Transfer pricing

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Transfer pricing refers to the setting, analysis, documentation, and

adjustment of charges made between related parties for good, services,
or use of property (including intangible property). Transfer prices among
components of an enterprise may be used to reflect allocation of
resources among such components, or for other purposes. OECD
Transfer Pricing Guidelines state, “Transfer prices are significant for
both taxpayers and tax administrations because they determine in large
part the income and expenses, and therefore taxable profits, of
associated enterprises in different tax jurisdictions.”

Many governments have adopted transfer pricing rules that apply in

determining or adjusting income taxes of domestic and multinational
taxpayers. The OECD has adopted guidelines followed, in whole or in
part, by many of its member countries in adopting rules. United States
and Canadian rules are similar in many respects to OECD guidelines,
with certain points of material difference. A few countries follow rules
that are materially different overall.

The rules of nearly all countries permit related parties to set prices in any
manner, but permit the tax authorities to adjust those prices where the
prices charged are outside an arm's length range. Rules are generally
provided for determining what constitutes such arm's length prices, and
how any analysis should proceed. Prices actually charged are compared
to prices or measures of profitability for unrelated transactions and
parties. The rules generally require that market level, functions, risks,
and terms of sale of unrelated party transactions or activities be
reasonably comparable to such items with respect to the related party
transactions or profitability being tested.
Most systems allow use of multiple methods, where appropriate and
supported by reliable data, to test related party prices. Among the
commonly used methods are comparable uncontrolled prices, cost plus,
resale price or markup, and profitability based methods. Many systems
differentiate methods of testing goods from those for services or use of
property due to inherent differences in business aspects of such broad
types of transactions. Some systems provide mechanisms for sharing or
allocation of costs of acquiring assets (including intangible assets)
among related parties in a manner designed to reduce tax controversy.

Most tax treaties and many tax systems provide mechanisms for
resolving disputes among taxpayers and governments in a manner
designed to reduce the potential for double taxation. Many systems also
permit advance agreement between taxpayers and one or more
governments regarding mechanisms for setting related party prices.

Many systems impose penalties where the tax authority has adjusted
related party prices. Some tax systems provide that taxpayers may avoid
such penalties by preparing documentation in advance regarding prices
charged between the taxpayer and related parties. Some systems require
that such documentation be prepared in advance in all cases.

Contents
[hide]

 1 Economic theory
 2 General tax principles
o 2.1 History
o 2.2 Government authority to adjust prices
o 2.3 Arm's length standard
o 2.4 Comparability
 2.4.1 Nature of property or services
 2.4.2 Functions and risks
 2.4.3 Terms of sale
  2.4.4 Market level, economic conditions and geography
o 2.5 Types of transactions
o 2.6 Testing of prices
 2.6.1 Best method rule
 2.6.2 Comparable uncontrolled price (CUP)
 2.6.3 Other transactional methods
 2.6.4 Profitability methods
 2.6.5 Tested party & profit level indicator
o 2.7 Intangible property issues
o 2.8 Services
o 2.9 Cost sharing
o 2.10 Penalties & documentation
 3 U.S. specific tax rules
o 3.1 Comparable profits method
o 3.2 Cost plus and resale price issues
o 3.3 Terms between parties
o 3.4 Adjustments
o 3.5 Documentation and penalties
o 3.6 Commensurate with income standard
 4 OECD specific tax rules
o 4.1 Comparability standards
o 4.2 Transactional net margin method
o 4.3 Terms
o 4.4 Adjustments
o 4.5 Documentation
 5 China specific tax rules
o 5.1 Documentation
o 5.2 General principles
o 5.3 Cost sharing
 6 Agreements between taxpayers and governments and dispute
resolution
 7 Reading & overall reference list
 8 References
  9 External links

[edit] Economic theory

Transfer Pricing with No External Market

The discussion in this section explains an economic theory behind

optimal transfer pricing with optimal defined as transfer pricing that
maximizes overall firm profits in a non-realistic world with no taxes, no
capital risk, no development risk, no externalities or any other frictions
which exist in the real world. In practice a great many factors influence
the transfer prices that are used by multinational corporations, including
performance measurement, capabilities of accounting systems, import
quotas, customs duties, VAT, taxes on profits, and (in many cases)
simple lack of attention to the pricing.

From marginal price determination theory, the optimum level of output

is that where marginal cost equals marginal revenue. That is to say, a
firm should expand its output as long as the marginal revenue from
additional sales is greater than their marginal costs. In the diagram that
follows, this intersection is represented by point A, which will yield a
price of P*, given the demand at point B.

When a firm is selling some of its product to itself, and only to itself (i.e.
there is no external market for that particular transfer good), then the
picture gets more complicated, but the outcome remains the same. The
demand curve remains the same. The optimum price and quantity remain
the same. But marginal cost of production can be separated from the
firm's total marginal costs. Likewise, the marginal revenue associated
with the production division can be separated from the marginal revenue
for the total firm. This is referred to as the Net Marginal Revenue in
production (NMR) and is calculated as the marginal revenue from the
firm minus the marginal costs of distribution.

Transfer Pricing with a Competitive External Market

It can be shown algebraically that the intersection of the firm's marginal

cost curve and marginal revenue curve (point A) must occur at the same
quantity as the intersection of the production division's marginal cost
curve with the net marginal revenue from production (point C).

If the production division is able to sell the transfer good in a

competitive market (as well as internally), then again both must operate
where their marginal costs equal their marginal revenue, for profit
maximization. Because the external market is competitive, the firm is a
price taker and must accept the transfer price determined by market
forces (their marginal revenue from transfer and demand for transfer
products becomes the transfer price). If the market price is relatively
high (as in Ptr1 in the next diagram), then the firm will experience an
internal surplus (excess internal supply) equal to the amount Qt1 minus
Qf1. The actual marginal cost curve is defined by points A,C,D.

Transfer Pricing with an Imperfect External Market

If the firm is able to sell its transfer goods in an imperfect market, then it
need not be a price taker. There are two markets each with its own price
(Pf and Pt in the next diagram). The aggregate market is constructed
from the first two. That is, point C is a horizontal summation of points A
and B (and likewise for all other points on the Net Marginal Revenue
curve (NMRa)). The total optimum quantity (Q) is the sum of Qf plus
Qt.

[edit] General tax principles

Commonly controlled taxpayers often determine prices charged between
such taxpayers based in part on the tax effects, seeking to reduce overall
taxation of the group. OECD Guidelines state, at 1.2, “When
independent enterprises deal with each other, the conditions of their
commercial and financial relations (e.g., the price of goods transferred or
services provided and the conditions of the transfer or provision)
ordinarily are determined by market forces. When associated enterprises
deal with each other, their commercial and financial relations may not be
directly affected by external market forces in the same way.”
Recognizing this, most national and some sub-national income tax
authorities have the legal authority to adjust prices charged between
related parties. Tax rules generally permit related parties to set prices in
any manner they choose, but permit adjustment where such prices or
their effects are outside guidelines.[1]

Transfer pricing rules vary by country. Most countries have an appeals

process whereby a taxpayer may contest such adjustments. Some
jurisdictions, including Canada and the United States, require extensive
reporting of transactions and prices, and India requires third party
certification of compliance with transfer pricing rules.

[edit] History

Transfer pricing adjustments have been a feature of many tax systems

since the 1930s. Both the U.S. and the Organization for Economic
Cooperation and Development (OECD, of which the U.S. and most
major industrial countries are members) had some guidelines by 1979.
The United States led the development of detailed, comprehensive
transfer pricing guidelines with a White Paper in 1988 and proposals in
1990-1992, which ultimately became regulations in 1994.[2] In 1995, the
OECD issued the first draft of current guidelines, which it expanded in
1996 and 1996.[3] The two sets of guidelines are broadly similar and
contain certain principles followed by many countries. The OECD
guidelines have been formally adopted by many European Union
countries with little or no modification.

The OECD[4] and U.S.[5] systems provide that prices may be set by the
component members of an enterprise in any manner, but may be
adjusted to conform to an arm's length standard. Each system provides
for several approved methods of testing prices, and allows the
government to adjust prices to the mid-point of an arm's length range.
Both systems provide for standards for comparing third party
transactions or other measures to tested prices, based on comparability
and reliability criteria. Significant exceptions are noted below.

[edit] Government authority to adjust prices

Most governments have granted authorization to their tax authorities to

adjust prices charged between related parties.[6] Many such
authorizations, including those of the United States, United Kingdom,
Canada, and Germany, allow domestic as well as international
adjustments. Some authorizations apply only internationally.[citation needed]
Most, if not all, governments permit adjustments by the tax authority
even where there is no intent to avoid or evade tax.[7]

Adjustment of prices is generally made by adjusting taxable income of

all involved related parties within the jurisdiction, as well as adjusting
any withholding or other taxes imposed on parties outside the
jurisdiction. Such adjustments generally are made after filing of tax
returns. For example, if Bigco US charges Bigco Germany for a
machine, either the U.S. or German tax authorities may adjust the price
upon examination of the respective tax return. Following an adjustment,
the taxpayer generally is allowed (at least by the adjusting government)
to make payments to reflect the adjusted prices.

Most rules require that the tax authorities consider actual transactions
between parties, and permit adjustment only to actual transactions. [8]
Multiple transactions may be aggregated or tested separately, and testing
may use multiple year data. In addition, transactions whose economic
substance differs materially from their form may be recharacterized
under the laws of many systems to follow the economic substance.

[edit] Arm's length standard

Nearly all systems require that prices be tested using an "arm's length"
standard.[9] Under this approach, a price is considered appropriate if it is
within a range of prices that would be charged by independent parties
dealing at arm's length. This is generally defined as a price that an
independent buyer would pay an independent seller for an identical item
under identical terms and conditions, where neither is under any
compulsion to act.

There are clear practical difficulties in implementing the arm's length

standard. For items other than goods, there are rarely identical items.
Terms of sale may vary from transaction to transaction. Market and
other conditions may vary geographically or over time. Some systems
give a preference to certain transactional methods over other methods
for testing prices.

In addition, most systems recognize that an arm's length price may not
be a particular price point but rather a range of prices. Some systems
provide measures for evaluating whether a price within such range is
considered arm's length, such as the interquartile range used in U.S.
regulations. Significant deviation among points in the range may
indicate lack of reliability of data.[10] Reliability is generally considered
to be improved by use of multiple year data.[11]

[edit] Comparability
Most rules provide standards for when unrelated party prices,
transactions, profitability or other items are considered sufficiently
comparable in testing related party items.[12] Such standards typically
require that data used in comparisons be reliable and that the means used
to compare produce a reliable result. The U.S. and OECD rules require
that reliable adjustments must be made for all differences (if any)
between related party items and purported comparables that could
materially affect the condition being examined.[13] Where such reliable
adjustments cannot be made, the reliability of the comparison is in
doubt. 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:[14]

 the nature of the property or services provided between the parties,

 functional analysis of the transactions and parties,
 comparison of contractual terms (whether written, verbal, or
implied from conduct of the parties),and
 comparison of significant economic conditions that could affect
prices, including the effects of different market levels and
geographic markets.

[edit] Nature of property or services

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.[15] For example, gold prices might be adjusted based on the
weight of the actual gold (one ounce of 10 carat gold would be half the
price of one ounce of 20 carat gold).

[edit] Functions and risks

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:[16]

 Product development
 Manufacturing and assembly
 Marketing and advertising
 Transportation and warehousing
 Credit risk
 Product obsolescence risk
 Market and entrepreneurial risks
 Collection risk
 Financial and currency risks
 Company- or industry-specific items

[edit] Terms of sale

Manner and terms of sale may have a material impact on price.[17] For
example, buyers will pay more if they can defer payment and buy in
smaller quantities. Terms that may impact price include payment timing,
warranty, volume discounts, duration of rights to use of the product,
form of consideration, etc.

[edit] Market level, economic conditions and geography

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.[18]

[edit] Types of transactions

Most systems provide variations of the basic rules for characteristics

unique to particular types of transactions. The potentially tested
transactions include:

 Sale of goods. Identical or nearly identical goods may be available.

Product-related differences are often covered by patents.[19]
 Provision of services.[20] Identical services, other than routine
services, often do not exist.
 License of intangibles.[21] The basic nature precludes a claim that
another product is identical. However, licenses may be granted to
independent licensees for the same product in different markets.
 Use of money.[22] Comparable interest rates may be readily
available. Some systems provide safe haven rates based on
published indices.
 Use of tangible property.[23] Independent comparables may or may
not exist, but reliable data may not be available.

[edit] Testing of prices

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. 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 or filing tax
returns. Such testing requires a determination of how the testing must be
conducted, referred to as a transfer pricing method.[24]

[edit] Best method rule

Some systems give preference to a specific method of testing prices.
OECD and U.S. systems, however, provide that the method used to test
the appropriateness of related party prices should be that method that
produces the most reliable measure of arm's length results.[25] This is
often known as a "best method" rule. Under this approach, the system
may require that more than one testing method be considered. 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.

[edit] Comparable uncontrolled price (CUP)

Most systems consider a third party price for identical goods, services,
or property under identical conditions, called a comparable uncontrolled
price (CUP), to be the most reliable indicator of an arm's length price.
All systems permit testing using this method.[26] Further, it may be
possible to reliably adjust CUPs where the goods, services, or property
are identical but the sales terms or other limited items are different. As
an example, an interest adjustment could be applied where the only
difference in sales transactions is time for payment (e.g., 30 days vs. 60
days). CUPs are based on actual transactions. For commodities, actual
transactions of other parties may be reported in a reliable manner. For
other items, "in-house" comparables, i.e., transactions of one of the
controlled parties with third parties, may be the only available reliable
data.

[edit] Other transactional methods

Among other methods relying on actual transactions (generally between

one tested party and third parties) and not indices, aggregates, or market
surveys are:

 Cost plus (C+) method: goods or services provided to unrelated

parties are consistently priced at actual cost plus a fixed markup.
Testing is by comparison of the markup percentages.[27]
  Resale price method (RPM): goods are regularly offered by a seller
or purchased by a retailer to/from unrelated parties at a standard
"list" price less a fixed discount. Testing is by comparison of the
discount percentages.[28]
 Gross margin method: similar to resale price method, recognized in
a few systems.

[edit] Profitability methods

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:

 Comparable profits method (CPM): profit levels of similarly

situated companies in similarly industries may be compared to an
appropriate tested party.[29] See U.S. rules below.
 Transactional net margin method (TNMM): while called a
transactional method, the testing is based on profitability of similar
businesses. See OECD guidelines below.[30]
 Profit split method: total enterprise profits are split in a formulary
manner based on econometric analyses.[31]

CPM and TNMM have a practical advantage in ease of implementation.

Both methods rely on microeconomic analysis of data rather than
specific transactions. These methods are discussed further with respect
to the U.S. and OECD systems.

Two methods are often provided for splitting profits:[32] comparable

profit split[33] and residual profit split.[34] The former requires that profit
split be derived from the combined operating profit of uncontrolled
taxpayers whose transactions and activities are comparable to the
transactions and activities being tested. 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 capitalized costs.

[edit] Tested party & profit level indicator

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.[35] Testing is to be done of that party
testing of which will produce the most reliable results. 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.[36] This may be net profit on the transaction, return on assets
employed, or some other measure. Reliability is generally improved for
TNMM and CPM by using a range of results and multiple year data.[37]

[edit] Intangible property issues

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. [38]
However, where the same property is licensed to independent parties,
such license may provide comparable transactional prices. The profit
split method specifically attempts to take value of intangibles into
account.

[edit] Services

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,[39] and the price charged for such services.[40] Tax authorities in
most major countries have, either formally or in practice, incorporated
these queries into their examination of related party services
transactions.

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.[41] For this purpose, some rules differentiate
stewardship services from other 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.[42] Rules for testing prices of services may differ
somewhat from rules for testing prices charged for goods due to the
inherent differences between provision of services and sale of goods.
The OECD Guidelines provide that the provisions relating to goods
should be applied with minor modifications and additional
considerations. In the U.S., a different set of price testing methods is
provided for services. 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.[43] Transfer pricing
rules recognize that it may be inappropriate for a component of an
enterprise performing such services for another component to earn a
profit on such services. Testing of prices charged in such case may be
referred to a cost of services or services cost method.[44] Application of
this method may be limited under the rules of certain countries, and is
required in some countries.[45]

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.S. rules provide that some level of profit is
appropriate to the service performing component.[46] Testing of prices in
such cases generally follows one of the methods described above for
goods. The cost plus method, in particular, may be favored by tax
authorities and taxpayers due to ease of administration.

[edit] Cost sharing

Multi-component enterprises may find significant business advantage to

sharing the costs of developing or acquiring certain assets, particularly
intangible assets. Detailed U.S. rules provide that members of a group
may enter into a cost sharing agreement (CSA) with respect to costs and
benefits from the development of intangible assets.[47] OECD Guidelines
provide more generalized suggestions to tax authorities for enforcement
related to cost contribution agreements (CCAs) with respect to
acquisition of various types of assets.[48] Both sets of rules generally
provide that costs should be allocated among members based on
respective anticipated benefits. 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.[49]

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.[50] Tax rules may impose additional contractual,
documentation, accounting, and reporting requirements on participants
of a CSA or CCA, which vary by country.

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. Thus, a CCA participant should be
entitled to use a process developed under the CCA without payment of
royalties. 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.[51]

Participants in CSAs and CCAs may contribute pre-existing assets or

rights for use in the development of assets. 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.[52]

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.[53]

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.[54]
Both sets of rules recognize that participants may enter or leave a CSA
or CCA. 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.[55]

[edit] Penalties & documentation

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.S. rules impose a 20%
penalty where the adjustment exceeds USD 5 million, increased to 40%
of the additional tax where the adjustment exceeds USD 20 million. [56]

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.[57] Documentation
by a taxpayer need not be relied upon by the tax authority in any
jurisdiction permitting adjustment of prices. 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.

[edit] U.S. specific tax rules

U.S. transfer pricing rules are lengthy,[58] They incorporate all of the
principles above, using CPM (see below) instead of TNMM. U.S. rules
specifically provide that a taxpayer's intent to avoid or evade tax is not a
prerequisite to adjustment by the Internal Revenue Service, nor are
nonrecognition provisions. The U.S. rules give no priority to any
particular method of testing prices, requiring instead explicit analysis to
determine the best method. U.S. comparability standards limit use of
adjustments for business strategies in testing prices to clearly defined
market share strategies, but permit limited consideration of location
savings.

[edit] Comparable profits method

The Comparable Profits method (CPM)[59] was introduced in the 1992

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).

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.S. and many countries through public filings of
comparable enterprises.

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.

[edit] Cost plus and resale price issues

U.S. rules apply resale price method and cost plus with respect to goods
strictly on a transactional basis.[60] Thus, comparable transactions must
be found for all tested transactions in order to apply these method.
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.

The rules on services expand cost plus, providing an additional option to

mitigate these data problems.[61] Charges to related parties for services
not in the primary business of either the tested party or the related party
group are rebuttably presumed to be arm's length if priced at cost plus
zero (the services cost method). Such services may include back-room
operations (e.g., accounting and data processing services for groups not
engaged in providing such services to clients), product testing, or a
variety of such non-integral services. This method is not permitted for
manufacturing, reselling, and certain other services that typically are
integral to a business.

U.S. rules also specifically permit shared services agreements.[62] Under

such agreements, various group members may perform services which
benefit more than one member. Prices charged are considered arm's
length where the costs are allocated in a consistent manner among the
members based on reasonably anticipated benefits. For instance, shared
services costs may be allocated among members based on a formula
involving expected or actual sales or a combination of factors.

[edit] Terms between parties

Under U.S. rules, actual conduct of the parties is more important than
contractual terms. Where the conduct of the parties differs from terms of
the contract, the IRS has authority to deem the actual terms to be those
needed to permit the actual conduct.[63]

[edit] Adjustments

U.S. rules require that the IRS may not adjust prices found to be within
the arm's length range.[64] Where prices charged are outside that range,
prices may be adjusted by the IRS unilaterally to the midpoint of the
range. The burden of proof that a transfer pricing adjustment by the IRS
is incorrect is on the taxpayer unless the IRS adjustment is shown to be
arbitrary and capricious. However, the courts have generally required
that both taxpayers and the IRS to demonstrate their facts where
agreement is not reached.

[edit] Documentation and penalties

If the IRS adjusts prices by more than $5 million or a percentage

threshold, penalties apply. The penalty is 20% of the amount of the tax
adjustment, increased to 40% at a higher threshold.[65]

This penalty may be avoided only if the taxpayer maintains

contemporaneous documentation meeting requirements in the
regulations, and provides such documentation to the IRS within 30 days
of IRS request.[66] If documentation is not provided at all, the IRS may
make adjustments based on any information it has available.
Contemporaneous means the documentation existed with 30 days of
filing the taxpayer's tax return. Documentation requirements are quite
specific, and generally require a best method analysis and detailed
support for the pricing and methodology used for testing such pricing.
To qualify, the documentation must reasonably support the prices used
in computing tax.

[edit] Commensurate with income standard

U.S. tax law requires that the foreign transferee/user of intangible

property (patents, processes, trademarks, know-how, etc.) will be
deemed to pay to a controlling transferor/developer a royalty
commensurate with the income derived from using the intangible
property.[67] This applies whether such royalty is actually paid or not.
This requirement may result in withholding tax on deemed payments for
use of intangible property in the U.S.

[edit] OECD specific tax rules

OECD guidelines are voluntary for member nations. Some nations have
adopted the guidelines almost unchanged.[68] Terminology may vary
between adopting nations, and may vary from that used above.

OECD guidelines give priority to transactional methods, described as the

“most direct way” to establish comparability.[69] The Transactional Net
Margin Method and Profit Split methods are used either as methods of
last resort or where traditional transactional methods cannot be reliably
applied.[70] CUP is not given priority among transactional methods in
OECD guidelines. The Guidelines state, "It may be difficult to find a
transaction between independent enterprises that is similar enough to a
controlled transaction such that no differences have a material effect on
price."[71] Thus, adjustments are often required to either tested prices or
uncontrolled proces.

[edit] Comparability standards

OECD rules permit consideration of business strategies in determining if

results or transactions are comparable. Such strategies include market
penetration, expansion of market share, cost or location savings, etc.[72]

[edit] Transactional net margin method

The transactional net margin method (TNMM)[73] compares the net

profitability of a transaction, or group or aggregation of transactions, to
that of another transaction, group or aggregation. Under TNMM, use of
actual, verifiable transactions is given strong preference. However, in
practice TNMM allows making computations for company-level
aggregates of transactions. Thus, TNMM may in some circumstances
function like U.S. CPM.

[edit] Terms

Contractual terms and transactions between parties are to be respected

under OECD rules unless both the substance of the transactions differs
materially from those terms and following such terms would impede tax
administration.[74]

[edit] Adjustments

OECD rules generally do not permit tax authorities to make adjustments

if prices charged between related parties are within the arm's length
range. Where prices are outside such range, the prices may be adjusted
to the most appropriate point.[75] The burden of proof of the
appropriateness of an adjustment is generally on the tax authority.

[edit] Documentation

OECD Guidelines do not provide specific rules on the nature of taxpayer

documentation. Such matters are left to individual member nations.[76]

[edit] China specific tax rules

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Please help improve this article by adding reliable references. Unsourced material may
be challenged and removed. (July 2010)

Prior to 2009, China generally followed OECD Guidelines. New

guidelines were announced by the State Administration of Taxation
(SAT) in March 2008 and issued in January 2009.[77] The new rules
continue to apply to domestic and international transactions. These
guidelines differ materially in approach from those in other countries in
two principal ways: 1) they are guidelines issued instructing field offices
how to conduct transfer pricing examinations and adjustments, and 2)
factors to be examined differ by transfer pricing method. The guidelines
cover:

 Administrative matters
 Required taxpayer filings and documentation
 General transfer pricing principles, including comparability
 Guidelines on how to conduct examinations
  Advance pricing and cost sharing agreement administration
 Controlled foreign corporation examinations
 Thin capitalization
 General anti-avoidance

[edit] Documentation

Under the Circular, taxpayers must disclose related party transactions

when filing tax returns.[78] In addition, the circular provides for a three-
tier set of documentation and reporting standards, based on the aggregate
amount of intercompany transactions. Taxpayers affected by the rules
who engaged in intercompany transactions under RMB 20 million for
the year were generally exempted from reporting, documentation, and
penalties. Those with transactions exceeding RMB 200 million generally
were required to complete transfer pricing studies in advance of filing
tax returns.[79] For taxpayers in the top tier, documentation must include
a comparability analysis and justification for the transfer pricing method
chosen.[80]

[edit] General principles

Chinese transfer pricing rules apply to transactions between a Chinese

business and domestic and foreign related parties. A related party
includes enterprises meeting one of eight different tests, including 25%
equity ownership in common, overlapping boards or management,
significant debt holdings, and other tests. Transactions subject to the
guidelines include most sorts of dealings businesses may have with one
another.[81]

The Circular instructs field examiners to review taxpayer's comparability

and method analyses. The method of analyzing comparability and what
factors are to be considered varies slightly by type of transfer pricing
analysis method. The guidelines for CUP include specific functions and
risks to be analyzed for each type of transaction (goods, rentals,
licensing, financing, and services). The guidelines for resale price, cost
plus, transactional net margin method, and profit split are short and very
general.

[edit] Cost sharing

The China rules provide a general framework for cost sharing

agreements.[82] This includes a basic structure for agreements, provision
for buy-in and exit payments based on reasonable amounts, minimum
operating period of 20 years, and mandatory notification of the SAT
within 30 days of concluding the agreement.

[edit] Agreements between taxpayers and

governments and dispute resolution
Tax authorities of most major countries have entered into unilateral or
multilateral agreements between taxpayers and other governments
regarding the setting or testing of related party prices. These agreements
are referred to as advance pricing agreements or advance pricing
arrangements (APAs). Under an APA, the taxpayer and one or more
governments agree on the methodology used to test prices. APAs are
generally based on transfer pricing documentation prepared by the
taxpayer and presented to the government(s). Multilateral agreements
require negotiations between the governments, conducted through their
designated competent authority groups. The agreements are generally
for some period of years, and may have retroactive effect. Most such
agreements are not subject to public disclosure rules. Rules controlling
how and when a taxpayer or tax authority may commence APA
proceedings vary by jurisdiction.[83]