TRANSFER PRICING CASE STUDIES WORKSHOP SAN JOSE 31 MARCH - 4 APRIL 2 014

1. TRANSFER PRICING CASE STUDIES WORKSHOP SAN JOSE 31 MARCH - 4 APRIL 2014 3-b. Transfer Pricing Methods OECD freely authorises the use of this material for non-commercial purposes. All requests for commercial uses of this material or for translation rights should be submitted to rights@oecd.org. The opinions expressed and arguments employed herein are those of the author and do not necessarily reflect the official views of the OECD or of the governments of its member countries.

2. 5 TRANSFER PRICING METHODS OECD Recognised methods TRADITIONAL TRANSFER PRICING METHODS • Comparable Uncontrolled Price (CUP) method • Cost-plus method • Resale price method TRANSACTIONAL PROFIT METHODS • Transactional Net Margin Method (TNMM) • Profit Split Method • Contribution Analysis • Residual Analysis

3. TRADITIONAL TRANSACTION METHODS

4. CUP METHOD • Preferred method because it is the “most direct and reliable way to apply the arm’s length principle” (OECD TP Guidelines, para. 2.14) • Focus on product • Can reliable adjustments be made for differences?

5. CUP METHOD • The market price for comparable goods, services and loans between independent companies • Difficulties in finding comparables: • Goods or Services • Market (ex. geographical differences) • Market-level (wholesale or retail) • If no exact comparables  comparability adjustments for the differences • Method can best be used for commodities, raw material, agricultural products, chemical base products, financial products

6. Example Facts of the Case A wine producer in France sells champagne to its associated wholesaler (distributor) in Costa Rica. Under the contractual arrangement made with the associated wholesaler, delivery is ex factory The associated Costa Rican wholesaler incurs transportation costs of 1.50 EUR per bottle.

7. Example Facts of the Case (continued) The same producer sells the same champagne to an independent Costa Rican wholesaler for 5 € per bottle. In the contractual arrangement with the independent wholesaler, delivery is c.i.f. (cost, insurance, and freight included, i.e. the seller arranges for the carriage of the goods and bears the transportation costs). The other circumstances are the same for the associated wholesaler and the independent wholesaler. The associated and the independent wholesaler sell the champagne to independent retailers at 12.50 € per bottle.

8. Example Associated WholesalerCosta Rica RetailerCosta Rica 12.50 EUR (controlled) transaction Transfer Price? Champagne Producer France Independent Wholesaler Costa Rica 12.50 EUR Retailer Costa Rica (uncontrolled) transaction Sales Price 5 EUR The associated wholesaler incurs transportation costs of 1.50 EUR. The independent wholesaler incurs no transportation costs.

9. Case 1 Questions • Which factors should be taken into account in determining the arm’s length transfer price? • What is the arm’s length transfer price?

10. Example • The example shows that the associated wholesaler and the independent wholesaler incur the same costs of goods sold (COGS) of EUR 5 (EUR 3.50 purchase price plus EUR 1.50 transportation costs equals EUR 5).

11. COST PLUS METHOD Tested Party Multinational Enterprise Group • Calculate gross profit mark-up for manufacturer • Easiest to apply for • Semi-finished goods • Services Third Party Supplier Transfer price Manufacturer Distributor Costs at arm’s length Gross profit mark-up Transfer Price =

12. COST PLUS METHOD • Gross profit level indicator • Looks at gross profit relative to costs of goods sold

13. COST PLUS METHOD Calculation of Arm’s length price (ALP): ALP = Costs + (Cost Plus Mark-up x Costs) Cost Plus Mark-up = Sales Price - Costs Costs

14. COST PLUS METHOD Example: Manufacturing Costs $ 100 Gross Profit Mark-up 10% Arm’s length price = $ 100 + ($100 x 10%) = $ 110 Determined from comparable companies

15. DIFFICULTIES APPLYING THECOST PLUS METHOD • Measurement of cost base: • Direct costs • Indirect costs • Adjust for inconsistencies in accounting treatment! • The size of the mark-up • If applied on full cost basis  company always profitable (unrealistic)

16. Example Facts of the case: • In this case, the French wine producer (the principal) of case 1 decides to incorporate a new subsidiary in Costa Rica which shall act as a toll manufacturer. The production costs incurred by the Costa Rican toll manufacturer amount to 1.6 € per bottle of white wine. The Costa Rican toll manufacturer also incurs transportation costs (transport is done by an independent enterprise) of 1.50 € per bottle on behalf of the principal. What is the arm’s length price if you know that independent champagne toll manufacturers would earn a 25 percent gross mark up on costs.

17. Example • What is the arm’s length price? • Alternative 1: 1.6 + 0.4 (25 % on 1.6) = 2 Or • Alternative 2: 1.6 + 1.5 + 0.4 (25 % on 1.6) = 3.5 Or • Alternative 3:1.6 + 1.5 + 0.78 (25 % on 3.1 (1.6 + 1.5)) = 3.88

18. RESALE PRICE METHOD Tested Party • Calculate gross margin for distributor/reseller • Easiest to apply if reseller does not add substantially to value of product TransferPrice Sales Price to Third Party Third PartyCustomer Manufacturer Distributor Multinational Enterprise Group Sales Price to 3rd Party - Gross Profit Margin Transfer Price

19. RESALE PRICE METHOD • Gross profit level indicator • Looks at gross profit relative to sales

20. RESALE PRICE METHOD Calculation of Arm’s length price (ALP): ALP = Resale Price - (Resale Price Margin x Resale Price) Resale Price Margin = Sales Price - Purchase Price Sales Price

21. RESALE PRICE METHOD Sale Price to Third Parties $ 100 Resale Price margin 20% Arm’s length price = $ 100 - (20% x $100) = $ 80 Determined from comparable companies

22. DIFFICULTIES APPLYING THE RESALE PRICE METHOD • Reseller employs reasonably valuable and possibly unique intangibles • Reseller adds significant value to product • Exclusive license

23. Example Facts of the Case This case is based on the situation in case 1 on the CUP method. In this case, however, the associated wholesaler is the French wine producer’s exclusive distributor in Costa Rica. Under the contractual arrangement made with the associated wholesaler, delivery is ex factory. The associated wholesaler incurs transportation costs of 1.50 € per bottle. The champagne is sold to independent retailers at 12.50 € per bottle.

24. Example Facts of the Case (continued) A competitor sells champagne to an independent wholesaler in Costa Rica for 6 EUR per bottle. Delivery is c.i.f. This champagne is sold to independent retailers at 15.00 € per bottle. The other circumstances are the same for the associated wholesaler and the independent wholesaler.

25. Example (controlled) transaction Transfer Price? Associated Wholesaler Costa Rica 12.50 € Retailer Costa Rica Champagne Producer France (uncontrolled) transaction Sales Price 6 EUR Independent Champagne Producer France Independent Wholesaler Costa Rica 15 € Retailer Costa Rica The associated wholesaler incurs transportation costs of 1.50 €. The independent wholesaler incurs no transportation costs.

26. Example Questions • Which factors should be taken into account in determining the arm’s length transfer price? • Which company should be selected as tested party and why? • What is the arm’s length transfer price?

27. Example Solution

28. Example Calculating the AL price

29. TRANSACTIONAL PROFIT METHODS

30. 5 TRANSFER PRICING METHODS OECD recognised methods TRADITIONAL TRANSFER PRICING METHODS • Comparable Uncontrolled Price (CUP) method • Cost-plus method • Resale price method TRANSACTIONAL PROFIT METHODS • Transactional Net Margin Method (TNMM) • Profit Split Method • Contribution Analysis • Residual Analysis

31. What is a “profit method”? • Uses net profitability to judge transfer pricing • Must be transactional • Total profit comparisons can only be used to select cases but not to examine them

32. What is “net”? • “Net” profit is gross profit (sales minus cost of goods sold/manufactured) less operating expenses • Operating expenses exclude • Extraordinary expenses; • Interest; and • Taxes • EBIT = Earnings Before Interest and Taxes

33. Two types of profit methods • Transactional Net Margin Method (TNMM) and • Profit Split • Last resort status : removed

34. Transactional Net Margin Method (TNMM) • Guidelines 2.58 • “[TNMM] examines the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realizes from a controlled transaction…. • Must be applied in a manner consistent with resale price/ cost plus method

35. TNMM: Comparability Analysis (I) • What factors influence net profit? • May be affected by factors unrelated to transfer prices • Examine factors affecting operating expenses • Management efficiency • Competitive position • Business experience • Varying cost structures

36. TNMM: Comparability Analysis (II) • Measurement must be consistent • Items included in calculating net profit • Timing (e.g. depreciation/ amortization) • Allocation (e.g. overhead, R&D, supervisory, general & administrative) • Aggregation (across products/ businesses)

37. TNMM compared to cost plus/ resale price method • Cost Plus/Resale Price methods use gross margins computed after direct and indirect production/selling costs • no clear line, allowing for some variation in practice, but generally excludes most operating expenses • e.g. selling, general, and administrative expenses would be excluded • TNMM is a fully net method; net margin computed after all operating expenses (except extraordinary items, interest and taxes)

38. Choosing the right net margin (1) • Net profit over sales • useful for distribution, e.g., functions where personnel rather than capital assets are important to the business • resale price method analogue

39. TNMM compared to RP METHOD • Operating income level indicator • Looks at operating income relative to sales

40. Choosing the right net margin (2) • Net profit over costs • useful for manufacturing • measurement consistency may be difficult • cost plus analogue

41. TNMM compared to CP METHOD • Operating income level indicator • Looks at operating income relative to all expenses

42. Choosing the right net margin • Net profit to assets • Asset intensive (certain manufacturing activities) and capital intensive financial activities • Operating assets only (tangible, intangible and working capital assets such as inventory and trade receivables)

43. Choosing the right net margin • Other net indicators • Case by case • Floor area of retail points, weight of product transported, number of employees, time, distance, …

44. Choosing the right net margin • Berry ratios • GP/OE • Case by case • Sensitive to classification of costs • Value of functions must be proportional to operating expenses • Value of functions is not materially affected by the value of the product • Function do not include other functions that should be rewarded using another method or indicator • May be useful for intermediary activities

45. Choosing the right net margin - Berry ratio • Operating income level indicator • Looks at gross profit to operating expenses

46. Example TNMM: Assumptions • P and S are associated enterprises in different countries; P owns S • P manufactures X, a home video game • S imports X and distributes it under P’s name on the wholesale level • P makes all its sales of X to associated enterprises that are exclusive distributors for their geographic markets. • You are the tax inspector of S • Assume TNMM is the Most Appropriate Method to the Circumstances of the Case

47. EXAMPLE: Don’t forget a functional analysis!

48. Financial data Company S

49. Return on sales (net profit margin)of comparables

50. EXAMPLE: What to do now? • 2011 not in range • Find an appropriate comparable margin from year under audit (2011) • Apply the margin to determine proper level of operating profit • Calculate arm’s length price