UN Manual on Transfer Pricing (2017)

A.1. Introduction


A.1.1.                 This chapter provides background material on Multinational Enterprises (MNEs); MNEs are a key aspect of globalization as they have integrated cross-border business operations. The chapter describes the factors that gave rise to MNEs and shows how an MNE is able to exploit integration opportunities in the cross-border production of goods and provision of services through a value chain (or value-added chain).

A.1.2.                 MNEs are groups of companies and generally operate worldwide through locally incorporated subsidiaries or permanent establishments; they may also use other structures such as joint ventures and partnerships. At the operational level, an MNE’s business operations may be organized in several different ways such as a functional structure, a divisional structure or a matrix structure. This chapter outlines the legal structures that may be used by MNEs, and considers the differences between them.

A.1.3.                 This chapter then uses a “value chain analysis” (see Paragraphs A.2.5 and A.3.5 below) as a measure for testing the performance of an MNE. It considers the management of the transfer pricing function in an MNE to minimize the risk of transfer pricing adjustments and to avoid double taxation. While MNEs test the performance of their business operations, for tax and company law purposes they are required to report the performance of associated entities in the countries in which they operate. An MNE’s transfer pricing policy should provide guidance on: transfer pricing documentation requirements; reporting for transfer pricing purposes; dealing with audits; and appropriate measures for dispute resolution with a tax authority.


A.2. Theory of the Firm and Development of Multinational Enterprises

A.2. Theory of the Firm and Development of Multinational Enterprises

A.2.1.                 In economic theory, firms are organizations that arrange the production of goods and the provision of services. The aim of a firm is to produce goods and provide services to maximize profits. In the absence of MNEs, production would be carried out through a series of arm’s length transactions between independent parties.7 These transactions would require contracts between the independent producers but a significant part of these resources would be used in the process of making contracts.

A.2.2.                 The expenses of making contracts are called “transaction costs” since expenses are incurred by individuals in finding other persons with whom to contract, as well as in negotiating and finalizing the contracts. As contracts cannot cover every possible issue that may arise between the contracting parties, there is a risk of disputes being created by unforeseen contingencies. When disputes occur between contracting parties they may incur considerable costs in resolving these disputes including negotiation costs, legal expenses, and litigation and mediation expenses. As transactions and associated costs would be significant in an economy without firms, it is rational for firms to be created to produce goods and services, provided that the firms’ costs of production are less than the costs of outsourcing the production.

A.2.3.                 Within a firm, contracts between the various factors of production are eliminated and replaced with administrative arrangements. Usually, the administrative costs of organizing production within a firm are less than the cost of the alternative, which is outsourcing market transactions. The theoretical limit to the expansion of a firm is the point at which its costs of organizing transactions are equal to the costs of carrying out the transactions through the market.

A.2.4.                A firm will internalize the costs of production to the extent that it can achieve economies of scale in production and distribution and establish coordination economies. The United Nations Conference on Trade and Development (UNCTAD) in its 1993 World Investment Report: Transnational Corporations and Integrated Production noted that in many industries the expansion of internalized activities within multinational enterprises indicates that there are significant efficiency gains that may be achieved.

A.2.5.                 A firm’s functions in providing goods and services are collectively called its supply chain, through which the firm converts inputs into goods and services. Most firms begin by operating in their home market and rely on their competitive advantages to enter markets abroad. The term “supply chain” is defined as “the chain of processes involved in the production and distribution of a commodity.” In this chapter the term “supply chain” is used for the provision of both goods and services by MNEs. The term “value chain” is defined in this Manual as “the process or activities by which a company adds value to an article, including production, marketing, and the provision of after-sales service.”

A.2.6.                 MNEs create organizational structures and develop strategies to arrange the cross-border production of goods and services in locations around the world and to determine the level of intra-entity or intra-group integration. UNCTAD considered that there was a trend in many MNEs across a broad range of industries to use structures and strategies with high levels of integration in their operations. The integration included structures giving an associated enterprise control over a group-wide function or the sharing of group-wide functions between two or more enterprises.

A.2.7.                Successful MNEs use their location and internalization advantages to maximize their share of global markets and growth opportunities. Thus, multinational enterprises are able to minimize their costs through their integration economies, which are not available to domestic firms.

A.2.8.                 The key feature of MNEs is that they are integrated (global) businesses. Globalization has made it possible for an MNE to achieve high levels of integration and the ability to have control centralized in one location. Modern information and communications systems also provide increased horizontal communications across geographic and functional business lines. This has resulted in many MNEs providing services such as advisory, research and development (R&D), legal, accounting, financial management, and data processing from one or several regional centres to group companies. Also, management teams of an MNE can be based in different locations, leading the MNE from several locations.

A.2.9.                 In order to optimize the value chain, MNEs may establish new business operations in a developing country. These investments often happen in stages, with the initial stage involving the establishment of infrastructure, improvement of the education of individuals and accordingly, provision of economic benefits to the country.

A.2.10.               MNEs have common control, common goals and common resources, and the units of the enterprise — parent company, subsidiaries and branches — are located in more than one country. Thus, many MNEs are fully integrated businesses that plan and implement global strategies. UNCTAD has noted that integration of production by MNEs creates challenges for policy-makers in adapting the methods for allocating the income and costs of MNEs between jurisdictions for tax purposes.

A.2.11.               In Multinational Enterprises and the Global Economy (2008) the authors argue that the history of MNEs was shaped by political, social and cultural events that influenced the ownership, organization and location of international production of their goods and services. The authors claim that MNE groups integrated their operations until the late 1980s and then more recently chose to outsource some activities in which they do not have competitive advantages.

A.2.12.               For most of the twentieth century, MNE groups and international enterprises operating through branches or subsidiaries tended to expand the range of their value adding activities and by the late 1980s firms had integrated their production and marketing functions. Up to the 1960s and 1970s, MNEs had engaged in limited or no outsourcing of operations and they became large integrated conglomerates. But the authors argue that from the late 1980s MNEs began outsourcing many activities that were previously performed by the firms themselves. From the early 1990s, MNEs began restructuring to specialize in the areas in which they had competitive advantages, such as unique firm-specific assets, in particular high value intangible assets, and the capabilities that provided the firms with their market position and competitive edge.

A.2.13.               MNEs examined their value chains to identify the functions in which they had no advantage over other firms. They then began deciding on which functions they would perform themselves and which functions would be outsourced to independent firms, a process called value chain optimization. For in-house services, MNEs might decide to provide some services through centralized service centres. While the initial functions that were outsourced were non-core activities such as payroll, billing and maintenance services, outsourcing has expanded to cover core activities. The core activities may involve producing goods or providing services. For example, many firms outsource call centre activities or certain administrative functions to independent firms in countries which have educated workforces and relatively low-cost labour. Consequently, modern MNE groups organize their cross-border operations through a network of contractual arrangements with independent enterprises and cooperative in-house relationships.

A.2.14.              MNEs vary in size and include some small and medium sized enterprises (SMEs). When SMEs commence operating in other jurisdictions through locally incorporated subsidiaries they will usually incur the additional requirement of complying with transfer pricing rules. Some SMEs may face challenges in complying with transfer pricing rules because of their lack of expertise with international tax issues in general and limited compliance resources that may hinder them from expanding their operations abroad. Consequently, domestic transfer pricing rules which apply to SMEs should reflect the capacity of SMEs to comply and the capacity of the tax authorities to administer them. Some countries may have special simplified rules for SMEs, such as simplified documentation requirements, and may use flexible approaches in handling transfer pricing issues involving SMEs. This creates the need to define an SME. Although there is no universal definition, an SME may be defined on the basis of criteria including: turnover; balance sheet value; number of employees; and transaction values.


A.3. Legal Structure

A.3. Legal Structure


A.3.1.       General Principles of Company Law

A.3.1.1.              The legal systems used by countries include the common law and civil law systems. The common law system originates in the UK and is used in countries such as Australia, Canada, India, Malaysia, New Zealand and the USA. The common law is based on judgments in court cases. A judgment of a superior court is binding on lower courts in future cases. The civil law system has its origins in Roman law and operates in Europe, South America and Japan. Under a civil law system, law is enacted and codified by parliament. Companies are recognized under both systems as artificial legal persons with perpetual life and limited liability. The domestic law treatment of a partnership varies in common law and civil law countries.

A.3.1.2.              Most countries treat partnerships as fiscally transparent entities with flow-through treatment under which the partnership is ignored and tax is imposed on the partners according to their respective shares of partnership income. Other countries treat partnerships as taxable units subject to taxation as entities, including company treatment. Some countries such as the USA have limited liability companies which provide the benefit of limited liability and allow the entity to choose either flow-through treatment or treatment as a taxable unit. This is called the “check the box” system and the entities are referred to as “hybrids”. A feature of common law countries is the “trust” concept which is an obligation in relation to property which allows for concurrent legal and beneficial ownership of the trust property. A trustee will be the legal owner of property but holds the property on trust for the beneficiaries which may include both income and capital beneficiaries. While business operations may be carried on in some common law countries using a trust structure, MNEs would not normally use trusts to carry on business operations.

A.3.1.3.              One of the key decisions facing any MNE when expanding its operations to another country is the type of legal structure it will use to operate in that jurisdiction. The alternatives for an MNE are to operate abroad through locally incorporated subsidiary companies (associated enterprises) or operate abroad using permanent establishments (branches). Foreign subsidiaries may be either fully-owned by the parent company or partly-owned.

A.3.1.4.              An MNE is a group of companies or other entities and under the company law of the country in which each company is incorporated it is a legal entity. This choice of legal structure will be affected by a number of factors, apart from the tax implications, including:

  • Legal liability;
  • Risk and control; and
  • Administrative and regulatory obligations and costs.

A.3.1.5.              Other factors which may affect the choice of the legal form of the enterprise include:

  • Exchange controls;
  • Requirements for minimum shareholding by local persons or entities;
  • Administrative costs;
  • Extraction of profits; and
  • Capital requirements.

A.3.1.6.              MNEs may also carry on business abroad through a partnership or joint venture. In most jurisdictions partnerships are not legal entities and are fiscally transparent. For a partnership to exist, an MNE would require other entities to be partners such as independent entities or subsidiaries. Joint ventures involve independent companies working together on a specific project and a joint venture party may include a government or a government authority. The business structures used by an MNE may change over time such as, for example, commencing operations in a jurisdiction using a joint venture structure and then buying out the joint venture partner and operating in that jurisdiction through an associated enterprise. An MNE may also operate abroad using an agent, which may be an independent agent, a dependent agent or a commissionaire.

A.3.2.       Companies and Permanent Establishments

A.3.2.1.              In an MNE group, the parent company and subsidiary companies are separate legal entities and they may enter into intra-group transactions. On the other hand, an international enterprise with a head office in the country of residence and permanent establishments abroad is one legal entity and a permanent establishment cannot legally enter into transactions with other parts of the enterprise because transactions require at least two legal entities. In the context of the Business Profits article of some tax treaties, notional transactions within an international enterprise (either between a head office and its permanent establishment or between permanent establishments) may be recognized provided they comply with the arm’s length principle. In addition, for accounting and management purposes, the head office of an international enterprise and a branch may be treated as “transacting” with each other. Whether or not dealings between a head office and its branch are subject to transfer pricing rules would depend on the scope of a country’s domestic legislation and its tax treaties.

A.3.2.2.              Operational structures used by MNEs vary and evolve over time. There are many types of structures or hybrids which an organization can choose to adopt, but an organization’s primary aim should be to adopt an operational structure that will most effectively support and help it to achieve its business objectives. MNE operational structures usually differ from the legal structures and as a result, employees generally operate beyond and across the boundaries of legal entities and countries. Examples of the types of modern operational structures an MNE may adopt include a functional structure, a divisional structure or a matrix structure as outlined below.

A.3.3.       Types of Organizational Structures

A.3.3.1.              In a functional structure an MNE’s functions are performed by the employees within the functional divisions. These functions are usually specialized tasks, for instance the information technology engineering department would be staffed with software engineers. As a whole, a functional organization is best suited to a producer of standardized goods and services at large volume and low cost to exploit economies of scale. Coordination and specialization of tasks are centralized in a functional structure, which makes producing a limited amount of products or services efficient and predictable.

A.3.3.2.              Under a divisional structure, each organizational function is grouped into a division with each division containing all the necessary resources and functions within it, such as human resources and accounts. Divisions can be categorized from different points of view. The distinction could for example be made on a geographical basis (e.g. a China division or a West Africa division) or on a product/service basis (e.g. different products for different customers: households or companies). For example, an automobile company may have a divisional structure with a division for hybrid cars and another division for other cars with each of these divisions having its own sales, engineering and marketing departments.

A.3.3.3.              The matrix structure groups employees by multiple criteria with the most common criteria being function and product. Alternative criteria would be function and geographic location. A matrix organization frequently uses teams of employees to accomplish tasks. An example of a function-geographic matrix structure would be a company that produces two types of products (A and B) in several geographic locations. Using the matrix structure, this company would organize functions within the company as follows:

Product A/Americas; Product B/Americas; Product A/Asia-Pacific; Product B/Asia-Pacific;

Product A/Europe, Middle East, Africa (EMEA); Product B/EMEA.

In terms of this matrix structure a person in the Product A division in Brazil may report to the head of the Global Product A division and the head of the Americas division.

A.3.4.       Financial Reporting

A.3.4.1. An MNE customarily maintains, parallel to its statutory accounts, a set of management accounts to mirror its operational structure in order to measure and report on the effectiveness of each operational unit for management purposes. Some of these divisions may be classified as cost centres for management account purposes (e.g. the human resources division) whilst others may be classified as profit centres (e.g. the product/services division). It is often challenging for an MNE to attempt to segregate the corporate and statutory financial statements to reflect the organization’s operational structure.

A.3.5.       Value Chain Analysis

A.3.5.1.              The aim of MNEs is to maximize profits from producing goods and services. The key feature of an optimal MNE business is to produce a profit from exploiting resources which produce property or services of greatest economic value. A useful starting point to understand how an MNE operates is a value chain analysis which will also form the basis for a transfer pricing functional analysis. An MNE’s value chain is used to convert its economic resources of lower value into economic resources of higher value which may involve the following steps:

  1. Mapping out a generic value chain for the industry.
  2. Mapping out an MNE’s value chain.
  3. Comparing the generic value chain to an MNE’s value chain and analyzing the differences which may explain why an MNE has a competitive advantage over its competitors.
  4. Distinguishing between an MNE’s main functions and its support functions.
  5. Identifying and understanding which of the MNE’s main functions are critical to the success of the organization (i.e. a critical success factor).
  6. Identifying and understanding which activities performed by an MNE add value to the goods and services it produces, which may distinguish the MNE from its competitors, i.e. value-adding activities.
  7. Understanding and confirming how the various functions across the value chain are split by the MNE between the various legal entities in the group.

A.3.5.2.              The following example shows how three different MNEs could adopt different operational structures using the same generic value chain.

MNE Group A uses three different companies to perform very specific functions across the value chain as follows:

Company 1 in Country A is an R&D company carrying out research and also undertaking activities relating to the design of products for the entire group. A company of this nature would employ technical personnel such as engineers and scientists.

Company 2 in Country B is a fully-fledged manufacturing company (i.e. not a limited-risk contract manufacturer, for example) which also performs some functions on the design and practical application of its products.

Company 3 in Country C is responsible for the marketing, distribution and after-sales functions within the group.

MNE Group B uses two subsidiaries which perform some of the functions across the value chain and the group also outsources some of the activities to third parties:

Company 1 in Country A is an R&D company and carries out all the research and design activities in relation to the company’s products. This company is similar to Company 1 of Group A, apart from the fact that the design function is fully located in Company 1 and not partly carried out by Company 2.

Company 2 in Country B is the company responsible for marketing and customer service. This company is therefore the customer interface for the group.

The MNE has decided to outsource the production and distribution functions to third party companies.

MNE Group C uses three companies to perform the same functions in different geographical locations using intangibles developed by a third party, which would typically be used by the group under licence.

A.3.5.3.              In addition to understanding the value chain of an MNE, it is also important to understand the context in which each of the companies within the MNE contributes to the value chain, as this will ultimately be relevant in analyzing the transfer pricing implications of the value chain.

A.3.5.4.              For example, in MNE group A (see Figure A.1 below) the value chain is defined as Company 1 performing R&D, Company 2 manufacturing, and Company 3 distributing the MNE’s products. The value chain, however, may be different depending on the legal and contractual arrangements between the companies.

A.3.5.5.              One possible context could be that Company 1 performs R&D at its own risk, and is the legal owner of any intangible property developed through that R&D; Company 2 acts as a limited-risk contract manufacturer through a contractual arrangement with Company 1, and Company 3 acts as a limited-risk distributor through a contractual arrangement with Company 1. In this case, Company 1 is the legal owner of the intangible property of the MNE, and bears substantial risk associated with the manufacturing and sales of the MNE’s products.

A.3.5.6.              A different possible context of exactly the same value chain could be that Company 1 performs R&D on a contract basis for Company 2, which is the legal owner of any intangible property developed through that R&D; and Company 3 acts as a limited risk distributor through a contractual arrangement with Company 2. In this case, Company 2 is the legal owner of the intangible property of the MNE, and bears substantial risk associated with the manufacturing and sales of the MNE’s products.

A.3.5.7.            A different possible structure of the same value chain could be that Company 1 performs R&D on a contract basis for Company 3, which is the legal owner of any intangible property developed through that R&D; and Company 2 acts as a limited risk contract manufacturer through a contractual arrangement with Company 3. In this case, Company 3 is the legal owner of the intangible property of the MNE, and bears substantial risk associated with the manufacturing and sales of the MNE’s products.

Figure A.1:

Value Chain Analysis

 A.3.5.8.              As will be discussed in subsequent chapters, each of these different contexts would very likely result in different transfer pricing outcomes.15


A.4. Managing the Transfer Pricing Function in a Multinational Enterprise

A.4. Managing the Transfer Pricing Function in a Multinational Enterprise

A.4.1.           MNEs face challenges in managing their transfer pricing function. While transfer pricing may be used in some MNEs for management control, MNEs nevertheless are required to comply with the transfer pricing rules for tax purposes in the countries in which they operate. The determination of the transfer price affects the allocation of taxable income among the associated enterprises of an MNE group.

A.4.2.           Entities in an MNE group conduct global business that gives rise to opportunities to optimize the value chain of goods or services and therefore look for synergies. A challenge facing an MNE conducting a global business with associated enterprises is whether the transfer pricing method used for internal transactions is acceptable to the tax authorities in the countries in which the MNE operates. The transfer pricing challenge becomes even greater when the MNE has multiple global businesses with different business models and multiple cost centres. The size of the MNE adds to the complexity.

A.4.3.          Financial reporting for MNEs is informed by two decision trees. On the one hand, corporate and tax law require an associated enterprise to determine its taxable income derived from a specific jurisdiction. On the other hand, an MNE will usually need to determine for management purposes the income and costs of its businesses lines, which, as the previous discussion shows, can operate across several jurisdictions. In other words, while tax authorities focus on an associated enterprise’s taxable income, an MNE’s managers focus on income from their business lines. MNEs, particularly those where the parent is listed on a stock exchange, are more likely to aim to meet their tax obligations in the countries in which they operate provided that they are not subject to double taxation. Consequently, MNEs should develop and publicize within the enterprise a global transfer pricing policy to help minimize the risk of transfer pricing adjustments which may result in double taxation.

A.4.4.           The following is an illustrative example of the two different decision trees within an MNE:

Figure A.2:

Multinational Enterprise Decision Trees

A.4.5.           The allocation of profits and costs to the various legal structures is based on the functions performed, risks assumed and assets employed. Since MNEs consist of numerous associated enterprises it is very difficult to allocate the profits and costs to all the separate legal entities due to the absence of market forces. It is a complex exercise to come up with a consistent global policy for allocating results to the legal structures.

A.4.6.           The arm’s length principle allows national tax authorities to make an adjustment to the profits of one enterprise where the terms of transactions between associated enterprises differ from terms that would be agreed between unrelated enterprises in similar circumstances. A tax authority should only disregard a controlled transaction in exceptional circumstances. If the terms of a transaction between associated enterprises differ from those between unrelated parties and comparisons are difficult to make, an MNE bears the risk of transfer pricing adjustments. If the income of an associated enterprise within Country A is increased as a result of a transfer pricing adjustment, it would be reasonable to expect that there would be a corresponding transfer pricing adjustment resulting in a proportionate reduction in the income of the other associated enterprise in Country B, provided a consistent transfer pricing method is used by both countries.

A.4.7.           But Country B may use different transfer pricing methods. Consequently, if transfer prices are adjusted by a tax authority in one country, double taxation will occur if the tax authority in the other country does not use the same transfer pricing method and allows a corresponding transfer pricing adjustment. It is the task of the transfer pricing function within an MNE to limit the risk of transfer pricing adjustments and the risk of double taxation. See the illustration of double taxation below in Figure A.3.

A.4.8.           In principle, designing, implementing and documenting an appropriate transfer pricing policy should not be viewed solely as a compliance issue for MNEs. The main goal should be to develop a consistent global policy which cannot be altered to exploit tax laws. A well-developed and consistently applied transfer pricing policy should reduce an MNE’s risk of transfer pricing adjustments and the potential for double taxation, thereby increasing profitability by minimizing transfer pricing costs. Moreover, a global transfer pricing policy may be used as evidence in negotiations with tax authorities when transfer pricing disputes occur.

A.4.9.           An MNE’s transfer pricing policy should ideally reduce the risk of transfer pricing adjustments and the risks of double taxation of cross-border transactions. A comprehensive transfer pricing policy should cover four key areas as shown in Figure A.4.

Ø Advisory;

Ø Reporting;

Ø Documentation; and

Ø Audit support/Dispute resolution.

Figure A.3:

Global Effect of Transfer Pricing Adjustments (before adjustment)



Global Business 2


Global Business 1


Global Business 3





Figure A.4:

Aspects of Transfer Pricing Policy

A.4.10.          Advising requires a thorough knowledge of an MNE’s business operations. It is a misconception that the tax department makes the key business decisions within an MNE. In practice, the business units of an MNE will identify business opportunities and a decision may be taken to exploit the opportunity if it fits into the MNE’s global business strategy. Advice can be provided to minimize the risk of transfer pricing adjustments and therefore optimize the business opportunity if the tax department is involved in an MNE’s decision-making.

A.4.11.          In today’s environment there is an increasing level of detail required to meet each country’s transfer pricing documentation requirements. Most MNEs therefore prepare global and regional documentation (master files) of the various global businesses. Subsequently, global and regional reports are prepared for local purposes based on the identified risks for each country in which the MNE operates.

A.4.12.          Tax authorities around the world are increasingly focused on transfer pricing and on expanding their transfer pricing capabilities. MNEs have to find a way to deal with the increasingly detailed, complex and often conflicting domestic transfer pricing legislation in the countries where they operate. Some countries follow guidance from international bodies, others only implement part of the guidance while some develop transfer pricing rules independently.

A.4.13.          Tax authorities should not start from the assumption that MNEs are manipulating their results in order to obtain tax benefits. Many MNEs and certainly those with shares quoted on a stock exchange (listed MNEs) have published codes of conduct or a set of business principles or both. These codes or principles require that an MNE must comply with the tax rules of the countries in which they operate. Violations of these codes may result in severe consequences for a listed MNE.

A.4.14.          As transfer pricing is often referred to as “an art, not a science”, the resulting uncertainty creates the potential for transfer pricing disputes with tax authorities, even if the MNE is seeking to comply with domestic transfer pricing rules. Despite the efforts MNEs invest in setting the appropriate transfer prices and preparing comprehensive documentation, there is always the risk that tax authorities disagree with the approach taken and there is thus the risk of a transfer pricing adjustment. This creates uncertainty for MNEs including the potential associated costs of preparing additional documentation, managing tax audits and conducting litigation. Notwithstanding this, there are cases where transfer prices are manipulated to shift prof its from one jurisdiction to another to gain tax benefits including low-taxation or no-taxation.

A.4.15.          Transfer pricing rules are considered very useful by MNEs if they are able to achieve a globally consistent approach and eliminate the risk of transfer pricing disputes. If in one country an MNE’s transfer prices are adjusted, resulting in a higher taxable income, the associated enterprise in the other country should in principle receive a “corresponding adjustment”, reducing its taxable income. If there is no corresponding adjustment, the MNE will suffer double taxation. In this situation, the dispute is between two tax authorities with the MNE seeking to have consistent transfer prices accepted by both countries.

A.4.16.          Countries should try to avoid such double taxation, though in some cases there may be legitimate reasons why a corresponding adjustment is not given, or is less than the original adjustment. In such a case, it is important that the two countries enter into discussions to resolve the double taxation issue under the mutual agreement procedure mechanism in a tax treaty.

A.4.17.          The following diagram illustrates a transfer pricing adjustment to relieve double taxation:

Figure A.5:

Global Effects of Transfer Pricing Adjustments (after adjustment)




Global Business 2

Global Business 1 Global Business 3


B.1. Introduction to Transfer Pricing?



B .1 .1 . What is Transfer Pricing?

B.1.1.1.              This introductory chapter gives a brief outline of the subject of transfer pricing and addresses the practical issues and concerns surrounding it, especially the issues faced and approaches taken by developing countries. These are then dealt with in greater detail in later chapters.

B.1.1.2.              Rapid advances in technology, transportation and communication have given rise to a large number of multinational enterprises (MNEs) which have the flexibility to place their enterprises and activities anywhere in the world, as outlined in Part A of this Manual.

B.1.1.3.              A significant volume of global trade consists of international transfers of goods and services, capital (such as money) and intangibles (such as intellectual property) within an MNE group; such transfers are called “intra-group transactions”. There is evidence that intra-group trade has been growing steadily since the mid-20th century and arguably accounts for more than 30% of all international transactions.

B.1.1.4.              In addition, transactions involving intangibles and multi-tiered services constitute a rapidly growing proportion of an MNE’s commercial transactions and have greatly increased the complexities involved in analyzing and understanding such transactions.

B.1.1.5.              The structure of transactions within an MNE group is determined by a combination of the market and group driven forces which can differ from the open market conditions operating between independent entities. A large and growing number of international transactions are therefore not governed entirely by market forces, but driven by the common interests of the entities of a group.

B.1.1.6.              In such a situation, it becomes important to establish the appropriate price, called the “transfer price”, for intra-group, cross-border transfers of goods, intangibles and services. “Transfer pricing” is the general term for the pricing of cross-border, intra-firm transactions between related parties. Transfer pricing therefore refers to the setting of prices18 for transactions between associated enterprises involving the transfer of property or services. These transactions are also referred to as “controlled” transactions, as distinct from “uncontrolled” transactions between companies that are not associated and can be assumed to operate independently (“on an arm’s length basis”) in setting terms for such transactions.

B.1.1.7.              Transfer pricing thus does not necessarily involve tax avoidance, as the need to set such prices is a normal aspect of how MNEs must operate. Where the pricing does not accord with internationally applicable norms or with the arm’s length principle under domestic law, the tax administration may consider this to be “mis-pricing”, “incorrect pricing”, “unjustified pricing” or non-arm’s length pricing, and issues of tax avoidance and evasion may potentially arise. Two examples illustrate these points:

Example: Solid State Drive Manufacturer

  • In the first example, a profitable computer group in Country A buys “solid state drives” from its own subsidiary in Country The price the parent company in Country A pays its subsidiary company in Country B (the “transfer price”) will determine how much profit the Country B unit reports and how much local tax it pays. If the parent pays the subsidiary a price that is lower than the appropriate arm’s length price, the Country B unit may appear to be in financial difficulty, even if the group as a whole shows a reasonable profit margin when the completed computer is sold.
  • From the perspective of the tax authorities, Country A’s tax authorities might agree with the profit reported at their end by the computer group in Country A, but their Country B counterparts may not agree they may not have the expected profit to tax on their side of the If the computer company in Country A bought its drives from an independent company in Country B under comparable circumstances, it would pay the market price, and the supplier would pay taxes on its own profits in the normal way. This approach gives scope for the parent or subsidiary, whichever is in a low-tax jurisdiction, to be shown as making a higher profit by fixing the transfer price to that effect and thereby minimizing its tax incidence.
  • Accordingly, when the various parts of the organization are under some form of common control, it may mean that transfer prices are not subject to the full play of market forces and the correct arm’s length price, or at least an “arm’s length range” of prices needs to be arrived

Example: Luxury Watch Manufacturer

  • In a second example, a luxury watch manufacturer in Country A distributes its watches through a subsidiary in Country It is assumed that the watch costs $1400 to make and it costs the Country B subsidiary $100 to distribute it. The company in Country A sets a transfer price of $1500 and the subsidiary in Country B retails the watch at $1600 in Country B. Overall, the company has thus made $100 in profit, on which it is expected to pay tax.
  • However, when the company in Country B is audited by Country B’s tax administration they notice that the distributor itself does not earn a profit: the $1500 transfer price plus the Country B unit’s

$100 distribution costs are exactly equal to the $1600 retail price. Country B’s tax administration considers that the transfer price should be set at $1400 so that Country B’s unit shows the group’s

$100 profit that would be liable for tax.

  • This poses a problem for the parent company, as it is already paying tax in Country A on the $100 profit per watch shown in its
  • Since it is a multinational group it is liable for tax in the countries where it operates and in dealing with two different tax authorities it is generally not possible to just cancel one out against the other. So the MNE can end up suffering double taxation on the same profits where there are differences about what constitutes the appropriate transfer

B.1.1.8.              A possible reason for associated entities charging transfer prices for intra-group trade is to measure the performance of the individual entities in a multinational group. The individual entities within a multinational group may be separate profit centres and transfer prices are required to determine the profitability of the entities. However, not every entity would necessarily make a profit or loss under arm’s length conditions. Rationally, an entity having a view to its own interests as a distinct legal entity would only acquire products or services from an associated entity if the purchase price was equal to, or cheaper than, prices being charged by unrelated suppliers. This principle applies, conversely, in relation to an entity providing a product or service; it would rationally only sell products or services to an associated entity if the sale price was equal to, or higher than, prices paid by unrelated purchasers. On this basis prices should gravitate towards the “arm’s length price”, i.e. the transaction price to which two unrelated parties would agree.

B.1.1.9.              While the above explanation of transfer pricing sounds logical and simple enough, arriving at an appropriate transfer price may be a complex task particularly because of the difficulties in identifying and valuing intangibles transferred and/or services provided. For example, intangibles could be of various different types such as industrial assets like patents, trade types, trade names, designs or models, literary and artistic property rights, know-how or trade secrets, which may or may not be reflected in the accounts. There are thus many complexities involved in dealing with transfer pricing in cross-border transactions between MNE entities.

B.1.1.10.            Transfer pricing is a term that is also used in economics, so it is useful to see how economists define it. In business economics a transfer price is considered to be the amount that is charged by a part or segment of an organization for a product, asset or service that it supplies to another part or segment of the same organization. This definition is therefore consistent with the approach described above.

B.1.2. Basic Issues Underlying Transfer Pricing

B.1.2.1.              Transfer prices serve to determine the income of both parties involved in the cross-border transaction. The transfer price therefore influences the tax base of the countries involved in cross-border transactions.

B.1.2.2.              In any cross-border tax scenario, the parties involved are the relevant entities of the MNE group along with the tax authorities of the countries involved in the transaction. When one country’s tax authority adjusts the profit of a member of the MNE group, this may have an effect on the tax base of another country. In other words, cross-border tax situations involve issues related to jurisdiction, allocation of income and valuation.

B.1.2.3.              The key jurisdiction issues are: which government should tax the income of the group entities engaged in the transaction, and what happens if both governments claim the right to tax the same income? If the tax base arises in more than one country, should one of the governments give tax relief to prevent double taxation of the relevant entities’ income, and if so, which one?

B.1.2.4.              An added dimension to the jurisdictional issue is that of the motivation for transfer pricing manipulation, as some MNEs engage in practices that seek to reduce their overall tax bills. This may involve profit shifting through non-arm’s length transfer pricing in order to reduce the aggregate tax burden of the MNE. However, while reduction of taxes may be a motive influencing the MNE in setting transfer prices for intra-group transactions, it is not the only factor that determines transfer pricing policies and practices.

B.1.2.5.              The aim of non-arm’s length transfer pricing in such cases is usually to reduce an MNE’s worldwide taxes. This can be achieved by shifting profits from associated entities in higher tax countries to associated entities in relatively lower tax countries through either under-charging or over-charging the associated entity for intra-group trade. For example, if the parent company in an MNE group has a tax rate in the residence country of 30%, and has a subsidiary resident in another country with a tax rate of 20%, the parent may have an incentive to shift profits to its subsidiary to reduce its tax rate on these amounts from 30% to 20%. This may be achieved by the parent being over-charged for the acquisition of property and services from its subsidiary.

B.1.2.6.              While the most obvious motivation may be to reduce the MNE’s worldwide taxation, other factors may influence transfer pricing decisions, such as imputation of tax benefits in the parent company’s country of residence.

B.1.2.7.              A further motivation for an MNE to engage in such practices is to use a tax benefit, such as a tax loss, in a jurisdiction in which it operates. This may be either a current year loss or a loss that has been carried forward from a prior year by an associated company. In some cases, an international enterprise may wish to take advantage of an associated company’s tax losses before they expire, in situations where losses can only be carried forward for a certain number of years. Even if there are no restrictions on carrying forward tax losses by an associated company, the international enterprise has an incentive to use the losses as quickly as possible. In other words, profits may sometimes be shifted to certain countries in order to obtain specific tax benefits.

B.1.2.8.              MNEs are global structures which may share common resources and overheads. From the perspective of the MNE these resources need to be allocated with maximum efficiency in an optimal manner.

B.1.2.9.              From the government’s perspective, the allocation of costs and income from the MNE’s resources is an essential element in calculating the tax payable. There can thus be a dispute between countries in the allocation of costs and resources, owing to their objective of maximizing the tax base in their respective jurisdictions.

B.1.2.10.            From the MNE’s perspective, any trade or taxation barriers in the countries in which it operates raise the MNE’s transaction costs while distorting the allocation of resources. Furthermore, many of the common resources which are a source of competitive advantage to an MNE cannot be separated from the income of the MNE’s group members for tax purposes. This is especially true in the case of intangibles and service-related intra-group transactions.

B.1.2.11.            Mere allocation of income and expenses to one or more members of the MNE group is not sufficient; the income and expenses must also be valued. A key issue of transfer pricing is therefore the valuation of intra-group transfers.

B.1.2.12.            As an MNE is an integrated structure with the ability to exploit international differentials and to utilize economies of integration not available to a stand-alone entity, transfer prices within the group are unlikely to be the same prices that unrelated parties would negotiate.

B.1.2.13.            International tax issues, especially transfer pricing related issues, throw open a number of challenges, the complexity and magnitude of which are often especially daunting for smaller tax administrations.

B.1.2.14.            One such complex yet pressing issue, especially given the exponential rise of the digital economy, is arriving at the appropriate arm’s-length price for transactions involving intangibles. Intangibles are often unique, mobile and difficult to value and this presents unique problems for taxpayers and tax authorities alike.

B.1.2.15.            Another set of challenges involve transfer pricing issues related to business restructuring and intra-group services. Transfer pricing documentation requirements for MNE’s represent one more key focus area given the evolution of stringent documentation standards, including country-by-country reporting, not to mention the increasing information exchange between governments on international transactions.

B.1.2.16.            All these basic and critical transfer pricing issues are addressed in detail in this Manual in separate chapters.

B.1.2.17.            Overall, it should be amply clear that transfer pricing rules are essential for countries in order to protect their tax base, to eliminate double taxation and to enhance cross-border trade. For developing countries, transfer pricing rules are essential to provide a climate of certainty and an environment for increased cross-border trade while at the same time ensuring that the country is not losing out on critical tax revenue. Transfer pricing is thus of paramount importance and hence detailed transfer pricing rules are essential.

B .1 .3 . Evolution of Transfer Pricing

B.1.3.1.              This section aims to trace the history and the reasons for transfer pricing taxation regimes. It is important to note that transfer pricing essentially involves the application of economic principles to a fluid marketplace. Thus new approaches and techniques that help arrive at the appropriate transfer price from the perspective of one or more factors in the system continue to be developed.

B.1.3.2.              The OECD Transfer Pricing Guidelines (OECD Guidelines) as amended and updated, were first published in 1995. This followed previous OECD reports on transfer pricing in 1979 and 1984. The OECD Guidelines represent a consensus among OECD Members, mostly developed countries, and have largely been followed in domestic transfer pricing regulations of these countries. Another transfer pricing framework of note which has evolved over time is represented by the USA Transfer Pricing Regulations (26 USC 482).

B.1.3.3.              Special attention must be focused on the meaning and scope of the term “associated enterprises”, which is a topic of importance but one not defined or discussed adequately so far. This issue is discussed in more detail below.

B.1.3.4.              From a financial perspective, transfer pricing is probably the most important cross-border tax issue globally. This is partly because the term “MNE” not only covers large corporate groups but also smaller groups with one or more subsidiaries or permanent establishments (PEs) in countries other than those where the parent company or head office is located.

B.1.3.5.              Parent companies of large MNE groups usually have intermediary or sub-holdings in several countries around the world. From a management perspective, the decision-making in MNE groups may range from highly centralized structures to highly decentralized structures with profit responsibility allocated to individual group members. Such group structures typically include:

Ø Research and development (R&D) and services that may be concentrated in centres operating for the whole group or specific parts of the group;

Ø Intangibles, developed by entities of the MNE group; these may be concentrated around certain group members;

Ø Finance and “captive insurance companies”19 which may operate as insurers or internal finance companies; and

Ø Production units, where the production or assembly of final products may take place in many countries around the world.

B.1.3.6.              The on-going and continuous relocation of the production of components and finished products to particular countries; the rise of many new economies in the developing countries with their infrastructure, skilled labour, low production costs, conducive economic climate etc.; the round-the-clock trading in financial instruments and commodities; and the rise of e-commerce and Internet-based business models are a few of the many reasons why transfer pricing has become such a high profile issue over the last couple of decades.

B.1.3.7.              Other considerations have also had an impact on the importance of transfer pricing. Some developed countries have tightened their transfer pricing legislation to address the issue of foreign enterprises active in their countries paying lower tax than comparable domestic groups. Consequently, some developing countries have introduced equally exhaustive transfer pricing regulations in their countries to keep their tax bases intact. Other developing countries are recognizing that they need to effectively address the challenges of transfer pricing in some way.

B.1.3.8.              Countries with less sophisticated tax systems and administrations have run the risk of absorbing the effect of stronger enforcement of transfer pricing in developed countries and in effect paying at least some of the MNEs’ tax costs in those countries. In order to avoid this, many countries have introduced new transfer pricing rules.

B.1.3.9.              The OECD Committee on Fiscal Affairs continues to monitor developments in transfer pricing, in particular developments in the use of profit-based methods, and in comparability matters. The recent thrust of the OECD has been studying, along with G20 countries, the current international taxation rules to identify weakness which may result in opportunities for Base Erosion and Profit Sharing (BEPS). In September 2013, the OECD launched the Action Plan on BEPS initiative which identified 15 actions aimed at providing new or reinforced international standards and measures to help countries tackle BEPS. The OECD BEPS initiative released 7 preliminary reports in 2014 and followed it with the release of a final package of 15 reports, one for each Action Plan, at the G20 Finance Ministers meeting in October 2015. The Action Plans provide Model provisions to prevent treaty abuse; call for standardized Country-by-Country Reporting in terms of documentation requirements; elucidate a peer review process for addressing harmful tax practices; endorse a minimum standard to secure progress on dispute resolution and make many other such recommendations.

B.1.3.10.            While the OECD BEPS initiative, theoretically, is aimed at revamping international tax standards to keep pace with the changing global business environment, the practical implementation of such BEPS measures is dependent on the individual countries making necessary changes to their domestic laws as well as modifying treaty provisions with other countries and doing all of this in a coordinated manner — which is yet to happen.

B.1.3.11.            It is to be noted that the OECD TP Guidelines have emerged from Article 9 of the OECD Model Convention; they have also been applied in the context of the UN Model Double Tax Convention. However, developing countries have found it very difficult to implement such guidelines in practice. There are presently five different prescribed transfer pricing methods (see Chapter B.3.) that may be used under the OECD Guidelines in various situations to arrive at an arm’s length price. However, while these methods may be able to provide  a computation of the arm’s length price (i.e., an appropriate transfer price) within the MNE, in practice disagreements between tax authorities in applying these methods may result in taxable profits between two MNEs being either more than 100% or less than 100% of actual combined profits. This situation could arise as a result of adjustments carried out by one tax authority without corresponding adjustments by the tax authority in the other country, where such adjustments are not endorsed in the relevant double taxation treaty.

B.1.3.12.            The European Commission has also developed proposals on income allocation to members of MNEs active in the European Union (EU). Some of the approaches considered have included the possibility of a “common consolidated corporate tax base (CCCTB)” and “home state taxation”. Under both options transfer pricing would be replaced by formulary apportionment, whereby taxing rights would be allocated between countries based upon the apportionment of the European business activity of an MNE conducted in those countries. Apportionment would be under an agreed formula, based upon some criteria of business activity such as some combination of sales, payroll, and assets. In recent years, the EU Joint Transfer Pricing Forum21 has developed proposals to improve transfer pricing dispute resolution (Mutual Agreement Procedure, arbitration and Advance Pricing Arrangements), and a proposal to harmonize transfer pricing documentation requirements. The proposals on EU transfer pricing documentation requirements and on the implementation of the EU Arbitration Convention have been adopted as “Codes of Conduct” by the EU Council. The EU Council also issued, on 17 May 2011, some guidelines on low-value-adding intra-group services; they are endorsed on the basis that their implementation should contribute to reducing tax disputes. In January 2016, the European Commission also published a Communication on a “Fair and Efficient Corporate Tax System in the European Union” which aims to set out how the OECD/G20 BEPS measures can be implemented within the EU.

B.1.3.13.            The United Nations for its part published an important report on “International Income Taxation and Developing Countries” in 1988. The report discusses significant opportunities for transfer pricing manipulation by MNEs to the detriment of developing country tax bases. It recommends a range of mechanisms specially tailored to deal with the particular intra-group transactions by developing countries. The United Nations Conference on Trade and Development (UNCTAD) also issued a major report on Transfer Pricing in 1999.The United Nations is again taking a leadership role, through this Transfer Pricing Manual, in trying to arrive at updated global transfer pricing guidance which can be used by countries all over the world in developing and implementing their transfer pricing regulations.

B .1 .4 .  Concepts in Transfer Pricing

B.1.4.1.              The UN Model Tax Convention Article 9(1) states the following


(a)  an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or

(b)  the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State, and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of these conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly”. In other words, the transactions between two related parties must be based on the arm’s length principle (ALP). The term “arm’s length principle” itself is not a term specifically used in Article 9, but is well accepted by countries as encapsulating the approach taken in Article 9, with some differing interpretations as to what this means in practice. The principle set out above in the UN Model has also been reiterated in the OECD Model Tax Convention and the OECD Guidelines as supplemented and amended.

B.1.4.2.              The arm’s length principle is thus the accepted guiding principle in establishing an acceptable transfer price under Article 9 of the UN Model. The arm’s length principle by itself is not new; it has its origins in contract law to arrange an equitable agreement that will stand up to legal scrutiny, even though the parties involved may have shared interests.

B.1.4.3.              Under the arm’s length principle, transactions within a group are compared to transactions between unrelated entities under comparable circumstances to determine acceptable transfer prices. Thus, the marketplace comprising independent entities is the measure or benchmark for verifying the transfer prices for intra-entity or intra-group transactions and their acceptability for taxation purposes.

B.1.4.4.              The rationale for the arm’s length principle itself is that because the market governs most of the transactions in an economy it is appropriate to treat intra-group transactions as equivalent to those between independent entities. Under the arm’s length principle, intra-group transactions are tested and may be adjusted if the transfer prices are found to deviate from comparable arm’s length transactions. The arm’s length principle is argued to be acceptable to everyone concerned as it uses the marketplace as the norm.

B.1.4.5.          An argument in favour of using the arm’s length principle is that it is geographically neutral, as it treats profits from investments in different places in a similar manner. However, this claim of neutrality is conditional on consistent rules and administration of the arm’s length principle throughout the jurisdictions in which an international enterprise operates. In the absence of consistent rules and administration, international enterprises may have an incentive to avoid taxation through transfer pricing manipulation.

B.1.4.6.              While it is relatively easy to describe the arm’s length principle, establishing guidelines on the practical application of the principle is a complex task. Practical application of the principle requires identification and application of reliable comparable transactions.

B.1.4.7.              A practical example follows of a situation where the arm’s length principle needs to be applied:

Example: Automobile Seat Manufacturer

Assume a Corporation P (parent) manufactures automobile seats in Country A, then sells the finished seats to its Subsidiary S in Country B which in turn sells those finished seats in Country B to unrelated parties (e.g., the public at large). In such a case S’s taxable profits are determined by the sale price of the seats to the unrelated parties minus the price at which the seats were obtained from its parent corporation (cost of goods sold in the accounts of S, in this case the transfer price) and its expenses other than the cost of goods sold.

If Country A where the seats are manufactured has a tax rate much lower than the tax rate in Country B where the seats are sold to the public at large, i.e. to unrelated parties, then perhaps Corporation P would have an incentive to book as much profit as possible in Country A and to this end show a very high sales value (or transfer price) of the seats to its Subsidiary S in Country B. If the tax rate was higher in Country A than in Country B, then the corporation would have an incentive to show a very low sales value (or transfer price) of the seats to its Subsidiary S in Country B and concentrate almost the entire profit in the hands of Country B.

This is a clear example that when associated enterprises deal with each other their commercial or financial relations may not be directly affected by market forces but may be influenced more by other considerations. The arm’s length principle therefore seeks to determine whether the transactions between related taxpayers (in this case Corporation P and its Subsidiary S) are appropriately priced to reflect their true tax liability by comparing them to similar transactions between unrelated taxpayers at arm’s length.

B.1.4.8.              Intangibles present a unique challenge to applying the arm’s-length principle to arrive at the appropriate transfer price as in practice they may be tough to identify, value and find comparables for. A whole host of transfer pricing issues has opened up due to the rapid increase in the use of intangibles by MNE’s.

B.1.4.9.              All parties involved, and especially the tax authorities conducting transfer pricing examinations, should be aware that there can be many factors affecting the arm’s length price. These factors range from government policies and regulations to cash-flows of the entities in the MNE group.

B.1.4.10.            There should not be an implicit assumption on the part of the tax authorities that there is profit manipulation by the MNE simply because there is an adjustment to approximate to the arm’s length transaction; any such adjustment may arise irrespective of the contractual terms between the entities. Another incorrect assumption, often made in practice, is that the commercial or financial relations between associated enterprises and in the marketplace will without fail be different and always at odds with each other.

B.1.4.11.            In many cases the MNEs themselves may have an incentive to set an arm’s length price for their intra-group transactions so as to judge the true performance of their underlying entities.

B.1.4.12.            Overall, the underlying idea behind the arm’s length principle is the attempt to place transactions, both uncontrolled and controlled, on equal terms with respect to the tax advantages (or disadvantages) that they create. The arm’s length principle has been widely accepted and has found its way into most transfer pricing legislation across the world.

B.1.4.13.            An alternative to the arm’s length principle might be a Global Formulary Apportionment Method, which would allocate the global profits of an MNE group amongst the associated enterprises on the basis of a multi-factor weighted formula (using factors such  as property, payroll and sales for example, or such other factors as may be defined when adopting the formula). A formulary apportionment approach is currently used by some states of the USA, cantons of Switzerland and provinces of Canada. Also, the Brazilian transfer pricing rules set out a maximum ceiling on the expenses that may be deducted for tax purposes in respect of imports and lay down a minimum level for the gross income in relation to exports, effectively using a set formula to allocate income to Brazil. The EU is also considering a formulary approach, at the option of taxpayers, to harmonize its corporate taxes under the Common Consolidated Corporate Tax Base (CCCTB) initiative.

Applying the arm’s length principle

B.1.4.14.            The process to arrive at the appropriate arm’s length price typically involves the following processes or steps:

Ø Comparability analysis;

Ø Evaluation of transactions;


B.2. Comparability Analysis


 B .2 .1 .       Rationale for Comparability Analysis

B.2.1.1.              The term “comparability analysis” is used to designate two distinct but related analytical steps:

1)     An understanding of

  1. The economically significant characteristics and circumstances of the controlled transaction, i.e. the transaction between associated enterprises, and
  2. The respective roles and responsibilities of the parties to the controlled transaction. This is generally performed through an examination of five “comparability factors”, see further para. B.2.1.6.

2)     A comparison between the conditions of the controlled transaction (as established in step 1 immediately above) and those in uncontrolled transactions (i.e. transactions between independent enterprises) taking place in comparable circumstances. The latter are often referred to as “comparable uncontrolled transactions” or “comparables”.

B.2.1.2.              This concept of comparability analysis is used in the selection of the most appropriate transfer pricing method, as well as in applying the selected method to arrive at an arm’s length price or financial indicator (or range of prices or financial indicators). It thus plays a central role in the overall application of the arm’s length principle.

B.2.1.3.              A practical difficulty in applying the arm’s length principle is that associated enterprises may engage in transactions that independent enterprises would not undertake. Where independent enterprises do not undertake transactions of the type entered into by associated enterprises, the arm’s length principle is difficult to apply because there is little or no direct evidence of what conditions would have been established by independent enterprises. The mere fact that a transaction may not be found between independent parties does not of itself mean that it is, or is not, arm’s length.

B.2.1.4.              It should be kept in mind that the lack of a comparable for a taxpayer’s controlled transaction does not imply that the arm’s length principle is inapplicable to that transaction. Nor does it imply anything about whether that transaction is or is not, in fact, at arm’s length. In a number of instances, it will be possible to use “imperfect” comparables, e.g. comparables from another country with comparable economic conditions or comparables from another industry sector. Such a comparable would possibly need to be adjusted to eliminate or reduce the differences between that transaction and the controlled transaction as discussed in Paragraph B.2.1.5 below. In other instances, where no comparables are found for a controlled transaction between associated enterprises, it may become necessary to use approaches not depending directly on comparables to find an arm’s length price35 (see further Chapter B.3.). It may also be necessary to examine the economic substance of the controlled transaction to determine whether its conditions are such that it might be expected to have been agreed between independent parties in similar circumstances — in the absence of evidence of what independent parties have actually done in similar circumstances.

B.2.1.5.              A controlled and an uncontrolled transaction are regarded as comparable if the economically relevant characteristics of the two transactions and the circumstances surrounding them are sufficiently similar to provide a reliable measure of an arm’s length result. It is recognized that in reality two transactions are seldom completely alike and in this imperfect world, perfect comparables are often not available. It is therefore necessary to use a practical approach to establish the degree of comparability between controlled and uncontrolled transactions. To be comparable does not mean that the two transactions are necessarily identical, but instead means that either none of the differences between them could materially affect the arm’s length price or profit or, where such material differences exist, that reasonably accurate adjustments can be made to eliminate their effect. Thus, in determining a reasonable degree of comparability, adjustments may need to be made to account for certain material differences between the controlled and uncontrolled transactions. These adjustments (which are referred to as “comparability adjustments”) are to be made only if the effect of the material differences on price or profits can be ascertained with sufficient accuracy to improve the reliability of the results.

B.2.1.6.              The aforesaid degree of comparability between controlled and uncontrolled transactions is typically determined on the basis of a number of attributes of the transactions or parties that could materially affect prices or profits and the adjustment that can be made to account for differences. An examination of these attributes is therefore necessary to both steps of the comparability analysis. These attributes, which are usually referred to as the five comparability factors, include:

Ø Characteristics of the property or service transferred;

Ø Functions performed by the parties taking into account assets employed and risks assumed, in short referred to as the “functional analysis”;

Ø Contractual terms;

Ø Economic circumstances; and

Ø Business strategies pursued.

B.2.1.7.              Obviously, as the degree of comparability increases, the number and extent of potential differences that could render the analysis inaccurate necessarily decreases. Also, in general, while adjustments can and must be made when evaluating these factors so as to increase comparability, the number, magnitude and the reliability of such adjustments may affect the reliability of the overall comparability analysis.

B.2.1.8.              The type and attributes of available comparables in a given situation also needs to be considered in determining the most appropriate transfer pricing method. For further information, see Chapter B.1, Paragraph B.1.5 and Chapter B.3. In general, closely comparable products or services are required if the Comparable Uncontrolled Price Method is used for arm’s length pricing; the Resale Price Method, Cost Plus Method and Transactional Net Margin Method, may also be appropriate where only functional comparables are available, i.e. where the functions performed, assets employed and risks assumed by the parties to the controlled transaction are sufficiently comparable to the functions performed, assets employed and risks assumed by the parties to the uncontrolled transaction so that the comparison makes economic sense. An example would be two comparable distributors of consumer goods of the same industry segment, where the goods distributed may not be exactly the same, but the functional analyzes of the two distributors would be comparable. See further Chapter B.3.

B.2.1.9.       Practical guidance is needed for cases without sufficient comparables. There seem to be two distinct problems relating to comparables for developing countries’ tax authorities. The first is lack of access to existing sources, such as existing non-local company databases; the second is the lack of reliable local country comparables. For each of these, there are problems associated with both administration (e.g., how the lack of data impedes the reliable and efficient determination of appropriate arm’s length results) and problems associated with double tax/dispute avoidance (e.g., how the lack of appropriate data impedes a developing country’s ability to reach agreement with other tax authorities, or prevent the developing country from being taken advantage of).

B.2.1.10.            The OECD Transfer Pricing Guidelines point out that non-domestic comparables should not be automatically rejected. The Guidelines further recommend that where independent transactions are scarce in certain markets and industries a pragmatic solution needs to be found on a case by case basis. This means that when the data are insufficient, stakeholders can still use imperfect comparables, after necessary adjustments are made, to assess the arm’s length price. The validity of such procedures depends heavily on the accuracy of the comparability analysis as a whole.

B.2.1.11.            This chapter discusses a possible procedure to identify, screen, select and adjust comparables in a manner that enables the taxpayer or tax administration to make an informed choice of the most appropriate transfer pricing method and apply that method correctly to arrive at the appropriate arm’s length price or profit (or range of prices or profits).

B .2 .2 .Comparability Analysis Process

A typical approach that can be followed while performing a comparability analysis is outlined below. The steps below are by no means exhaustive but rather suggest an outline based upon which a comparability analysis could be carried out. It may be noted that the process is not linear: for example, a number of the steps may need to be carried out repeatedly until a satisfactory result is achieved. The subsequent sections of this chapter deal with each of these steps in more detail:

Ø Understanding the economically significant characteristics of the industry, taxpayer’s business and controlled transactions

 Gathering of basic information about the taxpayer

 Identifying and accurately delineating the controlled transaction in question

 Evaluation of separate and/or combined transactions;

Ø Examination of comparability factors of the controlled transaction

 Characteristics of the property or service transferred

 Functional analysis of the controlled transaction under examination

 Contractual terms of the transaction

 Economic circumstances of the transaction

 Business strategies of the parties;

Ø Selecting the tested party/ parties (if applicable);

Ø Identifying potentially comparable transactions — internal and external;

Ø Comparability adjustments where appropriate;

Ø Selection of the most appropriate transfer pricing method;

Ø Determination of an arm’s length price or profit (or range of prices or profits);

Ø Documentation of comparability analysis and monitoring.

B .2 .3 .       Comparability Analysis in Operation

B.2.3.1.            Understanding the Economically Significant Characteristics of the Industry, Business and Controlled Transactions

Gathering of basic information about the taxpayer

B.            An essential first step to enabling effective transfer pricing analysis is the collection of information about the taxpayer to understand its business operations and activities. This fact-finding process should include identification of associated enterprises involved in the controlled transaction, and gathering information about relevant cross-border controlled transactions in the context of the commercial and financial relations between the enterprises (including the functions performed, assets used (including intangibles, see Chapter B.5.) and risks assumed, by each party, the nature of products/services transferred, the terms and conditions of the transaction, the economic circumstances, etc.).

B.            An analysis should be performed of the taxpayer’s circumstances including but not limited to an analysis of the industry, competition, economy, regulatory factors and other elements that may significantly affect the taxpayer and its environment. This analysis is by nature specific to each taxpayer and industry.

B.            Information about the taxpayer from its annual report, product brochures, news articles, research reports prepared by independent agencies, management letters and internal reports could act as a good starting point for understanding the taxpayer’s circumstances. A study of these documents will provide an idea of the industry to which the enterprise belongs, the nature of its business activities (i.e. manufacturer, wholesaler, distributor, etc.), its market segment, market share, market penetration strategies, type of products/services dealt in, etc.

Identify the accurately delineated transaction

B.            The arm’s length price must be established in relation to transactions actually undertaken. Thus, the critical first step in any comparability analysis is to accurately define those transactions by analyzing their economically relevant characteristics, as reflected not only in the contracts between the parties, but also their conduct and any other facts. In this regard, the contractual terms will generally be the starting point for the analysis (as clarified or supplemented by the parties’ conduct); and to the extent that the conduct or other facts are inconsistent with the written contract, the former should be taken as the best evidence of the transaction(s) actually undertaken.

B.            Tax authorities should not substitute other transactions in the place of those that have actually happened and should not disregard those transactions actually undertaken other than in exceptional circumstances. Such circumstances may exist, for example, where the arrangements viewed in their totality are not commercially rational thereby preventing the determination of an arm’s length price for each party to the transaction (taking into account their own perspectives and the options realistically available to each of them). This test is a substantive one and looks at the nature of the arrangements entered into: a lack of comparable, independent transactions does not, of itself, indicate that the controlled transaction lacks commercial rationality.

B.            The test for commercial rationality must be considered from each entity’s own perspective, as an arrangement that is commercially rational at group level is not necessarily arm’s length from the perspective of each party.

B.            In addition, an arrangement that is expected to leave the MNE group as a whole worse off on a pre-tax basis than it would be if it had not entered into the arrangement will raise the question whether it is primarily tax driven and it may warrant further examination as to whether it is commercially irrational thereby preventing the determination of an arm’s length price for each party to the transaction.

B.            Where a transaction that was actually undertaken is not commercially rational, any alternative transactions that are substituted for transfer pricing purposes should correspond as closely as possible to the actual facts of the case whilst achieving a commercially rational expected result: i.e. one which would have enabled party the parties to come to a price acceptable to both at the time the arrangement was entered into.

B.            In general, non-recognition or substitution of transactions should not be undertaken lightly as this would create significant uncertainty for taxpayers and tax administrations; this may also lead to double taxation due to the divergent views taken by countries on how any substitute transactions are structured. The ability of tax authorities to disregard or substitute transactions will depend on their powers under applicable domestic law, and should be considered in developing domestic transfer pricing legislation and administrative rules. See further Chapters B.8. and C.5.

Evaluation of separate and combined transactions

B.          An important aspect of transfer pricing analysis is whether this analysis has to be carried out with respect to a taxpayer’s individual international controlled transactions or to a group of international controlled transactions having a close economic nexus.

B.          The transfer pricing analysis should ideally be made on a transaction-by-transaction basis. However, there are cases where separate transactions are so closely linked that such an approach would not lead to a reliable result. Where transactions are so closely interrelated or continuous that application of the arm’s length principle on a transaction-by-transaction basis would become unreliable or cumbersome, transactions are often aggregated for the purposes of the analysis.

B.          An example can be the case of transactions involving the licensing of know-how to associated manufacturers together with the supply to the licensed associated manufacturers of components needed to exploit such know-how. In such a case, the transfer pricing analysis may be more reliable if it takes into account both the license and the supply of components together, compared to a consideration of each separate activity without recognizing that they are closely interrelated transactions. Similarly, long-term service supply contracts and pricing of closely linked products are difficult to analyze separately.

B.          Another important aspect of combined transactions is the increasing presence of composite contracts and “package deals” in an MNE group. A composite contract and/or package deal may contain a number of elements including leases, sales and licenses all packaged into one deal. Generally, it will be appropriate to consider the deal in its totality to understand how the various elements relate to each other, but the components of the composite contract and/or package deal may or may not, depending on the facts and circumstances of the case, need to be evaluated separately to arrive at the appropriate transfer price. In certain cases, it may be more reliable to allocate the price to the elements of the composite contract or package deal.

B.          “Aggregation” issues also arise when looking at potential comparables. Since third party information is not often available at the transaction level, entity level information is frequently used in practice when looking at external comparables (e.g. in the absence of reliable internal comparables; “external comparable” and “internal comparable” are defined in Paragraph B. below). It must be noted that any application of the arm’s length principle, whether on a transaction-by-transaction basis or on an aggregation basis, needs to be evaluated case by case, applying the most appropriate transfer pricing method to the facts in that particular case.

B.2.3.2.          Examination of Comparability Factors of the Controlled Transaction


B.            The first part of a comparability analysis for transfer pricing purposes involves understanding and defining the controlled transaction to be tested. In addition to the contextual information on the industry and the overall business of the taxpayer, this analysis is typically structured around the five comparability factors: the characteristics of the property or service; contractual terms; functional analysis; economic circumstances and business strategies.

Characteristics of the property or service transferred

B.            Property, whether tangible or intangible, as well as services, may have differing characteristics which may lead to a difference in their values in the open market. Therefore, these differences must be accounted for and considered in any comparability analysis of controlled and uncontrolled transactions. Characteristics that may be important to consider are:

Ø In the case of tangible property: physical features, quality, reliability, availability and the volume of supply;

Ø In the case of services: nature and extent of such services; and

Ø In the case of intangible property: form of the transaction (e.g. licensing or sale) and the type and form of property, duration and degree of protection and anticipated benefits from use of the property.

For example, comparability analysis should take into account the differences between trademarks and trade names that aid in commercial exploitation (marketing intangibles) as opposed to patents and know-how (trade intangibles).

Contractual terms of transaction

B.            The conduct of the contracting parties is generally a result of the terms of the contract between them. The contractual relationship thus warrants careful analysis when computing the transfer price. Other than a written contract, the terms of the transactions may be found in correspondence and communications between the parties involved. In cases where the terms of the arrangement between the two parties are not explicitly defined, the contractual terms have to be deduced from their economic relationship and conduct.

B.            An important point to note is that associated enterprises may not hold each other fully to the terms of the contract since they have common overarching interests; this contrasts with independent enterprises, which are expected to hold each other to the terms of the contract. Thus, it is important to figure out whether the contractual terms between the associated enterprises are a “sham” (something that appears genuine, but when looked at more closely lacks reality, and is not valid under many legal systems) and/or have not been followed in reality.

B.            Also, explicit contractual terms of a transaction involving members of an MNE may provide evidence as to the form in which the responsibilities, risks and benefits have been assigned among those members. For example, the contractual terms might include the form of consideration charged or paid, sales and purchase volumes, the warranties provided, the rights to revisions and modifications, delivery terms, credit and payment terms etc. In addition to an examination of these contractual terms, it will be important to check that the actual conduct of the parties conforms to them.

B.            Where there are material differences in economically significant contractual terms between the taxpayer’s controlled transactions and the potential comparables, such differences should be evaluated, in order to judge whether comparability between the controlled and uncontrolled transactions is nevertheless satisfied and whether comparability adjustments need to be made to eliminate the effects of such differences.

B.            How contractual terms may affect transfer pricing may be seen in the following example:

Example: Relevance of Contractual Terms

Consider Company A in one country, an agricultural exporter, which regularly buys transportation services from Company B (its foreign subsidiary) to ship its product, cocoa beans, from Company A’s Country to overseas markets. Company B occasionally provides transportation services to Company C, an unrelated domestic corporation in the same country as Company B. However, the provision of such services to Company C accounts for only 10% of the gross revenues of Company B and the remaining 90% of Company B’s revenues are attributable to the provision of transportation services for cocoa beans to Company A. In determining the degree of comparability between Company B’s uncontrolled transaction with Company C and its controlled transaction with Company A, the difference in volumes involved in the two transactions, volume discount if any, and the regularity with which these services are provided must be taken into account where such factors would have a material effect on the price charged.

Functional analysis

B.            Functional analysis typically involves identification of functions performed, assets employed and risks assumed (also called FAR analysis) with respect to the international controlled transactions of an enterprise. Functional analysis seeks to identify and compare the economically significant activities and the responsibilities undertaken by the independent and the associated enterprises. An economically significant activity is one which materially affects the price charged in a transaction and/or the profits earned from that transaction.

B.            Functional analysis is the cornerstone of any transfer pricing exercise; its purpose is to gain an understanding of the operations of an enterprise with its associated enterprises and of the respective roles of the parties to the controlled transaction under examination. These will affect the determination of an arm’s length remuneration for the transaction since compensation in transactions between two independent enterprises will usually reflect the functions that each enterprise performs, taking into account assets employed and risks assumed. Generally, the more valuable those functions and assets, and the greater the risks, the greater the expected remuneration. Functional analysis is also essential to the identification of potential comparables, as the search for such comparables will generally focus on uncontrolled transactions that present a similar allocation of functions, assets and risks between the parties.

B.          Functional analysis is a process of finding and organizing facts about the transaction in terms of the functions, risks and assets in order to identify how these are divided between the parties involved in the transaction. The functions, risks and assets are analyzed to determine the nature of functions performed, degree of risks undertaken and the nature of the assets employed by each party. This analysis helps to select the tested party/parties where needed (as explained below), the most appropriate transfer pricing method, the comparables, and ultimately to determine whether the profits (or losses) earned by the entities are appropriate to the functions performed, assets employed and risks assumed.

B.          The functional analysis is important because the expected return of the entities involved in a transaction depends on the importance of the functions performed, the nature and degree of risks assumed and the nature and value of assets employed. Generally, the more valuable the functions performed, assets employed and the greater the risks assumed by a party to a transaction the greater its expected return (or potential loss). It is therefore extremely important to map the functions performed, assets employed and risks assumed by all the associated enterprises in relation to the controlled transaction under examination.

B.          A clearer understanding of functional analysis may be gained from an example which can be examined in detail below. Further, hypothetical examples for illustration purposes concerning the different types of international transactions listed below are given with a view to explaining the chapter in a more practical manner. The situations are:

1)     Manufacturing of products by XYZ & Co, where the technology is owned by an associated enterprise ABC & Co; and

2)     Distribution by A Co of products imported from an associated enterprise B Co for sale in A Co’s country.

Further hypothetical examples for illustration purposes concerning other types of international transactions are provided at Appendix 1 at the end of this Manual with a view to explaining functional analysis in a more practical manner. The situations covered in such examples are that of a manufacturing entity and of a distributor.

Example: “A Co” — Energy Solutions

A Co is a company incorporated and registered under the laws of Country

  1. A Co is in the business of intelligent energy solutions and is a market leader in the development, production and supply of electronic meters and their components, software, energy monitoring, billing solutions and payment systems. Additionally, the company owns technologies related to electronic energy meters. A Co has an established marketing network in many developing and developed countries. A Co is a part of Entity, one of the largest metering consortia in the world, which shares technology and pools the extensive experience of development and manufacture within a network covering over thirty countries.

B Co is a company incorporated and registered under the laws of Country B and is a wholly-owned subsidiary of A Co. B Co intends to manufacture a wide range of electronic energy meters and portable calibrators, which would cater to all segments of the power generation, transmission, distribution and consumption sectors and offers similar features required for electricity revenue management. However, such equipment will have to be customized to cater to the needs of domestic users. Such adaptations would be developed by B Co in its own R&D facilities.

B Co entered into a license agreement with A Co to source its core technology, TECHNO A™ — developed and patented by A Co. TECHNO A™, being software driven, allows cost effective product feature enhancements and provides flexibility to utilities to effectively manage electricity revenue and demand, thereby limiting or eliminating revenue losses. TECHNO A™ technology was developed in Country A by A Co. TECHNO A™ technology measures electricity flow using digital and microprocessor based techniques and processes the measurements into useful information. Use

of TECHNO A™ technology has major advantages in the design and manufacture of meters.

With the above context, the controlled transactions between B Co and A Co are the purchase of certain components and the license of technology from A Co. As noted above, A Co is specialized in dealing with processors and other components of electronic meters and their sub-assemblies. These are critical components of an electronic meter. B Co manufactures energy meters in Country B and uses processors and related components purchased from A Co. B Co then sells energy meters to A Co, in line with its requirements.

B Co has its own R&D centre which tries to improve the technologies so as to achieve further efficiencies. This would mean that dependence on outside sources for technologies would be reduced in the future and cost-savings could be achieved. Also B Co has penetrated the market in the territory of Country B by incurring huge marketing expenditure to establish its own marketing intangibles. These are separate from the intangibles of A Co in Country A for which a technology license agreement is in place between A Co and B Co.

The following paragraphs describe how functional analysis can be carried out and documented in the example just given involving A Co. For these purposes it is necessary to have a qualitative description of the intra-group transactions and circumstances; this can be represented by the following type of table:

Table B.2.1.:

Qualitative Assessment of Intra-Group Transactions

Symbol Comparative risk level standards Comparative functional level standards Comparative asset level standard
No risk No Functions No assets
® Lowest risk Least Functions Few assets
®® Medium risk Lesser Functions Medium assets
®®® Highest risk Highest Functions Most assets


These symbols are a tool to summarize key aspects of a functional analysis, and to qualitatively compare the different enterprises in a MNE group across a number of categories related to functions, assets, and risks based solely on the facts of a particular case. This tool, commonly referred to as a “tick chart” is used extensively in this chapter and in Appendix 1. Tick charts, while very useful, are inherently subjective. Accordingly, the same set of facts in the hands of two different analysts may not result in identical tick charts. Caution should be used in giving tick charts quantitative significance. For example, three ticks do not reflect three times more value than a single tick. Moreover, all categories in the chart do not have equivalent weight. Accordingly, tick charts should primarily be used as a tool in evaluating qualitative aspects of the analysis, and should not be used mechanically to split profits according to the relative number of ticks.

B.          Functions performed are the activities that are carried out by each of the parties to the transaction. In conducting a functional analysis, economically significant functions are to be considered; as such functions add more value to the transactions and are therefore expected to fetch higher anticipated returns for the entity performing such functions. Thus, the focus should not be on identifying the maximum number of functions but rather on the identification of critical functions performed by the associated enterprises.

B.          Some of the relevant functions that are generally observed and examined in a transaction are:

Ø Research and development;

Ø Product design and engineering;

Ø Manufacturing,    production,    process    engineering     and design work;

Ø Purchasing, materials management and other procurement activities;

Ø Manufacturing, production or assembly work;

Ø Transportation, warehousing and inventory;

Ø Marketing, advertising, publicity and distribution;

Ø Market intelligence on technological developments; and

Ø Intra-group services, for example managerial, legal, accounting and finance, credit and collection, training and personnel management services.

B.          It should be emphasized that this list is purely indicative; the extent to which each of these functions (or other functions not listed above) is economically significant and contributes to the creation of value depends on the industry and on the taxpayer-specific circumstances. A typical check list is provided in Appendix 1.

B.          Functional analysis can be approached by evaluating all the economically significant activities performed in relation to the controlled transaction under examination (such as the list indicated above) and in potentially comparable uncontrolled transactions. In general, a taxpayer should prepare this list for both parties to the relevant controlled transaction (e.g. for the producing and selling/distributing activities in this example) to ultimately support the selection of the most appropriate transfer pricing method.

B.             Continuing the example from Paragraph B. the following are the functions performed by the respective parties.

Functions performed by A Co

With respect to the sale of technology and components of electronic energy meters:

In this example, it is assumed that in the context ...

B.3. Methods


B .3 .1 .       Introduction to Transfer Pricing Methods

B.3.1.1.                         This part of the chapter describes several transfer pricing methods that can be used to determine an arm’s length price and describes how to apply these methods in practice. Transfer pricing methods (or “methodologies”) are used to calculate or test the arm’s length nature of prices or profits. Transfer pricing methods are ways of establishing arm’s length prices or profits from transactions between associated enterprises. The transaction between related enterprises for which an arm’s length price is to be established is referred to as the “controlled transaction”. The application of transfer pricing methods helps assure that transactions conform to the arm’s length standard. It is important to note that although the term “profit margin” is used, companies may also have legitimate reasons to report losses at arm’s length. Furthermore, transfer pricing methods are not determinative in and of themselves. If an associated enterprise reports an arm’s length amount of income, without the explicit use of one of the recognized transfer pricing methods, this does not mean that its pricing should automatically be regarded as not being at arm’s length and there may be no reason to impose adjustments.

B.3.1.2.           Selection of Methods (How, Why and Use of Methods)

B.            The selection of a transfer pricing method serves to find the most appropriate method for a particular case. Considerations involved in selecting a method can include: the respective strengths and weaknesses of each method; the nature of the controlled transaction; the availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method; and the degree of comparability between the controlled and uncontrolled transactions.

B.            The starting point in selecting a method is an understanding of the controlled transaction (inbound or outbound), in particular based on the functional analysis which is necessary regardless of which transfer pricing method is selected. The functional analysis is a major part of selecting the transfer pricing method as it helps:

  • To identify and understand the intra-group transactions;
  • To identify the characteristics that would make a particular transaction or function suitable for use as a comparable;
  • To determine any necessary adjustments to the comparables;
  • To check the relative reliability of the method selected; and
  • Over time, to determine if modification of the method is appropriate because the transaction, function, allocation of risks or allocation of assets have been modified.

B.            The major components of a functional analysis are analyzes of the functions, assets and risks. The functional analysis is described and discussed in detail in Chapter B.2, at Paragraph B. Appendix I provides examples of a functional analysis for a manufacturing business and a distribution business. A summary is provided here for context in the case of selection of appropriate methods.

B.            The functions performed: The functional analysis describes the activities performed such as design, purchasing, inbound logistics, manufacturing, research and development (R&D), assembling, inventory management, outbound logistics, marketing and sales activities, after sale services, supporting activities, services, advertising, financing and management, etc. The functional analysis must specify which party performs each activity and in case both parties are involved in performing an activity it should provide for the relevant differences; for example if both have inventories but Company A holds inventories for a period of up to two years whereas Company B holds inventories for a period of one month. The activities that add most value must be identified and should be discussed in more detail.

B.            The risks undertaken: The functional analysis should identify risks undertaken. Examples are: financial risk (currency, interest rate, funding risks etc.) credit and collection risk (trading credit risk, commercial credit risk), operational risk (systems failure risk), commodity price risk, inventory risk and carrying costs, R&D risk, environmental and other regulatory risks, market risk (country political risk, reliability of customers, fluctuation in demand and prices) and product risk (product liability risk, warranty risk and costs and contract enforceability). A risk-bearing party would expect to have higher earnings than a non-risk bearing party, and will incur the expenses and perhaps related loss if and when risk materializes.

B.  The assets used or contributed: The functional analysis must identify and distinguish between tangible and intangible assets. Tangible assets such as property, plant and equipment have to be financed and an investment in such capital assets would usually be expected to earn a long term return based on the use and risk level  of the investment. Intangible assets are very important as substantial competitive advantage is often achieved by the use of intangible assets. Some intangibles have legal protection (e.g. patents, trademarks, trade names) but other intangibles with less legal protection may be equally important and valuable (e.g. know-how, trade secrets, marketing intangibles, etc.).

B.            Interplay of above factors: Today, in a multinational group, operations tend to be more integrated across jurisdictional boundaries and the functions, risks and assets are often shared between entities in different jurisdictions. This makes functional analyzes both more difficult and more necessary. The functional analysis can help identify which functions, risks and assets are attributable to the various related parties. For example, the functional analysis may reveal that one company performs one particular function but the cost of this  is borne by the other party to the transaction. The functional analysis could highlight that situation and consider the legal allocation of risk and the economic substance of the transaction. Another example would be where a company performs one particular function and bears the cost thereof but the benefit also accrues to the other party to the transaction. The functional analysis could emphasize that situation and consider which party bears the risk in legal terms and which party bears the risk according to the economic substance of the transaction. The functional analysis typically includes a discussion of the industry in which the tested party operates, the contractual terms of the transaction at issue, the economic circumstances of the parties and the business strategies they employ. The functional analysis helps to identify the operations that benefit a related party and require an arm’s length return.

B.            Selecting a method after the functional analysis: Once the functional analysis is performed the application of a transfer pricing method, with the associated evaluation of comparable transactions, may be considered. Transfer pricing methods typically use information on comparables; the lack of such comparables can make a particular method— even one that might seem initially preferred— inapplicable, and a different method more reliable. These comparable transactions are also referred to as “uncontrolled transactions” because the parties involved in the transactions are independent of each other. Although uncontrolled transactions of independent unrelated companies are usually used as comparables for transfer pricing purposes, in practice it is sometimes not possible to identify reliable comparable data in the same markets. In such cases practical solutions should be sought in good faith by taxpayers and the tax administration. Comparability issues are discussed in more detail at Chapter B.2.

B.            Solutions for cases where comparables are difficult to find may include the following:

  • Searching for comparables in other industries where such comparable companies have similar functions, assets and risks;
  • Searching for comparables in other geographical regions that share certain key similarities with the country in which a company conducts its business; and
  • Using industry analyzes (publicly available or conducted internally by the company) to identify profit levels that can reasonably be expected for various routine functions (e.g. production, services, distribution).

The suggestions above are not intended to be exhaustive, neither is any preference implied by the ordering of the alternatives. Rather, the approaches above are presented as examples of what might be done and are included for information purposes only. Due to the difficulty in obtaining access to (publicly available) data, in certain instances methods other than the ones presented above may need to be used.

B.          Intangibles: Among the factors to be considered to select the most appropriate method in the circumstances of the case it is important to determine which party has developed or acquired the intangibles used and in what capacity, which party has the legal ownership and which party receives the benefit of the intangibles. The party that developed the intangibles should be able to obtain benefits from those intangibles for example through:

  • A sale or licensing of the intangibles to another party who exploits it; or
  • Exploiting the intangible itself, for example by way of an increase in the price of products or services that make use of such intangibles.

B.3.1.3.          Choice of Available Methods

B.            There are two general categories of methods. “Traditional Transaction Methods”, consisting of the Comparable Uncontrolled Price, Cost Plus and Resale Price Methods. The “Transactional Profit Methods” consist of the Transactional Net Margin Method and the Profit Split Method. A number of jurisdictions also apply “other methods” which are considered to provide arm’s length results; however, it needs to be ensured that such methods are consistent with the arm’s length principle.

B.            No preference for particular methods is being advocated in this Manual. The most suitable method should be chosen taking into consideration the facts and circumstances. The taxpayer should for example take into account the type of transaction, the functional analysis, comparability factors, availability of comparable transactions and the possibility of making adjustments to the data to improve comparability. For further discussion on this issue, see Chapter B.2.

B.            Once a method is chosen and applied, taxpayers are generally expected to apply the method in a consistent fashion. Assuming that an appropriate transfer pricing method is being applied, a change in the method is typically required only if there are any changes in the facts, functionalities or availability of data.

B .3 .2 .       Traditional Transaction Methods

B.3.2.1.          Comparable Uncontrolled Price

B.            The Comparable Uncontrolled Price (CUP) Method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. The CUP Method may also sometimes be used to determine the arm’s length royalty for the use of an intangible asset. CUPs may be based on either “internal” comparable transactions or on “external” comparable transactions. Figure B.3.1 below explains this distinction in the context of a particular case study.

Figure B.3.1:

Comparable Uncontrolled Price Method



Transaction #3 (External)

Controlled transaction

                              Uncontrolled transaction

B.            Facts of the Case Study: The controlled transaction in this figure involves the transfer of bicycles between Associated Enterprise 1, a bicycle manufacturer in Country 1, and Associated Enterprise 2, a bicycle importer in Country 2, which purchases, imports and resells the bicycles to unrelated bicycle dealers in Country 2. Associated Enterprise 1 is the parent company of Associated Enterprise 2.

B.            In applying the CUP Method to determine whether the price charged for bicycles transferred in this controlled transaction is at arm’s length, the following information is assumed to be available for consideration:

  •  The price charged for bicycles transferred in a comparable uncontrolled transaction between Associated Enterprise 1 and Unrelated Party C (i.e. transaction #1);
  •  The price charged for bicycles transferred in a comparable uncontrolled transaction between Associated Enterprise 2 and Unrelated Party A (i.e. transaction #2); and
  •  The price paid for bicycles transferred in a comparable uncontrolled transaction between Unrelated Party A and Unrelated Party B (i.e. transaction #3).

B.            Comparable uncontrolled transactions, such as transaction #1 or #2, which involve a transaction between the tested party and an uncontrolled party, are referred to as internal comparables. Comparable uncontrolled transactions such as transaction #3, which involves a transaction between two parties neither of which is an associated enterprise, are called external comparables. The application of the CUP Method involves a detailed transactional comparison whereby the controlled and uncontrolled transactions are compared based on the five comparability factors mentioned in Chapter B.2.

B.3.2.2.          Comparability in Application of the CUP Method

B.   When applying the CUP Method, an uncontrolled transaction is considered comparable to a controlled transaction if:

  • There are no differences in the transactions being compared that would materially affect the price; or
  • Reasonably accurate adjustments can be performed to account for material differences between the controlled and the uncontrolled transaction.

B.   In performing the comparability analysis, the controlled transactions and uncontrolled transactions should be compared based on the comparability factors mentioned earlier and stated in detail  in Chapter B.2. In determining the degree of comparability between the controlled transactions and uncontrolled transaction #1 in Figure B.3.1, for example, the following factors should be taken into account:

(i)  characteristics of property being transferred or services provided,

(ii)   contractual terms, (iii) economic circumstances and (iv) business strategies. For the functional analysis it is necessary to analyze the functions performed, the risks assumed and the assets used.

B.   Product comparability should be closely examined in applying the CUP Method. A price may be materially influenced by differences between the goods or services transferred in the controlled and uncontrolled transactions. The CUP Method is appropriate especially in cases where an independent enterprise buys or sells products that are identical or very similar to those sold in the controlled transaction or in situations where services are rendered that are identical or very similar to those rendered in the controlled transaction.

B.   Although product comparability is important in applying the CUP Method, the other comparability factors should not be disregarded. Contractual terms and economic conditions are also important comparability factors. Where there are differences between controlled and uncontrolled transactions, adjustments should be made to enhance reliability.

B.   Reasonably accurate adjustments may be possible for differences in:

  • The type and quality of the products. E.g. unbranded Kenyan as compared with unbranded Brazilian coffee beans;
  • Delivery terms. E.g. Associated Enterprise 1 in Figure B.3.1 sells similar bicycles to Associated Enterprise 2 and Unrelated Party
  1. All relevant information on the controlled and uncontrolled transactions is available to Associated Enterprise 1, and hence it is probable that all material differences between the trans actions can be recognized. The uncontrolled price can be adjusted for the difference in delivery terms to eliminate the effect of this difference on the price;
  • Volume of sales and related discounts. E.g. Associated Enterprise 1 sells 5000 bicycles to Associated Enterprise 2 for US$90 per bicycle, while it sells 1000 similar bicycles to Unrelated Party C. The effect of the differences in volume on price should be analyzed, and if the effect is material adjustments should be made perhaps based on volume discounts in similar markets;
  • Product characteristics. E.g. the uncontrolled transactions to an unrelated party in Figure B.3.1 involve bicycles on which modifications have been made. However, the bicycles sold in the controlled transactions do not include these modifications. If the product modifications have a material effect on price, then the uncontrolled price should be adjusted to take into account this difference in price);
  • Contractual terms. E.g. Associated Enterprise 1 sells the bicycles to Associated Enterprise 2 offering a 90 day credit term but the contract terms dictate that all sales to Unrelated Party C are Cash On Delivery;
  • Risk incurred. E.g. Associated Enterprise 1 is exposed to inventory risk related to sales by Associated Enterprise 2 and the risk that customers of Associated Enterprise 2 will default on their bicycle purchase loans; whereas in the transaction between Associated Enterprise 1 and Unrelated Party C, the latter is exposed to the inventory risk and the risk of its customers’ default. This difference in risk allocation must be analyzed and its effect on price quantified before Associated Party 2’s prices and Unrelated Party C’s prices can be considered comparable; and
  • Geographical factors. E.g. Associated Enterprise 1 sells bicycles to Associated Enterprise 2 located in South Africa, while Unrelated Party C, to which it also sells the same bicycles, is located in Egypt. The only material difference that could be identified between the controlled and uncontrolled transactions concerns the locale. To perform adjustments to account for this difference one might have to consider, for example, differences in inflation rates between South Africa and Egypt, the competitiveness of the bicycle market in the two countries and differences in government regulations if relevant.

B.   Reasonably accurate adjustments may not be possible for:

  • Unique and valuable trademarks. E.g. assuming Associated Enterprise 1 in Figure B.3.1 is engaged in manufacturing high value branded goods, and attaches its valuable trademark to the goods transferred in the controlled transaction, while uncontrolled transaction #1 concerns the transfer of goods that are not branded. The effect of the trademark on the price of a watch may be material. However, it will be difficult, if not impossible, to adjust for effect of the trademark on price since the trademark is an intangible asset that is unique. If reasonably accurate adjustments cannot be made to account for a material product difference the CUP Method may not be the appropriate method for the transaction; and
  • Fundamental differences in the products E.g. if the products being sold are significantly different from the products sold in the proposed comparable transaction it may not be possible to adjust for the product differences.

B.   Notwithstanding the difficulties often associated with adjustments to address the sources of non-comparability described above, the need to make adjustments should not automatically prevent the use of the CUP Method. It is often possible to perform reasonably accurate adjustments. If reasonable adjustments cannot be performed the reliability of the CUP Method is decreased. In these circumstances another transfer pricing method may be more appropriate.

B.3.2.3.          Strengths and Weaknesses of the CUP Method

B.      The strengths of the CUP Method include that it:

  • Is a two-sided analysis as the price used reflects the agreed price between two unrelated parties to the transaction;
  • Avoids the issue of which of the related parties involved in the controlled transaction should be treated as the tested party for transfer pricing purposes;
  • Involves a direct transactional comparison of a similar transaction between unrelated parties. That is, it is a more direct measure of the arm’s length price than the other methods, all of which indirectly determine arm’s length prices through evaluation of the arm’s length profits. As it is a more direct measure, the CUP Method is less susceptible to differences in non-transfer pricing factors (such as differences in the accounting treatment of costs between controlled and uncontrolled parties); and
  • May be more readily used in instances such as, for example, transactions involving commodity products.

B.      The weakness of the CUP Method lies in the difficulty of finding comparable uncontrolled transactions in the light of the comparability standards that must be observed, particularly with respect to the comparability of products, intellectual property or services.

B.3.2.4.          When to Use the CUP Method

B.      In cases where comparable uncontrolled transactions can be found, the CUP Method is typically a very reliable method to use in determining whether the terms of commercial and financial transactions between associated enterprises are at arm’s length. This implies that an examiner should always consider the feasibility of applying the CUP Method. That is, an examiner should consider whether it is possible to locate acceptable internal comparables and external comparables. Consequently, a question that should be asked in any analysis is whether one of the associated enterprises involved is engaged in transactions with independent enterprises.

B.      In the example represented in Figure B.3.1 above, this would involve two distinct questions: (i) whether Associated Enterprise 1 sells comparable bicycles to an unrelated party and (ii) whether Associated Enterprise 2 purchases comparable bicycles from one or more unrelated bicycle manufacturers. If the answer to either one of these questions is in the affirmative, then the next step in the analysis is to determine the degree of comparability between the controlled and uncontrolled transactions based on the comparability factors.

B.      External comparables may be difficult to find in practice unless the transactions involve a fairly common and homogeneous product or service. However, the advantages of the CUP Method are great enough to warrant a significant effort to apply the method.

B.      Experience indicates that the CUP Method will be most useful where:

  • One of the associated enterprises involved in the transaction is engaged in comparable uncontrolled transactions with an independent enterprise (i.e. an internal comparable is available). In such a case all relevant information on the uncontrolled transactions is available and it is therefore probable that all material differences between controlled and uncontrolled transactions will be identified; and
  • The transactions involve commodity type products, but the differences between the products are minor.

B.3.2.5.          Case Examples of Use of the CUP Method

B .3 .2 .5 .1 . Example 1: Comparable Sales of Same Product

MCO, a manufacturer, sells the same product to both controlled and uncontrolled distributors. The circumstances surrounding the controlled and uncontrolled transactions are substantially the same, except that the controlled sales price is a delivered price and the uncontrolled sales are made free on board (f.o.b.) MCO’s factory (which means the buyer takes responsibility for delivery costs of the goods for the remainder of their transit). Differences in the contractual terms of transportation and insurance generally have a definite and reasonably ascertainable effect on price, and adjustments are made to the results of the uncontrolled transaction to account for such differences. No other material difference has been identified between the controlled and uncontrolled transactions. As MCO is engaged in both controlled and uncontrolled transactions, it is likely that all material differences between the two transactions have been identified. In addition, the Comparable Uncontrolled Price Method is applied to an uncontrolled comparable with no product differences, and there are only minor contractual differences that have a definite and reasonably ascertainable effect on price. The results of this application of the Comparable Uncontrolled Price Method will therefore provide the most direct and reliable measure of an arm’s length result.

B .3 .2 .5 .2 . Example 2: Effect of Trademark

The facts are the same as in Example 1 except that MCO affixes its valuable trademark to the property sold in the controlled transactions but does not affix its trademark to the property sold in the uncontrolled transactions. Under the facts of this case the effect on price of the trademark is material and cannot be reliably estimated. As there are material product differences for which reliable adjustments cannot be made the Comparable Uncontrolled Price Method is unlikely to provide a reliable measure of the arm’s length result.


B .3 .2 .5 .3 . Example 3: Minor Product Differences

The facts are the same as in Example 1 except that MCO, which manufactures business machines, makes minor modifications to the physical properties of the machines to satisfy specific requirements of a customer in controlled sales. MCO does not, however, make these modifications in uncontrolled sales. Only if the minor physical differences in the product have a material effect on prices should adjustments be made to the results of the uncontrolled transactions to account for these differences. These adjusted results may then be used as a measure of the arm’s length result.


B .3 .2 .5 .4 . Example 4: Effect of Geographic Differences

FM, a specialty radio manufacturer, sells its radios to a controlled distributor, AM, within the western region of Country A. FM sells its radios to uncontrolled distributors to serve other regions in Country A. The product sold in the controlled and uncontrolled transactions is the same and all other circumstances surrounding the controlled and uncontrolled transactions are substantially the same other than the geographic differences. If the geographic differences are unlikely to have a material effect on price, or they have definite and reasonably ascertainable effects for which adjustments are made, then the adjusted results of the uncontrolled sales may be used under the Comparable Uncontrolled Price Method to establish an arm’s length price. If the effects of the geographic differences would be material but cannot be reliably ascertained, then the reliability of the results will be diminished. However, the Comparable Uncontrolled Price Method may still provide the most reliable measure of an arm’s length result.


B.3.2.6.          Resale Price Method

B.      The Resale Price Method (RPM) is one of the traditional transaction methods that can be used to determine whether a transaction reflects the arm’s length principle. The Resale Price Method focuses on the related sales company which performs marketing and selling functions as the tested party in the transfer pricing analysis. This is depicted in Figure B.3.2 below.

B.      The Resale Price Method analyzes the price of a product that a related sales company (i.e. Associated Enterprise 2 in Figure B.3.2) charges to an unrelated customer (i.e. the resale price) to determine an arm’s length gross margin, which the sales company retains to cover its sales, general and administrative (SG&A) expenses, and still make an appropriate profit. The appropriate profit level is based on the functions it performs and the risks it incurs. The remainder of the product’s price is regarded as the arm’s length price for the inter-company transactions between the sales company (i.e. Associated Enterprise 2) and a related company (i.e. Associated Enterprise 1). As the method is based on arm’s length gross profits rather than directly determining arm’s length prices (as with the CUP Method) the Resale Price Method requires less direct transactional (product) comparability than the CUP Method.

Figure B.3.2:

Independent Enterprise

Resale Price Method



Associated Enterprise 2
Associated Enterprise 1

Arm’s length price?

Given price

Given price = US$100
Resale price margin (25%) = US$ 25
Arm’s length price = US$ 75

B.      Consequently, under the RPM the starting point of the analysis for using the method is the sales company. Under this method the transfer price for the sale of products between the sales company (i.e. Associated Enterprise 2) and a related company (i.e. Associated Enterprise 1) can be described in the following formula:

TP = RSP x (1-GPM), where:

  • TP = the Transfer Price of a product sold between a sales company and a related company;
  • RSP = the Resale Price at which a product is sold by a sales company to unrelated customers; and
  • GPM = the Gross Profit Margin that a specific sales company should earn, defined as the ratio of gross profit to net sales. Gross profit is defined as Net Sales minus Cost of Goods Sold.

B .3 .2 .6 .4 . Example of Resale Price Method Application

It is assumed that the resale price in Figure B.3.2 is $100. This means that Associated Enterprise 2 resells the bicycle to Independent Enterprise for $100. If we assume that an arm’s length gross profit margin that Associated Enterprise 2 should earn is 25%, Associated Enterprise 2 should cover its SG&A expenses and make an appropriate profit with this 25% gross margin. The resulting transfer price between Associated Enterprise 1 and Associated Enterprise 2 (i.e. the cost of goods sold of Associated Enterprise 2) is $75 (i.e. $100 x (1-0.25).

B. Other approaches are possible. For example, if the associated enterprise acts as a sales agent that does not take title to the goods, it is possible to use the commission earned by the sales agent (represented as a percentage of the uncontrolled sales price of the goods concerned) as the comparable gross profit margin. The resale price margin for a reseller should always be determined by taking into account the functions performed, assets used and risks assumed by the reseller.

B.3.2.7.            Arm’s Length Gross Profit Margin

B.            The financial ratio analyzed under the Resale Price Method is the gross profit margin. Gross profit is defined as net sales minus cost of goods sold. It is easiest to determine where the reseller does not add substantially to the value of the product. The net sales of a sales company are the sales revenue obtained by selling products to unrelated customers, while the cost of goods sold equals the cost of purchasing the goods sold plus certain additional non-operating costs. Thus, if we are determining the gross margin for products purchased from a related company, the cost of goods sold will include the transfer price paid to the related manufacturer.

B.            Accounting consistency is extremely important in applying the RPM. Gross profit margins will not be comparable if accounting principles and/or practices differ between the controlled transaction and the uncontrolled transaction. For example, the comparable distributors may differ from the related sales company in reporting certain costs (e.g. discounts, transportation costs, insurance and costs of performing the warranty function) as operating expenses or as cost of goods sold. Differences in inventory valuation methods will also affect the gross margins. It is thus important that the analysis does not compare “apples with oranges” but rather, “apples with apples”. Therefore, appropriate adjustments should be applied to the data used in computing the gross margin to make sure that “similar” gross margins are compared.

B.3.2.8.           Transactional Comparison versus Functional Comparison

B.            The arm’s length price or margin can result from looking at comparable functionality (distributors of broadly similar types of product) or from making a transactional comparison by looking at each transaction the tested party engages in involving comparable products (i.e. sales of different types of bicycles).

B.            The arm’s length (range of) gross profit margin(s) to be earned by the sales company in the controlled transaction can therefore be determined in the following two ...

B.4. Intra-Group Services



B .4 .1 .       Introduction

B.4.1.1.              This chapter considers the transfer prices for intra-group services within an MNE group. Firstly, it considers the tests for determining whether chargeable services have been provided by one or more members of an MNE group to one or more associated enterprises for transfer pricing purposes. Secondly, if chargeable intra-group services have been provided, it considers the methods for determining arm’s length consideration for the services. The chapter also considers the circumstances in which tax authorities may provide taxpayers with the option of using a safe harbour for low value-adding services or for minor expenses.

B.4.1.2.              Under the arm’s length principle, if a chargeable intra-group service has been provided to associated enterprises, arm’s length transfer prices should be charged to group members receiving or expected to receive an economic benefit from the services. The term “associated enterprises” is defined at Article 9(1) of the United Nations Model Double Taxation Convention between Developed and Developing Countries. It includes a parent company and its direct and indirect subsidiary companies. The test for determining whether chargeable intra-group services have been provided between associated enterprises is whether one or more associated enterprises have received or are expected to receive an economic benefit from the activity. Such an economic benefit exists if an independent entity in the same or similar circumstances would be willing to pay for the services or perform the activity itself. This principle is referred to in this chapter as the “benefit test” and is considered in more detail below (paras. B.4.2.3 – B.4.2.6).

B.4.1.3.              A transfer pricing analysis of intra-group services should be considered from both the perspective of the service-provider and of the associated enterprise receiving the services. Tax authorities may view the provision of intra-group services from either the perspective of a service provider or of a recipient of services. The tax authority of the service provider would seek to ensure that if chargeable intra-group services have been provided, the associated enterprise benefitting from the service is paying an arm’s length price for such services. The tax authority of the service-provider would be concerned if there were no payments for the intra-group cross-border services or if the charges for such services were below arm’s length prices. It would also be concerned if the service provider incurred costs for the benefit of foreign associated enterprises without reimbursement or arm’s length consideration if the benefits test has been satisfied.

B.4.1.4.              On the other hand, the tax authority of the recipient would be seeking to ensure that the services in question satisfy the benefit test and that the recipient was being charged arm’s length prices for the intra-group services. A tax authority of the service recipient would consider making an adjustment if it considered that the services provided a benefit to the recipient but that the service charges were excessive. Given the scale of business operations of an MNE group, service costs incurred and service charges may reflect significant amounts and any misallocation of service costs or charges within an MNE will affect the profit or loss allocations among group members.

B.4.1.5.              It should be noted that the requirement that chargeable services be paid for on an arm’s length basis is distinct from the question whether such arm’s length payments are deductible under the domestic law of the associated enterprise receiving the service. Transfer pricing rules require the payment of arm’s length transfer prices for chargeable services. Principles of domestic law are then applied to determine if such payments may be deducted by the associated enterprise making the payment in determining its taxable income. In some countries, although an expense may satisfy the arm’s length principle, the deduction may be denied, in full or in part, by domestic rules restricting deductions.

B.4.1.6.              MNE groups in a globalized economy may have highly integrated business operations. The associated enterprises comprising such groups may seek business advantages from exploiting information, technology and communications systems and other assets on a combined basis. Intra-group services may play an important role in MNE groups as they seek to obtain services at the lowest price to maintain or improve their competitive position. Transfer pricing analyzes of such service relationships should recognize that MNE groups seek to maximize their profitability and competitive positions and they do not generally incur costs without a business purpose.

B.4.1.7.              Many of the services that MNE groups require may either be performed within the group or acquired by the group from one or more independent service providers. Many types of services are not within the company’s core business but are nonetheless necessary for the MNE’s business operations. The performance of service activities required by members of the group may be centralized in one group member or dispersed among many group members. In some cases MNE groups may outsource services to independent enterprises and then charge out the cost of the services on a pass-through basis to those associated enterprises receiving a benefit.

B.4.1.8.              Most intra-group services are easily identifiable such as human resources services. In some situations a service may be connected with the provision of goods. For example, an associated enterprise might be provided with goods and it might also receive services to assist in the use of the goods. In other cases intra-group services may also be provided in conjunction with or embedded in intangibles or other assets.

B .4 .2 . Analysis of Intra-Group Services

Types of intra-group services

B.4.2.1.                         Many types of intra-group services may be provided between the associated enterprises comprising an MNE group. UNCTAD has noted in its World Investment Report 2004: The Shift towards Services, that it is “difficult to formulate a clear-cut definition of services. No commonly accepted definition exists.” A detailed list at the end of this chapter (drawn up by the European Commission) sets out some of the types of intra-group services. The list is intended to be illustrative and is not comprehensive. Activities can generally be divided into chargeable services and non-chargeable activities. Chargeable services can be divided into low value adding services and other services. Simplified transfer pricing approaches may be used for low value-adding services (see paras. B.4.5.3 – B.4.5.10) while a full transfer pricing analysis may be required for other services.

B.4.2.2.                         The profit margin which an associated enterprise may derive under the arm’s length principle from providing intra-group services varies. A lower profit mark-up is derived from low value-adding services such as administrative services. Such services are necessary for the efficient operation of the international operations of an MNE group but they do not create significant value for the MNE group. On the other hand, services associated with an MNE group’s core business activities, which are incurred to maintain or improve the MNE group’s profitability, viability or market position, may create greater value and carry a higher profit margin.

The benefit test

B.4.2.3.                           The benefit test is used to determine whether a member of the MNE group has received a chargeable service from an associated enterprise. The benefit test has two requirements both of which must be satisfied. Secondly, the associated enterprise must demonstrate that an independent entity in the same or similar circumstances would have been prepared to pay for the services or perform the services itself. Once the benefit test has been satisfied, there remains the question of the arm’s length price for the service (see para. B.4.3.1).

B.4.2.4.                         An examination of the facts and circumstances will be required to determine whether the benefit test has been satisfied for an enterprise receiving an intra-group service. The level of detail covered by such a factual examination, and the amount and nature of documentation required to demonstrate satisfaction of the benefit test, should be based on the materiality of the service charges.

B.4.2.5.                         The underlying notion of the benefit test is that, in order to be chargeable, the service must provide or be expected to provide the recipient with commercial value to enhance its actual or expected commercial position in an identifiable way. For example, a marketing programme may be designed by one member of an MNE group to be used by associated enterprises operating as fully fledged distributors with the expectation that all designated associated enterprises will benefit in each of their markets. Although the marketing strategy is a success in most countries, it may fail to deliver all of the expected benefits in some jurisdictions. As long as each associated enterprise within the MNE group taking up this marketing strategy has legitimately expected a benefit, they have received a benefit for the purpose of the benefit test, despite the fact that some of these enterprises do not fully achieve the expected results. The benefit test is satisfied as to these associated enterprises only if an independent distributor would be expected to pay for the marketing services under similar circumstances.

B.4.2.6.                         Whether or not the benefit test is satisfied does not depend on the level of risk that the expected benefit will or will not be achieved. Some intra-group services, such as research and development, may involve a higher level of risk than other services, such as accounting or bookkeeping services. Notwithstanding the risk involved, intra-group research and development services are chargeable if an independent party would have been expected to pay another independent party for the research and development services in the same or similar circumstances or it would have performed this activity itself. Provided the recipient associated enterprise expects a potential economic benefit from the research and development, the benefit test is satisfied and a chargeable service has been provided, even though the activity may not always actually result in benefits.

Service activities for the specific needs of an associated enterprise

B.4.2.7.                         Associated enterprises may request the provision of specific intra-group services. Services provided specifically to one member of the MNE group and designed specifically to its operations will generally satisfy the benefit test. For example, an associated enterprise which is part of an MNE group involved in telecommunications may suffer reputational damage and a potential loss of business if information technology (IT) problems prevent customers from using its telecommunications system. If an IT problem arises and direct assistance is provided promptly to the associated enterprise by another member of the MNE group specializing in the provision of IT services, the service would satisfy the benefit test as the associated enterprise has received an economic benefit to maintain its business operations.

B.4.2.8.              Similarly, if an associated enterprise seeks assistance in the design of a targeted marketing campaign from a related party which specializes in marketing strategies and practices, the associated enterprise providing the marketing strategy advice is providing a service designed to meet the specific needs of the recipient. The benefit test would generally be satisfied in such a circumstance because the associated enterprise expects a commercial benefit from the service, and an independent enterprise in the same or similar circumstances would be willing to pay for the provision of such services.

Centralized services

B.4.2.9.                         An MNE group will often centralize certain business functions within an associated enterprise operating as a service provider to the rest of the group or to a sub-group of associated enterprises, such as a regional sub-group, for their benefit. A wide variety of services may be centralized in this manner, including both low and high-value adding services. Depending on the facts, each associated enterprise benefitting from the services provided by a centralized service provider should be charged an arm’s length price for the services it acquires. The economic benefit is apparent if an associated enterprise would otherwise have to perform the activity itself or engage an external service provider.

B.4.2.10.                       There are numerous reasons for an MNE group to provide intra-group services on a centralized basis. Services may be provided by an associated enterprise for the rest of the group in order to minimize costs through economies of scale. This may allow the MNE group to increase its profits or improve its competitive position by being able to reduce the prices charged to customers. Centralizing services may allow for specialization within an MNE group which may also involve the creation of centres of excellence. Some MNE groups may centralize services in a regional management company for associated enterprises in a particular geographic region in order to align functional and management responsibilities. In some cases an associated enterprise may not have the skills or resources locally in-house for the service it requires and may rely on specialists that are responsible for providing the same type of services across a wider geographic or functional grouping of entities. Another potential benefit of having centralized services for an MNE group is the certainty that such services will be available when required and that the quality of the services is consistent within the MNE group.

Example 1

An MNE group carries on an airline business in 5 countries (Countries A, B, C, D and E) with the parent of the group being located in Country A. Customers of the airline in these countries are provided with the option of calling staff by telephone to book travel and receive advice where necessary. The MNE group decides to create a centralized call centre for the MNE group to exploit economies of scale. The low cost of telecommunications and the ability to share business information among group members allows for the centralized call centre to be located in any country in which the MNE group operates. The call centre can operate on a 24 hour basis in providing call services to all time zones in which the MNE group carries on business. The MNE group concludes that centralizing call centre functions in its subsidiary in Country E will allow the group to take advantage of both economies of scale and low costs. The call centre services provided by the subsidiary in Country E to the parent company and other group members satisfy the benefit test. Without the call centre the group members would either have to establish their own call centres or engage an independent party to provide call centre services on their behalf.

On-call services

B.4.2.11.                       Intra-group on-call services apply in a situation where an associated enterprise agrees to provide a particular type of service immediately or within a short period of time. In order to do so it must maintain the staff necessary to provide such services promptly as requested, even though some staff members may not be fully utilized by the MNE group at all times. On-call services may also be called ‘call off contracts’ and ‘stand by contracts’. The expected economic benefit to the recipient of being able to call on such services without delay when needed may be a sufficient business advantage to satisfy the benefit test, even if the contingency requiring the service never arises and actual services are never or infrequently provided. An associated enterprise that is a potential recipient of such on-call services would therefore be expected to pay the service provider for maintaining the necessary staff to provide the service, even during times when the potential recipient does not call on the associated enterprise to provide the service. The existence of an economic benefit for on-call services will need to be considered on a case-by-case basis to ensure that an associated enterprise is actually receiving a benefit from having a service provider on call and that an independent enterprise in the same or similar circumstances would have been willing to pay.

Non-chargeable activities

B.4.2.12.                       Certain intra-group service activities do not meet the benefit test for one or more associated enterprises, and so would not warrant charges. It is emphasized that a determination of whether an intra-group service has been provided to a particular associated enterprise depends on an analysis of the facts and circumstances of each case. The following section deals with four situations in which the benefit test is not met.

Shareholder activities

B.4.2.13.                       Shareholder activities are activities undertaken to provide an economic benefit only to the shareholder company (ultimate parent company or any other shareholder such as an intermediary holding company, depending on the facts of the case) in its capacity of shareholder. Accordingly, the cost of shareholder activities should be borne exclusively by the shareholder. Shareholder activities performed by an associated enterprise on behalf of its parent company should be charged to the parent company on an arm’s length basis.

B.4.2.14.                       Shareholder activities may include the following:

Ø the preparation and filing of reports required to meet the juridical structure of the parent company;

Ø the appointment and remuneration of parent company directors;

Ø the meetings of the parent company’s board of directors and of the parent company’s shareholders;

Ø the parent company’s preparation and filing of consolidated financial reports, reports for regulatory purposes, and tax returns;

Ø the activities of the parent company for raising funds used to acquire share capital in subsidiary companies; and

Ø the activities of the parent company to protect its capital investment in subsidiary companies.

B.4.2.15.                       Company law usually requires that a company should be managed by a board of directors. A company’s board of directors is required to make the key business, investment and policy decisions of the company. The role of company directors is usually to act in good faith in the best interests of the company. A jurisdiction’s company law will usually prescribe the legal duties of a board of directors. The cost of a parent company’s board of directors may constitute shareholder expenses and in that case the cost cannot be attributed to associated enterprises. In this situation, the only enterprise in an MNE group that would satisfy the benefit test is the parent company. The non-chargeable directors’ costs would include the directors’ fees and the cost of holding meetings. If a parent company in an MNE group is supervising its investments in the group through a supervisory board, the cost of the supervisory board may be a shareholder expense that cannot be attributed to an associated enterprise.

B.4.2.16.                       Directors of a company may also engage in other activities in connection with the parent’s ownership interests and these expenses would also be treated as shareholder expenses. However, directors may also provide services that result in the provision of material and recognizable benefits to members of an MNE group other than the parent company. In this situation, the determining factor is whether a service has been provided to associated enterprises. If it is determined that a service has been provided, the next issue to consider is which group members satisfy the benefits test for the service.

B.4.2.17.                       Another example of a shareholder expense is the cost of obtaining financing by the parent of an MNE group to acquire a company; as such costs fail to provide an immediate benefit to the acquired entity. If a parent company raises funds from an independent lender on behalf of an associated enterprise that is a regional headquarter company to acquire a new company, this activity can be a chargeable financial service. It would satisfy the benefit test if an independent party would have been willing to pay for the financial services in comparable circumstances. In this situation a service charge from the parent company to the associated enterprise on behalf of which the funds are raised would be appropriate, as the parent company has provided services in the form of being the associated enterprise’s agent to raise finance.

Example 2

Controller Co is a resident of Country A and it is the parent company of an MNE group (group). Controller Co is listed on the stock exchange in Country A, and it is required by the stock exchange and securities regulators to report its financial position periodically. The reporting requirements include the group’s consolidated profit and loss statements and balance sheet prepared in accordance with International Financial Reporting Standards. Subsidiary Co is a subsidiary company resident in Country B and maintains its own accounting function to support the operation of its business. Subsidiary Co is required under the domestic law of Country B to prepare its accounts in accordance with International Financial Reporting Standards and to annually file statutory financial statements. Subsidiary Co’s chief financial officer provides certain reports and financial statements to Controller Co for inclusion in the group’s consolidated financial statements.

The incorporation of this material into Controller Co’s consolidated financial statements are actions that Controller Co carries out as a shareholder of Subsidiary Co, Controller Co cannot impose a service charge on Subsidiary Co for reviewing and incorporating its financial statements into the group’s consolidated financial statements that Controller Co is required to file, as these activities do not provide Subsidiary Co with a bene fit. These activities are exclusively attributed to the obligations imposed on Controller Co as a listed company. If Subsidiary Co incurs costs in preparing financial statements required for the group’s consolidated financial statements that exceed what is necessary to meet the financial reporting requirements in Country B, Controller Co should compensate Subsidiary Co on an arm’s length basis for the additional activities.

Duplication of activities

B.4.2.18.                       Duplication of services occurs when a service is provided to an associated enterprise which has already incurred costs for the same activity performed either by itself or on its behalf by an independent entity. Duplicated activities are usually not chargeable services. The determination of duplication must be made on a case-by-case basis. There are some circumstances in which duplication may provide an associated enterprise with a benefit if an independent party would have been willing to pay for the duplicated services in similar circumstances. For example, this situation may arise if an associated enterprise receives in-house accounting advice on an issue but chooses to get a second opinion to minimize the risk of being penalized for failing to comply with accounting standards.

B.4.2.19.                       At times an MNE group may engage in service functions which have the same name but the functions are performed at different levels and therefore do not involve duplication. These functions may be carried out at group, regional or local level. For example, strategic marketing functions are performed at group level as they are for the benefit of the entire group, while at the local level a subsidiary engages in marketing analysis of the local market conditions. In this situation the marketing services are not duplicated as they are different types of services.

Example 3

Company X, resident in Country X, is part of an MNE group. Company X uses the group’s integrated IT system which is supported by IT services provided by a group service provider, Company T. Assume that these services meet the benefit test for Company X. It is determined that an arm’s length charge for Company X for these services is 60. As a result, Company X’s accounts include a charge for “IT services” paid to Company T of 60.

Company X also sources IT services from a third party supplier in Country X in order to customize its IT system to local requirements. As a result, Company X’s accounts include a further charge, also described as “IT services”, of 40.

In this example, despite being described the same way in Company X’s accounts, the two charges refer to different services and both would be allowable since the intra-group charge refers to services which meet the benefit test and are at an arm’s length price, and the other services are also at arm’s length.

If the IT services relating to localization of Company X’s systems were instead sourced from an associated enterprise, assuming both kinds of services meet the benefit test and constitute an arm’s length amount, the same outcome would apply.

B.4.2.20.                       When an activity is in the process of being centralized for an MNE group, acceptable duplication may occur during the transition phase. For example, an MNE group may decide to centralize its human resources function for the group and this alteration would require the closure of each associated enterprise’s human resources department after the necessary data has been provided to the centralized human resources database. This process is likely to involve a period of overlap and acceptable duplication during the transition phase. In this situation an independent entity would have a period of duplication if it were in the process of outsourcing its human resources function to an independent service provider. Nevertheless, care should be taken in determining whether a situation involves acceptable duplication.

Example 4

Subsidiary Co, a company resident in Country A, is part of an MNE group (the group). The group’s business is growing primary produce and distributing it in local markets. The parent company is Parent Co in Country B. Parent Co oversees treasury functions for the group. Parent Co’s treasury function ensures that there is adequate finance for the group and monitors the debt and equity levels on its books and those of its subsidiaries. Subsidiary Co maintains its own treasury function and manages its finances on an independent basis. It manages its treasury operations and ensures that it has finance available either in-house or externally. A functional analysis indicates that Subsidiary Co carries on its own treasury functions in order to ensure that it has adequate debt capital to finance its operations. In this situation duplication arises as Subsidiary Co is performing treasury functions necessary for its operations and Parent Co is performing the same treasury functions for Subsidiary Co. Accordingly, Parent Co’s treasury activities are duplicated activities that fail the benefit test. Under the arm’s length principle, Parent Co cannot charge a service fee to Subsidiary Co for Parent Co’s treasury functions.

Example 5

An MNE group has its Parent Company in Country A. Parent Company performs treasury functions for itself and its subsidiaries. The treasury functions include raising capital, obtaining financing and cash management. Subsidiary Company is an associated enterprise in Country B and does not perform any treasury functions itself. In this situation there is no duplication as Subsidiary Company does not perform treasury functions. In this case, Subsidiary Company is considered to obtain a benefit from the functions performed by Parent Company.

Example 6

An MNE group has a parent company called Controller Company in Country A. Controller Company has in-house legal advisers with expertise in intellectual property. The expertise includes registering patents and protecting intellectual property rights. Property Company is an associated enterprise in Country B and it is the legal and economic owner of patents that it has developed itself for its own benefit. Property Company has a dispute with one of its customers over the improper use of its intellectual property. Property Company attempts to discuss the dispute with the customer but the customer denies that there is a breach of the licence agreement and refuses to negotiate. Property Company does not have in-house legal counsel and engages an independent legal firm in Country B to provide it with advice on whether it is entitled to damages from the customer for the purported breach of the agreement.

The legal advice is that the customer is in breach of agreement and that Property Company should take legal action to recover substantial damages from the customer. As litigation is expensive, Property Company seeks a second opinion from Parent Company on whether it should take legal action against the customer. Both Country A and Country B have similar legal systems. Parent Company uses its in-house legal counsel to provide advice on whether Property Company is entitled to damages for the breach of agreement as well as assessing the extent of the damages. In this situation the legal advice provided by Parent Company has provided Property Company with an economic benefit as it has the comfort of the second opinion. In this situation there is no duplication and the use of a second legal opinion is a justified measure for dealing with a dispute with a customer. Independent entities involved in legal disputes may seek a second opinion to confirm their legal rights.

Passive association

B.4.2.21.                       Benefits to members of an MNE group may arise as a result of an associated entity’s membership of the MNE group. Such benefits are attributable to the entity’s passive association with the MNE group. The benefits of association with an MNE group are not a chargeable service for members of the MNE group. For example, independent enterprises transacting with an enterprise that is a member of an MNE group may be willing to provide goods or services to it at prices that are below the prices charged to independent buyers. These discounts may be provided because the independent supplier hopes that it will be able to generate future sales to other group members if it provides favourable pricing and good service. Moreover, the associated enterprise may be viewed by the independent supplier as a low risk customer that is unlikely to default on any trade credit. It is emphasized that in this situation the independent enterprise has made an assumption on credit risk as it cannot take legal action against the parent company if the subsidiary defaults, because the parent has not provided the enterprise with a formal guarantee.

B.4.2.22.                       Under these circumstances, the associated enterprise’s membership of the MNE group does not result in a chargeable service being provided to the associated enterprise by the MNE group. The key feature of this type of incidental benefit is that it is passive and cannot be attributed to an overt action taken by another member of the MNE group. In contrast, if a member of an MNE group provided a formal guarantee of an associated enterprise’s trade credit, the formal guarantee may be a chargeable service provided that an independent entity would have been willing to pay for a formal guarantee in similar circumstances. Another example of a situation in which a chargeable service may occur is where an associated enterprise is able to get additional discounts from an independent supplier on condition that other MNE group members commit to additional purchases from that supplier.

B.4.2.23.                       The passive association of an associated enterprise with its MNE group may improve the associated enterprise’s credit rating ...

B.5. Intangibles and valuation



B .5 .1 .       Introduction

B.5.1.1.              Intangibles affect nearly every aspect of economic activity in the twenty-first century. Intangibles have become a major source of sustainable competitive advantage for many firms. The importance of intangibles in the economy has been growing for decades in a number of sectors. The information and communication technology (ICT) revolution has made some technologies cheaper and more powerful, enabling improvement of business processes and boosting innovation across virtually all sectors of the economy. This technological evolution has made intangibles increasingly important profit drivers in many individual businesses. It is therefore necessary to give careful consideration to intangibles when conducting a transfer pricing analysis.

B.5.1.2.              Transfer pricing issues can arise when MNEs develop, acquire, exploit or transfer intangibles. Various entities within an MNE group may participate in intangibles development through functions like research, development and marketing, providing funding for acquisition and development of intangibles, and exploiting intangibles in a wide range of business activities. These activities should be rewarded on an arm’s length basis. The business operations of one member of an MNE group may require the use of intangibles developed or owned by other group members. Use by one member of the MNE group of intangibles belonging to or developed by other group members should be compensated on an arm’s length basis.

B.5.1.3.              Transfer pricing issues relating to intangibles should be resolved using the fundamental transfer pricing principles contained in Chapters B.1, B.2 and B.8 of this Manual. However, as intangibles may be unique, may be difficult to value and may be very important to the successful operation of the MNE group’s business, transfer pricing issues related to intangibles can be very challenging for both tax administrations and taxpayers in developed and developing countries. This Chapter therefore supplements the general principles contained in earlier Chapters to provide special practical guidance on transfer pricing matters related to intangibles.

B.5.1.4.              In carrying out a transfer pricing analysis involving intangibles it is necessary to consider: (i) the identification of the specific intangibles involved, (ii) the ownership of intangibles within the MNE group, (iii) the value of the identified intangibles, (iv) how the intangibles contribute to the creation of value by the MNE group, and (v) the identity of the members of the MNE group that contribute to intangible value and how they should be rewarded. This framework for analyzing transfer pricing issues related to intangibles is discussed in the following sections.

B .5 .2 .       Identifying Intangibles

Definition of intangibles

B.5.2.1.              Article 9 of the UN Model Tax Convention is concerned with the conditions of transactions between associated enterprises, not with assigning labels to such transactions. The key consideration is whether a transaction conveys economic value from one associated enterprise to another, whether that benefit derives from tangible property, intangibles, services or other activities. As is the case with other transfer pricing matters the analysis of cases involving the use or transfer of intangibles should begin with a thorough identification of the commercial and financial relations entered into by the associated enterprises and the economically relevant characteristics attached to those relations. Such an approach is pursued in order to accurately delineate the actual transaction involving the use or transfer of intangibles. However, whether a particular item falls within the definition of intangibles or not will have little consequence for the analysis, since the principles in Chapters B.1, B.2 and B.8 will apply in any event. The following definition is provided primarily to aid in discussion rather than to create a substantive difference between cases involving intangibles and those that do not.

B.5.2.2.              Difficulties can arise in a transfer pricing analysis as a result of definitions of the term intangibles that are either too narrow or too broad. If an overly narrow definition of the term intangible is applied either taxpayers or governments may argue, incorrectly, that certain items fall outside the definition and may therefore be transferred or used without separate compensation, even though such use or transfer would give rise to compensation in transactions between independent enterprises. If too broad a definition is applied, either taxpayers or governments may argue, again incorrectly, that the use or transfer of an item in transactions between associated enterprises should require compensation in circumstances where no such compensation would be provided in transactions between independent enterprises.

B.5.2.3.              For the purposes of this chapter the term “intangible” encompasses something which is neither a physical nor a financial asset, which is capable of being owned or controlled for commercial purposes, whose use or transfer would be compensated had it occurred between independent enterprises in comparable circumstances. Whether something is recognized as an intangible for legal or accounting purposes is an informative starting point but not determinative. It is not the case that all valuable intangibles are legally protected, registered or recognized for accounting purposes.

B.5.2.4.              It is recognized that some countries use a different definition in their domestic law. However, irrespective of whether an item is characterized as an intangible under domestic law, the transfer pricing analysis will be based on the definition above. Of course, other elements may need to be taken into account if they would affect pricing between unrelated parties. See for example the items discussed in section B.5.2.20. below.

Common categories of intangibles

B.5.2.5.              Notwithstanding the above, it is sometimes the case that labels, such as those described in paragraph B.5.2.7., are commonly applied to certain intangibles, often those with a legal status. While such categorization may be helpful in identifying intangibles as a starting point of the analysis, the approach contained in this chapter for determining arm’s length prices in cases involving intangibles does not rely on any categorization. As a result, no attempt is made to delineate with precision various classes or categories of intangibles or to prescribe outcomes that turn on such categories. The categories of intangibles described below are ones often considered in transfer pricing analyzes involving intangibles. They are illustrative and not intended to be comprehensive.

B.5.2.6.              From a transfer pricing standpoint it should be emphasized that generic references to the categorization as outlined below do not relieve taxpayers nor tax administrations from carrying out a thorough transfer pricing analysis in order to identify intangibles as accurately as possible, taking into account the risks actually assumed and controlled, associated with the functions performed and assets employed. Similarly, the arm’s length principle does not apply differently depending on the type of intangibles at stake.

B.5.2.7.              A common distinction is made between legally registered and non-registered intangibles. One category of intangibles includes intellectual property such as patents and trademarks, which can be registered. Other types of intangibles, such as copyrights or legal rights (including licenses) covering the utilization of patents, literary works, databases, trade secrets or designs can be legally or contractually protected even if not registered. These types of intangibles can be expressly registered, contractually acknowledged or legally protected, depending on the applicable national laws and treaties.

B.5.2.8.              As indicated above, it is not the case that all valuable intangibles are legally protected and/or registered. Know-how and trade secrets are proprietary information or knowledge that assist or improve a commercial activity, but that an enterprise may— for a variety of business reasons— choose not to register. Such know-how may nonetheless contribute substantially to the success of the enterprise and be of significance in some situations for transfer pricing purposes.

B.5.2.9.              Notwithstanding the fact that the availability and extent of contractual forms of protection may affect the value of an asset such as an intangible (and the returns attributable to it), the existence of any such contractual protection is not a necessary condition for an item to be characterized as an intangible for transfer pricing purposes.

B.5.2.10.            Conceptually, intangibles can cover a wide spectrum encompassing legally defined items such as patents and trademarks up to broader categories such as best practices, internal procedures, human capital, non-contractual relations to customers or suppliers and network effects. The latter categories of items are not necessarily legally defined but may, taking into account particular facts and circumstances, convey value that would be compensated between parties at arm’s length, and, as such, should be considered as a relevant economic characteristic in any comparability analysis involving the use or transfer of intangibles.

B.5.2.11.            In considering transfer pricing matters certain intangibles may sometimes be referred to as either (i) trade intangibles or (ii) marketing intangibles.

B.5.2.12.            Trade intangibles may be created through testing and research and development (R&D) activities. The developer may try to recover the expenditures on these activities and obtain a return thereon through manufacturing and selling products, service contracts, or licensing out.

Marketing intangibles

B.5.2.13.            Marketing intangibles may be created by marketing activities, can aid in the commercial exploitation of a product or service, and/or may have an important promotional value for the product concerned. Depending on the facts and circumstances of the case marketing intangibles may include, e.g., trademarks, trade names, customer lists and customer relationships as well as proprietary market and customer data that is deployed in marketing activities and in selling goods or services to customers.

B.5.2.14.            There can be a combination of central and local marketing activities in MNE groups. In some cases the local marketing team performs marketing activities which are comparable to the activities of comparable uncontrolled distributors. In other cases, the local marketing team carries out broader marketing activities than the ones of uncontrolled distributors, e.g. autonomously develops marketing campaigns or customizes the commercial offering beyond the guidelines set centrally and accordingly, incurs significantly greater expenses than comparable uncontrolled distributors. In the latter case, the local marketing team may succeed in developing a marketing intangible.

B.5.2.15.              A separate concept is whether a particular intangible will be regarded as “unique and valuable”. For transfer pricing purposes, a “unique and valuable intangible” is an intangible which is not present in otherwise comparable uncontrolled transactions (unique) and; leads to significant expected premium value in business operations (valuable).

B.5.2.16.            When looking at local marketing activities undertaken by a distributor, it should be determined:

Ø whether or not the marketing activities of Distributor X create a separate intangible distinct from the foreign-owned brand,

Ø irrespective of the answer to the first question, whether or not the marketing activities of Distributor X that are in excess of those of comparable uncontrolled distributors should attract a return greater than those comparables. See para. B.5.2.14. above.

B.5.2.17.            Depending on the facts and circumstances of the case, the broader marketing activities of the Distributor may give rise to differing outcomes:

  1. a) The activities may lead to the creation of a local marketing intangible but not attract a return greater than the return of otherwise comparable uncontrolled distributors, for instance if the resulting intangible is not unique, despite the expenses incurred being greater than those of comparable uncontrolled distributors;
  2. b) The activities may lead to the creation of a local market ing intangible (distinct from the foreign-owned brand) and attract a return greater than the one of otherwise comparable uncontrolled distributors, for instance if the resulting intangible is unique and valuable;
  3. c) The activities may not lead to the creation of a local marketing intangible and not attract a return greater than the return of otherwise comparable uncontrolled distributors, for instance if the additional value created is captured by the Distributor through anticipated increased sales volumes;
  4. d) The activities may not lead to the creation of a local marketing intangible but attract a return greater than the one of otherwise comparable uncontrolled distributors, for instance if the Distributor ‘s marketing activities are a valuable contribution to the foreign-owned

Example 1:

Distributor X distributes branded products for which the brand is owned by a foreign affiliated enterprise. Assume that Distributor X has an innovative marketing team whose activities go beyond the implementation of the guidelines set by the brand owner. Distributor X successfully develops customized campaigns for the local market in which Distributor X operates. As a consequence, Distributor X is very successful in its market and its marketing expenses are significantly greater than the ones of otherwise comparable uncontrolled distributors. Assume that the incremental marketing expenses are not reimbursed by the foreign brand owner.

In this case, the determination will likely be either solution b) or d) of the above list, i.e. Distributor X would attract a return greater than the return of otherwise comparable uncontrolled distributors.

Example 2:

Distributor Y distributes branded products for which the brand is owned by a foreign affiliated enterprise. Assume that the foreign brand owner runs a comprehensive global marketing team and that Distributor Y solely implements locally the market ing campaigns which are designed by the foreign brand owner. Furthermore, the foreign brand owner reimburses Distributor Y for incremental marketing expenses (if any) incurred above the expenses of comparable uncontrolled distributors.

In this case the determination will likely be either solution a) or c) of the list at para. B.5.2.17., i.e. Distributor Y would not attract a return greater than the return of otherwise comparable uncontrolled distributors.

Market features

B.5.2.18.            The specific characteristics of a given market may affect the arm’s length conditions of a transaction between associated enterprises in that specific market. In conducting a transfer pricing analysis taking into account the specific market features in which one or more of the associated enterprises is operating one should distinguish between the local market characteristics, which are not intangibles, and other features— such as contractual rights granting exclusivity in marketing certain products or government licenses—which meet the definition of intangibles relevant for transfer pricing purposes. While some of the economic circumstances existing in a market (e.g. cost of labour) may give rise to location savings, others may trigger the need to focus on comparability issues not directly associated with location savings. See Chapter 2, para. B. of the Manual.


B.5.2.19.            The manner in which an intangible comes into existence from an accounting standpoint is not relevant to the determination of whether the item is an intangible for transfer pricing purposes. In this respect, a significant item often arising in discussions regarding the transfer pricing aspects of intangibles in the context of a business restructuring relates to the notion of goodwill.

B.5.2.20.            Depending on the context, the terms “goodwill” and “ongoing concern value” can be used to refer to a number of different concepts.

Ø in some accounting and business valuation contexts, good will reflects the difference between the aggregate value of an operating business and the sum of the values of all separately identifiable tangible and intangible assets (see example at para.

B.5.2.29. below);

Ø alternatively, goodwill is sometimes described as a representation of the future economic benefits associated with business assets that are not individually identified and separately recognised;

Ø in still other contexts goodwill is referred to as the expectation of future trade from existing customers;

Ø the term ongoing concern value is sometimes referred to as the additional value that attaches to property by reason of its existence as an integral part of an ongoing business activity;

Ø it is also sometimes described as the value attributable to the ability of a trade or business (or a part of a trade or business) to continue functioning or generating income without interruption notwithstanding a change in ownership, aside from any intangibles; and

Ø it is also sometimes referred to as the value of the assembled assets of an operating business over and above the sum of the separate values of the individual assets.

B.5.2.21.            It is generally recognised that goodwill and ongoing concern value cannot be segregated or transferred separately from other business assets.

B.5.2.22.            It is not necessary for purposes of this Chapter to establish a precise definition of goodwill or ongoing concern value for transfer pricing purposes or to define when goodwill or ongoing concern value may or may not constitute an intangible. It is important to recognise, however, that an important and monetarily significant part of the compensation paid between independent enterprises when some or all of the assets of an operating business are transferred may represent compensation for something referred to by one or another of the alternative descriptions of goodwill or ongoing concern value.

B.5.2.23.            When similar transactions occur between associated enterprises, such value should be taken into account in determining an arm’s length price for the transactions. The absence of a single precise definition of goodwill makes it essential for taxpayers and tax administrations to describe specifically relevant intangibles in connection with a transfer pricing analysis, and to consider whether independent enterprises would provide compensation for such intangibles in comparable circumstances.

B.5.2.24.            When the reputational value, sometimes referred to as goodwill, is transferred to or shared with an associated enterprise in connection with a transfer or licence of a trademark or other intangible that reputational value should be taken into account in determining appropriate compensation.

B.5.2.25.            If features of a business such as a reputation for producing high quality products or providing high quality services allow that business to charge higher prices for goods or services than an entity lacking such reputation, and such features might be characterised as goodwill or ongoing concern under one or another definition of such terms, such features should be taken into account in establishing arm’s length prices for sales of goods or the provision of services between associated enterprises whether or not they are characterised as goodwill. In other words, all contributions of value should be compensated at arm’s length irrespective of how they are labelled.

Purchase Price Allocation

B.5.2.26.            When a multinational enterprise acquires a company, group of companies or business it may prepare a Purchase Price Allocation for financial accounting purposes (commonly referred to as a “PPA”). Such PPA typically provides a financial valuation of identified underlying tangible and intangible assets. In the event where one or more of the intangibles are further transferred after the acquisition, for instance as part of a business restructuring, the question arises as to the extent to which the PPA will provide a useful basis for valuation of the further transferred intangible(s).

B.5.2.27.            Goodwill under Purchase Price Allocation for financial accounting purposes is mechanically defined as the difference between the purchase price (typically of a company or a business) and the valuation of identified underlying tangible and intangible assets. While the PPA can be a useful starting point to identify intangibles and their value, it is worth noting that any mis-valuation of any of  the identified underlying tangible and intangible assets (due, for example, to unaccounted synergies, other unaccounted sources of value or measurement errors) mechanically affects goodwill valuation as illustrated below.

Illustration of Purchase Point Allocation

Assume Company A is acquired by Company B for a price of 1,000. In its PPA for consolidated financial accounts’ purposes, Company B allocates to underlying tangible and intangible assets the purchase price it paid for Company A. In doing this, valuations are made for identified assets of Company A. Goodwill will be recognized for the residual value as follows:

Tangible assets:                                                         100

Sum of Patents 1, 2 and 3 (if valued separately):      150

Trademark:                                                               250

Unallocated “goodwill”                                             500

Total purchase price allocated:                               1 000

Assume that in the post-acquisition context the patents will be exploited as a bundle in order to derive synergetic benefits. Assume that while the sum of the individual values of Patents 1, 2 and 3 is 150, their value, if sold as a bundle, would be 250, because .of incremental value that can be derived from the interrelated use of the patents.

In such a case, if the transaction analyzed is the sale of Patents 1, 2 and 3 as a bundle, part of the PPA measure of goodwill value should be allocated to the value of the bundle. The result would be the following:

Tangible assets:                                                          100

Patents 1, 2 and 3 (if valued as a bundle):                 250

Trademark:                                                                250

Unallocated “goodwill”                                             400

Total purchase price allocated:                               1 000

Example: MineCo

Assume MineCo owns a government license to carry out oil drilling activity in Ruritania as well another government license for the exploitation of the oil rig network existing within the country. The oil drilling license has a standalone market value of 70 as opposed to the oil rig license which has a market value of 30. MineCo does not own any other asset.

ExtraCo, an independent competitor of MineCo, acquires 100% of the equity interest in the latter company for a price of 150. In its PPA realized further to the acquisition, ExtraCo attributes 70 to the license associated with the drilling activity, 30 to the oil rig license and the remaining amount of 50 to goodwill arising because of the existence of synergies created between the drilling and oil rig licenses taken together.

As an immediate follow-up of the acquisition, MineCo transfers both the above licenses to Extra1, a subsidiary of ExtraCo. In carrying out a transfer pricing analysis related to determining the arm’s length consideration to be paid by Extra1 with respect to the transaction taking place with MineCo, the taxpayer values the combined transaction at 100, the market value of the two licenses considered separately.

In this case in calculating the arm’s length consideration the purported goodwill associated with the bundled transfer of licenses by MineCo should be taken into account, as a party at arm’s length would be willing to pay more than 100 for combined assets that have a value of 150.

Group synergies, including procurement activities

B.5.2.28.            Group synergies are not an intangible, but they can be significant in the analysis of the transfer pricing aspects of intangibles. Generally, because of the existence of an MNE group, the associated enterprises comprising such groups may benefit from the proactive or passive interactions amongst group members which are not accessible to comparable third party enterprises. This type of synergy does not constitute an intangible.

B.5.2.29.            Group synergies are particularly relevant to central procurement. For instance, group synergies arising as a result of combined purchasing power or the scalability of a certain activity, increased borrowing capacity due to being part of an MNE group, and so forth. To this end it is important to distinguish, on the one hand, between:

Ø incidental benefits which are arising simply because of group affiliation; and

Ø economic advantages arising due to the deliberate concerted action of one or more associated enterprises that are part of the MNE group resulting in what is normally labelled as “group synergy”.

B.5.2.30.            In the case under (i), an associated enterprise should not be deemed to have received an intra-group service, and should not be required to make an intra-group payment for such a service, simply because it has access to economic advantages by virtue of its group affiliation. In the case under (ii), however, there may be a clearly identifiable economic advantage due to the exact identification of the source of the activities which have been put in place by one or more of the associated enterprises in the MNE Group and which can be quantified from a transfer pricing standpoint in the light of an accurate comparability (including functional) analysis at the level of each of the relevant associated enterprises.

B.5.2.31 In order to illustrate a simple central procurement function, assume that the MNE Group N decides to implement a policy of cost savings. In this respect, it incorporates Company P in Country L to centralize the procurement function and take advantage of volume discounts that arise solely because of the MNE group’s aggregated purchasing. Assume that Company P does not take title of the raw materials from suppliers. The concerned group members directly acquire the raw materials from the suppliers under the conditions applying to the group. In this scenario, Company P performs a deliberate concerted action which should generally be reflected in the pricing of a procurement fee to be paid by the group members to Company

  1. The arm’s length consideration of Company P would typically be an administrative fee and should be less than the aggregated cost savings of the MNE group. This reflects the fact that in this scenario the most important driver in the discounts is the volume purchased by the group, not the services provided by Company P.

B.5.2.32.            To illustrate a strategic, high value added procurement function, assume now that Company P recruits procurement specialists with extensive experience in managing suppliers and cost cutting in the industry. Such procurement specialists build up expertise in the area of demand requirements for Group N, supply offerings and supplier contacts regarding Group N raw materials, industry supply chain strategies, etc. On the basis of their expertise they design the procurement strategy specifically for Group N based on demand, product specifications and price; they carry out the vendor selection and contract negotiation; and they perform vendor evaluation and manage quality control functions. Company P therefore implements a deliberate concerted action of Group N which would warrant Company P receiving from other members of the group arm’s length remuneration that is appropriate in view of the value created by Company P. Depending on the detailed facts such compensation may, but would not necessarily, include a share of the savings derived due to Company P’s actions. This reflects the fact that in this scenario, not only the volumes of purchases but also the know-how deployed by Company P both contribute to the ability to obtain discounts. In this case the know-how of Company P is an intangible which warrants remuneration. The volume effect, however, is not an intangible and the benefit associated with that aspect should go to the individual group company or companies purchasing the products.

B.5.2.33.            A further example illustrates a different scenario where title is customarily taken by a strategic, high value-added procurement function. Assume the fact pattern as in B.5.2.32., but assume additionally, that Company P takes title of the procured goods and through its personnel controls risks centrally regarding amongst others volume commitments, price fluctuations, exchange rate risks, quality control risks, etc. and has the financial capacity and capability to assume these risks. Company P resells the raw materials it purchases to other group members. In such cases, Company P would earn a profit margin on the products resold to the group members. Such profit margin should be appropriate in view of the value created by P, including the fact that it bears the working capital to fund inventory and reflect the range  of risks associated with the procurement. Depending on the detailed facts, such profit margin may include a share of the anticipated savings derived due to Company P’s actions, and may be an amount that is greater at 5.2.32. This reflects the fact that in this scenario Company P is not only contributing value through its know-how but also through bearing inventory costs and associated risks.

Workforce in place

B.5.2.34.            Another important aspect to be taken into account in a transfer pricing analysis can be the existence of a qualified and skilled workforce.

B.5.2.35.            Generally, the existence of the workforce does not need to be remunerated separately for transfer pricing purposes. This is because the value provided by a workforce is typically reflected in the arm’s length consideration to be paid for the goods produced or the services performed by the workforce. By contrast, rights under contracts—which may include the use of a workforce in place— could constitute an intangible within the meaning of paragraph B.5.2.3. of this Chapter.

B.5.2.36.            Another situation concerns the transfer of an assembled workforce, e.g. in the context of a business restructuring. Such a transfer may be justified for a variety of reasons, such as the possibility for the transferee of not hiring and training a new workforce. On the other hand the transfer of an assembled workforce may trigger some liabilities in the hands of the transferee in the event some contracts have to be terminated as part of the implementation of the business restructuring plan. In such a case the most appropriate transfer pricing method to be selected as well as the calculation of any potential indemnity has to take such elements into account.

B.5.2.37.            From a transfer pricing standpoint it is important to distinguish between the transfer of an assembled workforce in the context of a business restructuring and the mere secondment of employees, which is common in any MNE group. As a general rule, it is very rare that a transfer of individual employees between members of an MNE group should be compensated beyond the mere reimbursement of the employment and other associated costs, or the remuneration required for the services carried out by the seconded employees.

B.5.2.38.            The use or transfer of part or all of a workforce does not, in itself, constitute the transfer of intangibles. However, it can also be the case that the transfer of certain employees is accompanied by the transfer of intangibles such as know-how from one associated enterprise to another.

Example: Pricing algorithm

Assume that several employees of Company G have developed over the years a specific algorithm to accurately price derivative instruments. The algorithm is owned by Company G since it was developed by the individuals in their capacity as employees of Company G. Assume that the employees are seconded by Company G to the associated Company M. The secondment of the personnel from Company G to Company M does not constitute a transfer of an intangible.

Assume now that, as part of their secondment, the seconded employees, with the authorization of Company G, make the algorithm available to Company M to assist and use in its commercial operations. This may result in an intangible, i.e. the algorithm, being put at the disposal of Company M by Company G, for which arm’s length consideration may need to be paid by Company M to Company G.

B .5 .3 .                             Ownership of Intangibles and Transactions Involving Intangibles

Analytical framework for the use or transfer of intangibles

B.5.3.1.              Applying the arm’s length principle to transactions involving the use or transfer ...

B.6. Cost Contribution Arrangements



B .6 .1 .       Introduction

B.6.1.1.                         This chapter provides guidance on the use of cost contribution arrangements (CCAs) and the application of the arm’s length principle to CCAs for transfer pricing purposes. CCAs are contractual agreements between associated enterprises in an MNE group in which the participants share certain costs and risks in return for having a proportionate interest in the expected outcomes arising from the CCA. CCAs may also include independent parties. CCAs may be used for a broad range of purposes such as acquiring or creating tangible assets, acquiring or creating intangibles, and providing intra-group services. In relation to intangibles, the CCA will set out the interest of each participant in the intangibles to be developed. For services, the CCA will set out the services that each participant is entitled to receive. For CCAs involving tangible assets, the CCA will set out the interest of each participant in the tangible assets.

B.6.1.2.                         A CCA will satisfy the arm’s length principle if a participant’s share of contributions to the CCA is in proportion to its share of expected benefits under the CCA.

B.6.1.3.                         CCAs offer significant administrative advantages. As associated enterprises perform intra-group services for other group members and also benefit from intra-group services provided by other group members, a CCA can provide a mechanism for replacing a web of separate intra-group arm’s length payments with streamlined net payments based on aggregated benefits and aggregated costs associated with the services. Similarly, a CCA for sharing in intangibles development can eliminate the need for complicated cross-licensing payments and replace it with a more streamlined sharing of contributions and risks, effectively achieving joint ownership of the resulting intangible.

B.6.1.4.                         CCAs are used to develop future benefits such as tangible assets or intangibles, or to provide intra-group services. MNE groups use CCAs to share the costs and risks of developing intangibles. These activities involve risk as the expected benefits may not be realized. For example, it is uncertain whether research and development will result in the creation of an intangible which can be exploited by the participants. Given the degree of risk involved, the sharing of costs and expected benefits may be a preferred approach. Moreover, a single associated enterprise may not have the resources or the capacity to individually carry out the development by itself. Another advantage of a CCA is the flexibility to make contributions in the form of tangible assets, intangibles and services. A CCA may provide that the participants are allowed the exclusive right to exploit the intangible in specific countries or regions. A participant in a CCA must be able to use its interest in the intangibles and thus the participants cannot be required to pay royalties for the use of intangibles developed under the CCA.

B.6.1.5.                         Broadly, there are two distinct categories of CCAs: arrangements for sharing in the costs and benefits of intercompany services (service sharing arrangements), and arrangements established for the development, production, or obtaining of intangibles or tangible assets (development arrangements, most typically intangibles development arrangements). Both types of arrangements involve the sharing of contributions and the sharing of anticipated benefits. Contributions may be in the form of cash, tangible assets, intangibles, and services. While both types of CCAs derive from the same underlying frame work of sharing relative contributions in proportion to relative benefits, the motivation for these arrangements and some of the practical issues of implementing the arrangements may not be the same.

B.6.1.6.                         In service sharing arrangements, for example, an MNE may decide to centralize its human resources operations or information technology (IT) function in an associated enterprise so the participants will share the costs of providing these services. The advantage of intra-group service CCAs is that they provide for economies of scale to the participants, resulting in a lower proportional cost for these services than if each participant were providing the services in-house. For example, an MNE group may decide to have its IT services provided by a participant in a low cost country which has an established history of being an international leader in IT. The centralization of IT provides the group with access to high quality IT services provided at a lower cost through economies of scale and potential location savings.

B.6.1.7.                         Some of the savings from centralizing functions may arise from preventing unnecessary duplication of functions within an MNE group. The savings that arise from centralizing services provided in an associated enterprise will usually be immediate. The services that may be the subject of a CCA include management, administrative and technical services, marketing and purchasing of raw materials or products.

B.6.1.8.                         On the other hand, for example in an intangibles development CCA, participants within an MNE may decide to share in the costs, risks and potential benefits from undertaking a project to develop a new product such as a pharmaceutical product. Contributions may include patents and other existing intangibles relevant to the development, research and development services, and use of laboratories. Potential benefits might include the exclusive rights for each of the participants to exploit the intangible in its own market. There may be a significant time lag between development activities and the creation and exploitation of intangibles.

B .6 .2 .       CCA features

B.6.2.1.              The key characteristic of CCAs is that the participants agree to share the proportionate costs of creating or acquiring tangible assets, creating or acquiring intangibles or providing services. They accordingly agree to have corresponding proportionate interests in the tangible assets, intangibles, or services created by the CCA. Participants should thus share the benefits in a way that is consistent with their contributions to the CCA. The predictability of the bene fits of participating in CCAs varies. In some CCAs the benefits may be predictable at the outset but in other cases there may be uncertainty about the outcome. For example, it may be highly uncertain whether research and development will result in the creation of intangibles such as patents, know-how or IT software. In relation to services, a CCA may fail to provide the predicted benefits from economies of scale as a result of certain unexpected contingencies.

B.6.2.2.              The benefits for an MNE in using a CCA may include:

Ø exploiting economies of scale and global corporate efficiency for commonly required services;

Ø reducing duplication within an MNE group;

Ø increasing operational effectiveness through shared activities and synergies within the MNE group;

Ø the sharing of risks among the CCA participants; and

Ø exploiting the knowledge of the participants through the sharing of know-how and best practices.

B.6.2.3.              A participant in a CCA involving intangibles is entitled to use its interest in the intangibles in accordance with its share of the intangible and cannot be required to pay a fee or royalty to use its interest in the intangible. This is the case even where legal ownership is held by one associated enterprise on behalf of the group.

B.6.2.4.              The features of CCAs are:

Ø having at least two participants;

Ø a sharing of costs between the participants based on anticipated benefits;

Ø each participant should have a reasonable expectation of benefitting from taking part in the arrangement (mutual benefit);

Ø the details of the arrangement are documented;

Ø the form of the CCA and the economic substance are consistent; and

Ø arrangements exist for the departure of participants (“buy out”) from the CCA and the entry of new participants to the CCA (“buy in”).

B .6 .3 .       Participation in a CCA

B.6.3.1.              Under the arm’s length principle, a participant in a CCA must expect to benefit from participating in the CCA. In particular, the participant must have a specific interest in the tangible assets, intangibles or services of the CCA activity and must be capable of using the tangible assets, intangibles or services. The benefit that a CCA participant expects to receive is based on an objective prediction. Nevertheless, the decision is based on an expectation because of the associated uncertainty and there is no requirement that the CCA benefits may be realized as CCAs often involve risk.

B.6.3.2.              In some industries, the facts and circumstances indicate that the research and development project is risky and may fail to realize benefits. For example, in the pharmaceutical industry many research and development projects often fail to result in patents and products which can be exploited commercially. Nevertheless, the pharmaceutical industry is competitive and MNE groups must continue to engage in research and development to remain competitive, as the rewards flowing from the development of a new drug can be very significant. The facts and circumstances suggest that although there  is a high risk that an individual pharmaceutical research and development CCA may fail to actually provide benefits to the participants, this may simply reflect the playing out of risks, and is not in itself indicative that the CCA does not satisfy the arm’s length principle.

B.6.3.3.              The CCA activities may be carried out by one or more participants, or the activity may be undertaken by an associated enterprise which is not a participant. If a non-participant associated enterprise carries out the CCA activity under the arm’s length principle it will require consideration for the work it engages in and it will not, for example, have an interest in any resulting intangibles or tangible assets. The consideration would be determined using a functional analysis and applying the appropriate transfer pricing methods in the Manual.

B .6 .4 .       Valuing CCA contributions


B.6.4.1.                         To determine if a CCA satisfies the arm’s length principle, it is necessary to determine the value of each participant’s contributions. All contributions must be identified and valued generally at the time the contributions are made. A participant’s contributions may be in the form of cash, tangible assets, intangibles or services. The Guidance provided in this Manual is to be used in valuing contributions and taking into account the mutual sharing of risks by the participants and the expected benefits that will be derived by the participants.

B.6.4.2.                         Contributions to a CCA may take many forms. For service sharing arrangements, contributions primarily consist of the performance of the services. For development CCAs, contributions typically include the performance of development activities (e.g., research and development or marketing) and often include additional contributions relevant to a development CCA such as other pre-existing intangibles that will contribute to the development of a CCA intangible.

B.6.4.3.                         There is a difference between current contributions and pre-existing contributions. Examples of pre-existing contributions would include the contribution of patented technology with pre-existing value that is useful towards the development of the intangible which is the subject of the CCA, or the contribution of a tangible asset that had been acquired by one of the participants some time before the commencement of a CCA. Contributions of the pre-existing value of tangible assets and intangibles should be valued using the arm’s length principle in this Manual as outlined at Chapter B.5.

B.6.4.4.                         Current contributions, on the other hand, are ongoing contributions that should be valued at market value. An example would be the performance of research and development services directed to the objective of the CCA. Such services would be valued on the basis of the functions performed by the participants. The current value of contributions should be determined in accordance with the arm’s length principle in this Manual.

B.6.4.5.                         Although under the arm’s length principle all contributions should be measured at value, it may be easier for participants to measure current contributions at cost. If this approach is adopted, the value attributed to the pre-existing contributions should recover the opportunity cost of the ex ante commitment to contribute at cost resources to the CCA. For example, a contractual arrangement (i.e. the CCA) that commits an existing workforce to undertake work for the benefit of the CCA should reflect the opportunity cost of alternative R&D endeavours (e.g. the difference between the value of the next most valuable use of the research and development staff over anticipated research and development costs) if the research and development performed by the CCA is to be valued at cost. In making this determination it is important not to double count different contributions of value (e.g. the value of the workforce and the value of the intangible contributions).

B.6.4.6.                         In certain situations, current contributions may be valued at cost as a practical method of valuing the relative value of the current contributions, e.g. if the difference between value and costs is insignificant. However, if contributions involve a combination of tangible assets, intangibles and services measuring the current contributions at cost may be unreliable for valuing relative contributions and may result in non-arm’s length results. If it is claimed that the conditions of a CCA reflect those in comparable uncontrolled transactions, and the uncontrolled transactions use cost for valuing contributions, then the comparability of all the significant economic features of the controlled and uncontrolled transactions must be examined to ensure that the CCA and the uncontrolled transactions are comparable. Another issue that needs to be considered in comparing a CCA to uncontrolled transactions is whether other payments are made in the uncontrolled transactions such as milestone payments.

B.6.4.7.                         In some situations budgeted costs may be used for valu ing contributions. Budgeted costs may be justified on the basis that contributions to a CCA will reflect expected benefits. There are usually differences between budgeted costs and actual costs in a CCA. A key question is therefore to determine which participants bear the risk that actual costs may be greater or lower than the budgeted costs. Arm’s length parties will usually set out how to deal with the differences between budgeted costs and actual costs. Moreover, independent parties are likely to agree on the factors that are taken into account in developing the budget and how unforeseen anomalies are to be treated. If there are significant differences between budgeted costs and actual costs, the reasons for the differences should be examined to ensure that the CCA has not been significantly altered so that the changes may not benefit some of the participants.

B.6.4.8.              As stated above, all contributions by participants to a CCA must be recognized. Contributions to be considered include contributions used exclusively for the CCA and also contributions used partly in the CCA and partly in the participant’s business activities. The apportionment of valuation of contributions may be difficult in some situations. A participant may contribute the use of its business premises including tangible assets such as plant and equipment, and the participant may also provide certain services to the CCA. The participant may also be using the business premises and tangible assets concurrently for its own business. In these circumstances the arm’s length value of the use of the business premises and the access to the plant and equipment must be determined. The appropriate valuation would be the arm’s length rent for non-exclusive possession of business premises and the use of plant and equipment. The apportionment of contributions for valuation purposes should be based on the facts and circumstances and accepted accounting principles. If material changes occur during the life of the CCA, adjustments will be required to the apportionment. How these are treated for tax purposes will depend on domestic law.

Treatment of government subsidies

B.6.4.9.              In many jurisdictions governments provide specific tax incentives and subsidies for research and development, which raises the issue of whether these incentives should be taken into account in determining a participant’s contributions to a research and development CCA. The alternative approaches are to value the participant’s contribution and disregard the subsidy or to value the contribution taking into account the effect of the subsidy. Under the former approach, the participant enjoys the full benefit of the subsidy itself. Under the latter approach the participant’s contribution is reduced by the effect of the subsidy and in effect all participants share the benefit of the participant’s subsidy. The determination under the arm’s length principle depends on whether independent enterprises would have engaged in these activities in the same circumstances.

B .6 .5 .       Predicting expected benefits

B.6.5.1.                         For an associated enterprise to participate in a CCA it must have an expected and identifiable benefit. An associated enterprise’s expected benefit is important in determining the enterprise’s contribution and whether the allocation method (e.g. allocation key) used by the MNE group is acceptable for the tangible assets, intangibles or services. An associated enterprise’s contributions must reflect its anticipated share of expected benefits in order to satisfy the arm’s length principle. An independent enterprise would not engage in a CCA unless it is able to identify a proportionate expected benefit. The notion of expected benefit is broad and means an economic advantage that may be in the form of reduced costs, increased income or maintaining its commercial and financial position. For intra-group services one of the main advantages which would be expected from the centralized provision of services would be the cost reduction achieved through economies of scale. The analysis of the expected benefits must be based on an associated enterprise’s facts and circumstances.

B.6.5.2.                         “Allocation keys” are often used by MNEs as an indirect method to approximate the respective future benefits of each participant in a CCA. An allocation key may be based on factors including: turnover, gross profit, net profit, the number of employees and capital. The allocation key used is a proxy for determining the nexus between the contribution and the participant’s entitlement in expected benefits; the factors to be used must be determined on the facts and circumstances of the CCA.

B.6.5.3.                         The determination of a participant’s contributions should be based on objective projections of its expected benefits and the respective advantages that they will provide to the participants. The projections should reflect projections that would have been made by independent parties in similar circumstances. A tax authority reviewing projections should only review them on the basis of information available to the participants rather than using hindsight which would be deemed unfair. In addition, CCAs should provide for adjustments to be made to contributions during the course of the CCA on a prospective basis to reflect changes in the ratio of the expected benefits of the participants.

B.6.5.4.                         For some CCAs, such as for intangibles development, the benefits from the CCA will be realized in the future, and the time lag between commencement and realization may be significant. Accordingly, it can be difficult to measure the expected benefits flowing from research and development CCAs. Discounted income or cash flow methods are often used (See paras B.5.6.8. and following of Chapter B.5). Under the arm’s length principle, a participant’s contributions to a CCA must be consistent with its share of the expected benefits. This requires a direct approximation of a participant’s expected benefits and ensuring that its contributions reflect its expected benefits. Consequently, if a participant is expected to receive a significant direct benefit if the goals of the CCA are realized, the participant should make a significant contribution.

Example: Development of new technology

Assume that Company A and Company B enter into a CCA in Year 1 to develop new technology. At the inception of the CCA it is projected that the development process will take five years and that once the new technology is commercialized in Year 6 Company A will receive 75% of the benefits and Company B will receive 25% of the benefits. Total development costs are 100 each year.

In years 1, 2 and 3, Company A pays 75 in CCA related costs and Company B pays 25 in CCA related costs. At the end of Year 3, regulatory changes take place in the expected market for the new technology in Company A’s territory. As a result of those changes, it is projected in year 4 and thereafter that Company A will derive 50% of the total benefits and Company B will also derive 50% of the projected benefits over the useful life of the technology being developed. As a result of the changes in total projected benefit shares, Company B should make balancing payments to Company A equal to 75 (the difference between 25% and 50% of the costs incurred in Years 1, 2 and 3). This balancing payment should be made in Year 4. Also in Year 4 and Year 5, based on the new benefit ratio calculation, Company A and Company B should each pay 50 of the current annual CCA related costs.

Thus, at the end of the development period, both Company A and Company B would have paid 50% of the CCA development costs and each would anticipate receiving 50% of the benefits of exploiting the new technology, as follows:

Year 1 Year 2 Year 3 Balancing Payment Year 4 Year 4 Year 5 Total
75 75 75 (75) 50 50 250
25 25 25 75 50 50 250

B .6 .6 .       Non-arm’s length CCAs

B.6.6.1.              A CCA will fail the arm’s length test if the participant’s contributions are inconsistent with their share of the expected or realized benefits. As a consequence, other participants will be receiving  a corresponding excessive share of the benefits and accordingly, an adjustment based on the facts and circumstance of the case may be required. The potential adjustments a tax authority may make in the case of a participant failing to comply with the arm’s length principle are to alter the contributions or to disregard the terms of the CCA.

Balancing payments

B.6.6.2.              A CCA will satisfy the arm’s length principle if the value of every participant’s proportionate share of the total contributions  is reflected in the participant’s share of the expected benefits. If a participant’s share of overall contributions is inconsistent with the participant’s share of the expected benefits, the contributions of at least one participant is excessive and correspondingly, the contributions of at least one other participant will be inadequate. In this situation, under the arm’s length principle a balancing payment is required by the participants whose contributions are inadequate. The balancing payment will increase the value of contributions of the payer and decrease the value of contributions by the payee.

B.6.6.3.              Participants may also make an additional contribution to a CCA if the participant’s proportionate contributions are too low when compared to its expected benefits. Adjustments may be the result of a periodic review of a participant’s contributions and its relative share of the expected benefits. In some cases, the need for periodic adjustments is anticipated at the commencement of the CCA.

B.6.6.4.              Balancing payments may also be required by tax authorities. A tax authority may make an adjustment to remedy an identified imbalance in contributions to the CCA relative to the participant’s share of anticipated benefits. An adjustment may be required if a participant’s contributions in the form of tangible assets, intangibles or services were under-valued. An adjustment may also be required when a participant’s share of expected benefits is too low relative to its share of expected costs because the allocation key has failed as a proxy for expected benefits or when changes occur during the life of the CCA that would suggest the initial anticipated benefit shares have changed.

B.6.6.5.              When such deficiencies are identified they may be remedied by a balancing payment. A tax authority examining a CCA and concluding that an adjustment is required may treat a participant as receiving a notional balancing payment which may result in a corresponding payment being made between the participants. Nevertheless, if a CCA has been established in good faith, tax administrations should be cautious in making adjustments, and only consider them when the participant’s relative contributions are excessive compared to its share of the expected benefits over several income years rather than in one income year. When required, balancing payments should be calculated to ensure that each participant’s share of the total contributions over the life of the CCA is consistent with that participant’s share of the projected benefits over the useful life of the tangible assets and intangibles developed under the CCA.

Disregarding the CCA terms

B.6.6.6.              If an analysis of a CCA discloses that the terms of the CCA differ from the economic reality, a tax authority may disregard some of the terms of the CCA consistent with the determination of the accurately delineated transaction. In addition, paragraphs B. – B. are relevant as to the ability of tax authorities to disregard CCA arrangements in limited circumstances.

B.6.6.7.  A tax authority may conclude that a participant is unlikely to benefit from a CCA or that any expected benefits would be trivial, especially if its contributions are significant. In this case, a tax authority may conclude that the arrangement fails to comply with the arm’s length principle (since an independent enterprise would not participate in such an arrangement) and it may thus disregard the CCA.

B .6 .7 . CCA entry, withdrawal and termination

B.6.7.1.                         At the time when a CCA is established, one or more participants may be required to make a payment for their share of tangible assets, intangibles or other contributions of pre-existing value made available to the CCA by other participants. Similarly, after a CCA is established, an associated enterprise entering the CCA as a new participant may be required to make a payment in return for acquiring an interest in the benefits that have been created under the CCA. A participant withdrawing from a CCA is required to receive a payment for its share of the value of the CCA. In addition, existing participants in   a CCA may either increase or decrease their involvement in a CCA. These situations are considered below.

“Buy-in” payments

B.6.7.2.                         When an associated enterprise joins a CCA, either at the commencement of the CCA or as a new participant after the CCA has been in operation, the associated enterprise may obtain an interest in contributions of pre-existing value made by other participants or in the realized benefits of the CCA created by such participants. This may include, for example, intangibles, other rights and work-in-progress. As the new participant acquires an interest in such benefits, the arm’s length principle requires the participant to make an arm’s length payment for this transfer from the other participants that created the pre-existing value. The sum payable for pre-existing benefits by a new participant on entering the CCA is called a “buy-in” payment.

B.6.7.3.                         The buy-in payment should be based on the arm’s length value of the rights that the new participant is acquiring and its interest in the expected benefits of the CCA. If the work of a pre-existing CCA has been fruitless and a change in approach is being considered, there may be no buy-in payment as the new participant is not acquiring an interest in tangible assets or intangibles, rights or work-in-progress. The new participant may also be making a contribution to the CCA in the form of intangibles or other pre-existing tangible assets. The items being contributed would have to be valued under the arm’s length principle and a balancing payment made to make up differences if the buy-in payment required is greater than the value of the items being contributed by the new participant. Alternatively, if the value of the intangibles exceeds the required buy-in amount, a balancing payment will be required from the existing participants to the new participant. This may involve a netting of the buy-in payment and the balancing adjustment.

B.6.7.4.                         The treatment of a buy-in payment for tax purposes should be determined under the domestic law and tax treaties of the participants’ countries. The payment should be treated as a payment to an independent enterprise to acquire an interest in intangibles, rights and work-in-progress.

“Buy-out” amounts

B.6.7.5.                         When a participant leaves a CCA a “buy-out” occurs in which the departing participant sells its interest in the tangible assets, intangibles and rights under the CCA to the remaining participants.

The buy-out amount should be the arm’s length value of the departing participant’s interest in the CCA. In some cases, the CCA’s efforts may not have resulted in any realized benefits and consequently, the payment of consideration to the departing participant is unnecessary. The treatment of a buy-out payment for tax purposes should be determined under the domestic law and tax treaties of the participants’ countries. The payment should be treated as a payment from an independent enterprise to acquire an interest in intangibles, rights and work-in-progress.

B.6.7.6.                         When new participants join a CCA, or when existing participants leave a CCA, an adjustment to the contributions of the continuing participants may be required to reflect the changes in their proportion of future anticipated benefits.

Termination of a CCA

B.6.7.7.                         On the termination of a CCA the participants must receive their respective shares in the tangible assets, intangibles and rights acquired and developed under the CCA. If a participant surrenders its entitlements under the CCA, the other participants would be required to make a payment, following the requirements for a buy-out set out above.

B .6 .8 . General CCA Requirements

B.6.8.1.              CCAs should list the participants and their respective interests in order to minimize the risk of disputes over the ownership of the fruits of the CCA and disputes with tax authorities. Under a CCA the legal owner of tangible assets and intangibles may be one associated enterprise, but the CCA participants have joint interests in the tangible assets and intangibles. A feature of CCAs is that the participants must have an interest in the tangible assets, intangibles or benefit from the services that are the subject of the CCA. In the case of intangibles, a participant must be able to use its interest in the intangibles.

B.6.8.2.              In general, CCAs between associated enterprises should meet the following requirements:

Ø the participants would include only enterprises expected to derive mutual and proportionate benefits from the CCA activity itself (and not just from performing ...

B.7. Business Restructuring



B .7 .1 .       Setting the framework and definition issues


B.7.1.1.                   In recent years the tax aspects of business restructurings undertaken by multinational enterprises (MNEs) have attracted much attention from tax authorities all around the globe. From a transfer pricing standpoint such reorganizations require consideration of how to apply the arm´s length principle to a sound cross-border redeployment of functions, assets and risks within the same group.

B.7.1.2.                   There is no legal or universally accepted definition of “business restructurings”. In a transfer pricing scenario these transactions are defined as the cross-border redeployment of functions, assets (tangible and/or intangible) and risks to which a profit/loss potential may be attached. In this respect business restructurings undertaken by MNEs need not be confused with the ordinary acquisition of a business or an ongoing concern. However, it may be common to proceed with a business restructuring of the supply chain operations of an MNE group following an acquisition, divestiture of a business, or in response to the changing business environment.

B.7.1.3.                   Common examples of business restructurings are reorganizations involving conversions of the manufacturing and/or distribution layer of an MNE such as (i) conversion of a buy-sell distributor into a commissionaire or (ii) conversion of a fully-fledged manufacturer into a provider of manufacturing services. Business restructurings may also involve the transfer of the ownership and management of intangible property rights such as patents, trademarks, brand names etc.

B.7.1.4.                   As a general rule businesses are entitled to organize their activities in the way they see fit. Business restructuring undertaken in a manner consistent with the arm’s length principle is entirely appropriate. However, there may be situations in which business restructurings facilitate inappropriate income shifting through non-arm’s length pricing or through commercially irrational structures. The guidance in this Manual, including this Chapter, applies to business restructurings to ensure that they are consistent with the arm’s length principle.

B.7.1.5.                   The application of Article 9 of the United Nations Model Double Taxation Convention to business restructurings requires that the arm’s length consideration for a supply, acquisition or transfer of property is that which might reasonably be expected to be made under an agreement between independent parties dealing at arm’s length. As a result, a business restructuring generally involves the determination of whether at arm’s length a payment would be warranted for the transfer of something of value, or for the termination or substantial renegotiation of commercial arrangements between associated enterprises, and if so what the amounts of such arm’s length consideration would be.

Business Restructurings: Considerations regarding Developing Countries

B.7.1.6.                   The changes triggered by the implementation of a business restructuring can have significant effects on the allocation of profits (or losses) between the countries in which the entities operate, regardless of whether or not tax savings are a driver. When a multinational group changes its business model, the tax and legal structure of the group would generally require an alignment with the new business model.

B.7.1.7.                   Business restructurings increasingly affect developing countries. In recent years a number of large MNEs have either (i) transferred their manufacturing facilities into low-cost countries, e.g. where the cost of labor of a skilled workforce is lower and/or (ii) similarly moved certain distribution functions and/or (iii) similarly moved valuable intangible property out of the jurisdiction where they were acquired, developed or exploited. This Chapter discusses how to determine, on a case by case basis, whether or not the conditions of such restructurings comply with the arm’s length principle.

B.7.1.8.                   In a business restructuring context, the arm’s length principle entails a comparison of the conditions (including the pricing) of a transaction or arrangement between associated enterprises and those which would have been agreed between independent enterprises dealing at arm’s length in similar circumstances. Where a particular transaction is a part of a broader arrangement in respect of a business restructuring, setting (as well as testing) the arm’s length consideration for that transaction requires that all the circumstances relevant to the broader arrangement are taken into account in evaluating the comparability factors that might reasonably apply under an agreement between independent parties dealing at arm’s length.

B.7.1.9.                   In the absence of reliable uncontrolled comparable data, an assessment has to be made of the consistency of the conditions  of the controlled transaction with those that might reasonably be expected under an agreement between independent parties dealing at arm’s length.

B.7.1.10.                The above mentioned process with respect to the implementation of the arm’s length principle highlights the need for authorities in developing countries to be alert to business restructurings and their potential consequences. As already stated in other parts of this Manual, while it is for each country to determine its own tax system, the desire to avoid double taxation has been an important factor in the very broad acceptance of the arm’s length principle internationally.

Process for setting or testing the arm’s length principle in business restructuring operations

B.7.1.11.                This paragraph describes a typical process which may be followed when setting or reviewing transfer prices in the context of a business restructuring. This process is neither prescriptive nor exhaustive

B.7.1.12.                As a first step, it is important to characterize the transactions entered into by the associated enterprises, taking into account the business environment in which the MNE group is operating. This entails carrying out the following activities:

Ø identifying the scope, type (e.g. supply of goods, provision of services, licensing arrangements) and economic nature of the arrangements between the associated enterprises involved in the business restructuring;

Ø performing a functional analysis of the pre and post-business restructuring activities of associated enterprises affected by the restructuring. Such an analysis requires as a starting point reference to any relevant contract, including those entered into to implement the business restructuring (e.g. contracts transferring the legal ownership of certain intangible property and those evidencing the terms and conditions of the pre and post-restructuring arrangements for the business activities affected by the restructuring) as well as an examination of risks assumed and functions performed by the associated enterprises; and

Ø examining the consistency of the contractual terms with the outcome of the functional analysis of the associated enterprises taking part in the business restructuring, in order to determine the true nature of the transactions, including the legal, economic and tax effects thereof. It should not be automatically assumed that the contracts, though they are the starting point of any transfer pricing analysis, accurately or comprehensively capture the actual commercial or financial relations between the parties. The core part of such an examination is the performance of a thorough functional analysis, which is needed to identify the value-adding activities and functions performed, assets used and risk assumed in respect of the business activities affected by the restructuring.

B.7.1.13.                The selection of the most appropriate method or methodologies applicable to the transaction(s) at stake follows from the functional analysis. As discussed in more detail below, a business restructuring is commonly implemented through a series of intertwined transactions. For instance, a business restructuring might involve transferring functions, assets and risks to a tax favorable location. This should not of itself warrant the conclusion that a non-arm’s length arrangement has been implemented.

B.7.1.14.                Provided the pricing of the business restructuring itself and of the post-restructuring arrangements are consistent with what would occur under an agreement between independent parties in comparable circumstances the arm’s length principle and its requirements are met.

B.7.1.15.                   For example, an associated enterprise may transfer the ownership of an intangible asset to its foreign principal and also agree to enter into a licensing agreement with that company. In determining whether the transfer of ownership is consistent with the arm’s length principle, taking into account that the transaction is part of a broader business restructuring arrangement, comparability needs to be assessed.

B.7.1.16.                In practical terms, in many instances relevant third party data are not available as the types of business restructurings commonly taking place tend to be unique to the various business models exist ing within MNE groups. However, the lack of reliable third party data should not lead the tax authorities to automatically conclude that the business restructuring as a whole is not respecting the arm’s length principle. Where s