Hierarchical Selection of Arm’s Length Test Models on Transfer Pricing between Related Parties
Transfer pricing between related parties requires the arm’s length test. Default test models have been developed over the course of almost half a century and proposed by the OECD in its various issues of the OECD Transfer Pricing Guidelines. Being a tax jurisdiction, the addressee of the OECD recommendations on how to test for the arm’s length character of transfer prices primarily is the national tax jurisdiction which can opt to integrate such OECD output in domestic tax code, regulations, or administrative principles. Of course, courts may also rule on the applicability of such test models.
This handout describes the GTP Concept on the application of the OECD Transfer Pricing Methods
1 Legal Provision
As is the case for business transactions between third parties, transfer pricing between related parties within the multinational group is underlying a given legal framework. The legal provisions subject to a particular related-party transaction may vary across business models, industries, countries, and times. Yet, some basic structures on the legal framework can be referred to.
1.1 Law of Obligations
First, the Law of Obligations is pivotal to set, and assess, transfer prices. The underlying understanding is that the contractual arrangement framing the related-party transaction enjoys the principle of freedom of contract. Contractual features such as
▪ the choice of the related-party transaction partners,
▪ the definition of the type of exchange on products, services, rights, or guarantee,
▪ the allocation of function, risk, and assets,
▪ the model of price setting, invoicing, and updating over the contractual terms,
▪ the application of force majeure rights and the place of jurisdiction, and other features,
are subject to the Law of Obligations of the respective jurisdictions involved. In most transfer pricing cases, such a law of obligation does not stipulate the way transfer prices need to be calculated, nor does this law rule on the allocation of cost or profit. In particular, in almost all countries around the globe, the Law of Obligations does not bind the decision-makers on the amount, or the ratio, of a profit element assigned to either transaction partner involved. Any definition of transfer pricing methods for price-setting or the arm’s length test is not provided.
1.2 Commercial Code
Second, the Commerical Code of the countries involved does neither specify the calculation model, the amount charged, any expense accounted for, nor does it rule on the profit amount and the profit ratio included in the given related-party transaction. Consequently, the Commercial Code of most jurisdictions – through binding to corporate companies – is of little help to analyze the arm’s length character of a transfer price or the transfer pricing model of the multinational group. Likewise importantly from the perspective of the commercial code of countries involved, transfer pricing allows broad decision-making freedom on the size of the transaction volume and the allocation of costs and profits to the related parties involved. Again, any definition of transfer pricing methods, be it for price-setting or for the arm’s length test, is not provided for in constitutional states.
1.3 Corporate Law
Third, another area of legal provisions to be reflected in the Corporate Law of the country in which the related party is resident or elsewhere bound to by its business model and the presence of business activities. Also, this body of the legal framework of performing related-party business within multinational firms does not provide explicit guidance on the arm’s length nature of transfer pricing. To some extent, transactions among shareholders or transactions between shareholders and the incorporated entities of the multinational group are determined by such law, referring to the concepts of constructive dividends (hidden profit distribution) and constructive equity contribution. Shareholder issues and shareholder accounts could be of relevance regarding the stewardship costs and accruals for the benefit of the shareholder. However, in this area of legal provisions, any definition of transfer pricing methods can hardly be found.
1.4 OECD Transfer Pricing Guidelines
Fourth, the international tax law of jurisdictions involved in the transfer pricing fact pattern is obviously the legal arena where particular transfer pricing provisions can be found. Here, the OECD has issued its OECD Transfer Pricing Guidelines on transfer pricing methods. The OECD is constituted as an international institution providing for substantial input to harmonize the international tax regime of member states and non-member affiliates. From this perspective follows that the purpose of the OECD guidance on the transfer pricing methods – in contrast to any other kind of testing the arm’s length character of transfer prices – is thought to reduce the risk of double taxation, or non-taxation, by providing for a harmonized approach of delineating the fact pattern. In particular, guidance on transfer pricing methods is applicable for the following procedural steps:
▪ Transfer pricing documentation and cooperation in local/domestic tax audits (either in countries of self-assessment procedures, e.g. USA, or official investigation procedures, e.g. Germany);
▪ during the MAP processes (MAP; Mutual Agreement Procedures) between tax jurisdictions involved in the particular controversy procedure of the transfer pricing fact pattern, and subject to respective Double Tax Treaty (DTT) existent; and
▪ Advance pricing agreements.
The template of such DTTs, worldwide, is the OECD Model Tax Convention.
The OECD guidance on transfer pricing methods is defined in the OECD Transfer Pricing Guidelines to somehow generate a level of harmonization from both/all tax jurisdictions on the fact pattern involving two or more countries and their tax administrations.
Of course, the OECD Transfer Pricing Guidelines, together with the United Nations Transfer Pricing Manual, can be applied by non-members of the OECD circle as well. Also, the taxpayer is invited by such guidance to deploy the concepts for arguing on the arm’s length character of transfer pricing – be it at the time of the decisions on price setting (comp. OECD BEPS Action Plan 8-10) or for documentation purposes (comp. OECD BEPS Action Plan 13)
2 The Transfer Pricing Method
The purpose of the transfer pricing methods, as defined by the OECD Transfer Pricing Guidelines (latest version: 2017) is the application of a coordinated analysis model on the given transfer pricing fact pattern. In theory, each test model (=OECD Transfer Pricing Method) would arrive in the same analysis result, i.e., as to whether the transfer price is/was at arm’s length or not. In practice, however, such various test models exist, as different types of fact patterns require specific items of the transfer pricing case with corresponding information on the side of the third parties. While the information on specific related-party fact patterns may exist within the multinational group, the corresponding third-party information to reason on the “comparability” is often not available. This is one of the reasons for the fact that in practice the TNMM model is the most often used arm’s length transfer pricing method worldwide. The other main reason has to do with the business model of the transfer pricing consulting industry which, driven by business reasons, favors the application “benchmarking” which often is a highly profitable component of transfer pricing projects.
The following table provides an overview of the test models on transfer pricing.
| Abbreviation | OECD Method | Method Type | Object of Analysis | Indicator (price, profit level, other) | Type of third-party information | Default applicability in transfer pricing systems | Relative importance in practice 1 (low) till 5 (high) |
|---|---|---|---|---|---|---|---|
| CUP | Comparable Uncontrolled Price Method | Standard, Transactional profit | Amount of transfer price | Euro, Dollar, Rupee, Won, etc. (currency) | Unit prices are subject to the number of units sold | If the number of units, qualities, and terms & conditions is comparable | 2 |
| C+ | Cost Plus Method | Standard, Transactional profit | A markup ratio of transfer pricing volume at the provider | Net Profit Markup (%) on Full Costs, or Gross Profit Markup (%) on Costs of Function | Markups of individual transactions between third parties | Where the provider of the transaction is routine regarding risk and assets; Default markup ratios available in practice | 4 |
| R- | Resale Minus Method | Standard, Transactional profit | Gross margin ratio of transfer pricing volume at the recipient | Gross Margin (%) of Sales Volume | Markups of individual transactions between third parties | For reselling functions | 1 |
| TNMM | Transactional Net Margin Method | Transactional, Approximation | Operating Margin of transfer pricing volume (usually of the recipient) | Operating Margin (%) of Sales Volume of Function | EBIT% margins of third parties | The standard approach in more than 90 percent of transfer pricing studies; applicable to a functional approach of the analysis performed; In the continental European context and other OECD countries | 5 |
| RPS | Residual Profit Split Method | New Profit method; Transactional or on an entity level | Routine profitability (usually operating margin) plus excess profitability (or loss), both/all transaction partners involved in the value chain | Markups or Operating Margins (%) on “routine functions” plus additional operating profitability related to non-routine functions | EBIT% margins of third parties | In cases where both/all related parties involved are assessed as non-routine units | 2 |
| CPM | Comparable Profit Method | Entity | Profitability of related-party entity, involved in the transfer pricing system | EBIT% | EBIT% margins of third parties | Applied to the entity level of analysis; most often applied as TNMM approach. In the anglo-American context. | 5 |
3 Most Appropriate Method – The GTP Position
Some jurisdictions require the taxpayer to elaborate on the “most appropriate method” for the arm’s length test. Subsequently, a given order of applicability is herewith proposed:
▪ The test making use of the CUP is considered to be the most appropriate one if price comparables are available subject to the conditions of quantities, qualities, and terms & conditions on the transaction exchanged. In most cases, such specifics on the third-party side of the arm’s length test are not available in sufficient detail. Also, in practice many tax jurisdictions do not accept the arm’s length test using only CUP as this model does not tell them much about the profit allocated by this transaction in the jurisdictions involved. The method only measures monetary values, i.e. prices per unit or per project.
▪ The C+ test is most applicable for product and service transactions when the transaction provider performs a limited set of functions for this transaction, bears little risk, and deploys only routine assets. The profit level indicator deployed in this test is the net markup or gross markup on a given transaction. Comparables need to be transaction-specific which, in most cases, is not possible to find for individual transactions. Using information from published financial statements of comparable companies is rarely transaction-specific, as such statements on “transaction-specific profits” cannot be drawn from financial figures of the financial statements of a particular comparable unit. If the analyst uses such published financial statements, the method actually is deemed to be a kind of net transactional margin model in a similar manner to TNMM (i.e. Transactional Markup Model).
▪ The R- test suits best to test the gross margin of reselling functions. However, in audit practice, the model rarely appears sufficient to the tax authorities as the gross margin does not say much about the arm’s length character of the basis for corporate income tax rates applicable, i.e. the net profit or net profitability. Also, transaction-based comparables are not often available in practice. Nevertheless, if R- is confronted with gross margins from published financial statements, the model becomes a kind of gross transaction margin model.
▪ The RPS test model is more complex to apply. It is conceived for situations in which more than one transaction partner is non-routine. The arm’s length reference can be the interquartile statistics of the benchmarking approach. This model enjoys an increasing relevance in transfer pricing practices.
▪ The TNMM model tests the operating margin (profitability) of the function considered. The function is either the recipient (usually the sales/reselling function) or the provider of the related-party transaction (usually the contract manufacturer or service provider). If the tested party only performs this single function OR if that entity only performs related-party transactions with only one other related party, the EBIT% margin of the tested party is usually used, and sufficient, as a profit level indicator. Consequently, in such a specific situation, the TNMM approach is actually turned into the CPM model as applied in many Anglo-American jurisdictions.
As a result, most often the TNMM approach is deployed as a method of last resort as it is the only method to confront transaction-related data of the multinational group with arm’s length data available. In more than 90 percent of the transfer pricing documentation, the TNMM / CPM approach is the key part of the arm’s length test.
Another reason for the prominence of the TNMM / CPM approach can be found in the sales proposition of consulting teams pretending the benchmarking study is a “must” for the arm’s length tests within the transfer pricing documentation. Of course, many tax jurisdictions also rule that the “benchmark study” must be provided within the documentation package. In addition, the TNMM / CPM approach is easy to perform since the related party’s total profitability (EBIT%) can be deployed as a proxy for testing with the EBIT%-profitabilities of comparables which anyway are legal-entity profit margins derived from published financial statements.
The GTP® TEAM applies the other test models if individual transactions are observed at the tested party. For more information, see legal provisions.
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