Transfer Pricing

Planning for and pricing of intra-company transactions

C. Beuselinck – 15 March 2018

Transfer Pricing (TP) defined
• Hirschleifer (1956): On the Economics of Transfer Pricing
• « pricing the goods and services that are exchanged between [autonomous
profit-center divisions] within a firm »

• U.S. IRS Code Section 482: arm’s length principle (i.e., set a price as
though the transaction occurs between unrelated parties for similar
goods under similar terms)

• Concept versus fixed value

 Multinational transfer pricing debate

Since tax rates are different in different countries,

companies have incentives to set transfer prices
that will increase revenues in low-tax countries and
increase costs in high-tax countries.
Source: Beuselinck et al. 2015
 A simplified example

Deutsche
Telekom

Hamburg Dublin
(t=35%) (t=15%)

German office buys 100 components from its plant located in Ireland
What is the effect on corporate profit if Hamburg pays 20 per unit
versus 30 per unit?
Transfer Pricing Types
Transfer Pricing concepts relate to:
• Planning
• Are transfer prices set appropriately?

• Documentation
• Compliance exercise

• Avoid Controversy
• Tax Scrutiny

• « It is almost more common than not to have a transfer pricing dispute with
the U.S. » (R. Willens, tax consultant NY)
Controversy…YES!
TP and taxation
• Jacob (1996) finds that the magnitude of income shifting is related to the
volume of intrafirm sales and regional tax rate differences

• Beuselinck and Deloof (2014) find that the magnitude of income shifting is
related to the volume of intrafirm sales and subsidiary tax rate status

• Hopland, Lisowsky, Mardan and Schindler (2016) show that intangible

property transfer prices are used to shift income to loss affiliates

• Bernard, Jensen and Schott (2006) find that transfer prices to related
customers are higher compared to those for unrelated customers when
sold to countries with lower corporate tax rates
De Simone 2016 (IFRS and transfer pricing)
• Adoption across jurisdictions of a common set of accounting standards, such
as International Financial Reporting Standards (IFRS), expands the set of
potential benchmark firms and could allow MNEs more flexibility to support tax-
advantaged transfer prices.
• As of 2014, 14 of the 27 EU member states require IFRS for unconsolidated financial
reporting for certain types of firms, 9 countries allow IFRS for certain firms, and 4
countries do not allow IFRS
• tax authorities in the EU historically rejected potential benchmark firms that use
different accounting standards (i.e., foreign firms using local GAAP).
• MNEs with an affiliate in a high-tax jurisdiction could “cherry-pick” among
potential benchmark firms and select less profitable firms to substantiate low
taxable profits for their high-tax affiliate.
• The average mandatory IFRS adopter affiliate shifts 11.5 percent more
income relative to pre-adoption and non- adopter affiliate-years.
 The Arm’s Length Principle
• OECD Article 9: … “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.”
Arm’s length range?
• By applying the principle to multiple comparable data

• By applying different transfer pricing methods

• Comparable Uncontrolled Transactions (CUT)

• Comparability Analysis
A French-Dutch Bicycle Company
• A French bicycle manufacturer sells bikes via a Dutch subsidiary.
• Production Cost: 900
• Distribution Cost: 100
• Transfer Price: 1,000
• Sales price: 1,100

• Which problems may arise from a taxation perspective?

TP Study Report Design
Functional Analysis
• The purpose of the functional analysis is to identify:
• Functions performed and risks assumed by the tested party
• Intercompany flows and transactions among such entities

• The tested party functional profile serves as the basis for:

• Transfer pricing method selection
• Comparables search criteria
• Tested party segmentation and financial analysis
Functional Analysis
• Identify interdependencies

• Define concept of control

• Is incomplete until material risks have been identified

• Q: « Effect of uncertainty on the business objectives? »

• Strategic/Operational/Financial/Transactional/Hazard
Interviews to explore
• Is global marketing organized at the group or subsidiary level?
• Does [Company X] pay for any global marketing activity undertaken by another
group company?
• I the entity Y responsible for achieving targets? (market risk)
• Who determines pricing to the customers?
• Which entity bears the risks related to the freight function (f.o.b.)?
• Which entity fulfills the obligation of the warranty?
• …
Illustration (1)
• Company Alpha pursues a development opportunity and hires an
unrelated specialist firm Beta to perform part of the research on its
behalf. Beta reports back to Alpha on predefined milestone dates.

1. Development risk: Y/N?

2. Who? Alpha, Beta or both?
3. Decisions versus control?
Illustration (2)

• Company Alpha, resident in the U.S.A., has a functional currency in US

dollars and sells goods to an associated distributor in France, whose
functional currency is Euro. The written contract states that the
distributor assumes all exchange risks in relation to the controlled
transaction.
1. Financial risk: Y/N?
2. Who? Alpha, Beta or both?

• But what if the price of the goods is charged over an extended period
in Euro, i.e., the currency of the distributor?
Pricing of transactions
• Risk allocation is non-negligible
• ~open-market offers

• A party should always be appropriately compensated for its control

functions in relation to risk.

• A party will be entitled to receive the full upside benefits and bear the
downside costs if the risk is allocated entirely.

• In a situtation when a party contributes to the control of risk, but does not
entirely assume the risk, a compensation that takes the form of a sharing in
the upside/downside may be appropriate (OECD, TP Guidelines 1.105).
Transfer Pricing Methods
Traditional versus Transaction Methods
Overview
1. Comparable Uncontrolled Price Method (CUP)

• Usually used to benchmark products and services

• Compares intra-group price to prices earned in comparable uncontrolled
transactions under comparable circumstances
• Internal / External CUPs

• +++: “the most direct and reliable way” to apply the arm’s length principle (OECD § 2.7)
• ---: High comparability required (products, volumes, markets); Lack of publicly available data

• Variations in product designs/features

• Intermediate products
• Intangibles
Comparable Uncontrolled Price: Illustration
Discussion cases
1. Colombian coffee beans sold by Starbucks Colombia to an
associated enterprise

2. Safety helmets sold by an associated enterprise versus sold by an

independent enterprise and where the only difference relates to
the f.o.b. specifications

3. 1,000 tons of chemicals sold for $80 per ton to an associate

enterprise and 500 tons of identical chemicals sold to an
independent enterprise but for $100
2. Resale Price Method
• Compares the intra-group resale margin (gross margin) to resale margins
earned in comparable uncontrolled transactions under comparable
circumstances
• PROS:
• Less comparability required than in the CUP method
• Well adapted to distribution activities
• CONS:
• Financial data (gross profit) of comparable companies may not be available
• Difficult if goods are further processed or incorporated in more complex products (loss of
identity)
• Consistency of accounting standards in Europe

• Typically used to price the routine distribution functions of an affiliated

party using functional market comparables
Resale Price Method: Illustration
TP = RSP X (1 – GPM)
RPM and Intangibility
• Special care is needed if the reseller contributes substantially to the
creation or maintenance of intangible property associated with the
product (trademarks/trade name)

• In reality, if the reseller is clearly carrying on a substantial commercial

activity
3. Cost Plus Method
• Compares the markup on costs of the tested party to the markups
earned in comparable uncontrolled transactions under comparable
circumstances
• Less comparability required than in the CUP method
• Well adapted to manufacturing activities and provision of services
• Typically used to price the routine manufacturing functions using
functional market comparables
Cost Plus Method: Illustration

TP = CoGS X (1 + Cost Plus Mark Up)

Schematically:
4. Transactional Net Margin Method
• Compares the controlled company’s profitability to the one of similar companies
Typically used to price routine distribution, manufacturing or other functions
PROS:
• Simple so in practice, the mostly used
• Less comparability required than in CUP, RPM and CPLM

• Commonly used by European tax authorities

• Adjustments necessary: Working capital (A/R, A/P, inventory), conditions of the sale, currency
risk, accounting practices…

• Comparability
• The degree of required functional comparability is less under TNMM than previous methods
• Product similarity may not be of critical importance
indicator of intensity and complexity of mfg activity
34 Source:
February 03, 2010 35
5. Profit Split Method
• In practice:
• Splits the profits between the related companies engaged in the same transaction(s)
based on the relative value of each company’s contribution to the combined profit

+++: Adapted when both parties in the related-party transaction have significant intangible assets
---: Complex Economic Analysis

• Profit-split methods are appropriate when:

• Valuable, non-routine intangibles exist on both sides of the transaction
• Significant differences between controlled and uncontrolled transactions are
attributable to economies of vertical/horizontal integration
• Adequate comparables are unavailable to set margins for either party
Residual Profit Split Method (RPSM)
• Prices all of the routine functions performed by the affiliated entities at each stage of the value chain, using
product, functional, or factor market comparable
• The difference between the total profits earned and those attributable to the routine functions is residual profit
(loss) to be distributed among affiliated entities in proportion to the levels of non-routine intangibles employed
Case Study
• A large Multinational Enterprise (MNE) in the Chemical Sector has a production plant in China.
• This plant sells quasi exclusively to related Commercial Entities in Europe. Related means that the plant and the
Commercial Entities are part of the same MNE. The plant also sells to independent distributors but much lower
volumes in different countries than the ones where related Commercial Entities operate.
Question 1: The Group CFO is preparing its budget for next year and would like to review its transfer pricing
policy between China and Europe. He is asking you what is the arm’s length transfer prices for one unit of
product.
1. Indicate what questions you would want to ask him to be in a position to provide an adequate advice on the
transfer pricing policy.
2. Indicate which methods you think is the most appropriate in the case at hand among the above described
OECD methods.
3. Provide ideas in terms of implementation of this method : what would you recommend in terms of Budget
Unit Price between China and Europe.

Question 2: After a couple of months, the Group CFO calls you back explaining that a severe crisis in Europe has
led to a significant decrease of the volumes ordered by the related Commercial Entities. The drop in orders has
been 40%. He is asking you whether he needs to change its transfer pricing policy under such circumstances and
what would be the impact for the unit price.