Action 13 of the OECD Action Plan on Base Erosion and Profit Shifting (BEPS) recognises that enhancing transparency for tax administrations by providing them with adequate information to conduct transfer pricing risk assessments and examinations is an essential part of tackling the BEPS problem.
Multinationals with a turnover above €750m in their countries of residence will be required to start using the new Country by Country (CbC) reporting template for fiscal years ending on or after 31 December 2016 with a filing deadline of 31 December 2017.
However, groups with consolidated group revenue less than €750m as at 01/01/2015 will be exempted from filing a CbC report
Therefore, existing standards on TP reporting remain valid for the foreseeable future. This note is a reminder of the key elements of those standards.
A transfer pricing report may be commissioned by an enterprise for a number of reasons, e.g. to set the parameters for a TP policy, to support an existing TP policy or to demonstrate the arm’s length nature of a historical position when there was no TP policy in place.
Whatever the reason for its production, in the initial stages of a transfer pricing audit the tax authority will inevitably ask for this documentation, which will then be examined in considerable detail to determine whether the enterprise’s transfer prices are consistent with the arm’s length position.
A well-constructed TP report will provide all the detail and evidence a tax authority could reasonably require to perform its due diligence obligations.
Whilst the enterprise may have chosen the transfer pricing method and tested party etc. it considers appropriate, the tax authority may challenge those choices. Therefore, the enterprise should be prepared to explain how the profitability of each link in the chain of related-party transactions aligns with its functions, risks, and assets.
The key elements of a well-prepared transfer pricing report are discussed below. More detail can be found in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and by following the embedded links below.
Overview of the Company, the Group and the Industry Sector
The TP report should include an overview of the industry sector and the key issues affecting it.
For both the company under review and the wider group the report should include a brief history, financial results, a structure chart (legal, organisational and operational as appropriate) and details of connected party transactions.
Details of intellectual property held within the group and company should also be given, along with their business strategies, risks and key performance indicators.
Functional analysis and review of the controlled transactions
The functional analysis is a vitally important component of the transfer pricing report. The entire report’s credibility will depend on the detail, extent and scope of the functional analysis and the quality of the supporting evidence.
The functional analysis should provide a detailed description of the transactions under review and identify and compare the “economically significant activities and responsibilities, assets used and risks assumed by the parties to the transactions.” (OECD Guidelines)
It should also cover where the various activities are carried out and who gets what reward.
The operational people in the enterprise with day to day involvement in its functions should contribute fully to the functional analysis. All assumptions should be credible and “facts” confirmed. The enterprise should be prepared to prove the accuracy of its functional analyses, with witness testimony and documentary evidence consistent with its representations.
A sound evidence-based functional analysis is also essential for the choice of tested party. This would normally be the party to the transaction(s) to which a TP method can be applied most reliably and for which the most reliable comparables can be found. It is usually the party with the less complex functional analysis. If the connected parties are involved in a number of transactions it may be that the “home” enterprise is the appropriate tested party for some and the “away” connected party for others.
It should be clear from the report what connected party transactions are being assessed and how they are carried out and priced. If any transactions are not included then this should also be clearly stated, with reasons for the omission.
In addition to assessing the transactions individually or in closely-linked groups, the report should also consider whether the combined return for all transactions may be greater than the sum of the individual component parts.
Summary of the relevant statute
A TP report will normally include a review of the relevant legislation. If it was initially prepared for the benefit of country “A” and is subsequently presented to country “B”, this section should be amended accordingly.
Leaving the report as originally written and simply stating “country B’s legislation works along similar lines” might be viewed by some in country B as suggesting that a lack of care and attention has gone in to the preparation of the report.
Review and selection of the OECD transfer pricing methods
This section often comprises a significant part of the TP report.
An enterprise is not required to use one of the OECD methods. It is entitled to set its prices as it sees fit, but of course they must be demonstrably arms length if they are to be accepted by the relevant tax authority.
Nevertheless, in the vast majority of cases one of the OECD methods will be used and so the TP report should include a review of the various TP methodologies with an explanation of why they have been selected or rejected.
The reasoning behind these decisions should be clearly presented, credible and based on the full facts and circumstances of the case.
Although no absolute hierarchy now exists within the Guidelines, the OECD states that where the comparable uncontrolled price/transaction (‘CUP’/”CUT”) method and an alternative pricing method can be applied in an equally reliable way, the CUP/CUT method is the most effective for determining the arm’s length price, because it is based on direct observations of the market.
Therefore the report should demonstrate that significant and credible work has been undertaken to identify a CUP/CUT before discarding the method and moving on to an alternative.
My earlier post here gives a detailed overview of the OECD methods.
Selection of comparables and the arm’s length range
The choice of comparables must also be considered alongside the choice of the most appropriate Transfer Pricing method for the case under review, i.e. the most appropriate benchmark for the facts and circumstances of the case, e.g. CUP/CUT, gross margin or net margin etc.
And the method chosen will only yield a reliable measure of the arm’s length result if the selected comparables are genuinely similar to the tested party.
So the enterprise must be prepared to support its chosen comparables with a factual analysis.
The best source of comparables is often the enterprise itself, when it transacts with independent third parties. Therefore, as above, the report should demonstrate that significant and credible work has been undertaken to identify internal comparables before looking externally.
External comparables should be based on data available to both the business and the relevant tax authority. In most cases this means data in the public domain because the enterprise would not be able to defend its position if based on data that cannot be disclosed or independently confirmed.
The comparability study normally delivers a range of results, which should be the result of very careful analysis, filtering and testing. Each data point in the range should be critically examined for degree of comparability and any point with a lesser degree should be discarded.
The final range is normally then refined statistically to an interquartile range against which the tested party’s results are compared.
HMRC International Manual
OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations
Transfer Pricing Audits: Flipping the Tested Party, 13/08/2015, Caplin & Drysdale (US Attorneys)
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