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Most rules provide standards for when unrelated party prices, transactions, profitability or other items are considered sufficiently comparable in testing related party items. The U. Comparability of tested prices with uncontrolled prices is generally considered enhanced by use of multiple data.
Transactions not undertaken in the ordinary course of business generally are not considered to be comparable to those taken in the ordinary course of business. Among the factors that must be considered in determining comparability are: [37].
Comparability is best achieved where identical items are compared. However, in some cases it is possible to make reliable adjustments for differences in the particular items, such as differences in features or quality. Buyers and sellers may perform different functions related to the exchange and undertake different risks. For example, a seller of a machine may or may not provide a warranty. The price a buyer would pay will be affected by this difference.
Among the functions and risks that may impact prices are: [39]. Manner and terms of sale may have a material impact on price. Terms that may impact price include payment timing, warranty, volume discounts, duration of rights to use of the product, form of consideration, etc. Goods, services, or property may be provided to different levels of buyers or users: producer to wholesaler, wholesaler to wholesaler, wholesaler to retailer, or for ultimate consumption. Market conditions, and thus prices, vary greatly at these levels. In addition, prices may vary greatly between different economies or geographies.
For example, a head of cauliflower at a retail market will command a vastly different price in unelectrified rural India than in Tokyo.
Buyers or sellers may have different market shares that allow them to achieve volume discounts or exert sufficient pressure on the other party to lower prices. Where prices are to be compared, the putative comparables must be at the same market level, within the same or similar economic and geographic environments, and under the same or similar conditions.
Tax authorities generally examine prices actually charged between related parties to determine whether adjustments are appropriate. Such examination is by comparison testing of such prices to comparable prices charged among unrelated parties.
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Such testing may occur only on examination of tax returns by the tax authority, or taxpayers may be required to conduct such testing themselves in advance of filing tax returns. Such testing requires a determination of how the testing must be conducted, referred to as a transfer pricing method.
Some systems give preference to a specific method of testing prices. OECD and U. Factors to be considered include comparability of tested and independent items, reliability of available data and assumptions under the method, and validation of the results of the method by other methods. The comparable uncontrolled price CUP method is a transactional method that determines the arm's-length price using the prices charged in comparable transactions between unrelated parties.
Adjustments may be appropriate where the controlled and uncontrolled transactions differ only in volume or terms; for example, an interest adjustment could be applied where the only difference is time for payment e. For undifferentiated products such as commodities, price data for arm's-length transactions "external comparables" between two or more other unrelated parties may be available.
For other transactions, it may be possible to use comparable transactions "internal comparables" between the controlled party and unrelated parties. The criteria for reliably applying the CUP method are often impossible to satisfy for licenses and other transactions involving unique intangible property, [47] requiring use of valuation methods based on profit projections. Among other methods relying on actual transactions generally between one tested party and third parties and not indices, aggregates, or market surveys are:. Some methods of testing prices do not rely on actual transactions.
Use of these methods may be necessary due to the lack of reliable data for transactional methods. In some cases, non-transactional methods may be more reliable than transactional methods because market and economic adjustments to transactions may not be reliable. These methods may include:.
Both methods rely on microeconomic analysis of data rather than specific transactions. These methods are discussed further with respect to the U. Two methods are often provided for splitting profits: [54] comparable profit split [55] and residual profit split. The residual profit split method requires a two step process: first profits are allocated to routine operations, then the residual profit is allocated based on nonroutine contributions of the parties.
The residual allocation may be based on external market benchmarks or estimation based on capitalised costs. Where testing of prices occurs on other than a purely transactional basis, such as CPM or TNMM, it may be necessary to determine which of the two related parties should be tested. Generally, this means that the tested party is that party with the most easily compared functions and risks.
Comparing the tested party's results to those of comparable parties may require adjustments to results of the tested party or the comparables for such items as levels of inventory or receivables. Testing requires determination of what indication of profitability should be used. Valuable intangible property tends to be unique. Often there are no comparable items. The value added by use of intangibles may be represented in prices of goods or services, or by payment of fees royalties for use of the intangible property.
Licensing of intangibles thus presents difficulties in identifying comparable items for testing.
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The profit split method specifically attempts to take value of intangibles into account. Enterprises may engage related or unrelated parties to provide services they need. Where the required services are available within a multinational group, there may be significant advantages to the enterprise as a whole for components of the group to perform those services. Two issues exist with respect to charges between related parties for services: whether services were actually performed which warrant payment, [61] and the price charged for such services. There may be tax advantages obtained for the group if one member charges another member for services, even where the member bearing the charge derives no benefit.
To combat this, the rules of most systems allow the tax authorities to challenge whether the services allegedly performed actually benefit the member charged. The inquiry may focus on whether services were indeed performed as well as who benefited from the services. Stewardship services are generally those that an investor would incur for its own benefit in managing its investments. Charges to the investee for such services are generally inappropriate.
Where services were not performed or where the related party bearing the charge derived no direct benefit, tax authorities may disallow the charge altogether. Where the services were performed and provided benefit for the related party bearing a charge for such services, tax rules also permit adjustment to the price charged. The OECD Guidelines provide that the provisions relating to goods should be applied with minor modifications and additional considerations. In the U. In both cases, standards of comparability and other matters apply to both goods and services.
It is common for enterprises to perform services for themselves or for their components that support their primary business. Examples include accounting, legal, and computer services for those enterprises not engaged in the business of providing such services. Testing of prices charged in such case may be referred to a cost of services or services cost method. Where services performed are of a nature performed by the enterprise or the performing or receiving component as a key aspect of its business, OECD and U.
The cost-plus method, in particular, may be favored by tax authorities and taxpayers due to ease of administration. Multi-component enterprises may find significant business advantage to sharing the costs of developing or acquiring certain assets, particularly intangible assets. Detailed U. Inter-member charges should then be made so that each member bears only its share of such allocated costs.
Since the allocations must inherently be made based on expectations of future events, the mechanism for allocation must provide for prospective adjustments where prior projections of events have proved incorrect. However, both sets of rules generally prohibit applying hindsight in making allocations. A key requirement to limit adjustments related to costs of developing intangible assets is that there must be a written agreement in place among the members.
Generally, under a CSA or CCA, each participating member must be entitled to use of some portion rights developed pursuant to the agreement without further payments. Ownership of the rights need not be transferred to the participants. The division of rights is generally to be based on some observable measure, such as by geography. Such contribution may be referred to as a platform contribution. Such contribution is generally considered a deemed payment by the contributing member, and is itself subject to transfer pricing rules or special CSA rules. A key consideration in a CSA or CCA is what costs development or acquisition costs should be subject to the agreement.
This may be specified under the agreement, but is also subject to adjustment by tax authorities. In determining reasonably anticipated benefits, participants are forced to make projections of future events. Such projections are inherently uncertain. Further, there may exist uncertainty as to how such benefits should be measured. One manner of determining such anticipated benefits is to project respective sales or gross margins of participants, measured in a common currency, or sales in units.
Upon such events, the rules require that members make buy-in or buy-out payments. Such payments may be required to represent the market value of the existing state of development, or may be computed under cost recovery or market capitalization models. Some jurisdictions impose significant penalties relating to transfer pricing adjustments by tax authorities.
These penalties may have thresholds for the basic imposition of penalty, and the penalty may be increased at other thresholds. For example, U. The rules of many countries require taxpayers to document that prices charged are within the prices permitted under the transfer pricing rules. Where such documentation is not timely prepared, penalties may be imposed, as above. Documentation may be required to be in place prior to filing a tax return in order to avoid these penalties.
Some systems allow the tax authority to disregard information not timely provided by taxpayers, including such advance documentation. India requires that documentation not only be in place prior to filing a return, but also that the documentation be certified by the chartered accountant preparing a company return.
The Comparable Profits method CPM [80] was introduced in the proposed regulations and has been a prominent feature of IRS transfer pricing practice since. Under CPM, the tested party's overall results, rather than its transactions, are compared with the overall results of similarly situated enterprises for whom reliable data is available. Comparisons are made for the profit level indicator that most reliably represents profitability for the type of business. For example, a sales company's profitability may be most reliably measured as a return on sales pre-tax profit as a percent of sales.
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CPM inherently requires lower levels of comparability in the nature of the goods or services. Further, data used for CPM generally can be readily obtained in the U. Results of the tested party or comparable enterprises may require adjustment to achieve comparability.
Such adjustments may include effective interest adjustments for customer financing or debt levels, inventory adjustments, etc. Industry averages or statistical measures are not permitted. Where a manufacturing entity provides contract manufacturing for both related and unrelated parties, it may readily have reliable data on comparable transactions. However, absent such in-house comparables, it is often difficult to obtain reliable data for applying cost-plus.