Open University of Mauritius

BSC FINANCE & TAXATION AND BA BUSINESS ACCOUNTING AND FINANCE

Tax Planning

S ES S I ON F I VE

TRANSFER PRICING
Presented by: Ehshan Jannoo
25 May 2024
 General
• The World – A Global Village

• Multinational enterprises (MNEs) have the flexibility to place their enterprises and business
activities anywhere in the world.

• Transfer pricing is an economic term, which refers to the valuation process for transactions
between related entities. It is defined as “the amount charged by one segment of an organisation for
a product or service that it supplies to another segment of the same organisation”. Improper
transfer pricing methods lead to unjustified profit transfers between countries. For example,
artificially deflated or inflated prices on transactions would reduce or increase the taxable profits of
associated companies in other countries. Such practices are considered as unacceptable tax
avoidance.

• The real issue affecting transfer pricing today relates to the sharing of the taxable income by the
countries, in which MNEs operate lawfully. Transfer pricing deals with sharing of global tax
revenues by countries on cross-border transactions.

• Each country wants to attract MNEs to their country, but it also wants to ensure that its legitimate
rights over the tax receipts due from their activities in its tax jurisdiction are protected. Therefore,
national tax authorities may question the transfer pricing on international transactions, if they
lead to an unacceptable loss of tax revenue that they believe is due to them and not to another
country
 Transactions involving transfer pricing issues
• Transfer pricing issues affect situations when goods and services are provided, knowingly or
otherwise, on a non-arm’s length basis by related entities. These situations arise in a wide range of
cross-border transactions. For example:

• (a) Transfers of tangible property

• Sale and purchase of inventory and other physical assets.

• Transfer of machinery and equipment.

• Rental of property and leasing arrangements.

• (b) Transfers of intangible property rights

• Manufacturing or trade intangibles, e.g. copyrights, patents and unpatented technical know-how,
trade secrets, and other technology transfers.

• Marketing intangibles, e.g. trained salesforce, marketing and sales knowledge and skills, market
research, trade names and trademarks, brand equity, corporate reputation, promotional material,
advertising, distribution network, quality control, after sales service, customer training, sales
manuals.
 Transactions involving transfer pricing issues
(cont’d)
• (c) Provision of services
• The provision of technical services and assistance with or without the transfer of an intangible property
right.
• Management assistance and services, e.g. assignment of trained personnel, training, legal or accounting
support, marketing assistance, systems, training.
• Centralised management, distribution and other inter-group co-ordination arrangements.
• Sharing of overhead costs at headquarters, training costs, etc.
• Research and development services where this activity does not involve a transfer of intangible property
rights, e.g. subcontracted research and development activities.
• (d) Provision of finance
• Interest rate, amount, guarantees or collaterals on related party debt.
• Short-term working capital finance through inter-company transactions, advances of capital or parent
guaranteed bank loans.
• Market penetration or maintenance payments through lump-sum payments or a reduction in transfer
price.
• Credit terms and financing arrangements including deferred payment arrangements or factoring of inter-
company debts.
 The basic problem illustrated
• Multinat plc has two trading subsidiaries.
• One is tax resident in the country of Konganga where the effective rate of
corporation tax is 10%. This company extracts and exports greensand, the raw
materials used in the group’s production processes. The open market price for
greensand is $100 per tonne.
• The other subsidiary is resident in the country of Ruritania, where the effective
tax rate is 40%. The Ruritanian subsidiary buys its raw materials in bulk from
the Konganga subsidiary. The quantity purchased each year is 80,000 tonnes.
• Multinat plc wishes to instruct the two subsidiaries to adopt a pricing policy that
optimises the after-tax profits for the group as a whole.
Questions to be considered are:
 Should the price charged by Konganga be lower or higher than the price it might
charge to an unrelated customer?
 Which government might object to the pricing policy and why?
 The basic problem illustrated (cont’d)
Tonnes Intra-group price per
1000 tonnes ($000)

000s 100 70 130

Accounts of Konganga subsidiary
Sales to Ruritanian subsidiary 80 8,000 5,600 10,400
Sales to other customers $100 per tonne 200 20,000 20,000 20,000
280 28,000 25,600 30,400 Selling at $70 per tonne produces an
Deduct: increase in the global tax liability whereas
Fixed and operating costs 15,000 15,000 15,000 selling at $130 per tonne produces a
Net profit before tax 13,000 10,600 15,400
reduction.
Konganga tax @ 10% 1,300 1,060 1,540
Profit after tax 11,700 9,540 13,860
Given that the combined profit before tax
Account of Ruritanian subsidiary
is $20,000,000 whatever the transfer price
Sales 20,000 20,000 20,000
the tax position is optimised if the
Purchase of raw materials from Konganga 8,000 5,600 10,400 transfer price is $130.
Other fixed and operating costs 5,000 5,000 5,000
Profit before tax 7,000 9,400 4,600 The government which loses tax revenue
Ruritanian tax @ 40% 2,800 3,760 1,840 as a result of this policy is Ruritania.
Profit after tax 4,200 5,640 2,760

Tax in Konganga 1,300 1,060 1,540

Tax in Ruritania 2,800 3,760 1,840
Combined tax liabilities 4,100 4,820 3,380
 OECD and transfer pricing
• As transfer pricing in international taxation deals with cross-border
transactions, it requires international acceptance of both the issues and
their solutions.
• The OECD has studied the international tax implications involving
transfer pricing and evolved a common approach. Their reports provide a
framework within which the tax authorities and taxpayers can judge, and
manage, the transfer pricing issues on cross-border transactions.
• The report defined the principle as “the price which would have been
agreed upon between unrelated parties engaged in the same or
similar transactions under the same or similar conditions in the
open market”.
• Therefore, the arm’s length price on transactions between group entities
should be derived from prices that would have been applied by unrelated
parties in similar transactions under similar conditions in an open market.
 OECD and transfer pricing (cont’d)
This definition contains six basic features:
• (i) Transactional analysis; the arm’s length price must be established with
respect to a single identified transaction.
• (ii) Comparison (or similarity): the identified transaction must be compared with
another transaction (hypothetical or actual) with similar characteristics.
• (iii) Private law contractual arrangement: the arm’s length price must take into
account any legal obligations entered by the contracting states.
• (iv) Open market features: any arm’s length price must be based on market
conditions and reflect ordinary business practices.
• (v) Subjective features: the arm’s length price must consider the particular
circumstances that characterise the transaction.
• (vi) Functional analysis: the arm’s length price must consider the functions
performed, assets used and risks assumed by the related entities.
 OECD and transfer pricing (cont’d)
The Transfer Pricing Guidelines recommend that both the tax authorities
and the taxpayers apply the arm’s length principle.
• The OECD MC Article 9 is the “authoritative statement of the arm’s length
principle”.
• Article 9(1) states that

“where 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 those conditions, have not so accrued, may be included in the
profits of that enterprise and taxed accordingly.”
 Methods for determining the arm’s length price
• The arm’s length principle requires that each associated company within a
multinational organisation should earn the income under prevailing market forces
for the value it adds to the transaction or relationship.
• The Guidelines apply to the actual transaction of the MNEs; they do not permit
the tax authorities to substitute it with another transaction.
• They recommend the use of one of the traditional transaction or transactional
profits methods of computation, namely
(a) Traditional transaction methods:
(i) the comparable uncontrolled price (‘CUP’)
(ii) the resale price method (‘RPM’)
(iii) the cost plus method (‘CPP’)
(b) Transactional profits methods:
(iv) the transactional net margin method (‘TNMM’)
(v) the profit split method (‘PSM’)
 Methods for determining the arm’s length price (cont’d)
• These transfer pricing methods rely directly or indirectly on the comparable
price, margin or profit information of similar transactions or functions.
• This information may be an ‘internal comparable’ based on similar
uncontrolled transactions between the entity and a third party, or an
‘external comparable’ involving independent companies in the same
industry and market.
• The Guidelines state that for comparability it is necessary that
(a) there is no difference between intra-group transaction and an open-
market transaction which could materially affect the price (or margin); or
(b) reasonably accurate adjustments can be made in order to eliminate such
differences.
 Traditional transaction methods
(a) Comparable uncontrolled price method (CUP)
• The price is based on the sale or purchase of an uncontrolled party, or from an
uncontrolled transaction of third parties, of identical goods or services under
comparable circumstances.
• Therefore, the method requires a comparison with a transaction undertaken
either with an unrelated party, or by unrelated parties on similar terms.
• The Guidelines refer to five comparability factors namely:
(i) the characteristics of the property supplied or the services provided,
(ii) the functions performed (having regard to assets used and the risks assumed)
by the parties,
(iii) the contractual terms and conditions,
(iv) market circumstances; and
(v) business strategies.
Traditional transaction methods
CUP
 Traditional transaction methods (cont’d)
(b) Resale price method
• This method is suitable when goods or services are purchased from a related or controlled party. It
is based on the price at which a trader (as purchaser from a associated enterprise) resells the goods
to an independent enterprise, and the resale price margin adequate to compensate him for his
services in reselling the goods. The arm’s length purchase price is the resale price as reduced by the
adjusted uncontrolled resale price margin.
• The margin should cover his selling and other operating expenses and allow him to make an
appropriate profit for the functions performed, the assets used and the risks assumed. The resale
price margin in the controlled transaction is determined by reference to similar margin which he
makes in comparable uncontrolled transactions. This margin rate should be adjusted for material
differences that exist between the controlled transaction and the comparable uncontrolled
transactions due to factors, such as:
 The contribution by the reseller in terms of manufacturing or processing functions;
 The contribution the reseller makes to the ultimate sale;
 The application to the product of owned proprietary rights by the reseller;
 Other transfers of the product either within the group or to unrelated parties;
 The characteristics of similar industry situations; etc.
Traditional transaction methods (cont’d)
Resale Price Method
 Traditional transaction methods (cont’d)
(c) Cost plus method (‘CPP’)
• This method is appropriate when goods or services are sold to a related or controlled
party. Like RPM, this method relies on comparison of gross margin (e.g. mark up) to
establish the arm-s length price. The arm’s length sale price is the cost of the product or
service plus a mark up. The appropriate mark up is the margin percentage earned by a
manufacturer on comparable transactions in uncontrolled sales.
• The method assumes that there is a fixed relationship between costs and profits, and
relies on the direct and indirect production costs (but not operating expenses) incurred by
the supplier. The mark up should reflect any differences in the functions performed and
cover both operating (e.g. marketing) and non-operating expenses (e.g. risks).
• The products compared should be of the same basic category, although they need not be
identical. There should be a general similarity between the products compared in terms of
product characteristics, product market, functions performed, sales volume and
proprietary rights. Consistent costing methods should be used for both the arm’s length
and non arm’s length product comparisons.
Traditional transaction methods (cont’d)
CPP
 Transactional Profit methods (cont’d)
(d) Transactional net margin method (TNMM)
• The TNMM method compares the net profit margin of an individual controlled
transaction (or a group of aggregated transactions) with an uncontrolled
transaction with uncontrolled parties or between unrelated parties.
• The net operating margin of the transaction with unrelated parties is expressed
relative to sales, costs or assets (generally the return on sales or assets) for the
taxpayer under review.
• These Profit Level Indicators (PLI) are based on their average data from the
balance sheet and income statements, usually for three years.
• The PLI must be applied to the tested party’s most narrowly identifiable business
activity covering the controlled transaction.
• A functional analysis of both the related enterprise and the non-related enterprise
is required to determine the degree of comparability.
Transactional Profit methods (cont’d)
TNMM
 Transactional Profit methods (cont’d)
(e) Profit split method (PSM)
• The profit split method allocates the combined (generally: operating) profit or loss
of associated enterprises, based on the relative value of each party’s contribution
to the total profit or loss of the controlled transaction or transactions.
• This method is useful where transactions are strongly interrelated.
• The combined profit under examination may also be split under a residual profit
split method (RPSM).
• A basic market return for similar transactions, as achieved by comparable
independent enterprises, is computed first and allocated to each participant.
• In the second stage, the residual profit is allocated to them based on their
respective contributions determined by an analysis of the facts and
circumstances.
Transactional Profit methods (cont’d)
PSM
 Transfer pricing under domestic tax law
• The tax authorities in several countries have adopted the OECD Guidelines for
transfer pricing rules and compliance requirements.
• Many of them specifically refer to the Guidelines in their domestic laws or follow
its recommendations.
• Although countries generally limit their transfer pricing rules to cross border
relation transactions only, several of them include similar domestic transactions
as well.
• Most countries apply the transfer pricing rules only to certain related party
transactions.
• However, some countries use a broader definition of “associated enterprises”
based on mutual benefit or influence.
• Few countries include transactions with tax havens and preferential tax regimes
under the transfer pricing rules.
• Finally, many countries still do not have specific transfer pricing rules in their
domestic tax law, and rely on their other anti-avoidance rules.
 Transfer pricing under domestic tax law
The tax authorities may make four different types of transfer pricing adjustments under their
domestic law:

• (a) the transaction is respected and only the price is changed;

• (b) the transaction is re-categorised for the purposes of deciding what a fair price would be;

• (c) a pricing adjustment is made in the form of a constructive dividend or regarded as a contribution
to capital; or

• (d) the non-arm’s length payment may be disallowed as a deduction, or additional income may be
required to be recognised under other provisions in the tax law.

• Some countries have safe harbour rules, under which they grant partial or total relief from transfer
pricing obligations.

• For example, the agreed minimum percentage mark-ups based on industry norms may be used in
specific transactions.

• The Guidelines discourage them since they do not reflect the arm’s length standard. Their use can
also create conflicts with the Revenue authorities in countries where the approach is unacceptable.
Transfer pricing under domestic tax law (cont’d)
• As transfer pricing adjustments affect the taxation in more than one country, double taxation could
arise, if the tax authorities adopt conflicting tax treatment of an affected transaction. It is necessary
for the tax authorities in each country to harmonise their approach on transfer pricing issues. A few
developed countries have formalised bilateral procedures to deal with factual issues involving more
than one tax authority. Some countries allow simultaneous tax examinations by both countries in
transfer pricing cases.

• Several countries have established procedures to grant unilateral, bilateral or multilateral rulings
on transfer pricing issues under an “advance pricing arrangement” (APA).

• These arrangements, where bilateral or multilateral, can provide the taxpayer with certainty on
taxation of certain cross-border transactions among related parties.

• APAs differ from private rulings in that APAs deal with factual issues, whereas rulings are
concerned with explaining the law based on facts presented by the taxpayer. In the case of rulings,
the facts may not be questioned by the tax administration, whereas under an APA the facts are
subject to investigation.

• APAs usually cover several or all of a taxpayer’s transactions for a given period of time, whereas a
ruling covers only one particular transaction.
 Transfer pricing under tax treaties
• The OECD Model treaty establishes a common basis for allocating the income
under an internationally accepted standard.
• It applies the arm’s length principle to transactions between related or associated
parties, and provides a dispute resolution procedure through the competent
authorities in each Contracting State.
• OECD MC Article 9 allows for profit adjustments if the actual price on
transactions between associated enterprises differences from the price that would
be charged by independent enterprises under normal market commercial terms
(i.e. arm’s length basis).
• It also requires that an appropriate correlative or corresponding adjustment be
made by the other Contracting State in such cases to avoid economic double
taxation, if it is justified in principle and amount.
• The competent authorities of the Contracting States are required to consult with
each other in determining the adjustment.
 Transfer pricing under tax treaties (cont’d)
Other OECD MC Articles, which apply the arm’s length principle, include:
• Article 7(2) - the transactions between the head office and the permanent
establishment.
• Article 7(4) - permits the use of the profit-split method, provided the result
is consistent with the arm’s length principle.
• Articles 11(6) and 12(4) - The Model treaty also excludes the amount of the
interest and royalties in excess of the arm’s length amount from treaty
benefits.
Model tax treaties use the term “associated enterprises” to cover
relationships between enterprises, which are sufficiently close to allow
transfer pricing rules to be applicable.
 Transfer pricing under tax treaties (cont’d)
• Article 25 (Mutual Agreement Procedure) enables the settlement of disputes on
corresponding adjustments by mutual agreement among competent authorities.
The OECD Commentary makes the following recommendations for the resolution
of transfer pricing disputes:
• (a) Tax authorities should notify the taxpayers as soon as possible of their
intention to make a transfer pricing adjustment.
• (b) Competent authorities should communicate with each other in these matters
in as flexible a manner as possible.
• (c) The taxpayer should be given every reasonable opportunity to present the
relevant facts and arguments to the competent authorities both in writing and
orally.
• Under the Mutual Agreement Procedure, there is a duty to negotiate but not to
achieve a result or to resolve a transfer pricing dispute under the tax treaty. As
the Mutual Agreement Procedure under tax treaties is voluntary, it may not
grant relief. In the last resort, a possible solution is arbitration.
Thank you for your kind attention

Any Questions?