Presented By: Prof A Venter CA(SA)

SESSION INCLUDES: TRANSACTIONAL PROFITS METHODS Selection of TP Methods: Part II Transactional Net Margin Method (TNMM ) Transactional Profit Split Method

TRANSACTIONAL PROFIT METHODS Transactional Net Margin Method (TNMM): Examination of a net profit indicator: ratio of net profit relative to an appropriate base (costs, sales or assets) of controlled transactions with those of uncontrolled transactions. Internal or external comparable transactions: based on functional comparability (not product specifically) Weighted costs or sales, similar to “Cost plus method” and “Resale Price Method” respectively: except Net profit is compared, not gross profit/mark-up. Most often indicator used: Operating profit (before interest, tax and extraordinary items) Selection of TP Methods

TRANSACTIONAL PROFIT METHODS Transactional Net Margin Method (TNMM): Profit indicator uses: Against costs: manufacturing and service activities Against sales: sales activities Against: assets: asset-intensive activities Financial indicator should: Reflect the value of functions performed (assets and risks) Based on objective data Capable of being measured reliably and consistently at level of both controlled and uncontrolled transactions Selection of TP Methods

Example 1 CoA Sales: 50% Product X 50% Product Y CoA Sales: 50% Product X 50% Product Y Independent Party Parent Co Product X Product Y

Example 1

Example 2 DDI DDI US DDI CANADA DDI CANADA Clients

Example 2 Asset Value $ ROA (Canada): 10% Profit: $1 ooo 000 $1 m/ units = $2 profit per unit Cost: $10 per unit Price: $2 per unit Asset Value $ ROA (Canada): 10% Profit: $1 ooo 000 $1 m/ units = $2 profit per unit Cost: $10 per unit Price: $2 per unit

Example 3 Good Food Independent Retailers UK Parent

Example 3

TRANSACTIONAL PROFIT METHODS Transactional Net Margin Method (TNMM): Illustration 1: difference between Resale Price and TNMM for distributor. TP Methods DescriptionAmount Sales to independent customers1000 Cost of goods (from associated enterprises)(400) Gross Profit (60%) (Tested in resale Price Method)600 Selling and other operating expenses(400) Operating Profit (20% of sales) (Tested in a TNMM)200 Interest and exceptional items(20) EBT (Earnings before Tax)180 Income Tax(60) Net profit120

TRANSACTIONAL PROFIT METHODS Transactional Net Margin Method (TNMM): Illustration 2: difference between Cost Plus and TNMM for manufacturer. TP Methods DescriptionAmount Cost of raw materials1000 Production costs(400) Total cost base600 Mark –up (20%) (tested in a cost-plus method)(400) Transfer price200 Overheads and operating expenditure(20) Operating profit (5% of cost) (tested in a TNMM)180

ZE(Zambia) ZE (Botswana) A1 Swaziland A2 RSA ZE (Kenya) ZE (Tanzania) Import & local Kenya Agent Tanz Agent Angola Mozam bique ZE(Zim) GP: 20% SP: $1286 GP: 20% SP: $1286 GP: 20% SP: $1286 GP: 20% SP: $1286 GP: 9% SP: $990 Raw product GP: 9% SP: $990 Raw product GP: 50% SP: $4000 GP: 50% SP: $4000 GP: 39% SP: $1700 GP: 39% SP: $1700

Transfer Pricing Handbook, 2 Volume Set, editor Robert Feinschreiber (available in Amazon.com Kindle) 11.3 WIDGET WHOLESALE (Kindle Location 2550). Kindle Edition.

WW WW-US FM1 FM2 Imports widgets from WW Distribution Manufacturing Independent distributors CA FM3 Retailers CA Other Retailers

1. Classification: Identify the issue under investigation: income of US taxpayer Payments made to foreign parent for purchased goods will be investigated The question is whether an independent company would be willing to pay the same prices for the goods, as WW-US is paying the foreign parent Business classification: WW-US is a pure importer/distributor

1. Classification (continued) Import consideration: in order to earn a profit importers need to limit costs and expenses, such as purchase price of goods; shipping and transport, import duties, storage, advertising and selling expenses Import contract: when dealing with independent manufacturer, the importer will deal negotiate contract covering various issues Wholesale Relationship: wholesaler imports large quantities and makes profit from high turnover of products, Usually has a large marketing investment.

2. Finding Comparables No independent importers of widgets Numerous importers of other durable goods with publicly available information Widgets do not have separate SIC code Wholesale trade category Comparables: distributors of consumer durables with motorised and electronic technology, used in the home (perceived product similarity)* 100 companies over 5 years

3. Method used WW-USA needs to be adjusted to reflect arm’s length purchase price for goods imported Logic: distributors would not buy at prices it could not sell profitably. Only possible comparable for the transaction : resell of independent California Distributors, adjusted for differences for conditions of sale, models, market level, services provided etc. The Resale Price Method (RPM) can then be used to determine an arm’s lengthy price. CPM: reflects the effectiveness of applying the arm’s length price

4. PLI’s used Gross profit to operating expenses Operating income on sales Return on operating assets:

Transfer Pricing Handbook, 2 Volume Set, editor Robert Feinschreiber (available in Amazon.com Kindle) 11.2 Location 2409

CM -US CM-EU AP1 AP2 Independent Contractor Cost +15% Royalty 5% Imports ingredients Exports final product to CM-US Manufacturing: Modern industrial plant Integrated functions Independent wholesalers

CM –US Jupiter Drinks CM-Nigeria AP1 AP2 Contract Manufacturer Cost +15% Imports ingredients From CM-US Fully-fledged manufacturer Manufacturing functions Independent wholesalers in Nigeria Distributors Technology for 5% Royalty

A summary of the broad guidelines suggested: establish economic justification before the transaction is entered into; be satisfied that the consideration is an arm’s length consideration; prepare and retain contemporaneous documentation to support the above matters and the assessment of market conditions at the time when the pricing decisions were made; justify the choice of method; and establish and consistently follow a systematic process for setting arm’s length international transfer prices.

1. Classification: Identify the issue under investigation: income of US taxpayer CM-EU income comes under scrutiny: receives intangibles from US taxpayer and had higher profit margins than the Parent CM-EU classified as drug manufacturer (SIC #2833)

2. Finding Comparables CM-EU: Direct comparables: may possibly be CM-US assembly plants or independent contractor used CM- US Indirect comparables: possibly other large integrated drug companies or smaller contract manufacturers Functions are closer to contract manufacturers, but incurs the costs and risks of operating in a foreign market place.

2. Finding Comparables: Direct comparables (transaction based) Assembly plants of CM-US: various product lines and integrated functions, difficult to separate one product line for comparison. Independent contractor: differences: Patent rights: reduce COS with royalty payment Market risks: no contract guarantee, foreign market: difficult to quantify Advanced physical facilities: difficult to identify which operating expenses to add back

2. Finding Comparables: Indirect comparables (profit based)(public data needed) Integrated drug companies: owns intangibles and incurs risks like these companies, but do not have integrated functions Independent contract manufacturers : independent manufacturing, but not guaranteed by contract and owns intangibles.

3. Method used CPM: more than one type of transaction, with no direct comparables as to similar transactions Intangibles transferred with effect on profitability Profit methods reflects reasonableness Transaction method used to ascertain appropriate royalty rate

4. Arm’s length range Profit Level Indicator (PLI) range: high-end of large companies’ PLI’s and low end on contract manufacturer’s PLI’s. Adjust royalty rate to an arm’s length rate, by doing market research, scrutinizing third party contracts and independent transaction. This indicated that a proper rate should increased to 25%

5. PLI’s used Gross profit to operating expenses Operating income on sales Return on operating assets: good indicator for manufacturers, but assets may vary quite extensively. Good PLI for CM-EU which owns intangibles and state of the art plant and equipment with one product for allocation purposes. Not so good for parent with various product lines, and previous investment in assets.

TRANSACTIONAL PROFIT METHODS Transactional Profit Split Method: Starting point: identifies combined profits to be split between associated enterprises. Some cases: total profits from controlled transactions Other cases: residual profit that cannot be readily assigned to a specific party, from the application of other TP methods, such as profits from intangibles (may even be a loss). Division of anticipated profits on economically valid basis TP Methods

TRANSACTIONAL PROFIT METHODS Transactional Profit Split Method: Economically valid basis: may be supported by independent market data (division ratios of uncontrolled transactions) may also be (most often) internal data Internal data: depends on the facts an circumstances (sales, R & D expenditure, assets, operating expenses) Splitting factor: should reflect respective contribution of parties to generating of income from controlled transactions Must be based on objective data, rather than remuneration from controlled transactions. TP Methods

TRANSACTIONAL PROFIT METHODS Transactional Profit Split Method: TP Methods Associated Enterprise A Associated Enterprise B Controlled Transaction Profit Contribution by A to controlled transaction: x% Contribution by B to controlled transaction: y% Profit share attributable to A: X% Profit share attributable to b: Y%

DescriptionAmountPercentageCurrentlyPercentage Cost contributed to ZE Zambia ,18% Cost contributed to ZE Botswana 22317,82% Total costs % Selling Price Total Profit % % Profit allocated to ZE Z ,18%25711,44% Profit allocated to ZE B40117,82% ,56% New GP% on transaction for ZEB 11.44%57% Price to ZEZam2 876 New GP% on transaction for ZEZam based on new price 64.24%20%

Selecting the Appropriate Method: Four criteria: Strengths and weaknesses of OECD TP methods Results of functional analysis Availability of reliable information Degree of comparability between controlled and uncontrolled transactions Selection of TP Methods

Selecting the Appropriate Method: STRENGTHS AND WEAKNESSES OF OECD TP METHODS CUP: most direct and reliable method high product similarity needed, not always available in practice Resale Price Method: most useful for marketing operations fewer adjustments needed for product differences, functions based Selection of TP Methods

Selecting the Appropriate Method: STRENGTHS AND WEAKNESSES OF OECD TP METHODS Cost Plus Method: useful for transfer of semi-finished goods, manufacturing and services functions base: fewer adjustments for product differences Challenges: cost determination and accounting inconsistencies TNMM: Less affected by transactional differences, more tolerable for functional differences (reflected in operating expenses) Selection of TP Methods

Selecting the Appropriate Method: STRENGTHS AND WEAKNESSES OF OECD TP METHODS TNMM (…continued): Useful for integrated transactions, or when difficult to obtain info on one of the parties Weaknesses: difficulty establishing comparability (transactional level) Timing of transaction: net profit info usually not yet available (multiple year data may be a solution) Difficulty establishing corresponding adjustment Selection of TP Methods

Selecting the Appropriate Method: STRENGTHS AND WEAKNESSES OF OECD TP METHODS Profit Split Method: Solution for highly integrated operations Solution for when unique and valuable contributions are made Not used when one of the parties does not make a significant contribution Comparables data can support split ratio, otherwise internal data can be used Flexibility in unique circumstances and facts Both parties tested: very fair method Weakness: difficulty in application when info of foreign affiliate not readily available. Selection of TP Methods

Selecting the Appropriate Method: FUNCTIONAL ANALYSIS Method should be consistent with functions performed by “tested party”: Cost plus method: seller is tested party Resale price method: buyer is tested party TNMM or CUP: either seller or buyer is tested party Profit Split method: both parties are tested Selection of TP Methods

Selecting the Appropriate Method: AVAILABLE RELIABLE INFORMATION CUP method when uncontrolled transactions are highly comparables Availability of gross or net profit information will determine whether traditional or profits methods are used. DEGREE OF COMPARABILITY Data with a high level of comparability will be a priority when the appropriate method is selected. Keep in mind that comparables are very rarely perfect or complete: professional judgment will be involved Selection of TP Methods

Selecting the Appropriate Method: Don’t have to proof other methods are not suitable Traditional methods preferred over transactional profit methods Where CUP preferred over other methods, if both can be applied equally reliable manner Situations where Profits Methods more appropriate than Traditional methods Profit Methods only accepted it compatible with Article 9: comparability May use “other methods” More than one method may be used, but is not mandatory See Illustration on page 16 OECD document on TP Methods July 2010 Selection of TP Methods

Source: OECD Guidelines: Chapter 2 UN TP Manual for Developing Countries: Chapter 5 ATAF: TP for Policy Makers: Session 1: “TP Methods” by OECD (PDF) Transfer Pricing Handbook, 2 Volume Set, editor Robert Feinschreiber (available in Amazon.com Kindle) IBFD TP Database: “Introduction to Transfer Pricing” BNA Transfer Pricing International Journal “CUPs and Profit Splits – when and how to use” Selection of TP Methods