The arm’s length principle – proxy to allocate income in a Multinational (MNE

Question 1

How to tax profits in an MNE

Answer 1

Unitary taxation and formulary apportionment
*The MNE (the whole group) is treated as a unitary entity
*The profit is divided among the individual entities based
on several indicators - apportionment formula (example:
sales/ number of workers/assets)
*Difficult agreement for tax share - weigh indicators
between countries + tax planning opportunities
* The arm’s length – intercompany prices should be
adjusted as if they were between un-related parties!
*The arm’s length method/principle adopted by most
countries in the world in Transfer Pricing

Question 2

Arms length principle

Answer 2

Treat your group entities as if they were stand alone (independent) companies

Question 3

Comparability

• We need to allocate profit to the entities of the group. Example
  – I.E. profit of a group company providing legal services to the
  whole group. How do we remunerate this group company

Answer 3

• The aim of the comparability analysis is now twofold:
  1. Identification of the commercial and financial relations between the associated enterprises in order to establish an accurate delineation of the controlled transaction [functional
  analysis – assets/risks/functions. Ie. loan/equity]
  2. Comparison of the conditions and economically relevant
  circumstances of the controlled transaction with the
  conditions of comparable transactions between independent
  enterprise

Question 4

Functional analysis

Answer 4

It analyzes the functions performed (taking into account assets used and risks assumed) by associated enterprises in a transaction.
* How will be the remuneration of these entities according to the previous functional analysis (risks, assets,
functions?
*full-fledged distributors vs limited-risk distributors
*full-fledged manufacturers vs. contract manufacturers or
toll manufacturers

Question 5

Comparability after functional analysis

Answer 5

*Identification of comparables [benchmarking]
*Internal comparables – problem of availability but also:
not always more reliable than external comparables
*External comparables: usage of commercial
databases (Amadeus). exact external comparables
are very rare (i.e. royalty for roasting coffee, unique
intangible. Data may need adjustments (e.g.
accounting models)

Question 6

Transfer pricing methods

Answer 6

One sided methods:
Resale Price Method (RPM), Cost Plus Method (CPM) and transactional Net Margin Method (TNNM)

 they apply only to one party of the transaction (the so-called “tested party”

 as a general rule: party with the less complex functional analysis

 two sided methods: Comparable Uncontrolled Price (“CUP” and Profit Split Method (“PSM”)

 apply to two or more parties of the transaction

Question 7

CUP transaction method
Comparable uncontrolled price method

Answer 7

• One company (A) sell a product to a company of the group (B) that sell to final customers (minimum of processing/no added value)
• Search for comparable – determine price paid by B to A.
• Resale price – gross margin (selling expenses leaving a net profit) = intercompany price

Question 8

Cost plus transaction method

Answer 8

*Cost of production plus a an appropriate mark-up to
make an appropriate profit in light of the functions
performed

*An arm’s length mark-up can be determined based on
the mark-up applied on comparable transactions among
independent enterprises

*low-risk, routine-like activities (manufactured products)-
no intangibles

Question 9

TNmM - Transactional profit method

Answer 9

compares the net profit margin of a taxpayer arising from a non-arm’s length transaction with the net profit margins realized by arm’s length parties from similar transactions

Question 10

Profit split - transactional profit method

Answer 10

*Intangibles
*Split the total profit by all the group companies
*Use of a formula by studying comparables

Question 11

Article 9(1) OECD MC:

Answer 11

[Where] conditions are made or
imposed between the two [associated] companies in their
commercial or financial relations which differ from those
which would be made between independent companies, then
any profits which would, but for those conditions, have
accrued to one of the companies, but, by reason of those
conditions, have not so accrued, may be included in the
profits of that enterprise and taxed accordingly.”