1. Centre for Tax Policy and Administration 13 th SGATAR Working Level Meeting “Transfer Pricing” Macau, 5-8 September 2011 2010 Revision of the OECD Transfer Pricing Guidelines - More Guidance on Comparability and Profit Methods - Wolfgang Büttner OECD

2. Overview Country Experiences on the Use of Transfer Pricing Methods Results from a survey by Ernst & Young Observations in APA reports of Australia, Canada, China, Italy, Japan, Korea and the United States 2010 Revision of the OECD Transfer Pricing Guidelines Selection of “the most appropriate method to the circum- stances of the case” Specific strengths and weaknesses of each of the methods New guidance on comparability and profit methods

3. Overview (2) Practical Example on the Use of the Profit Split Method Complex transactions and use of intangibles in the automotive industry Recent Trends and Developments in Transfer Pricing Transfer Pricing Aspects of Business Restructurings - New Chapter IX OECD TP Guidelines - Authorised OECD Approach (“AOA”) on the Attribution of Profits to Permanent Establishments (new Article 7 OECD Model Tax Convention and July 2010 PE Report)

4.  2010 Global Transfer Pricing Survey by Ernst & Young 4 Country Experiences on the Use of Transfer Pricing Methods Tangible Goods

5.  2010 Global Transfer Pricing Survey by Ernst & Young 5 Country Experiences on the Use of Transfer Pricing Methods Services

6.  2010 Global Transfer Pricing Survey by Ernst & Young 6 Country Experiences on the Use of Transfer Pricing Methods Licensing

7. Country Experiences on the Use of Transfer Pricing Methods  Data from APA Reports

8.  www.oecd.org/ctp/tp/cpm  Comparability and Profit Methods (revised Chapters I-III)  Transfer Pricing Aspects of Business Restructurings - New Chapter IX – 2010 Revision of the OECD Transfer Pricing Guidelines  www.oecd.org/ctp/tp/br  New Annexes – Practical illustration of issues in relation to the application of transactional profit methods – Example of working capital adjustments to improve comparability

9. 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

10. OECD Transfer Pricing Methodology Matrix TP MethodMain FocusBenchmark Comparable Uncontrolled Price (CUP) ProductPrice Resale Price (RP)FunctionGross Profit Margin Cost Plus (C+)FunctionGross Mark-Up Transactional Net Margin (TNMM) FunctionNet Profit Margin Profit Split (PS) Function (Contribution) Gross/Net Profit

11.  The “most appropriate method to the circumstances of the case”  Selection criteria, in particular: 1.Respective strengths and weaknesses of each method 2.Nature of the controlled transaction (determined in particular by functional analysis) 3.Availability and reliability of information (in particular on uncontrolled comparables)  Preference for traditional methods if equally reliable The OECD Transfer Pricing Methods Which Method to Select?

12. Comparable Uncontrolled Price Method (CUP) 12 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

13. Cost Plus Method 13 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

14. Resale Price Method 14 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

15. TNMM 15 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

16. Profit Split (1) 16 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

17. Profit Split (2) 17 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

18.  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

19.  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) 9-step process to be followed to perform a comparability analysis Comparability Analysis

20. 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

21. Routine vs. Complex Functions - Tested Party - Transfer Price? BMW Co Germany Retail price $ 120,000 21 BMW Sub Singapore 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

22. Routine vs. Complex Functions - Tested Party - 22 Answers: 1.The distribution subsidiary 2.The distribution subsidiary 3.Resale Price Method or TNMM (resale price analogue) Tested PartyCompany 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 Singapore

23. 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.

24.  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

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

26.  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

27. 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)

28. Loss-making comparables (2)  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?

29.  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

30. 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 Lack of comparables (2)

31.  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  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 Limitations in available comparables

32.  Types of comparability adjustments, e.g.:  accounting differences/consistency  segmentation of financial data  adjustments for differences in (working) capital, functions, assets, risks  idle capacity  geographical market / country risk  Comparability adjustments to be considered only  if they increase the reliability of the results  for material differences  No “routine” adjustments! Comparability adjustments

33.  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

34.  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 Profit Split Method

35. New Guidance on Profit Split Method  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

36. Profit Split Method Advantages / Disadvantages Profit Split is two-sided approach Advantages  tends to rely less on information about independent enterprises  less likely that either party left with extreme/improbable profit  useful to achieve division of profits from economies of scale Disadvantages  may be difficult to access information from foreign affiliates  may be difficult to calculate combined profit from controlled transaction(s)

37. Profit Split Method When to apply?  Where the fo llowing 3 conditions are all met (cumulative) The controlled transactions are highly integrated, i.e. they cannot be evaluated on a separate basis, and/or a one-sided method would not be appropriate Both parties make unique and valuable contributions and Reliable comparables for other methods unavailable  What if a) one party to the controlled transaction(s) performs only simple functions? b) comparable data scarce, imperfect or unavailable?

38. Determining the combined profit to be split  Profit Split also a transactional method  Compute combined profit from controlled transaction(s) of the associated enterprises  Note: “profits” losses  Generally, operating / net profit (although not always)  Gross profit split occasionally appropriate 1. Split gross profit 2. Deduct expenses incurred in / attributable to each party separately

39.  Financial accounting generally the starting point  The use of cost accounting should be permitted where such accounts exist, are reliable, auditable and sufficiently transactional  In this context, product-line income statements or divisional accounts may prove to be the most useful accounting records.  Generally, anticipated profits rather than actual profits (“ex ante”)  Actual profits where associated enterprises used other TP method Determining the combined profit to be split (2)

40. How to split the combined profit?  Combined profit to be split on an economically valid basis  Case-by-case approa ch  2 types of profit split: a) Contribution Analysis (total profit split) b) Residual Analysis (residual profit split)

41.  Allocation keys can be a figure (e.g. a 30% - 70% split) a variable (e.g. relative value of participants’ marketing expenditure multiple allocation keys (need to weighed!)  Allocation keys can be based on Assets/Capital Costs Sales Headcounts/salaries/t ime spent by employees Data storage, floor area etc. How to split the combined profit? Allocation Keys

42. Contribution Analysis (Total Profit Split) 1.Compute combined total (net) profit from controlled transaction(s) 2.Examine functions 3.Determine relative value (value added) of contributions / functions (taking account of assets used and risk assumed)  some factors: expenses incurred, assets used, payroll 4.Examine external data 5.Assign a profit split percentage replicate the outcome of bargaining !

43. Residual Analysis (1) 2-step approach 1.Step 1.Compute combined net profit 2.Examine functions performed (routine and non- routine) 3.Use other methods (CUP, Cost Plus, Resale Price, TNMM) to assign basic return to each (non-unique, routine) contribution / function of each company  often can assign profit from activities not involving significant intangible property  examples: distribution function (resale price); manufacturing function (cost plus), possibly some TNMM applications

44. 2. Step  Divide residual profit (or loss) according to a contribution analysis  R&D and/or marketing expenditures may be relevant Residual Analysis (1) 2-step approach

45. Residual Profit Split Method Example Parent Company XSubsidiary Y Marketing (owner of brand name) Distribution Retailers R&D Manufacturing Product Sales Price 800 Transfer Price? Manufacturing Costs 600

46. Assumptions  Company X’s reported net profit on the transaction: 60  Company Y’s reported net profit on the transaction: 40  Total net profit: 100 Residual Profit Split Method Example (2)

47. Co.FunctionsProfit Reported Basic Profit Residual Allocation Adjusted profit XManufacturing R&D 60 12 40%X80 = 32 44 (12+32) YDistribution Marketing 40 8 60%X80 = 48 56 (8+48) Total1002080 (100 – 20) 100 Residual Profit Split Method Example (3)  Basic profit for (routine) manufacturing function of X = TNMM (cost plus analogue) 2% net margin on manufacturing costs of 600 = 12  Basic profit for (routine) distribution function of Y = TNMM (resale price analogue) 1% net margin of 800 sales price to independent retailers = 8

48. Profit to be split: operating (net) versus gross profit  Normally, split operating (net) profit  Where allocation of expenses to controlled transactions is impossible, might exceptionally split gross profit and then deduct for each participant separately operating expenses incurred or attributable  Ensure that the expenses are consistent with the activities and risks undertaken (functional analysis)!

49. Split of operating (net) profit Example 20 Company A Gross profit 60 Operating expenses 30 Operating/net Profit 30 total operating (net) profit split between A and B based on their contributions A=70% B=30% A =14 Company B Gross profit 40 Operating expenses 50 Operating/net Loss -10 B=6 Net Profit Share

50. Split of gross profit Example continued Company A Gross profit 60 Gross Profit share 70 Operating expenses - 30 Operating (net) Profit/Loss 40 Gross profit split between A and B based on their contributions A=70% B=30% Company B Gross profit 40 100 30 - 50 - 20

51. Transfer Pricing Aspects of Business Restructurings - New Chapter IX - www.oecd.org/ctp/tp/br

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

53. 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)

54. 2 Main Transfer Pricing Issues 1. Remuneration for the restructuring itself 2. Remuneration for the post-restructuring transactions Focus: How does the arm’s length principle and TP Guidelines apply to business restructurings?

55. 1. Remuneration for the restructuring itself 2 Situations identified: 1. Transfer of “something of value” (rights or other assets)  Profit potential not an asset – does not require remuneration per se: a)are there underlying assets that carry profit potential and are transfered? b)What are the options that would be realistically available to the parties at arm’s length?

56. 2 Situations identified: 2. Indemnification for the termination or substantial renegotiation of existing arrangements:  No presumption that there should be an indemnification: determine what independent parties at arm’s length would do: Role of contractual terms Actual behaviour of parties Commercial legislation  Need to look at both perspectives (transferor and transferee) 1. Remuneration for the restructuring itself (2)

57.  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  But there may be differences in the comparability analysis 2. Remuneration for the post-restructuring transactions

58. NEXT TOPICS FOR CONSIDERATION (2011-2013)  Transfer Pricing Aspects of Intangibles  Effective administration of Transfer Pricing

59. 59 Thank you for your attention. Any questions ? Following and Engaging in Our Work: Visit our transfer pricing webpage: www.oecd.org/ctp/tp Sign up for OECD Tax News e-mail alerts through “OECDdirect” in the online services portion of the OECD home page: www.oecd.org