www.pwc.co.

ke

OECD Transfer Pricing

Methods

July 2016
Agenda

• Introduction
• Traditional Transactional Methods
o Comparable Uncontrolled Price Method
o Cost Plus Method
o Resale Price Margin Method
• Transactional Profit Methods
o Transactional Net Margin Method
o Profit Split Method

PwC ICPAK Conference July 2016

PwC 2
The arm’s length principle

• Purpose of a transfer pricing method is described in the OECD Guidelines

2.1:
“to establish whether the conditions imposed in the commercial or financial
relations between associated enterprises are consistent with the arm’s
length principle”
• OECD definition based on Article 9 of the OECD Model Tax
Convention:
‘[Where] conditions are made or imposed between the two [associated]
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 occurred, may be
included in the profits of that enterprise and taxed accordingly’

PwC ICPAK Conference July 2016

PwC 3
Comparability
OECD Guidelines 1.33-1.63; Chapter III

• Application of the arm’s length principle is generally based upon a

comparison of the economically relevant characteristics of a controlled
transaction with the economically relevant characteristics of transactions
between independent enterprises.
• To establish the degree of actual comparability it is necessary to compare the
controlled and uncontrolled transactions based on 5 comparability factors:
- Characteristic of property or services
- Functional Analysis
- Contractual Terms
- Economic Circumstances
- Business strategies
• The importance of each factor will vary from case to case and depending on
the Transfer Pricing method used.
PwC ICPAK Conference July 2016
PwC 4
OECD Methods

Traditional transactional
methods • Comparable uncontrolled price
method (CUP)
Rely on data relating to actual • Cost plus method (CP)
comparable transactions between
• Resale price method (RP)
companies

Transactional profit methods

Rely on companies involved in • Transactional net margin
comparable transactions or on the method (TNMM)
appropriate apportionment of total • Profit split method (PSM)
profit between related enterprises

PwC ICPAK Conference July 2016

PwC 5
Selection of the most appropriate method
OECD Guidelines 2.2 & 2.11

The appropriateness of the method is based on a consideration of:

• the respective strengths and weaknesses of each method;
• the nature of the controlled transaction;
• the degree of comparability between controlled and uncontrolled transactions; and
• the availability of reliable information needed to apply the selected method.

There is no hierarchy of methods, however:

• Where, after taking account of the above, the CUP and another method can be applied
in an equally reliable manner, the CUP method is preferred (OECD Guidelines 2.3).
• Since it provides a direct estimate of the price the parties would have agreed to had
they resorted directly to a market alternative to the controlled transaction.

PwC ICPAK Conference July 2016

PwC 6
 TP Methods - relationship to P&L accounts

REVENUE
CUP
(COST OF SALES)

GROSS PROFIT Resale Cost Profit

(SALES AND ADMINISTRATION
Price Plus Split
EXPENSES)

OPERATING PROFIT TNMM

PwC ICPAK Conference July 2016

PwC 7
Comparable Uncontrolled Price
(“CUP”) Method

PwC ICPAK Conference July 2016

PwC 8
CUP Method
OECD Guidelines 2.13-2.20

Introduction:
• The method compares the price charged for property or services
transferred in a controlled transaction to the price charged in a comparable
uncontrolled transaction in comparable circumstances.
• Where it is possible to locate comparable uncontrolled transactions, the CUP
method is the most direct and reliable way to apply the arm’s length
principle. Consequently, in such cases the CUP is preferable over all other
methods.
Application:
• Royalties
• Interest rates
• Raw materials, sold on open market (oil, sugar, metals)

PwC ICPAK Conference July 2016

PwC 9
CUP Method - Comparability

• The reliability of a CUP analysis is highly dependent upon the

comparability in product and contractual terms (e.g. volume, credit
terms, shipment, insurance, warranty) between the controlled and
uncontrolled transactions.
• Comparable only if the products/services and circumstances are
“substantially the same” as in the uncontrolled transaction(s), i.e.
where no difference exist which would materially affect the price.
• Reasonably accurate adjustments may be able to be performed to
account for differences between the controlled and uncontrolled
transaction, where differences can be quantified.

PwC ICPAK Conference July 2016

PwC 10
CUP Method
Case Study

BikeCo Plc BikeCo Italia

Manufacturer Distributor
(purchases,
Third Party 3 imports and
resells bicycles)

Third Party 2 Third Party 1

Uncontrolled transactions
Internal comparable transaction
External comparable transaction
Controlled transaction

PwC ICPAK Conference July 2016

PwC 11
CUP Method
Case Study
In which of the following circumstances would you make an adjustment?
Delivery terms
• BikeCo Plc sells similar bicycles to BikeCo Italia and Third Party 3. All relevant information on
the controlled and uncontrolled transactions is available to BikeCo Plc. It is noted that the price
relating to the controlled transaction is a delivered price (i.e. including transportation and
insurance), while the uncontrolled transaction is made ex works, with the buyer taking
responsibility from the named place of delivery, which is BikeCo Plc’s factory.
Volume of sales and related discounts
• BikeCo Plc sells 5000 bicycles to BikeCo Italia for £90 per bicycle, while it sells 1000 similar
bicycles to Third Party 3.
Product characteristics
• The sale of bicycles to Third Party 2 by Third Party 1 involve bicycles on which modifications
have been made. However, the bicycles sold in the controlled transactions do not include these
modifications.
Contractual terms
• BikeCo Plc sells the bicycles to BikeCo Italia offering a 90 day credit term but the contract
terms dictate that all sales to Third Party 3 are Cash On Delivery.

PwC ICPAK Conference July 2016

PwC 12
Application of the CUP method post BEPS

How to apply the CUP

• Default method for use in
commodity transactions.
• Commodity – physical product for
which a quoted price is used a
reference.
• How is the CUP applied?
• Physical comparability
• Contractual terms eg vol,
• Period and timing
• Incoterms
• Currency
PwC ICPAK Conference July 2016
PwC 13
Application of the CUP method post BEPS

How to apply the CUP

• Emphasis on comparability of
functions, assets and risks between
controlled and uncontrolled
transactions.
• If not comparable, reasonably
accurate adjustments should be made.

Documentation needed for a CUP

• Price index (emphasis on date) and
adjustments to the price index in
line with the functionality of the
parties to the transaction.

PwC ICPAK Conference July 2016

PwC 14
Resale Price (“RP”) Method

PwC ICPAK Conference July 2016

PwC 15
Resale Price Method
OECD Guidelines 2.21-2.38

Introduction:
• Compares the resale margin (i.e. the gross margin) earned by the tested party with the
resale margins earned by comparable independent distributors
• The gross profit represents the amount a reseller would seek to cover its operating
expenses and make an appropriate profit (in light of its functions and risks)
• This calculation provides an arm’s-length costs of sales (COS) for the reseller.
Application:
• Applicable for analysing transactions involving tangible goods
• Typically used for testing a reseller/distributor who has not added substantial value to
the products
Comparability:
• Comparability depends on functions performed and market circumstances
• Less sensitive to small product differences compared to the CUP method

PwC ICPAK Conference July 2016

PwC 16
Resale Price Method - illustrated

Related Party A Related Party B Third Party

a b

Selling price to third party (b) = £1,000

Resale price margin (20%) = £(200)
Arm’s length price (a) = £800

PwC ICPAK Conference July 2016

PwC 17
Resale Price Method
Case Study

BikeCo Plc BikeCo Italia

Manufacturer Distributor
(purchases,
Third Party 3 imports and
resells bicycles)

Third Party 2 Third Party 1

Uncontrolled transactions
Internal comparable transaction
External comparable transaction
Controlled transaction

PwC ICPAK Conference July 2016

PwC 18
Resale Price Method
Case Study

Transactional comparison
• You could determine the gross profit margin that BikeCo Italia earns when
reselling bicycles purchased from Third Party 1.
• May initially have been rejected as an internal comparable for purposes of applying
the CUP Method because, for example, the transaction involves a different type of
bicycle.
• If products are broadly similar with comparable accounting measures of COS, this
would make gross margin comparisons sufficiently reliable.
Functional comparison
Involves a search for comparable distribution companies rather than comparable
transactions. This could, for example, include comparable distributors of
wheelbarrows, carts etc.

PwC ICPAK Conference July 2016

PwC 19
Resale Price Method Post BEPS
Compensation for enhancement and development of
marketing intangibles

• Traditionally, benchmarking of Bike Co Italia’s gross margin against that of

comparable independent distributors would have been adequate.
• In accordance with BEPS Action on intangibles, further analysis on the application
of the Resale Price Method would be necessary to establish:
• Legal obligations and rights;
• Functions, assets and risks;
• Intangible value to be created through activities; and
• Compensation provided for the functions performed
• How do the intangibles related return impact on application of Resale
Price Method i.e discount on price , royalty, etc ?

PwC ICPAK Conference July 2016

PwC 20
Cost Plus (“CP”) Method

PwC ICPAK Conference July 2016

PwC 21
Cost Plus Method
OECD Guidelines 2.39-2.55

Introduction:
• An appropriate arm’s length “cost-plus” mark-up is applied to costs incurred by the supplier of
property or services in a controlled transaction for property transferred or services provided to an
associated purchaser.
• Compares the return on costs the tested party earns with the return on costs earned by comparable
companies
Application:
• Per paragraph 2.39, the method is most useful where:
– semi-finished goods are sold between related parties
– there are long-term buy and supply agreements (e.g. contract manufacturing), or
– the controlled transaction is the provision of services.
Comparability:
• Comparability depends on functions performed and risks borne (e.g. complexity of manufacturing,
R&D activities, inventory levels)
• May be difficult to identify the cost base to be marked up

PwC ICPAK Conference July 2016

PwC 22
Cost Plus Method - illustrated

Uncontrolled transaction
Controlled transaction Cost + X%

Related Party 1 Related Party 1

Circuit Boards (Japan)
ManufactureCo
(China)

Third Party 1 Third Party 2

Circuit Boards (South Korea)

Cost + 7%

If ManufactureCo sells similar products to an unrelated company, performs the same

functions and bears the same risks under similar market conditions – sales to Third Party
1 may be considered a Cost Plus Method comparable.

PwC ICPAK Conference July 2016

PwC 23
Cost Plus Method – the cost base

• e.g. Comparable enterprises may classify costs in different ways in their accounts
- some at operating expense level, some at gross margin level.
• Costs may not be the determinant of the appropriate profit in a specific case
for any one year (e.g. where a valuable discovery has been made and the owner has
incurred only small research costs in making it).
• The costs that may be considered are limited to those of the supplier of
goods or services. This limitation may raise a problem of how to allocate some costs
between suppliers and purchasers.

Thus, although in principle the cost plus methodology should compare margins at the
gross profit level, the guidelines recognise that there may be practical difficulties in so
doing (Guidelines 2.46 - 2.52).

PwC ICPAK Conference July 2016

PwC 24
Cost Plus Method
Shortcoming of the Cost plus post BEPS
• The Cost Plus works on the premise that costs are a driver of value and that profits are
referenced or reflective of the costs incurred.
• In the post BEPS world, need to further investigate where the value is created (BEPS
Action 8 to 10) through a value chain analysis:
› In an industry where consumers are brand sensitive, a cost based method may
not be appropriate.
› Where a highly valuable product is developed with minimal costs going into R &
D, a cost based method may be inaccurate.
› Comparability of cost structure of tested party vis a vis the comparable very
relevant as different cost structures maybe indicative of non comparability.
› Cost Plus method focuses more on the supplier to the transaction. In the post
BEPS world, increased emphasis on a two sided analysis.

PwC ICPAK Conference July 2016

PwC 25
Transactional Net Margin Method
(“TNMM”)

PwC ICPAK Conference July 2016

PwC 26
TNMM
OECD Guidelines 2.58-2.107

Introduction:
• Tests the profitability of the related party against the profitability of “comparable”
third parties engaged in similar business activities relative to an appropriate base.
• Profits are compared using Profit Level Indicators (“PLIs”), which are ratios that
measure relationships between profits and costs incurred or resources employed, e.g.
– Operating profit to sales (operating margin)
– Operating profit to total costs (full cost mark-up)
– Operating profit to assets (return on assets)

• The TNMM is a “one-sided” method. The ‘tested party’ is the least complex of the
related parties, i.e. performs less functions, has no intangibles, etc.
Application:
• Where there are several varied transactions
• Data for traditional transactional methods is limited (uses operating profits)

PwC ICPAK Conference July 2016

PwC 27
TNMM – comparability

The OECD Guidelines makes it clear that to use TNMM should begin by:
• Comparing the net margin which the tested party makes from a controlled transaction with
the net margin it makes from an uncontrolled one (an “internal comparable”).
• Only where this proves impossible (perhaps because there are no transactions with
uncontrolled parties), then the net margin which would have been made by an independent
enterprise in a comparable transaction (an “external comparable”) may serve as a guide.
– Functional analysis of the transactions to determine comparability is key
– It might be possible to adjust results for minor functional differences, provided that there
is sufficient comparability to begin with.
• Based on net profits, therefore comparability standards are not as stringent as for traditional
transacational methods.
• Fewer issues over inconsistent allocation of costs to COS/OPEX.
• However, the PLI of a company can be influenced by a range of factors that either have no
effect or a different effect on gross margins or the actual price of a transaction.

PwC ICPAK Conference July 2016

PwC 28
Sensitivity of using a gross vs. a net margin profit
indicator

Distributor (limited Distributor (significant

marketing) marketing)

Sales price (same good/volume/price) £1,000 £1,000

Purchase price from manufacturer

£600 £480
(considers extent of marketing activity)

Gross margin £400 (40%) £520 (52%)

Marketing spend £50 £150

Other OPEX £300 £300

Net profit margin £50 (5%) £70 (7%)

Depending on comparability, risk of error could amount to £120 (in case a gross margin
method is applied) compared to £20 (in case a net margin method would be applied).

PwC ICPAK Conference July 2016

PwC 29
TNMM Post BEPS

In the post BEPS world, the following should be considered in applying the TNMM:
• More focus on a value chain and functional analysis in order to identify who creates
and drives value in the business which may have an impact on both selection of tested
party and selection of external comparable.
• The TNMM is traditionally a one sided method but in line with the BEPS
recommendations, a two sided analysis should be done in order to identify the simpler
party to test.

PwC ICPAK Conference July 2016

PwC 30
Profit Split Method (“PSM”)

PwC ICPAK Conference July 2016

PwC 31
Profit Split Method
OECD Guidelines 2.108-2.145

Introduction:
• Evaluate whether the allocation of the combined operating profit or loss
attributable to one or more intercompany transactions is arm’s length based
on the relative value of each controlled party’s contribution to that
operating profit or loss.
Application:
• Interdependent and integrated transactions exist
• Transactions involve valuable intangibles or high-value services
Comparability:
• Each taxpayer’s relative contribution must reflect the functions performed,
risks assumed, and resources employed by each participant.

PwC ICPAK Conference July 2016

PwC 32
Profit Split Method
Case Study

BikeCo Plc BikeCo Italia

• Responsible for core • Responsible for

R&D Advertising
Third Party 3 • Responsible for
• Manufactures certain
critical components Assembly
• Responsible for
Sales

Third Party 2 Third Party 1

The profit split method divides the profit or loss that would result from an arrangement
between uncontrolled taxpayers, each performing functions similar to those of the various
controlled taxpayers engaged in the relevant business activity.
PwC ICPAK Conference July 2016
PwC 33
Profit Split Method

There are two types of PSMs:

• Contribution analysis: the total profits from the controlled transaction(s)

are split between the associated enterprises based on the relative value of
their functions performed, assets employed and risks borne participating in
the controlled transaction(s).

• Residual analysis: requires the allocation of market returns to routine

functions based on a functional analysis and the allocation of the residual
profit in proportion to the relative value of non-routine contributions (e.g.
intangibles) as measured by, for example, expenditures related to
development of intangible assets.

PwC ICPAK Conference July 2016

PwC 34
Profit Split Method
Residual Analysis

The total profits from the controlled transaction(s) are split between the associated
enterprises in two stages:
• Each participant is rewarded for its non-unique contributions
• The residual profit is split between each participant based on the relative value of
their unique and valuable contributions

Profits
Services (FCMU under TNMM)

Distribution (OM under TNMM)

Manufacturing (FCMU under TNMM)

Residual profits

PwC ICPAK Conference July 2016

PwC Slide 35
Profit split method post BEPS
The Profit Split method as it currently stands is intended to provide solutions for highly
integrated operations for which a one-sided method would not be appropriate.
Need to further consider clarifying, improving, and strengthening the guidance on when
it is appropriate to apply a transactional profit split method and how to do so.
Further draft guidance expected in 2016, final version in 2017.

Most appropriate method Unique and valuable

Highly integrated business
Potential for the PSM to be contributions
operations
misused, depending on the Further attempts to define
Significant levels of integration
nature of the transaction and “unique” and “valuable”
alone should not be enough to
functional circumstances of This will link to revised
justify use of a PSM
parties guidance on intangibles.

Interaction between profit Synergistic benefits

Profit splitting factors split and TNMM Additional guidance to be
Need to ensure that there is a Additional guidance to be provided on circumstances
strong correlation between provided on circumstances where PSM could be
profit allocation factors and where PSM can be used as a appropriate for dealing with
value creation secondary ‘sense check’ for scenarios with significant
TNMM Group synergies

PwC ICPAK Conference July 2016

PwC 36
This publication has been prepared for general guidance on matters of interest only, and does
not constitute professional advice. You should not act upon the information contained in this
publication without obtaining specific professional advice. No representation or warranty
(express or implied) is given as to the accuracy or completeness of the information contained
in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its
members, employees and agents do not accept or assume any liability, responsibility or duty of
care for any consequences of you or anyone else acting, or refraining to act, in reliance on the
information contained in this publication or for any decision based on it.

© 2015 PricewaterhouseCoopers LLP. All rights reserved. In this document, "PwC" refers to
the UK member firm, and may sometimes refer to the PwC network. Each member firm is a
separate legal entity. Please see www.pwc.com/structure for further details.