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Presented By: Anneline Venter CA(SA)

Presented By: Anneline Venter CA(SA). Transfer Pricing Year Course Lecture 5. Arm’s length Principle And Introduction to Comparability. Arm’s Length Principle. Introduction If prices do not reflect arm’s length prices tax it will distort: Tax liabilities of associated enterprises

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Presented By: Anneline Venter CA(SA)

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  1. Presented By: Anneline Venter CA(SA) Transfer PricingYear Course Lecture 5

  2. Arm’s length Principle And Introduction to Comparability

  3. Arm’s Length Principle Introduction • If prices do not reflect arm’s length prices tax it will distort: • Tax liabilities of associated enterprises • Tax revenues of host countries • Other factors than tax considerations may also distort commercial and financial relations between associated enterprises: • Customs valuations • Exchange or price controls • Cash flow requirements of enterprises

  4. Arm’s Length Principle Introduction (…continued) • Adjustment to arm’s length price sometimes needed irrespective of: • Contractual obligation to pay a particular price • Intention of the parties to minimize tax • Tax authorities should not automatically assume MNEs have sought to manipulate profits.

  5. Arm’s Length Principle Statement of arm’s length principle Article 9 OECD Model Tax Convention: “[Where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”

  6. Arm’s Length Principle Justification for use of arm’s length principle • Puts associated enterprises and independent enterprises on a more equal footing for tax purposes, thereby promoting trade. • Adopts as benchmark the normal operations of the market • No realistic or legitimate alternative exists: • Global formulary apportionment would not be acceptable in theory, implementation or practice

  7. Arm’s Length Principle Application of the arm’s length principle • Comparability analysis is at the heart of the application of the arm’s length principle (par 1.6) • Significance of Comparability analysis and meaning of “comparable’.

  8. Arm’s Length Principle Internal and External Comparable Transactions Internal Comparable External Comparable Co A Co A Co B Controlled Transaction Uncontrolled Transaction Uncontrolled Transaction Controlled Transaction

  9. Factors affecting Comparables Characteristics or Property/Services Functional Analysis Contractual Terms Economic Circumstances Business Strategies

  10. Characteristics of Property or Services Factors affecting Comparables • Tangible Property: physical features; quality and reliability, availability and volume of supply • Services: nature (shareholder or stewardship) and extent • Intangible Property: • Form of transaction: licensing or sale • Type of property: patent, trademark, know-how • Duration and degree of protection • Anticipated benefits

  11. Functional Profile Factors affecting Comparables Main category of type of transaction: • Distributor, wholesaler, retailer • Fully fledged or contract manufacturer • Fully fledged or contract marketing Sub-functions: • Manufacturing, material purchasing, • Packaging, storage of inventory, shipping • Quality control, negotiation, admin

  12. Full-Fledged Manufacturer Contract Manufacturer Profit expectation follows functions, risks and assets Expected Profit + High Manufacturing + R&D + Regional/global marketing + All risks Low _ Integrated (High) Simple (Low) Functions/Risks/ Assets Employed Loss possible 27

  13. Contractual Terms Factors affecting Comparables • Define how risks, benefits and responsibilities are divided • Analyse terms whether written or oral, explicit or implied • Independent parties will hold one another to terms and only rarely will modify • Less incentive to do so in controlled transaction:therefore examination necessary • Analysis: whether the actual conduct of the parties is consistent with terms of contract

  14. Economic Circumstances Factors affecting Comparables • Prices vary across different markets even for similar products • Essential to identify relevant market(s) related to transaction • Whole variety of factors to take into account: • Location, size, competitive position, availability of substitute goods/services, level of supply and demand, purchasing power, regulation and local costs, level of market (retail or wholesale), date and time of transactions etc.

  15. DIFFERENT ECONOMIC CIRCUMSTANCES: GDP PER CAPITA 48328 38077 35068 10970 1611 USA FRANCE GERMANY RSA ZAMBIA

  16. DIFFERENT ECONOMIC CIRCUMSTANCES: INFLATION 11,45% 7,65% 1,71% 1,67% 1,38% USA ZAMBIA RSA FRANCE GERMANY

  17. DIFFERENT ECONOMIC CIRCUMSTANCES: RISK FREE RATE 8,30% 6,85% 3,50% 2,22% 1,28% RSA ZAMBIA USA MALAWI FRANCE

  18. Business Strategies Factors affecting Comparables • Business strategies may include • start up (entering a new market) • marketing strategy to increase of market share; • Business strategy may sacrifice current for anticipated profits • What happens if anticipated profits are not in fact realized? • evaluate position critically to see if strategy is credible: e.g. look for consistent behaviour and see who bears costs and is intended to reap rewards • would independent enterprise have entered into such a scheme and would it have continued long after anticipated profits have not materialized?

  19. Arm’s Length Principle Recognition of actual transactions undertaken • Be careful of restructuring of transactions • Circumstances were restructuring will appropriate: • Economic substance differs from the form • “…(T)he arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner….”

  20. Arm’s Length Principle Losses • Situation: one group entity experience consistent losses while overall group is profitable. • Legitimate business reasons may exist: heavy start-up costs, unfavourable economic conditions or inefficiencies. • Independent enterprises would not tolerate losses indefinitely. • Loss enterprise may not be receiving adequate compensation. • Example

  21. Arm’s Length Principle Other issues • The effect of government policies • Government interventions (interest rate controls, control over royalty payments etc.) should be treated as normal market conditions. • Use of customs valuations • May not be aligned with OECD TP methods • May provide valuable contemporaneous information • Taxpayers may have competing incentive in setting prices for customs valuations and tax purposes

  22. Arm’s Length Principle Source: • OECD Guidelines: Chapter 1 • UN TP Manual for Developing Countries: Chapter 1 (section 4) • ATAF: TP for Policy Makers: Session 1: “Arm’s length range” by OECD (PDF)

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