presented by: anneline venter ca(sa). arm’s length principle and introduction to comparability...
TRANSCRIPT
Presented By:Anneline Venter CA(SA)
Transfer PricingYear Course
Lecture 5
Arm’s length PrincipleAnd Introduction to
Comparability
IntroductionIf prices do not reflect arm’s length prices
tax it will distort:Tax liabilities of associated enterprisesTax revenues of host countries
Other factors than tax considerations may also distort commercial and financial relations between associated enterprises: Customs valuationsExchange or price controlsCash flow requirements of enterprises
Arm’s Length Principle
Introduction (…continued)Adjustment to arm’s length price
sometimes needed irrespective of:Contractual obligation to pay a
particular priceIntention of the parties to minimize tax
Tax authorities should not automatically assume MNEs have sought to manipulate profits.
Arm’s Length Principle
Statement of arm’s length principleArticle 9 OECD Model Tax Convention:“[Where] conditions are made or imposed between thetwo [associated] enterprises in their commercial orfinancial relations which differ from those whichwould be made between independent enterprises, thenany profits which would, but for those conditions,have accrued to one of the enterprises, but, by reasonof those conditions, have not so accrued, may beincluded in the profits of that enterprise and taxedaccordingly.”
Arm’s Length Principle
Justification for use of arm’s length principle Puts associated enterprises and independent
enterprises on a more equal footing for tax purposes, thereby promoting trade.
Adopts as benchmark the normal operations of the market
No realistic or legitimate alternative exists:Global formulary apportionment would not be
acceptable in theory, implementation or practice
Arm’s Length Principle
Application of the arm’s length principle Comparability analysis is at the heart
of the application of the arm’s length principle (par 1.6)
Significance of Comparability analysis and meaning of “comparable’.
Arm’s Length Principle
Internal and External Comparable Transactions
Arm’s Length Principle
Internal Comparable
External Comparable
Co A
ControlledTransactio
n
UncontrolledTransaction
Co A Co B
ControlledTransactio
n
UncontrolledTransaction
Factors affecting ComparablesCharacteristics or Property/Services
Functional Analysis
Contractual Terms
Economic Circumstances
Business Strategies
Tangible Property: physical features; quality and reliability, availability and volume of supply
Services: nature (shareholder or stewardship) and extent
Intangible Property: Form of transaction: licensing or sale Type of property: patent, trademark, know-howDuration and degree of protectionAnticipated benefits
Characteristics of Property or ServicesFactors affecting Comparables
Main category of type of transaction:Distributor, wholesaler, retailerFully fledged or contract manufacturerFully fledged or contract marketingSub-functions:Manufacturing, material purchasing, Packaging, storage of inventory, shippingQuality control, negotiation, admin
Functional ProfileFactors affecting Comparables
FunctionalAnalysis
Contract Manufacturer Full- Fledged Manufacturer
Functions
Research & Development √
Purchasing √ √
Manufacturing √ √
Assembling and Packaging √ √
Warehousing and Logistics √ √
Engineering √ √
Quality Control √ √
Labour Management, Training √ √
Marketing √
Sales & Distributions √
After Sales Services √
Risks
Business risks √
Market risks √(volume) √
Manufacturing risk √ √
Foreign exchange risk ? √
Inventory risk √ √
Credit risk √ √
Research & Development risk √
Warranty risk √
Assets
Product intangibles √
Manufacturing intangible ? ?
27
Full-FledgedManufacturer
Manufacturing+ R&D+ Regional/global marketing+ All risks
Simple(Low)
Integrated(High)
Functions/Risks/Assets Employed
Low_
+High
ExpectedProfit
Profit expectation follows functions, risks and assets
Loss possible
Contract Manufacturer
Define how risks, benefits and responsibilities are divided
Analyse terms whether written or oral, explicit or implied
Independent parties will hold one another to terms and only rarely will modify
Less incentive to do so in controlled transaction: therefore examination necessary
Analysis: whether the actual conduct of the parties is consistent with terms of contract
Contractual TermsFactors affecting Comparables
Prices vary across different markets even for similar products
Essential to identify relevant market(s) related to transaction
Whole variety of factors to take into account: Location, size, competitive position, availability
of substitute goods/services, level of supply and demand, purchasing power, regulation and local costs, level of market (retail or wholesale), date and time of transactions etc.
Economic CircumstancesFactors affecting Comparables
DIFFERENT ECONOMIC CIRCUMSTANCES: GDP PER CAPITA
USA
GER
MAN
Y
FR
AN
CE
RSA
ZAM
BIA
10970
1611
35068
38077
48328
DIFFERENT ECONOMIC CIRCUMSTANCES: INFLATION
USA
GER
MAN
Y
FR
AN
CE
RSA
ZAM
BIA
1,67%
1,38%
1,71%
7,65%
11,45%
DIFFERENT ECONOMIC CIRCUMSTANCES: RISK FREE RATE
USA
MALA
WI
FR
AN
CE
RSA
ZAM
BIA
2,22%
1,28%
3,50%
6,85%
8,30%
Business strategies may include start up (entering a new market)marketing strategy to increase of market share;
Business strategy may sacrifice current for anticipated profits
What happens if anticipated profits are not in fact realized?evaluate position critically to see if strategy is credible:
e.g. look for consistent behaviour and see who bears costs and is intended to reap rewards
would independent enterprise have entered into such a scheme and would it have continued long after anticipated profits have not materialized?
Business StrategiesFactors affecting Comparables
Recognition of actual transactions undertakenBe careful of restructuring of transactionsCircumstances were restructuring will
appropriate:Economic substance differs from the form “…(T)he arrangements made in relation to the
transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner….”
Arm’s Length Principle
LossesSituation: one group entity experience consistent
losses while overall group is profitable. Legitimate business reasons may exist: heavy start-
up costs, unfavourable economic conditions or inefficiencies.
Independent enterprises would not tolerate losses indefinitely.
Loss enterprise may not be receiving adequate compensation.
Example
Arm’s Length Principle
Other issuesThe effect of government policies
Government interventions (interest rate controls, control over royalty payments etc.) should be treated as normal market conditions.
Use of customs valuationsMay not be aligned with OECD TP methodsMay provide valuable contemporaneous information Taxpayers may have competing incentive in setting
prices for customs valuations and tax purposes
Arm’s Length Principle
Source:OECD Guidelines: Chapter 1UN TP Manual for Developing Countries:
Chapter 1 (section 4)ATAF: TP for Policy Makers: Session 1:
“Arm’s length range” by OECD (PDF)
Arm’s Length Principle