Centre for Tax Policy and Administration Overview of the 2010 Revision of the OECD Transfer Pricing Guidelines Workshop on Transfer Pricing and Exchange of Information Guatemala 2 – 5 May 2011 Wolfgang Büttner OECD

  Comparability and Profit Methods (revised Chapters I-III)  Transfer Pricing Aspects of Business Restructurings - New Chapter IX Revision of the OECD Transfer Pricing Guidelines 

Comparability and Profit Methods  New guidance on – the selection of the “most appropriate transfer pricing method to the circumstances of the case” – comparability analysis – how to apply transactional profit methods (TNMM and profit split) in practice 3

Which Method to Select?  The “most appropriate method to the circumstances of the case”  Selection criteria, in particular:  Respective strengths and weaknesses of each method;  Nature of the controlled transaction (determined in particular by functional analysis);  Availability and reliability of information (in particular on uncontrolled comparables);  Preference for traditional methods if equally reliable 4 Selection of the “Most Appropriate Method” to the Circumstances of the Case”

Comparable Uncontrolled Price Method (CUP) 5 OECD Transfer Pricing Methods: Strengths and Weaknesses of Each Method StrengthsWeaknessesBest applied to Most direct and reliable way to apply the arm’s length principle High degree of product comparability required In practice, often difficult to find uncontrolled transactions similar enough that no differences have material effect on the price Transactions where the same product is sold to the associated enterprise and independent enterprise(s) (internal comparable) Transactions where an independent enterprise sells the same product as the associated enterprises (external comparable) In particular commodities and interest rates

Cost Plus Method 6 StrengthsWeaknessesBest applied to Product differences are less significant, i.e. are less likely to have material effect on profit margins than on price. Less product comparability required compared with CUP method. Fewer comparability adjustments needed compared with the CUP method to account for product differences, because focus is on functions performed. In practice, often difficult to determine appropriate cost basis Costs incurred may not always be determinant of profit level Not always discernible link between level of costs incurred and a market price Accounting consistency important for comparability purposes (Contract) Manufacturer, in particular of semi- finished goods (Contract) R&D Service Provider OECD Transfer Pricing Methods: Strengths and Weaknesses of Each Method

Resale Price Method 7 StrengthsWeaknessesBest applied to Product differences are less significant, i.e. are less likely to have material effect on profit margins than on price. Fewer comparability adjustments needed compared with the CUP method to account for product differences, because focus is on functions performed. Gross profit margins may be affected by management efficiency etc. which may have an impact on profitability but not on the price of the goods or services. Accounting consistency important for comparability purposes. Resale price method difficult to use when (i) goods are further processed before resale, or (ii) reseller contributes substantially to creation or maintenance of intangible associated with the product (e.g. trademarks, tradenames). Marketing operations (distributor not adding significant value to the product) OECD Transfer Pricing Methods: Strengths and Weaknesses of Each Method

TNMM 8 StrengthsWeaknessesBest applied to Net profit indicators (e.g. return on assets, operating profit to sales, etc.) are less affected by transactional differences than price. Net profit indicators are more tolerant to some functional differences between controlled and uncontrolled transactions. Net profit indicators avoid problem in some countries of lack of clarity in public data as regards the classification of expenses in the gross or operating profits. Net profit indicator can be influenced by factors that would not have a significant effect on price or gross margins, making accurate and reliable determinations of arm’s length net profit indicators difficult. Taxpayers may not have access to enough specific information on the net profits attributable to comparable uncontrolled transactions. Cost Plus Analogue: (Contract) Manufacturer Service Provider not adding significant unique intangibles Resale Price Analogue: Distributor not adding significant value to the product Asset Based TNMM: Manufacturer if reasonably reliable comparables for Cost Plus or cost based TNNM unavailable OECD Transfer Pricing Methods: Strengths and Weaknesses of Each Method

Profit Split (1) 9 StrengthsWeaknessesBest applied to Offers flexibility by taking into account specific, possibly unique, facts and circumstances of the associated enterprises that are not present in independent enterprises. Tends to rely less on information about independent enterprises Often difficult to have access to information from foreign affiliates, especially where the foreign affiliate is the parent company or a sister company rather than a subsidiary of the taxpayer Difficult to measure combined revenue and costs for all the associated enterprises participating in the controlled transactions, which would require stating books and records on a common basis and making adjustments in accounting practices and currencies. Residual Profit Split (Residual Analysis): Highly integrated transactions, e.g. global trading of financial instruments Transactions where both parties make unique and valuable contributions (e.g. intangibles) to the transaction OECD Transfer Pricing Methods: Strengths and Weaknesses of Each Method

Profit Split (2) 10 StrengthsWeaknessesBest applied to Less likely that either party to the controlled transaction is left with an extreme and improbable profit result, since both parties to the transaction are evaluated. Two-sided approach may also be used to achieve a division of the profits from economies of scale or other joint efficiencies that satisfies both the taxpayer and tax administrations. When applied to operating profit, it may be difficult to identify the appropriate operating expenses associated with the transactions and to allocate costs between the transactions and the associated enterprises' other activities. Residual Profit Split (Residual Analysis): Highly integrated transactions, e.g. global trading of financial instruments Transactions where both parties make unique and valuable contributions (e.g. intangibles) to the transaction OECD Transfer Pricing Methods: Strengths and Weaknesses of Each Method

 Profit split for cases where both parties to the controlled transaction make significant, unique contributions (e.g. intangibles); highly integrated activities  Difficulties in finding or adjusting comparables not sufficient to select profit split if this method is not appropriate given the functional analysis of the transaction  Note: a one-sided method can be seen as a residual profit split whereby 100% of the residual is attributed to the non- tested party 11 Selection of the “Most Appropriate Method” to the Circumstances of the Case”

 Objective: find the most reliable comparables  No requirement for an exhaustive search of all possible sources of comparables  Acknowledge limitations in availability of information and compliance costs  “Reasonably reliable comparables”: defined as the most reliable comparables in the circumstances of the case, keeping in mind the above limitations  Typical (non-compulsory) 10-step process to be followed to perform a comparability analysis Comparability Analysis

 New guidance on the choice of the tested party;  Use of databases;  Internal/external comparables;  Secret comparables;  Foreign comparables;  Loss-making comparables;  Difficulties in finding comparables;  Comparability adjustments Comparability Analysis

 Lack of comparables does not mean that the taxpayer’s controlled transaction is not arm’s length  Lacking evidence of what independent parties have done in comparable circumstances... ... need to determine whether the conditions of the taxpayer’s controlled transaction are comparable to what independent parties would have agreed Lack of comparables 14 Lack of Comparables

1) Due to uniqueness of the controlled transaction? 2) Due to lack of comparable independent enterprises (vertically integrated industry; small market)? 3) Due to limitation on publicly available information on potential comparables?  In the first case: profit split, especially if valuable, unique intangibles contributed by both parties  In the two other cases: is the risk of error greater with a one-sided method applied with “imperfect comparables” or with a profit split applied with no comparables? Lack of comparables 15 Lack of Comparables

 Traditional transaction methods (CUP, Cost Plus, Resale Price)  unchanged  Transactional Profit Methods (TNMM and Profit Split):  Further guidance on practical application  TNMM: selection and determination of the net profit margin indicator  Profit Split: determination of profit to be split and of splitting factors  Berry ratios Transfer Pricing Methods

New Guidance on the Use of Profit Split  How to split the combined profits in a profit split method?  Preference for “objective” allocation keys, e.g. based on costs, assets or other relevant contributions of the parties to the transaction  The allocation key must reflect the parties’ contribution to the creation of value in the particular case  OECD reluctant to accept completely subjective keys (such as “value chain analysis”)  No fixed allocations keys that would not account for the facts and circumstances of the case 17

Choice of the tested party  The choice of the tested party should be consistent with the functional analysis of the transaction;  The party to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found,  It will most often be the one that has the less complex functions

Use of databases  Comparability analysis should encourage quality over quantity (standard processes). In particular:  The use of commercial databases may give rise to concerns about the reliability of the analysis compared to other sources of information, such as internal comparables  Use of commercial databases should not encourage quantity over quality.

 Internal comparables can:  be easier to find and more reliable;  be more complete and less costly to document  This is not always the case  there is no hierarchy between internal and external comparables  But where internal comparables are reasonably reliable  no need to make a database search Internal and external comparables

 Use of secret comparables discouraged  Exception: in Mutual Agreement Procedures to eliminate double taxation Secret comparables

 Non-domestic comparables should not be automatically rejected  Examine whether non-domestic comparables are reasonably reliable on a case-by-case basis:  Five comparability factors  Careful consideration of market differences and accounting standards, and of whether reasonably reliable comparability adjustments can be made where needed Foreign comparables

Loss-making comparables  Not systematically rejected; no systematic inter-quartile range in the OECD TP Guidelines  But are they truly comparable to the tested party? (risk profile in particular)  Independent enterprise would not continue loss-making activities unless reasonable expectation of future profits  Independent enterprise would not remain loss-making indefinitely unless it has reasonable expectation of future profits  Where an associated enterprise remains loss-making over several years: is it providing a service to the group by maintaining a commercial presence?

 Assess the relative importance of missing information before rejecting a potential “comparable”  A pragmatic solution may need to be found on a case-by-case basis Limitations in available comparables

1.REVISION OF CHAPTERS I-III OF THE OECD TP GUIDELINES

Reorganization of Chapters I-III 1995 TP Guidelines2010 Revision Chapter I: Arm’s length principle and comparability Chapter I: Arm’s length principle and fundamentals of comparability Chapter II: Traditional transaction methods Chapter II: TP methods: -Part I: Selection of the method -Part II: Traditional transaction methods -Part III: Transactional profit methods Chapter III: Transactional profit methods Chapter III: Comparability analysis

 Exceptionality of profit methods (“last resort status”) replaced by a standard whereby the selected transfer pricing method should be “the most appropriate method to the circumstances of the case”. Selection of a TP Method

4 selection factors: 1)Respective strengths and weaknesses of each of the OECD recognised methods; 2)Appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis; 3)Availability of reasonably reliable information (in particular on uncontrolled comparables) in order to apply the selected method and/or other methods; and 4)Degree of comparability of controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate differences between them Selection of the most appropriate method to the circumstances of the case

 Where, taking account of those 4 factors: – The CUP and another transfer pricing method can be applied in an equally reliable manner  CUP method is to be preferred – A traditional transaction method and a transactional profit method can be applied in an equally reliable manner  traditional method is preferred 29 Selection of the most appropriate method to the circumstances of the case

 Traditional transaction methods (CUP, Cost Plus, Resale Price)  unchanged  Transactional Profit Methods (TNMM and Profit Split):  Further guidance on practical application  TNMM: selection and determination of the net profit margin indicator  Profit Split: determination of profit to be split and of splitting factors  Berry ratios Transfer Pricing Methods

 Objective: find the most reliable comparables  No requirement for an exhaustive search of all possible sources of comparables  Acknowledge limitations in availability of information and compliance costs  “Reasonably reliable comparables”: defined as the most reliable comparables in the circumstances of the case, keeping in mind the above limitations  Typical 10-step process to be followed to perform a comparability analysis Comparability Analysis

 New guidance on the choice of the tested party;  Use of databases;  Internal/external comparables;  Secret comparables;  Foreign comparables;  Loss-making comparables;  Difficulties in finding comparables;  Comparability adjustments Comparability Analysis

Choice of the tested party  The choice of the tested party should be consistent with the functional analysis of the transaction;  The party to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found,  It will most often be the one that has the less complex functions

Routine vs. Complex Functions - Tested Party - Transfer Price? BMW Co Germany Retail price $ 120, BMW Sub Ecuador Distributor R&D Manufacturing - approx. 40 different cars - approx. 10 different motorbikes - approx. 100 different engines Questions: 1.Which company performs the least complex functions? 2.Which company should be selected as “tested party”? 3.Which TP method seems appropriate? Company under TP examination

Routine vs. Complex Functions - Tested Party - 35 Answers: 1.The distribution subsidiary 2.The distribution subsidiary 3.Resale Price Method or TNMM (resale price analogue) Tested Party Company under TP examination Transfer Price? Retail price $ 120,000 R&D Manufacturing - approx. 40 different cars - approx. 10 different motorbikes - approx. 100 different engines BMW Co Germany BMW Sub Ecuador Distributor

Use of databases  Comparability analysis should encourage quality over quantity (standard processes). In particular:  The use of commercial databases may give rise to concerns about the reliability of the analysis compared to other sources of information, such as internal comparables  Use of commercial databases should not encourage quantity over quality.

Internal Comparables Example: ABC Ecuador (Related Distributor) ABC Ecuador (Related Distributor) Potential Internal Comparable ABC Germany (Manufacturer) ABC Germany (Manufacturer) Controlled Transaction Uncontrolled ) Transaction (arm’s length price) XYZ Mexico (IndependentDistributor) XYZ Mexico (IndependentDistributor)  Transaction between one party to the controlled transaction and a non-associated party

External Comparables Example: ABC Ecuador (Related Distributor) ABC Ecuador (Related Distributor) ABC Germany (Manufacturer) ABC Germany (Manufacturer) Controlled Transaction Uncontrolled ) Transaction (arm’s length price) XYZ Mexico (Independent Distributor) XYZ Mexico (Independent Distributor) Ind. Germany (Manufacturer) Ind. Germany (Manufacturer)  Transaction between two independent enterprises, neither of which is a party to the controlled transaction Potential Internal Comparable

 Internal comparables can:  be easier to find and more reliable;  be more complete and less costly to document  This is not always the case  there is no hierarchy between internal and external comparables  But where internal comparables are reasonably reliable  no need to make a database search Internal and external comparables

 Use of secret comparables discouraged  Exception: in Mutual Agreement Procedures to eliminate double taxation Secret comparables

 Non-domestic comparables should not be automatically rejected  Examine whether non-domestic comparables are reasonably reliable on a case-by-case basis:  Five comparability factors  Careful consideration of market differences and accounting standards, and of whether reasonably reliable comparability adjustments can be made where needed Foreign comparables

Loss-making comparables  Not systematically rejected; no systematic inter-quartile range in the OECD TP Guidelines  But are they truly comparable to the tested party? (risk profile in particular)  Independent enterprise would not continue loss-making activities unless reasonable expectation of future profits  Independent enterprise would not remain loss-making indefinitely unless it has reasonable expectation of future profits  Where an associated enterprise remains loss-making over several years: is it providing a service to the group by maintaining a commercial presence?

 Assess the relative importance of missing information before rejecting a potential “comparable”  A pragmatic solution may need to be found on a case-by-case basis Limitations in available comparables

Arm’s length range and statistical tools  In some cases it will be possible to arrive at a single figure (e.g. price or margin)  In most cases: arm’s length range where all figures are relatively equally reliable  Eliminate uncontrolled transactions (“potential comparables”) with a lesser degree of comparability than others  If comparability defects remain that cannot be identified and/or quantified, and are therefore not adjusted  use of statistical tools that take account of central tendency might help to enhance the reliability of the analysis

 If the relevant conditions of the controlled transaction (e.g. price or margin) are within the arm’s length range  no adjustment should be made  If the relevant conditions of the controlled transaction (e.g. price or margin) fall outside the arm’s length range asserted by the tax administration  taxpayer should have the opportunity to present arguments that the conditions of the transaction satisfy the arm’s length principle, and that the arm’s length range includes their results. Arm’s length range and statistical tools Transfer Pricing adjustment to be made?

 “Point within the range that best reflects the facts and circumstances of the particular controlled transaction”  Where the range comprises results of relatively equal and high reliability  any point in the range satisfies the arm’s length principle  Where comparability defects remain  use measures of central tendency (for instance the median, the mean or weighted averages, etc.) to minimise the risk of error due to unknown or unquantifiable remaining comparability defects Taxpayer’s price/margin is outside range Adjustment to which point in the range?

Statistical tools  Statistical tools are used to enhance the reliability of the arm’s length range  Use of statistical tools comes after review of the comparability factors  Statistical tools cannot replace the comparability analysis.  Use of statistical tools should not be indiscriminate, e.g. rely on statistics automatically generated by software 47

Statistical tools 48  Statistical tools are used for: 1. selecting cases for audit 2. selecting a transfer price in a range of comparables  Mid-point: the middle point of the range  Average: the arithmetic mean  Median: half the scores are above the median and half are below the median When there is an even number of numbers, the median is the arithmetic mean of the two middle numbers  Inter-quartile range Range from the 25th to the 75th percentile of the results derived from the uncontrolled comparables

Calculation of inter-quartile Range Example e.g. Operating margin (%) Median Upper Quartile Lower Quartile inter-quartile Range Number of observations: 16

 Number of observations (comparables): 11  Range: to 5.80  Mid-point of full range: 2.30  Average of full range: 2.72  Median: 3.00  Inter-quartile range: 2.20 (lower quartile) to 3.55 (upper quartile) Statistical Tools (2) - Example

3 New Annexes  Practical illustration of issues in relation to the application of transactional profit methods  Different measures of profits when applying a transactional profit split method  Sensitivity of gross and net profit margin indicators  Example of working capital adjustments to improve comparability

2. Transfer Pricing Aspects of Business Restructurings - New Chapter IX

Relevance of the issue  Implementation of global organisations; cross-border redeployment by multinational enterprises of their functions, assets and risks and of the associated profit / loss potential.  Intangible property and entrepreneur risks, which carry the biggest part of the profit / loss potential, are also the most geographically mobile.

What do we see in practice?  Since the mid 90s: typically, conversion of “full fledged distributors” into “commissionaires”; of “full fledged manufacturers” into “toll-manufacturers”; etc.  Migration of intangible assets and of risks, together with asociated profit potential, often to low tax jurisdictions

Example: restructuring of the sales function Pre-restructuringPost-restructuring “Full fledge distributor” in country A.Commissionaire in country A. Purchases products from related and unrelated suppliers and on-sells them to unrelated customers. Does not take title of inventory. Sells on behalf of the Principal who owns the products. Responsible for marketing activities and brand development on territory. Marketing policy decided by Principal. Commissionaire has limited role. Inventory risk, market risk, credit riskInventory risk, market risk, and credit risk are transferred to Principal Owner of the clientele; rights on the brandname Intangibles are transferred to Principal Remuneration taking account of functions, intangible and risks: or Remuneration taking account of functions, intangible and risks ++ (residual profit or loss = Principal)

Example: restructuring of the R&D function and IP ownership  Pre-restructuring: X-Co performs R&D function on its own account and at its own risk; it retains ownership of the IP that its develops.  X-Co is acquired by foreign company ForCo. Further to the acquisition, Existing IP is transferred from X-Co to related party in “tax friendly jurisdiction” R&D function is now performed by X-Co as a contract researcher on behalf of ForCo, remunerated on a cost plus basis. Future IP rights will be owned by ForCo. Risk of failure no longer borne by X-Co. 56

Business Restructurings  Can significantly affect the corporate income tax base in some countries  Can be needed by business to adapt to globalisation  OECD objective: arrive at a consensus on the correct treatment from an international tax point of view.  Recognise legitimate concerns of governments,  Not create tax barriers to MNE groups that need to restructure for genuine commercial reasons. 57

 Definition of business restructurings: “Cross-border redeployment (transfer) by a multinational enterprise of functions, assets and/or risks with associated profit/loss potential”  Profit/loss potential is not an asset  Focus: How does the arm’s length principle and TP Guidelines apply to business restructurings? Transfer Pricing Aspects of Business Restructurings 58

Remuneration for the restructuring itself: 1. Transfer of something of value (rights or other assets)  Profit potential not an asset – does not require remuneration per se: are there underlying assets that carry profit potential and are transfered? What are the options that would be realistically available to the parties at AL? 2. Indemnification for the termination or substantial renegotiation of existing arrangements:  No presumption that there should be an indemnification: determine what independent parties at AL would do: Role of contractual terms Actual behaviour of parties Commercial legislation

 The arm’s length principle and TP Guidelines apply in the same way to transactions that result from a restructuring and those which were structured as such from the beginning Remuneration for the post-restructuring transactions

3.NEXT TOPICS FOR CONSIDERATION ( )  Transfer Pricing Aspects of Intangibles  Effective administration of Transfer Pricing

Transfer Pricing Aspects of Intangibles  Current guidance: Chapters VI and VIII of the TP Guidelines  Emerging issues:  Definition (“soft intangibles”): marketing intangibles, workforce in place, business opportunities, etc: Are they intangibles? More importantly, should they be compensated at arm’s length?  Legal / economic ownership; right to share in the return of an intangible that is owned by another party  Valuation methods

Effective Administration of TP What are the Objectives?  The capacity to ensure an efficient use of tax administrations’ and taxpayers’ resources  Improved compliance by taxpayers – making non ‑ compliance less attractive than compliance  Increased transparency, fairness and certainty  Speedy resolution of cases  Prevention of disputes  Limitation of cases left with unresolved double taxation  Etc.