Author: M. Özgür Benzeş / 10639284 Contact: ozgur.benzes@gmail.com Supervisor: Dr. R.J. (Rui) Oliveira Vieira
Program: Amsterdam MBA – Part-time
Date of Submission: 09/09/2015
A Dutch Bank at Arm’s Length:
How a multinational bank in the Netherlands identifies transfer prices of
related-party transactions
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Abstract
The purpose of this company project is to examine the transfer pricing methodologies of a multi-national Dutch Bank’s business environment from an analytical perspective taking into account the OECD Transfer Pricing Guidelines, arm’s length principle critics, the management and cost accounting literature, the transaction cost economics and finally the strategy, structure and product design. It is designed as a three-section study comprised of theory, case description and the discussion practice from the theoretical perspective. The first section visits the OECD Transfer Pricing Guidelines and a transfer pricing literature review on management and cost accounting, criticisms on the arm’s length principle, transaction cost economics and the diversification strategy, product design and organizational structure. The second section unfolds the Bank’s case by providing the general information, business overview, mission, vision, strategy and values, products and services and ownership structure of the Bank; and describes in detail the transactions between the Bank and its branches and associated entities. The third section reviews the OECD Transfer Pricing Guidelines and the literature from the perspective of the Bank’s case. The approach under this company project therefore is to test the transfer pricing issue in a suitable real-life business setting by giving references to various disciplines.
Main findings in the project are as follows: Firstly, it shows how OECD and the scholars assume the main source of transfer prices as the market while it is not adequate to explain the Bank’s case. Secondly, the project discusses how the compliance to arm’s length principle does not have any negative effect on the international investment appetite, flexibility and interdependencies of the Bank, unlike the critics of the arm’s length principle argue. Thirdly, the project reveals how the management and cost accounting literature is manufacturing oriented. Fourthly, the study explores the transaction cost economics within the structure of the Bank and its transfer prices. Finally, the project connects how the transfer prices are affected by the diversification strategy, product design and organizational structure. Being a multi-disciplinary study, the value of this project might be in discovering how the transfer pricing connects and interacts with multiple research areas.
Keywords: Transfer pricing, arm’s length principle, banking, market based transfer prices, comparable uncontrolled price method, cost-plus method, management accounting, cost accounting, tax compliance, diversification strategy, product design, organizational structure, transaction cost economics.
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Table of Contents
List of Abbreviations ... 3
I. Introduction ... 4
II. Literature Review ... 10
III. A Dutch Bank at Arm’s Length ... 38
IV. Theoretical Discussion of the Case ... 58
V. Conclusion ... 70
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List of Abbreviations
ALP Arm’s Length Principle
BE Belgium
BEPS Base Erosion and Profit Shifting
CH Switzerland
CITA Dutch Corporate Income Tax Act 1969
COGS Cost of Goods Sold
CP Method Cost-Plus Method
CUP Method Comparable Uncontrolled Price Method
DE Germany
EONIA Euro Overnight Index Average
EURIBOR The Euro Interbank Offered Rate
FX Spots Foreign Exchange Spots
G&A Expenses General and Administrative Expenses
ICT Information and Communication Technologies
IRS Interest Rate Swaps
ISM Information Security Management
IT Information Technologies
LIBOR London Interbank Offered Rate
MNE Multinational Entities
MT Malta
NBB Central Bank of Belgium
NL The Netherlands
O/N Overnight
OECD Organization for Economic Co-operation and Development OECD Transfer Pricing Guidelines The 2010 version of the OECD Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administrations
PS Method Profit Split Method
RO Romania
RP Method Resale Price Method
RU Russia
SME Small and Medium-sized Entity
TNM Method Transactional Net Margin Method
TP Transfer Pricing
UA Ukraine
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I. Introduction
Recently, the discussion topic in United States was on Net Neutrality. The simplest explanation of the topic I could be able to reach was from a Business Insider page1 as follows: “Net neutrality" prevents Internet providers like Verizon and Comcast from dictating the kinds of content you're able to access online. Instead, Internet providers have to
treat all traffic sources equally.…
For example, Comcast would probably like to promote NBC's content over ABC's to its Internet subscribers. That's because Comcast and NBC are affiliated. But net neutrality prevents Comcast from being able to discriminate, and it must display both NBC's and ABC's content evenly as a result. That means no slower load time for ABC, and definitely no blocking of ABC altogether.
In short, net neutrality creates an even playing field among content providers — both large and small — to the web. And it's great for consumers because they can access everything they want online for no extra charge.”
The rest of the discussion on the net neutrality is not the main concern of this project; yet the similarities with transfer pricing are remarkable. Transfer pricing takes the “arm’s length” as the main principle that affiliated companies should realize the transactions in between under
equal conditions as if they were not affiliated. The even playing field in the net neutrality
discussion is the market prices for transfer pricing. As a result, extra charges between affiliated companies for tax purposes should be eliminated. Of course this is just a short explanation of transfer pricing from the perspective of Organization for Economic Co-operation and Development (“OECD” hereafter) and tax authorities of any concerned countries.
1http://www.businessinsider.com/net-neutralityfor-dummies-and-how-it-effects-you-2014-1?IR=T retrieved in
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In fact, multinational entities (“MNE” hereafter) exist in more than one territory. Considering the cost efficiency, local knowledge advantages or other possible reasons, MNEs purchase / sell goods and/or services between their divisions, branches, subsidiaries, and group companies. These transfers of goods or services, whether internally –between divisions and branches- or externally –between subsidiaries and related parties- of an MNE, has a direct impact on its consolidated financial statements, thus its profitability.
Although it is not a new agenda, since the end of 70’s transfer pricing got more of the attention of OECD and since has grown into a topic from an internal cost measure to a method of tax base erosion and a way of shifting the profits to the countries where taxation rates are relatively low or zero. OECD countries adopted transfer pricing measures successively and collaborated for information exchange systems to prevent profit shifting and tax base erosion via transfer pricing. Almost all MNEs now has to comply with the transfer pricing rules as accepted in the country of legislation and has to disclose / document the related party transactions under the radar. Going forward, OECD had a separate effort on preventing base erosion and profit shifting (BEPS), which is a detailed derivative of its transfer pricing approach. “BEPS refers to tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity, resulting in little or no overall corporate tax being paid. BEPS is of major significance for developing countries due to their heavy reliance on corporate income tax, particularly from multinational enterprises (MNEs).”2 The details will be discussed in the following section, together with the OECD Transfer Pricing Guidelines.
As mentioned briefly under the net neutrality discussion as well, a transfer pricing system should be based on the underlying premise that transactions must take place on an arm’s length basis. The arm’s length principle is “the international transfer pricing standard that OECD Member countries have agreed, should be used for tax purposes by MNE’s and tax administrations” (OECD, 2010, p.I-1) and is reflected in local country law. In essence, the standard mandates that transactions between controlled or related parties take place under terms and conditions similar to those that would take place between uncontrolled parties participating in similar transactions.
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Transfer pricing is not an exact science, as also stated in OECD Transfer Pricing Guidelines (2010) so it requires a judgmental effort in understanding or proving the suitability of transactions under focus to arm’s length principle. That of course makes the equation a bit more complicated than it is explained with the arm’s length principle. Further from the taxation point of view, one may realize that transfer pricing is a topic already raised, analyzed and elaborated before OECD did, if focused on the academic discussion on transfer pricing in the strategy, strategic performance management, management accounting, cost accounting, operations and supply chain management, economics, international business and so on. For example, Horngren et al. (2012, p.774) states that “Top management uses transfer prices to focus managers’ attention on the performance of their own subunits and to plan and coordinate the actions of different subunits to maximize the company’s income as a whole….Controversy also arises when multinational corporations seek to reduce their overall income tax burden by charging high transfer prices to units located in countries with high tax rates. Many countries, including the United States, attempt to restrict this practice…” In this example transfer pricing is given as a tool that MNE’s take into account as a performance control tool and a way of tax avoidance at the same time. Cools & Emmanuel (2007, p.580) in explaining the importance of the topic regarding the strategy argues that “…MNE’s have reaped the benefits of internalization and in so doing have created endogenous market imperfections by organizing activities and trades in specific ways. When following a transfer pricing policy consistent with maximization of global after-tax profit, the capacity to arbitrage tariffs and taxes may have led to a perception of manageable control over the tax regime. Most theoretical attempts to model strategy, interdependencies and transfer pricing in the international area have, therefore, treated tax regulations as exogenous (…). The time may now be right to change this assumption and to recognize fiscal regulation as an endogenous variable capable of influencing the MNE strategy.”
Being under the radar of multiple research areas, this project gives a start from a transfer pricing literature review. The section is going to be comprised of the OECD transfer pricing guidelines, management and cost accounting, critics on arm’s length principle, transaction cost economics and diversification strategy, product design and organizational structure topics. When it comes to identifying the transfer pricing methodologies, Horngren et al. (2012, p.780) states that, “Activities within an organization are clearly nonmarket in nature; products and services are not bought and sold as they are in open-market transactions. Yet,
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establishing prices for transfers among subunits of a company has a distinctly market flavor.” According to OECD, transfer prices can be defined via traditional transaction methods like “comparable uncontrolled prices”, “cost-plus” or “resale price”; or via transactional methods such as “profit split” or “transactional net margin” methods, while it does not recognize methods such as negotiation or dual pricing mentioned in the management and cost accounting literature. Usage of these different methods is depending on the context, companies and underlying goods/services.
In the contemporary business environment, the Netherlands is one of the most significant destinations, where the headquarters of MNE’s are established because of several advantages the business environment of the country offers. It also leads to the fact that the Netherlands has to closely monitor and go over the standards defined by OECD for transfer pricing. When banking is mentioned, one should consider the sector among the most regulated sectors under the attention of the government, central bank, tax authority and other regulatory bodies.
All the banks around the world experience a series of complex service flows, which puts the banking sector under the radar for the transfer pricing principles as well. As this company project aims to examine the theories and explanations of the transfer pricing literature through a concrete business setting, a Dutch Bank will be under the focus. This Bank has its Headquarter in the Netherlands, foreign branches and associated entities at the different parts of Europe and the rest of the world and it has multiple service flows and banking transactions. This business setting provides a suitable research area to examine the arguments put forward by the OECD transfer pricing guidelines and transfer pricing literature in general from the perspective of the banking industry.
There are multiple reasons that makes the Bank’s case remarkable for the transfer pricing area. First of all, the case is significant in testing the assumptions of OECD Transfer Pricing guidelines and various scholars who research transfer pricing. OECD and scholars take the market based methods as the main reference to the transfer prices, while the transactions under the focus in the Bank’s case represents a different pattern than this market focus. Although OECD addresses alternative transfer pricing methods, the preferred method is
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stated as taking the market as the reference. This study is going to discuss how this paradigm might not be adequate in the Bank’s case and how the cost based identification of transfer prices of the services and banking transactions address the problem. It is also going to explain the different pattern of the banking and servicing transactions of the Bank in a comparative perspective to the OECD’s and selected scholar’s views. Consequently, alternatives such as internal comparable uncontrolled prices method to the general market based transfer prices paradigm within the Bank’s case is going to be elaborated. The topics of pricing range, functional analysis and special considerations for intra-group services are also covered in this section.
Secondly, the Bank’s case is important to test the critics to the arm’s length principle regarding the international business motivation. The critics of the arm’s length principle of OECD such as Cools and Emmanuel (2007) takes an international business perspective and argues about how the transfer pricing compliance may affect the international investment appetite of MNE’s. The Bank’s case is going to be a suitable playground to test those assumptions of scholars and develop a connection to the competitive advantage, dynamism and interdependencies concepts given as the theoretical explanations regarding the existence of MNE’s.
Third point is that the Bank’s case is worthwhile in revealing the limited coverage of the management and cost accounting research. The resources used for management and cost accounting merely explain the transfer pricing topic from the perspective of manufacturing industry, while the remaining industries are rarely stated as a separate case that requires additional attention. In fact, manufacturing was the main source of growth for many companies a couple of decades ago. Today more input for service industry can be a reference for the transfer pricing problem. The case is going to address the problem of lack of reference from the banking industry’s point of view.
Fourthly, the Bank’s case is also going to be touching upon the interrelation of transfer pricing and transaction cost economics area where entities look for the competitive advantage from a transaction costs perspective. In doing so, the project will explore how the asset
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specificity, uncertainty and extent concepts given by Williamson (1985) under Colbert and Spicer’s (1995) research applies or not in a multinational Dutch bank.
Finally, the Bank’s case is a suitable one to connect the strategy, structure and products under the discussion to the transfer pricing in the company. According to Spicer (1988, p.316) “the dimensions of intra-firm transfers of intermediate product are jointly related to a firm’s diversification strategy, its product design and its organization structure. Diversification strategy and product design determine the types of transactions entered into by firms. Organization structure determines how the firm will divide these transactions or activities among operating subunits.” As a concluding section, the Bank’s case is going to discuss the transfer pricing methodology of the selected service flows and banking transactions between the Bank and its foreign branches or its associated entities via taking its diversification strategy, product design and organization structure into account.
As the outline of this company project, in the following section, OECD Transfer Pricing Guidelines, transfer pricing relevant concepts, frameworks in the TP literature is going to be elaborated. Following that, the case of the Bank is going to be explained. The theoretical explanations from the OECD guidelines and the TP literature are going to be discussed in the business setting of the Bank in the following section. The project is going to be concluded in the wrap up section that provides a short summary and an analysis of the take away points and recommendations for further research on the subject matter.
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II. Literature Review
When transfer pricing is mentioned, it is imperious to treat the issue from a taxation point of view. The base document in explaining the arm’s length principle will therefore be based on OECD Transfer Pricing Guidelines. In the meantime, the transfer pricing literature relevant to the disciplines other than taxation matters will be under the focus; since the scholars approach the matter from fiscal as well as strategical, organizational, economical and international business perspectives. Going forward the literature, the parts of the puzzle will be completed via its references to the guidelines and the project case.
A. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations
OECD issued its first report in 1979 as “Transfer Pricing and Multinational Enterprises”. The report evolved into “OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations”, which is updated in 2010 latest.3 It covers the sections of The
Arm's Length Principle, Traditional Transaction Methods, Other Methods, Administrative Approaches to Avoiding and Resolving Transfer Pricing Disputes, Documentation, Special Considerations for Intangible Property, Special Considerations for Intra-Group Services and Cost Contribution Arrangements chapters and annexes. For the main purpose of this project, the arm’s length principle, transactional transaction and other methods and special considerations for intra-group services chapters will be covered.
Before beginning to cover the chapters aforementioned, it is worth to explain that the guidelines take the “separate entity” treatment where each entity in a MNE group is treated separately for taxation purposes as long as the transactions in between are realized through
3 “The Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations were originally
approved by the OECD Council in 1995. They were completed with additional guidance on cross-border services, intangibles, costs contribution arrangements and advance pricing arrangements in 1996-1999. In the 2009 edition, some amendments were made to Chapter IV, primarily to reflect the latest developments on dispute resolution.
In 2010, Chapters I-III were substantially revised with the addition of new guidance on the selection of the most appropriate transfer pricing method to the circumstances of the case, on how to apply transactional profit methods (the transactional net margin method and the profit split method) and on how to perform a comparability analysis. Furthermore, a new Chapter IX was added, dealing with the transfer pricing aspects of business restructurings.” (http://www.oecd.org/tax/transfer-pricing/transfer-pricing-guidelines.htm retrieved in August 2015)
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arm’s length principle. Arm’s length pricing eliminates special conditions that may be created within a group of MNE’s and that may affect the profitability levels of this group of related entities. OECD states that this is to “…serve the dual objectives of securing the appropriate tax base in each jurisdiction and avoiding the double taxation, thereby minimizing conflict between tax administrations and promoting international trade and investment.” (OECD, 2010, p.P-2). The report defines two enterprises as “associated” when “one of the enterprises participates directly or indirectly in the management, control, or capital of the other or if “the same persons participate directly or indirectly in the management, control, or capital” of both enterprises.” (ibid, p.P-3). In such a case then, “transfer prices are the prices at which an enterprise transfers physical goods and intangible property or provides services to associated enterprises.” (ibid). The report indicates that “transfer prices are significant for both taxpayers and tax administrations because they determine in large part the income and expenses and therefore taxable profits, of associated enterprises in different tax jurisdictions.” (ibid). Since the matter itself is complicated and more than one tax jurisdictions are affected, to prevent the double taxation of the same income in those jurisdictions a consensus is necessary, so that the guidelines also aim for the cooperation of different countries involved.
In addition to the points mentioned above, it is worth to note that OECD simply sees the issue from a “what if the transactions were done in between two independent enterprises” point of view, and try to apply this perspective in the transfer pricing discussion.
In the following section as a beginning the arm’s length principle will be discussed.
i. Arm’s Length Principle
OECD sets forward he arm’s length principle (“ALP” hereafter) exactly as follows4:
“When conditions are made or imposed between ... 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,
4 As stated in “...paragraph 1 of Article 9 of the OECD Model Tax Convention, which forms the basis of
bilateral tax treaties involving OECD Member countries and an increasing number of non-Member countries.” (OECD 2010 p. I-3)
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have not so accrued, may be included in the profits of that enterprise and taxed accordingly” (OECD, 2010, p. I-3)
In a simpler way, a transaction is priced in arm’s length when the price is identified in between the associated enterprises as it is identified with the third party enterprises. In such a way, market is the identifier of the price and there are no tax motivations behind.
However, ALP is not as simply applicable as it is explained above. OECD admits this difficulty and complicatedness for some cases where “...MNE groups dealing in the integrated production of highly specialized goods, in unique intangibles, and/or in the provision of specialized services” (ibid, p.I-4) and where “...associated enterprises may engage in transactions that independent enterprises would not undertake.” (ibid). These kind of transactions may not be a result of tax avoidance motivation but simply the dynamics are different between associated enterprises. In such cases it is difficult to identify the market price of such transactions since no direct similar transaction can be found in the market.
Furthermore, ALP is usually not very easy to apply because of getting and interpreting a comparable transaction data is not easy. There are many issues associated with comparability, and OECD stresses upon the fact that TP “...is not an exact science but does require the exercise of judgement on the part of both tax administration and taxpayer” (ibid p.I-5). In any case, comparability analysis is required because of the fact that any two independent enterprises would evaluate a potential transaction with the other available options and choose the most attractive / beneficial option among them. “...one enterprise is unlikely to accept a price offered for its product by an independent enterprise if it knows that other potential customers are willing to pay more under similar conditions.” (ibid p.I-7)5 For the sake of a
healthy comparison, it is necessary to take into account “...material differences
5 The comparison mentioned here addresses the comparable uncontrolled price method, which is going to be
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between the compared transactions or enterprises...that would affect conditions in arm’s length dealings.” (ibid, p.I-8).
When it comes to the factors determining comparability, OECD takes into account several factors as characteristics of property or services, that results in the differences in the values; functional analysis, that compares the functions performed, assets utilized and risks assumed; contractual terms, that distributes or divides “...the responsibilities, risks and benefits” between the parties (ibid p.I-12); economic circumstances, where the parties should take into account the separate market circumstances into account; and the business strategies, that could affect the comparability of the transactions.
The first factor in determining comparability as the characteristics for services, it is important to take “...the nature and extent of the services...” (ibid p.I-9) provided into account. The second factor -the functional analysis- is to identify the functions that each enterprise performs by taking the assets utilized and risks undertaken into account “...will determine to some extent the allocation of risks between the parties, and therefore the conditions each party would expect in arm’s length dealings.” (ibid, p.I-11). Especially, “in arm’s length dealings it generally makes sense for parties to be allocated a greater share of those risks over which they have relatively more control.” (ibid). While the contractual terms –as the third factor- would be binding for both parties, the fourth factor mentioned as economic circumstances takes the market differences into account. According to OECD, it is of importance to identify “...available goods or services... the geographic location; the size of markets; the extent of competition in the markets and the relative competitive positions of the buyers and sellers; the availability (risk thereof) of substitute goods and services; the levels of supply and demand in the market as a whole and in particular regions, if relevant; consumer purchasing power; the nature and extent of government regulation of the market; costs of production, including the costs of land, labor, and capital; transport costs; the level of the market (e.g. retail or wholesale); the date and time of transactions; and so forth.” (ibid, p.I-13). As the final factor in determining comparability, the business strategies such as “...innovation and new product
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development, degree of diversification, risk aversion, assessment of political changes, input of existing and planned labor laws, and other factors bearing upon the daily conduct of business.” (ibid). Also an entity “...might temporarily charge a price for its products that is lower than the price charged for otherwise comparable products in the same market.” (ibid) to penetrate a market or increase market share; or the same entity may follow a strategy “...that temporarily decreased profits in return for higher long-run profits...” (ibid, p.I-14). However it should be noted that such strategies “...may fail, and the failure does not of itself allow the strategy to be ignored for transfer pricing purposes.” (ibid).
The comparability factors are succeeded by the recognition of actual transactions undertaken section, where the substance over form is taken into account briefly and the tax authorities may correct or restructure the transactions according to a normal business relationship between two separate entities.
An ALP usually is determined via a pricing range. “...because transfer pricing is not an exact science, there will also be many occasions when the application of the most appropriate method[s] produce[s] a range of figures all of which are relatively equally reliable... [Because of the fact that] the application of the ALP only produces an approximation of conditions that would have been established between independent enterprises.... [Or] when more than one method is applied to evaluate a controlled transaction.” (ibid, p.I-19).
In order to identify the pricing motivation, OECD suggests linking the transfer pricing analysis to the multiple year financial statements of the enterprise. As a result “...whether a taxpayer’s reported loss on a transaction is part of a history of losses on similar transactions, the result of particular economic conditions in a prior year that increased costs in the subsequent year, or a reflection of the fact that a product is at the end of its life cycle.” (ibid p.I-20) could be better understood. If an entity in an MNE group is constantly in a loss making position, while the remaining companies are profitable, it is questionable from a transfer pricing point of view since an
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independent entity in such a position would be spun off or liquidated in short a while. “...an MNE group may need to produce a full range of products and/or services in order to remain competitive and realize an overall profit, but some of the individual product (or service) lines may regularly loss revenue. ... An independent enterprise would perform such a service only if it were compensated by an adequate service charge.” (ibid p.I-21) But when business strategies are taken into account “recurring losses for a reasonable period may be justified in some cases ... to set specially low prices to achieve market penetration.” (ibid p.I-22)
The OECD guidelines are much more detailed in terms of the explanations to each possible scenario that could be possible regarding the ALP, however for this project the section above probably covers the most relevant areas. These items will be examined under the results section in detail. The traditional transaction methods will be the subject of next section.
ii. Traditional Transaction Methods
OECD recognizes three methods under traditional classification which are comparable uncontrolled price (“CUP” hereafter), resale price (“RP” hereafter) and cost plus (“CP” hereafter) methods. Before the discussion of these methods, it is worth to remind once again that OECD’s perspective on transfer pricing is from a “what if the transactions were done in between two independent enterprises” point of view. In that respect, OECD’s preferred TP methodologies are traditional transaction methods. It is also noted in the guidelines as “traditional transaction methods are to be preferred over transactional profit methods as a means of establishing whether a transfer price is at arm’s length, i.e. where there is a special condition affecting the level of profits between associated enterprises...” (ibid, p.III-16). OECD however recognizes that in some cases “...traditional transaction methods cannot be reliably applied alone or exceptionally cannot be applied at all. These would be considered cases of last resort.” (ibid). In such conditions even, an entity should first check the eligibility of the traditional transaction methods, and only then if it does not work should check for the other methods.
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The details will be explained further below:
a. CUP: Being the preferred method by the OECD, it “compares the price charged for property or services transferred in a controlled transaction to... a comparable uncontrolled transaction in comparable circumstances. If there is any difference between the two prices, this may indicate that the conditions of the commercial and financial relations of the associated enterprises are not arm’s length, and the price in the uncontrolled transaction may need to be substituted for the price in the controlled transaction.” (ibid p.II-2). For the comparability of the uncontrolled transaction, one of the two conditions mentioned should be met: 1) none of the differences of transactions or entities could materially affect the open market price or 2) reasonably accurate adjustments could be made to get rid of those material differences. As stated above, OECD perceives that “where it is possible to locate comparable uncontrolled transactions, the CUP Method is the most direct and reliable way to apply the ALP.” (ibid p. II-3).
Although it may be difficult to determine reasonably accurate adjustments in cases there are differences between transactions or entities OECD again asks being insistent on application of CUP via practical changes or flexible ways: “every effort should be made to adjust the data so that it may be used appropriately in a CUP method” (ibid p. II-3) “If a reasonably accurate adjustment cannot be made, the reliability of the CUP method would be reduced, and it might be necessary to combine the CUP method with other less direct methods, or to use such methods instead” (ibid p.II-4)
b. RP: This is a method where the reseller’s margins are compared for ALP purposes. It is explained with the gross margin (or resale price margin) of the reseller entity in a three entity setting, where a product is sold between the first two associated entities (i.e. manufacturing company to marketing / sales company) and then resold to an independent entity. The reseller entity
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“...would seek to cover its selling and other operating expenses and, in the light of the functions performed (...assets used and risks assumed), make an appropriate profit.” (ibid p.II-5). In such a case the gross margin of the reseller entity should be comparable to the gross margin of an independent reseller.
According to OECD, this method requires fewer adjustments than the CUP since the reselling function is not really affected from the product differences that much. As an example “...a distribution company performs the same functions (taking into account assets used and risks assumed) selling toasters as it would selling blenders, and hence in a market economy there should be a similar level of compensation for the two activities.” The two different products however would have different cost structures in the production level, so the margins should not be necessarily the same as they are not substitute products to each other. Yet closer products would prove better comparability, according to OECD (ibid p.II-6).
In any case OECD’s explanations are conservative in RP method, since it is also possible that two different entities may be conducting business on different levels of gross margins. Accordingly, “...if there are material differences in the ways the associated ... and independent...” entities conduct their business, the reliability of the RP might be affected (ibid p.II-7). Also the functional analysis may prove that two enterprises are not comparable. In cases the value of a product is not altered by the reseller, it might be easier to define an appropriate reselling margin; while “...it may be more difficult to use the RP method to arrive at an arm’s length price where, before resale, the goods are further processed or incorporated into a more complicated product so that their identity is lost or transformed (e.g. where components are joined together in finished or semi-finished goods.)” Adding to that, if the reseller adds “...substantially to the creation or maintenance of intangible property associated with the product (e.g. trademarks or tradenames) which are owned by an associated enterprise...” the gross margin comparable could not be easily identified. (ibid) It is also noted that if the time between purchase and resale is
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short, the RP method will be more accurate since the time factor might bring other elements into the equation such as currency fluctuations, inventory costs and so on (ibid).
Similar to the points mentioned above, “it should be expected that the amount of RP margin will be influenced by the level of activities performed by the reseller.... if the reseller in the controlled transaction does not carry a substantial activity but only transfers the goods to a third party, the RP margin could, in light of the functions performed, be a small one.” So the more expertise performed by the reseller that adds value to the product, or the reseller assumes more risks, a higher RP margin should be expected. As a result, in such situations the margins derived from uncontrolled transactions which do not have similar conditions must be adjusted to make them comparable.
c. CP: This is probably the simplest method among all the TP methods, as long as the costs of the entity that supplies the product or service to an associated entity are accurately measured. The CP method is applied via adding an appropriate profit mark-up on top of the costs incurred by this supplying entity. According to OECD, “this method probably is most useful where semi-finished goods are sold between related parties, where related parties have concluded joint facility agreements or long-term buy-and-supply agreements, or where the controlled transaction is the provision of services.” (ibid p.II-11). “The cost plus mark-up of the supplier in the controlled transaction should ideally be established by reference to the cost plus mark-up that the same supplier earns in comparable uncontrolled transaction.” (ibid).
As the cost plus requires the profit margin to be added on the costs, an entity should well estimate its costs to be profitable. However in some cases, these costs even might not be determinants of the appropriate profits. “While in many cases companies are driven by competition to scale down prices by reference to the cost of creating the relevant goods or providing the relevant
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service, there are other circumstances where there is no discernible link between the level of costs incurred and a market price (e.g. where a valuable discovery has been made and the owner has incurred” (ibid p.II-12). Cost bases of the comparable entity and the associated entity are recommended to be comparable as well: “for instance, if the supplier to which reference is made in applying the CP method in carrying out its activities employs leased business assets, the cost basis might not be comparable without adjustment if the supplier in the controlled transaction owns its business assets.” (ibid). Again a functional analysis, where the assets utilized and risks assumed might be necessary. Further than that point, comparability issue also depends on consistent accounting practices: “Where the accounting practices differ in the controlled transaction and the uncontrolled transaction, appropriate adjustments should be made to the data used to ensure that same type of costs are used in each case to ensure consistency.” (ibid, p.II-14)
It might be useful to check all the explanations that OECD puts forward regarding those items, but for our case, these explanations seem to be detailed enough. In the following section, other methods will be examined.
iii. Other Methods
The other methods mentioned in OECD TP Guidelines are “profit split method” (“PS” hereafter) and “transactional net margin method” (“TNM” hereafter). These methods are also referred as transactional methods or transactional profit methods, since in such methods the profits derived from specific transactions between associated entities are under the focus. It is stated that methods specified as comparable profits or modified cost plus / resale price would be acceptable as long as they are consistent with OECD guidelines. Global formulary apportionment is absolutely not relevant and rejected (ibid p.III-1). The guidelines has a dedicated section explaining the reasons to not to apply global apportionment formula and why the ALP is comparably better than this alternative. This project does not cover any cases relevant to the formula apportionment matter; thus in this section only the two main transactional methods is going to be examined.
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According to OECD the transactional profit methods are rarely needed. But there might be conditions where a specific controlled transaction is necessarily compared to an uncontrolled transaction. “... in those exceptional cases in which the complexities of real life business put practical difficulties in the way of application of the traditional transaction methods...” transactional profit methods may be used to get an arm’s length price (ibid). The methods however should not be used to over-tax entities with lower than average profits or vice versa, because “there is no justification under the arm’s length principle for imposing additional tax on enterprises that are less successful than average...” because of the commercial factors. (ibid p.III-2)
a. PS: The name of the method explains the underlying idea: “The PS method first identifies the profit to be split, for the associated enterprises from the controlled transactions in which associated enterprises are engaged. It then splits those profits between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length.” (ibid p.III-2/3). The functional analysis for the entities engaged in the transaction, which is the identification of functions performed by different entities (taking into account assets used and risks assumed), is required in the PS process.
According to the guidelines, this method is applicable even when no uncontrolled comparable transactions exist, so it is not dependent on the market data. So it offers a sort of flexibility in such situations. It is added that since the existing profit is split between the entities engaged in the transaction, it is highly unlikely for one entity to get an extremely high portion of the profit. However in the cases where the external market data is analyzed, the relevancy level would be lower since the method is used for specific transactions. Also it may be difficult to apply the method itself since it requires judgement of parties involved, the accounting practices, currencies
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and other relevant elements would be creating complexity issues. With these qualities, it might be a more relevant practice for the joint ventures than the other forms of enterprises (ibid p.III-3/4).
In the application of the method, the profits would be usually projected profits rather than actual ones (ibid p.III-5) and generally the profit to be split is the operating profit (ibid p.III-6). There might be exceptional cases where gross profits could be used as well or the profits might be split in such a way that each company involved in the transaction would earn the same return on capital. The bottom line of all the explanations that the guideline makes is that the case of associated entities should be elaborated as approximate as possible to a case where independent entities would take the same business relationship at arm’s length and split the overall profit from the relevant transaction accordingly (ibid p.III-8).
b. TNM: This method analyses the net profit margin of an entity -relevant to a suitable base such as cost, asset or sales i.e. return on assets, operating income to sales- from a controlled transaction realized with an associated entity with the reference ideally to the net profit margin that the same entity earns in a comparable uncontrolled transaction, or in cases where this is not possible, to the net profit margin that an independent entity would have earned in a comparable transaction (ibid p.III-9).
Usually TNM method is less sensitive to price differences and more tolerant to some functional differences than CUP method. In addition, although the functional analysis is necessary, it is not necessary to do it for more than a company. Yet the net margins could be affected from many factors which has no direct relationship with the transfer pricing itself and could make the method less reliable in comparison to other methods (ibid p.III-10/11). For example, the price differences would have an effect on the gross margin (revenues minus COGS) but the net margin –by covering the remaining part of
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the income statement- is not going to reflect the price differences of a product directly. In such a case it is not very easy task to find a similar comparable entity with both similar products and similar cost structure, operating expenses, financing expenditures and so on. As the net margins could be affected by internal factors, external factors could have a significant effect on the net margins. OECD guidelines give reference to several possible factors including the ones in Michael Porter’s Five Forces (2008) analysis “... threat of new entrants, competitive position, management efficiency and individual strategies, threat of substitute products, varying cost structures ... , differences in the cost of capital (e.g. self-financing versus borrowing), and the degree of business experience.” (ibid, p.III-12/13). As it is a very sensitive method to many factors including the ones mentioned above, it should be used with utmost care according to OECD (ibid).
Regarding how to use the method, as it is a transactional profit based method, it would not be a correct application if it is applied on a company wide basis where a company is involved more than a product line. The net margin under the analysis should be free from any distortions of the net margin of comparable product line and multiple year data should be considered for consistency purposes. “...multiple year data could show whether the independent enterprises that engaged in comparable uncontrolled transactions had suffered from the effects of market conditions in the same way and over a similar period as the associated enterprise under examination. Such data could also show whether similar business patterns over a similar length of time affected the profits of comparable independent enterprises in the same way as the enterprise under examination.” (ibid, p.III-15).
iv. Special Considerations for Intra-Group Services
MNE’s can perform or receive intra-group services that may be available from a wide scope like administrative, financial, technical, commercial and so on. OECD here addresses two main questions regarding these intra-group services: whether the services are actually performed and what the arm’s length price for such services
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would be (ibid, p.VII-1/2). In addressing the first question, it is significant to identify “...whether the activity provides a respective group member with economic or commercial value to enhance its commercial position.” (ibid). The value of the intra-group services can be detected whether the entity would pay for the same service to an independent entity or would perform it in-house as well. If the answer is no, then the services are deemed not performed (ibid). OECD names these types of activities as “shareholder activity”. “Such an activity would be one that a group member (usually the parent company or regional holding company) performs solely because of its ownership interest in one or more other group members, i.e. in its capacity as shareholder. This type of activity would not justify a charge to the recipient companies.” (ibid, p.VII-3). Some types of shareholder activities are specified in the guidelines as well: “...costs of activities relating to the juridical structure of the parent company itself, such as meetings of shareholders of the parent, issuing of shares in the parent company and costs of supervisory board; costs relating to reporting requirements of the parent company including the consolidation of reports; costs of raising funds for the acquisition of its participations.” (ibid, p.VII-4). The general guide for identifying shareholder services from non-shareholder services would be considering if an independent entity would be willing to pay for such services (ibid).
The TP Guidelines also specify centralized services which are deemed as intra-group services since an independent entity would be willing to pay for: “Other activities ... are those centralized in the parent company or a group service center ... and made available to the group (or multiple members thereof). The activities that are centralized depend on the kind of business and on the organizational structure of the group, but in general they may include administrative services such as planning, coordination, budgetary control, financial advice, accounting, auditing, legal, factoring, computer services; financial services such as supervision of cash flows and solvency, capital increases, loan contracts, management of interest and exchange rate risks, and refinancing; assistance in the fields of production, buying, distribution and marketing; and services in staff matters such as recruitment and training.” (ibid, p.VII-5). The main principle is always “what an independent entity would do” in such a situation, so for intra-group services we have the same perspective of OECD.
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After the identification of intra-group services, the next step is to determine the arm’s length price for such services. The TP Guidelines distinguish between direct and indirect charging of such services. Direct charging occurs where associated enterprises are charged for specific services (ibid, p.VII-7). Indirect charging occurs where it is difficult to identify the amount to charge directly; so arrangement of such charges are done by MNE’s by allocating or apportioning relevant costs with approximated values. “While every attempt should be made to charge fairly for the service provided, any charging has to be supported by an identifiable and reasonably foreseeable benefit. Any indirect-charge method should be sensitive to the commercial features of the individual case (e.g., the allocation key makes sense under the circumstances), contain safeguards against manipulation and follow sound accounting principles, and be capable of producing charges or allocations of costs that are commensurate with the actual or reasonably expected benefits to the recipient of the service.” (ibid, p.VII-8). As an example to indirect charging would be to use an allocation key, such as turnover or stuff size, where any service activity is centrally conducted and direct or indirect effects of this service could not be easily measured; or where it does not commercially make sense to measure / analyze the service per each associated entity. The allocation key should have a degree of relevance and consistency with the underlying service.
Pricing of intra-group services should be also identified via the methods explained above; especially recommended methods are CUP and CP. Where there is a comparable intra-group service (of which the comparability is examined according to the details explained in the previous sections) the CUP would be the preferable method. However “A cost plus method would likely be appropriate in the absence of a CUP where the nature of the activities involved, assets used, and risks assumed are comparable to those undertaken by independent enterprises.” (ibid, p. VII-10/11). Where these two methods are not applicable, other methods could be considered as well.
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In terms of other conditions, a functional analysis where functions performed (taking into account the assets employed and risks assumed) would be necessary to justify the pricing of such services.
One other important point is whether an intra-group service should always make profit according to ALP. The regular conduct of business would be aiming at profit for an independent entity. However OECD accepts that even for independent entities, it may not be always possible to realize profit from services performed, as also explained earlier, for the reasons of penetrating to a market, gaining new customers and so on. “Therefore, it need not always be the case that an arm’s length price will result in a profit for an associated enterprise that is performing an intragroup service.” (ibid, p.VII-11). This may be also the case for a group of associated entities, where they seek the convenience / benefit of their own company group. “It would not be appropriate in such a case to increase the price ... just to make sure the associated enterprise makes a profit. Such a result would be contrary to the arm’s length principle.” (ibid, p.VII-12).
In cases where an entity makes a central purchasing of any specific service, the underlying nature of the recharges to the associated entities should be taken into account. For instance “...an associated enterprise may incur the costs of renting advertising space on behalf of group members, costs that the group members would have incurred directly had they been independent. In such a case, it may well be appropriate to pass on these costs to the group recipients without a mark-up, and to apply a mark-up only to the costs incurred by the intermediary in performing its agency function.” (ibid, p.VII-13).
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B. Transfer Pricing Literature
The OECD TP guidelines document as explained to the extent that is relevant to the project case. It explains the subject matter and sets the stage for the ALP from the perspective of countries and the taxation authorities. How the scholars approach the matter yet is another story. Having a much more earlier background on the transfer pricing matter, scholars have a wider perspective on the transfer pricing issue than the OECD does. For example, Cools & Emmanuel (2007, p.574) stated that OECD standards are accepted by 30 member governments but “this does not mean that all tax authorities interpret or apply the standard in the exact same way…As Pagan and Wilkie (1993) clearly state: Tax authority thinking is national, not global, and principally uses methodology for establishing individual transaction profit. By contrast, the commercial thinking of the MNE is global, not national, and the emphasis is on consolidated accounts or results.” In this section, the transfer pricing literature is going to be revisited and details from several point of views of those scholars will be examined within the structure of the company project in the following section.
i. TP in Management & Cost Accounting Literature
As a part of Management and Cost Accounting discipline, transfer pricing is usually explained with only a limited reference to its taxation consequences. The major focus is on – but not limited to- how management control systems work, how decentralization and divisional autonomy would affect transfer prices, how to calculate TP and how the relevant problems are, what are the possible conflict points between managers of different units / entities, how the motivation of sub-unit managers are affected, performance management in its reference to overall strategy of the entity (Drury, 2013, p.358-359; Horngren et al. 2012, p796-797).
Horngren et al. (ibid) start with explaining what a management control system is and how it should be designed to make it effective. Accordingly “a management control system is a means of gathering and using information to aid and coordinate the planning and control decisions throughout the organization and to guide the behavior of managers and other employees. Effective management control systems (a) are closely aligned to the organization’s strategy, (b) support the organizational responsibilities of individual managers,
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and (c) motivate managers and other employees to give effort to achieve the organization’s goals.” (ibid). Then the authors continue with the benefits of decentralization including greater responsiveness to local needs, faster decision making process, positive effect on the motivation of subunit managers; and costs of decentralization including less than optimal decision making, too much focus on subunits, costly information gathering and duplicate activities. For Horngren et al., the transfer pricing between these subunits could be market or cost based or a mix of these two. The main goals of TP are promoting goal congruence, motivating management effort, and helping evaluating the performances and, if desired, preserving the autonomy of subunits. The authors explain that in theory, the perfectly competitive markets promote market-based prices where there is no unused capacity and where autonomous subunit managers buy and sell as they require (ibid). The optimal decision of market-based prices are dependent on the conditions as existence of perfectly competitive markets for intermediate products, minimal level interdependencies of subunits and no difference between buying internally or from the market. Since the markets are not perfectly competitive, TP is usually below the external market level but above the variable cost of the selling entity (ibid, p.784-785). If there is no external market for the intermediate product, no market prices are available, not relevant or too costly to find out, the intermediate product is customized, or different than the alternatives in the market, the cost-based TP would be appropriate to use (ibid). It might not result in the optimal decision-making since cost-based TP results in the buying entity would treat the fixed costs plus the mark-up of the selling entity as variable cost. The authors define the minimum transfer price as “…the incremental cost per unit incurred up to the point of transfer, plus the opportunity cost per unit to the selling division resulting from transferring products or services internally.” (ibid). Dual-pricing as a method of making both the receiving and selling divisions happy is also detailed, but for reporting and tax purposes, although it serves the goal congruence, the method is not preferred. Taxation discussion is kept minimal but it is worth to underline that the authors are aware of the fact that “tax issues may conflict with other objectives…” of TP (ibid).
Drury (2013) adds to the points discussed by Horngren et al. with the purposes of a TP system as to intentionally move profits between divisions or locations and to ensure that divisional autonomy is not undermined. The author mentions negotiated transfer prices as a separate TP method. Dual-pricing (or two-part transfer pricing) is also discussed and
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presented as the method of TP that has been advocated to resolve the conflicts between the decision making and performance evaluation objectives since both divisions could be able to report profit that would be beneficial for the separate performance evaluations of those division managers (ibid).
If short-term and long-term goals of a divisionalized entity is taken into account, as Adams & Drtina (2008, p.415-416) did, the conflict between these occurs in situations where the selling division operates below the capacity and the differential cost for internal TP is recommended. In such a situation “…buying division buys the optimal amount to maximize corporate profit. Yet the selling division calculates a lower NPV [net present value] than corporate calculates, and therefore it may not proceed with new investment. The firm would then fail to maximize shareholder value”. The solution recommended for maximizing the long-term shareholder value creation is to take market prices as TP, so that the selling division can add more capacity and for buying division it is the same as buying from the market (ibid). Obviously this approach ignores the conditions where there is no market for the intermediate product.
ii. Critics on ALP and OECD’s TP methodologies.
Counter arguments exist regarding the ALP, in which a group of associated entities should conduct their business as the independent entities would normally do. According to Cools & Emmanuel (2007, p.578-579) ALP is a concept against the theoretical explanations regarding the existence of MNEs and it is explained under three main headings as competitive advantage, dynamism and interdependencies. In explaining the competitive advantage perspective, they show evidence from the existing research on MNE’s, where they exist “…overseas in order to take advantage of structural market imperfections…” and “…the foreign direct investment…where the specific advantages of ownership, location and internalization…” justifies the motivation for global existence of entities. The MNE’s as a result being multinational enjoy some advantages in comparison to independent entities. Another perspective under the competitive advantage is the transaction cost economics that “…offers an analysis at the specific level of the transaction where investment in specific assets, the frequency of trades and market uncertainty may combine to suggest TP methods that preserve the internalization-specific advantage.” (ibid). Cools & Emmanuel specify in a
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situation “…where idiosyncratic goods or services are traded and there is high asset specificity…actual manufacturing cost is recommended as TP. In contrast “when sub-units (or associated entities in general– author) trade standard goods because inter alia asset specificity is low, market prices or the CUP is preferred” (ibid). In a situation in between these two alternatives “…where customized products or specialized designs are transferred…” negotiated transfer prices could be the alternative. (ibid) Accordingly, except the CUP, the use of negotiated transfer prices or hard bargaining is not recognized by ALP of OECD. As a result, an ALP compliant entity would lose majority of its motivation for the foreign direct investment.
In the dynamism part, Cools & Emmanuel (2007) argues that compliance with ALP may put a limit on the flexibility and readiness to change for product designs, sourcing patterns and pricing policies of an MNE. Accordingly, they point that the focus with ALP is more on “…extensive maintenance and updating of documents for tax compliance” rather than the role of strategic change (ibid).
Finally in the interdependencies part, Cools & Emmanuel (2007) examine the integration strategies of MNE’s, whether horizontal or vertical, those are caused by the internalization-specific advantages. The main idea here is that entities integrate in order to get efficiency, whether scale of economies or know how. An integrated structure of an MNE may prove hard to get any comparable structure in the market where “…the tax authorities are… forced to accept some allocation based on a cost-benefit analysis…” (ibid). Supply and demand interdependencies therefore make “providing detailed justification for the inter-connection between strategy and TP…” difficult and CUP might not be an appropriate method in doing so since “…for intangibles and some business support services, comparables do not exist and the problem becomes one of justifying apportionment or allocation methods.” (ibid). As a result, ALP assumes markets or functions can provide comparables, while foreign direct investments relate the existence of MNE’s with internalization-specific advantages that overseas markets / firms do not have (ibid p.583).
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As a criticism on TP methods of OECD, Cools & Emmanuel (2007, p.580-583) claims that all methods but CUP under ALP may have economic efficiency and performance measurement distortions. “Even CUP is questionable when supply or demand interdependencies exist.” (ibid). Accordingly, RP method that takes the deduction of a market average gross margin of independent distributors, results in a TP that tends to over-estimate the profit for the reseller if the function is transaction specific or the reseller incorporates some internalization-specific advantage. For CP method, the over-estimation tendency is with the buying unit / entity. While under PS, the accounting profit becomes important where it is possible to get an operating profit figure distorted via overhead allocations and “it is difficult to understand how the resulting transfer price or profit measure contributes in a meaningful way to economic efficiency or resource allocation.” (ibid). The TNM method’s case is alike; there are efficiency or resource allocation problems with this method as well, according to the authors.
Furthermore, the implications on performance management of the ALP within this perspective may also be distorting and the underlying tax-compliant data may not be that useful in decision making and ability to evaluate performance may be limited and potentially distorted (ibid). Cools & Emmanuel reminds however that tax authorities may not be interested in this side of the story and defend the ALP with its primary objective of equality / neutrality.
iii. Transaction Cost Economics and TP
Although explained in Cools & Emmanuel’s article above, it is worth to mention the transaction cost economics of Williamson (1985) and its relationship with transfer pricing by referring Colbert & Spicer’s “A Multi-Case Investigation of a Theory of Transfer Pricing Process” (1995). “Transaction costs are the costs of engaging in transactions via a particular institutional arrangement or governance structure.” and the discipline focuses on “the relative costs and hazards of conducting transactions within alternative governance structures.” (Colbert & Spicer, 1995, p.425). The alternative arrangements are increasingly sought by entities as the cost of transactions increase, such as internalization of transaction. The level of transaction costs are determined by asset-specificity, uncertainty or the extent of the
