated to contribute to the value of the intangibles, they should be compensated on an arm’s length basis for the functions they perform under the principles set out in Chapters I – III. The determination of arm’s length compensation for functional contributions should consider the availability of comparable uncontrolled transactions, the importance of the functions performed to the creation of intangible value, and the realistically available options of the parties. The specific considerations described in paragraphs 6.53 to 6.58 should also be taken into account ...

Legal ownership and contractual relationships serve simply as reference points for identifying and analysing controlled transactions relating to the intangible and for determining the appropriate remuneration to members of a controlled group with respect to those transactions. Identification of legal ownership, combined with the identification and compensation of relevant functions performed, assets used, and risks assumed by all contributing members, provides the analytical framework for identifying arm’s length prices and other conditions for transactions involving intangibles. As with any other type of transaction, the analysis must take into account all of the relevant facts and circumstances present in a particular case and price determinations must reflect the realistic alternatives of the relevant group members. The principles of this paragraph are illustrated by Examples 1 to 6 in the Annex to Chapter VI ...

This section sets out circumstances in which the transaction between the parties as accurately delineated can be disregarded for transfer pricing purposes. Because non-recognition can be contentious and a source of double taxation, every effort should be made to determine the actual nature of the transaction and apply arm’s length pricing to the accurately delineated transaction, and to ensure that non-recognition is not used simply because determining an arm’s length price is difficult. Where the same transaction can be seen between independent parties in comparable circumstances (i.e. where all economically relevant characteristics are the same as those under which the tested transaction occurs other than that the parties are associated enterprises) non-recognition would not apply. Importantly, the mere fact that the transaction may not be seen between independent parties does not mean that it should not be recognised. Associated enterprises may have the ability to enter into a much greater variety of arrangements than can independent enterprises, and may conclude transactions of a specific nature that are not encountered, or are only very rarely encountered, between independent parties, and may do so for sound business reasons. The transaction as accurately delineated may be disregarded, and if appropriate, replaced by an alternative transaction, where the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances, thereby preventing determination of a price that would be acceptable to both of the parties taking into account their respective perspectives and the options realistically available to each of them at the time of entering into the transaction. It is also a relevant pointer to consider whether the MNE group as a whole is left worse off on a pre-tax basis since this may be an indicator that the transaction viewed in its entirety lacks the commercial rationality of arrangements between unrelated parties ...

Therefore, the process of identifying the economically relevant characteristics of the commercial or financial relations should include consideration of the capabilities of the parties, how such capabilities affect options realistically available, and whether similar capabilities are reflected in potentially comparable arm’s length arrangements ...

The actual contributions, capabilities, and other features of the parties can influence the options realistically available to them. For example, an associated enterprise provides logistics services to the group. The logistics company is required to operate warehouses with spare capacity and in several locations in order to be able to cope in the event that supply is disrupted at any one location. The option of greater efficiency through consolidation of locations and reduction in excess capacity is not available. Its functions and assets may, therefore, be different to those of an independent logistics company if that independent service provider did not offer the same capabilities to reduce the risk of disruption to supply ...

All methods that apply the arm’s length principle can be tied to the concept that independent enterprises consider the options realistically available to them and in comparing one option to another they consider any differences between the options that would significantly affect their value. For instance, before purchasing a product at a given price, independent enterprises normally would be expected to consider whether they could buy an equivalent product on otherwise comparable terms and conditions but at a lower price from another party. Therefore, as discussed in Chapter II, Part II, the comparable uncontrolled price method compares a controlled transaction to similar uncontrolled transactions to provide a direct estimate of the price the parties would have agreed to had they resorted directly to a market alternative to the controlled transaction. However, the method becomes a less reliable substitute for arm’s length transactions if not all the characteristics of these uncontrolled transactions that significantly affect the price charged between independent enterprises are comparable. Similarly, the resale price and cost plus methods compare the gross profit margin earned in the controlled transaction to gross profit margins earned in similar uncontrolled transactions. The comparison provides an estimate of the gross profit margin one of the parties could have earned had it performed the same functions for independent enterprises and therefore provides an estimate of the payment that party would have demanded, and the other party would have been willing to pay, at arm’s length for performing those functions. Other methods, as discussed in Chapter II, Part III, are based on comparisons of net profit indicators (such as profit margins) between independent and associated enterprises as a means to estimate the profits that one or each of the associated enterprises could have earned had they dealt solely with independent enterprises, and therefore the payment those enterprises would have demanded at arm’s length to compensate them for using their resources in the controlled transaction. Where there are differences between the situations being compared that could materially affect the comparison, comparability adjustments must be made, where possible, to improve the reliability of the comparison. Therefore, in no event can unadjusted industry average returns themselves establish arm’s length prices ...

Independent enterprises, when evaluating the terms of a potential transaction, will compare the transaction to the other options realistically available to them, and they will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objectives. In other words, independent enterprises would only enter into a transaction if it is not expected to make them worse off than their next best option. For example, one enterprise is unlikely to accept a price offered for its product by an independent commercial enterprise if it knows that other potential customers are willing to pay more under similar conditions, or are willing to pay the same under more beneficial conditions. Independent enterprises will generally take into account any economically relevant differences between the options realistically available to them (such as differences in the level of risk) when valuing those options. Therefore, identifying the economically relevant characteristics of the transaction is essential in accurately delineating the controlled transaction and in revealing the range of characteristics taken into account by the parties to the transaction in reaching the conclusion that there is no clearly more attractive opportunity realistically available to meet their commercial objectives than the transaction adopted. In making such an assessment, it may be necessary or useful to assess the transaction in the context of a broader arrangement of transactions, since assessment of the options realistically available to third parties is not necessarily limited to the single transaction, but may take into account a broader arrangement of economically related transactions ...

K-steel S.A. purchased steel from its parent company which again purchased steel from unrelated steel mills. The tax authorities found that prices paid to the parent company by “K-steel S.A.” were not arm’s-length. The arm’s length price was established based on the prices paid for similar steel products by unrelated companies active in similar business activities. According to the tax authorities, purchasing steel directly from manufacturers would be a better alternative in terms of prices. Judgement of the Court The Court found that the authorities correctly established that arm’s-length prices were not applied and dismissed the appeal of “K-steel S.A.”. According to the court, a option realistically available for the taxpayer, and at the same time cheaper, would be to purchase the goods in question directly from steel mills, without the participation of the parent. Click here for English translation Click here for other translation ...

A company, which belonged to a Nordic group, had until August 2005, two loans with an independent party outside the group. The interest of the loans was 3.135 to 3.25 percent. The company’s long-term loans amounted to over EUR 36 million and the guarantees granted by the Company for its loans amounted to about 41 million. In August 2005 the financing of the entire group was re organised. A Ltd paid off old bank loans and took up a new loan from the Swedish company B AB, which belonged to the group. For loans between the group companies was 9.5 percent interest rate. The interest rate had been affected by interest rate percentages on unrelated loans , risk loans and loans from shareholders. After the change in funding A Ltd’s long-term debt totaled just over EUR 38 million and the guarantees granted by the Company for the group was around 300 million euros. A Ltd’s capital structure was not affected significantly by the change. The interest rates that A Ltd had paid to B AB had clearly exceeded the amount that two independent companies would have paid. The average external financing rate for the entire group, which was 7.04 percent, could not be used as the basis for deductible interest into a situation where the company’s own credit condition and other circumstances, would have made it possible for the Company to obtain financing at considerably more favorable conditions. To A Ltd’s taxable income for 2005 would thus non-deductible interest added 845,354 euros, corresponding to the difference between an interest rate of 9.5 percent and an interest rate of 3.25 percent. The law on the taxation of business income § 18 subsection 1. 2 point Click here for translation he ...

The reference to the notion of options realistically available is not intended to create a requirement for taxpayers to document all possible hypothetical options realistically available. As noted at paragraph 3.81, when undertaking a comparability analysis, there is no requirement for an exhaustive search of all possible relevant sources of information. Rather, the intention is to provide an indication that, if there is a realistically available option that is clearly more attractive, it should be considered in the analysis of the conditions of the restructuring ...

The arm’s length principle requires an evaluation of the conditions made or imposed between associated enterprises, at the level of each of them. The fact that the cross-border redeployment of functions, assets and/or risks may be motivated by sound commercial reasons at the level of the MNE group, e.g. in order to try to derive synergies at a group level, does not answer the question whether it is arm’s length from the perspectives of each of the restructured entities ...

At arm’s length, there are also situations where the restructured entity would have had no clearly more attractive option realistically available to it than to accept the conditions of the restructuring, e.g. a contract termination – with or without indemnification as discussed at Section E below. In longer-term contracts, this may occur by invoking an exit clause that allows for one party to prematurely exit the contract with just cause. In contracts that allow either party to opt out of the contract, the party terminating the arrangement may choose to do so because it has determined, subject to the terms of the termination clause, that it is more favourable to stop using the function, or to internalise it, or to engage a cheaper or more efficient provider (recipient) or to seek more lucrative opportunities (provider). In case the restructured entity transfers rights or other assets or an ongoing concern to another party, it might however be compensated for such a transfer as discussed in Section D below ...

At arm’s length, there are situations where an entity would have had one or more options realistically available to it that would be clearly more attractive than to accept the conditions of the restructuring (taking into account all the relevant conditions, including the commercial and market conditions going forward, the profit potential of the various options and any compensation or indemnification for the restructuring), including possibly the option not to enter into the restructuring transaction. In such cases, an independent party may not have agreed to the conditions of the restructuring ...

Thus, in applying the arm’s length principle, a tax administration evaluates each transaction as structured by the taxpayer, unless such transaction is not recognised in accordance with the guidance at paragraph 1.65. However, alternative structures realistically available are considered in evaluating whether the terms of the controlled transaction (particularly pricing) would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under comparable circumstances. If a more profitable structure could have been adopted, but the economic substance of the taxpayer’s structure does not differ from its form and the structure is not commercially irrational such that it would practically impede a tax administration from determining an appropriate transfer price, the transaction is not disregarded. However, the consideration in the controlled transaction may be adjusted by reference to the profits that could have been obtained in the alternative structure, since independent enterprises will only enter into a transaction if they see no alternative that is clearly more attractive ...

The application of the arm’s length principle is based on the notion that independent enterprises, when evaluating the terms of a potential transaction, will compare the transaction to the other options realistically available to them, and they will only enter into the transaction if they see no alternative that is clearly more attractive. In other words, independent enterprises would only enter into a transaction if it does not make them worse off than their next best option. Consideration of the other options realistically available may be relevant to comparability analysis, to understand the respective positions of the parties ...