Abstract
This chapter provides the reader with a pragmatic introduction to the arm’s length principle. Why the concept of one “true price” is erroneous will be explained but that MNEs can, nevertheless, find ways to set prices for intercompany transactions that reliably approximate those agreed upon between independent entities. The reader will be introduced to One Lesson of Transfer Pricing, namely, that the art of transfer pricing consists in never losing sight of the reality of a specific business when applying the arm’s length principle. By understanding how to establish an adequate level of segmentation (aggregation) when analyzing intercompany transactions and by learning how to conduct a value chain analysis, the reader will learn how to appropriately balance business and tax considerations for transfer pricing purposes. The chapter will illustrate that the arm’s length principle is not a means for tax avoidance but rather a pragmatic and comparatively transparent mechanism for appropriately “translating” a specific business model into a tax viable transfer pricing structure.
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- 1.
See OECD (2017a), Paragraph, 1.5. Note: These Guidelines will be quoted frequently throughout this book—so all OECD references (i.e., “OECD Guidelines” or “OECD-GL”) will refer to these Guidelines unless indicated otherwise. The OECD-GL are arguably the main international reference for transfer pricing—reading this book will ensure that you are familiar with the most important provisions contained in the OECD-GL.
- 2.
See OECD Guidelines (2017a), Paragraph, 1.6.
- 3.
For an entertaining introduction (on the water-diamond paradox), I highly recommend the essay by Sanchez (2011).
- 4.
Note: Make no mistake—infighting among individual profit centers within an MNE can be fierce.
- 5.
See OECD-GL (2017a), Paragraph 1.2.
- 6.
OECD-GL (2017a), Paragraph 1.13.
- 7.
Note: As will be discussed below, the lever is much smaller when adopting profit margins of comparable companies as references (i.e. when applying Cost Plus of TNMM)—this form of benchmarking is by far the most frequently utilized reference in day-to-day transfer pricing.
- 8.
In this context, the OECD also is correct in pointing out that “The consideration of transfer pricing should not be confused with the consideration of problems of tax fraud or tax avoidance, even though transfer pricing policies may be used for such purposes”—see OECD-GL (2017a), Paragraph 1.2. For a quick but witty insight on this issue, I recommend reading Forstater (2018).
- 9.
For a brief account on the importance of an entrepreneurial approach to transfer pricing to counter, the momentum gained by the proponents of formulary apportionment, please refer to Treidler (2017).
- 10.
Just to be on the safe side, you will find a concise (10-point) questionnaire in the Annex A. The issues discussed in Chap. 2 of this book are essentially covered by questions 1–3.
- 11.
Please note that this is a highly abbreviated description of a VCA. For guidance on applying a full-scope VCA for transfer pricing purposes, I recommend Baumgartner (2018).
- 12.
Complementary or refining questions would be: What is the competitive advantage of the company? What is the competitive strategy of the company? See also Baumgartner (2018), who defines “competitive strategy” as “choosing a different set of activities to deliver a unique mix of value. Competitive strategy is the search for a favorable competitive position in an industry, the fundamental arena in which competition occurs”.
- 13.
See OECD Guidelines (2017a), Paragraph 3.7.
- 14.
Note: The issues of intangibles will be addressed in detail in a separate section of this book (see below). For introductory purposes, it is sufficient to point out that the OECD here refers to the fact that intangibles are often transferred as a part of a “package”; i.e., “licensing of manufacturing know-how and the supply of vital components to an associated manufacturer; it may be more reasonable to assess the arm’s length terms for the two items together rather than individually.”
- 15.
Note: Popular examples for portfolio approaches include selling a package of technical equipment and the related captive aftermarket consumables (i.e., coffee machines and coffee capsules, or printers and cartridges)—See OECD Guidelines (2017a), Paragraph 3.7.
- 16.
See OECD Guidelines (2017a), Paragraphs 2.84 and 2.85, i.e., “Costs and revenues that are not related to the controlled transaction under review should be excluded where they materially affect comparability with uncontrolled transactions.”
- 17.
Note: The relevant German Transfer Pricing Regulations (Verwaltungsgrundsätze—Verfahren, BMF-Schreiben v. 12.4.2015 (“Administrative Principles—Procedure”) (Paragraph 3.4.13) are almost identical to the guidelines contained in the OECD Guidelines (which are explicitly referenced in this context).
- 18.
The Prima Group is entirely fictitious. As the OECD sometimes refers to the “Prima Group” in its examples, it seems appropriate to adopt the name—especially, as some aspects of the case studies will be based on OECD examples. Please note the disclaimer that we are dealing with somewhat simplified situations.
- 19.
Note: As in many other disciplines, the use of illustrations can be highly advantageous also in transfer pricing. Most notably, it allows you emphasize the most important aspects of your transfer pricing system, while clarifying that certain other aspects are of subordinary nature. Among others, a consistent narrative will be important when deciding (arguing) on the aggregation of individual transactions and the limitation of the scope of a transfer pricing documentation (as will be demonstrated below).
- 20.
It is recommended that you utilize graphical illustrations to summarize and visualize the value chain of an MNE. A respective illustration can help you to sustain a coherent framework when quantifying the value of individual functions—I recommend the book by Osterwalder and Pigneur (2010) for pragmatic guidance and step-by-step guidance on how to use the so-called “business canvas” to illustrate your value chain.
- 21.
Note: In day-to-day transfer pricing practice, you should thus always defer the decision on the level of segmentation until the functional and risk analysis is concluded.
- 22.
Yes, arguments could be made that a value chain analysis is generally more comprehensive than a functional and risk analysis, but for practical purposes, this is a rather moot point.
- 23.
These two differing perspectives tend to have a rather substantial impact on day-to-day transfer pricing. One of the central arguments to be derived from the lesson is that a transfer pricing system that is based on (closely aligned to) the business realities will minimize respective conflicts and risks. For a concise explanation of the merits of such an “entrepreneurial approach” to transfer pricing, please refer to Treidler (2017).
- 24.
Note: There is no empirical basis for this claim—which would be incredibly difficult to obtain, i.e., how would you collect data on transfer pricing tax adjustments that is sufficiently detailed to segment the adjustment according to different causes? It is, however, firmly rooted in experiences from tax audit proceeding (including my own as well as those of trusted colleagues) and will also be made plausible in the context of our Prima case study (see below). How accurate 75% is as an estimate is not that decisive, i.e., if you think 60% or 90% is closer to the truth, the message stays the same: “Focusing your efforts on the functional and risk analysis will pay dividends.”
- 25.
Note: Make no mistake, even if, thanks to a good functional and risk analysis, only 25% of the potential risks are subjected to bazaar-type of negotiations with tax authorities, a good comparability analysis (benchmark) will often put you in a much-improved negotiation position. Depending on the monetary value of 25% of the risk potential, the cost-reward ratio of a benchmark can be very positive indeed (for detailed remarks on benchmarking, see below).
- 26.
In the interest of brevity, we rigorously stuck to an extremely short presentation of the main facts. In practice, you will generally have to elaborate a little more on the individual functions to avoid ambiguity with respect to the classification of the entities.
- 27.
For very small companies, it will even be feasible to limit the functional and risk analysis to a respective illustration (“star-chart”).
- 28.
The description of the Warehousing and Logistics function provided by this case study can be considered insufficient, especially because, first, the total value-added attributable to this function is not explicitly put into perspective and, and second, the functions are not delineated between Prima and the Subsidiaries. We will later see that such ambiguity can result in additional risk. One advantage of compiling a star-chart is that it forces you to revisit the consistency of the functional analysis. In the case at hand, additional explanations were required to evaluate the logistics and warehousing function. A possible explanation here could have been: Prima operates a state-of-the art logistics center and is responsible for ensuring efficient freight and transport processes, while the local subsidiaries generally outsource local logistics (delivery).
- 29.
This statement is relevant in view of the required level of aggregation. Considering that the services provided by Prima are merely of supporting nature, it will generally be feasible to argue that a segmented analysis is not required—this will, however, also depend on the respective transaction volumes. The explanations provided above, however, suggest that the local entities have substantial local capacity—so that the transaction volume for centralized services is likely limited.
- 30.
A separate analysis of risks (and assets) can be deliberately forgone when dealing with fairly “straightforward” transactions. The basic assumption in this context is that the risks and assets will ideally “follow” the functions and that therefore a separate evaluation would be redundant—i.e., it would add an additional layer of complexity without substantially enhancing the reliability of the analysis and the resulting classification. For more detailed explanations and practical implementation, see the value chain analysis tool available for download. Even though these assumptions would apply in the case of the Prima Group, we found it preferable to provide you with an explicit description of the relevant risks—i.e., provide you with a complete picture.
- 31.
Admittedly, the explanation is somewhat vague. It is, however, not uncommon to encounter such situations in practice, especially in SMEs. In the case of Prima, however, there does not seem to exist a glaring misalignment between functions and risks, i.e. Prima performs all production functions as well as the strategic functions regarding quality assurance—hence, it seems to be plausible that Prima will bear the respective risks by recompensing the local subsidiaries for costs related to faulty manufacturing. While it would be highly recommendable to clarify the allocation of product liability risks (i.e. by amending existing contracts or drafting new contracts), the potential for (aggressive) transfer pricing adjustments seems limited.
- 32.
Whether or not this statement is accurate, i.e., whether the resulting transfer prices are commensurate with the arm’s length principle, can only be assessed in the context of the comparability analysis. Considering that the analysis here leaves a rather high degree of ambiguity regarding such a vital (sensitive) issue, we would strongly recommend providing additional explanations when encountering a similar situation in practice. Compared to the product liability and quality risk (see previous footnote), the ambiguity regarding the market risk seems much more severe in the case of Prima.
- 33.
There are almost infinitesimal options to assign weights to the different functions—with some being better than others, but ultimately, it is a matter of taste as well. Under no circumstance, however, should you refrain from assigning (plausible) weights, as this will render the analysis factually worthless and cause severe harm. For a detailed example, please refer to the complementary Excel-Tool, which includes a detailed “how-not-to” example based on an OECD case study. A further “how not to example” in the context of Prima is provided at the end of this section.
- 34.
The Excel Tool (“Value Chain Analysis”) is available inhttp://extras.springer.comfor download on the homepage of Transfer Pricing in Lesson.
- 35.
Please also note that these labels are at least somewhat fuzzy and that there is no international consensus on the definition (at least not in the realm of transfer pricing); the OECD refers to specific labels such as a limited risk distributor merely in the context of Chapter IX. These references, however, are made without providing a clear-cut definition but rather provide a case-study-type of delineation between a limited risk distributor and a full-fledged distributor.
- 36.
Note: Various countries such as Germany have explicitly integrated the categories “entrepreneur” and “routine entity” into their transfer pricing regulations. Germany, being Germany, has created a third, in-between, category, the so-called hybrid entity. Such an ostensibly more “fine-grained” categorization is, however, rather disadvantageous in practice. In this context, the most notable disadvantage is that the TNMM may not be utilized for “hybrid” entities.
- 37.
I have highlighted several ambiguities myself and will further elaborate on the impact as well as on additional ambiguities below.
- 38.
In the case at hand, the degree of quibbling would depend on the financial results, i.e., whether it is worthwhile to quibble, and it is safe to assume that the quibbling would be confined to the comparability analysis (which, as we shall see below, implied much smaller risks than challenges to the functional and risk analysis).
- 39.
Note: We have thus far not put specific emphasis on the role of intangibles. If only one party contributes to unique and valuable intangibles, integrating these in the analysis will often result in a much clearer functional profile—as the functional profile above is, however, deemed to be sufficiently clear, the discussions of intangibles are deferred to the more advanced sections.
- 40.
The Excel Tool is available inhttp://extras.springer.comfor download on the homepage of Transfer Pricing in Lesson.
- 41.
Note: This is not intended as a derogative comment to tax auditors. They naturally have an agenda and are in no way obliged or incentivized to make interpretation in favor of the taxpayer. This is just how the game is played and most people can appreciate this without bitterness. Submitting a poor functional and risks profile is akin to scoring in your own goal, i.e., while the opposition may not exactly pat themselves on the back, they will certainly be happy to take advantage of the opportunity.
- 42.
That statement is feasible here even without knowing the transaction volumes. In case the transaction volumes for the service transaction would later turn out to be disproportionately high, this should trigger additional scrutiny in the sense that the accuracy of the functional analysis should be double-checked.
- 43.
Note: As the “net margin” is to be understood as the EBIT margins, the rationalization of integrating the transactions will not easily extend to including financial transactions. While the evaluation of financial transactions will also have to consider the broad economic conditions of the taxpayers, they will generally be evaluated as a separate analysis—in any case, however, you should be careful to ensure that interest payments do not cannibalize the routine profits of your tested party—for details on financial transactions, please refer to the “advanced” section.
- 44.
Note: In the case of Prima, at least for the simple setup discussed thus far, it would also be feasible to argue (again based on Paragraph 3.9) that it is impractical to determine pricing for each individual product or transaction, i.e., the arm’s length nature of the compensation of the “services” rendered by Prima could appropriately be included in the net margin agreed for the sales transaction.
Bibliography
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Treidler, O. (2020). The Lesson. In: Transfer Pricing in One Lesson. Management for Professionals. Springer, Cham. https://doi.org/10.1007/978-3-030-25085-0_2
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