Lecture_8_TP

Report
Presented By:
Prof A Venter CA(SA)
Selection of TP Methods:
Part II
SESSION INCLUDES:
 TRANSACTIONAL PROFITS METHODS
Transactional Net Margin
Method (TNMM)
Transactional Profit Split
Method
Selection of
TP Methods
TRANSACTIONAL PROFIT METHODS
Transactional Net Margin Method (TNMM):
 Examination of a net profit indicator: ratio of net profit
relative to an appropriate base (costs, sales or assets) of
controlled transactions with those of uncontrolled
transactions.
 Internal or external comparable transactions: based on
functional comparability (not product specifically)
 Weighted costs or sales, similar to “Cost plus method” and
“Resale Price Method” respectively: except Net profit is
compared, not gross profit/mark-up.
 Most often indicator used: Operating profit (before interest,
tax and extraordinary items)
Selection of
TP Methods
TRANSACTIONAL PROFIT METHODS
Transactional Net Margin Method (TNMM):
 Profit indicator uses:
 Against costs: manufacturing and service activities
 Against sales: sales activities
 Against: assets: asset-intensive activities
 Financial indicator should:
 Reflect the value of functions performed (assets and risks)
 Based on objective data
 Capable of being measured reliably and consistently at level of
both controlled and uncontrolled transactions
Example 1
Product X
Independent
Party
Product Y
Parent Co
CoA
Sales:
50% Product X
50% Product Y
Example 1
Example 2
DDI
DDI US
DDI
CANADA
Clients
Example 2
Asset Value $10 000 000
ROA (Canada): 10%
Profit: $1 ooo 000
$1 m/ 500 000 units = $2 profit per
unit
Cost: $10 per unit
Price: $2 per unit
Example 3
UK Parent
Good Food
Independent
Retailers
Example 3
TP Methods
TRANSACTIONAL PROFIT METHODS
Transactional Net Margin Method (TNMM):
Illustration 1: difference between Resale Price and TNMM
for distributor.
Description
Sales to independent customers
Cost of goods (from associated enterprises)
Gross Profit (60%) (Tested in resale Price Method)
Selling and other operating expenses
Amount
1000
(400)
600
(400)
Operating Profit (20% of sales) (Tested in a TNMM)
200
Interest and exceptional items
(20)
EBT (Earnings before Tax)
Income Tax
Net profit
180
(60)
120
TP Methods
TRANSACTIONAL PROFIT METHODS
Transactional Net Margin Method (TNMM):
Illustration 2: difference between Cost Plus and TNMM for
manufacturer.
Description
Cost of raw materials
Production costs
Total cost base
Mark –up (20%) (tested in a cost-plus method)
Amount
1000
(400)
600
(400)
Transfer price
200
Overheads and operating expenditure
(20)
Operating profit (5% of cost) (tested in a TNMM)
180
ZE(Zambia)
ZE
(Botswana)
GP: 9%
SP: $990
Raw product
GP: 20%
SP: $1286
GP: 20%
SP: $1286
ZE
(Kenya)
ZE(Zim)
ZE
(Tanzania)
Import & local
GP: 50%
SP: $4000
A1
Swaziland
A2
RSA
Kenya
Agent
Tanz
Agent
Angola
GP: 39%
SP: $1700
Mozam
bique
Feinschreiber
Transfer Pricing Handbook (1)
Transfer Pricing Handbook, 2
Volume Set, editor Robert
Feinschreiber (available in
Amazon.com Kindle) 11.3
WIDGET WHOLESALE (Kindle
Location 2550). Kindle Edition.
FM1
FM2
Manufacturing
WW
FM3
Independent
distributors
CA
Retailers
CA
Imports widgets
from WW
WW-US
Distribution
Other
Retailers
Feinschreiber
Transfer Pricing Handbook (2)
1. Classification:
 Identify the issue under investigation: income of US
taxpayer
 Payments made to foreign parent for purchased
goods will be investigated
 The question is whether an independent company
would be willing to pay the same prices for the goods,
as WW-US is paying the foreign parent
 Business classification: WW-US is a pure
importer/distributor
Feinschreiber
Transfer Pricing Handbook (3)
1. Classification (continued)
 Import consideration: in order to earn a profit
importers need to limit costs and expenses, such as
purchase price of goods; shipping and transport,
import duties, storage , advertising and selling
expenses
 Import contract: when dealing with independent
manufacturer, the importer will deal negotiate
contract covering various issues
 Wholesale Relationship: wholesaler imports large
quantities and makes profit from high turnover of
products, Usually has a large marketing investment.
Feinschreiber
Transfer Pricing Handbook (4)
2. Finding Comparables
 No independent importers of widgets
 Numerous importers of other durable goods with




publicly available information
Widgets do not have separate SIC code
Wholesale trade category
Comparables: distributors of consumer durables with
motorised and electronic technology, used in the
home (perceived product similarity)*
100 companies over 5 years
Feinschreiber
Transfer Pricing Handbook (5)
3. Method used





WW-USA needs to be adjusted to reflect arm’s length
purchase price for goods imported
Logic: distributors would not buy at prices it could not
sell profitably.
Only possible comparable for the transaction : resell of
independent California Distributors, adjusted for
differences for conditions of sale, models, market level,
services provided etc.
The Resale Price Method (RPM) can then be used to
determine an arm’s lengthy price.
CPM: reflects the effectiveness of applying the arm’s
length price
Feinschreiber
Transfer Pricing Handbook (6)
4. PLI’s used



Gross profit to operating expenses
Operating income on sales
Return on operating assets:
Feinschreiber
Transfer Pricing Handbook (7)
1.7
1.6
1.5
1.4
1.3
Mean less one
Mean plus one
Mean
WW adjusted
WW-USA
1.2
1.1
1
0.9
0.8
0.7
Y1
Y2
Y3
Y4
Y5
Feinschreiber
Transfer Pricing Handbook (1)
Transfer Pricing Handbook, 2
Volume Set, editor Robert
Feinschreiber (available in
Amazon.com Kindle) 11.2
Location 2409
Integrated
functions
AP1
CM -US
Independent
Contractor
Cost +15%
AP2
Imports ingredients
Exports final product to
CM-US
Royalty
5%
Independent
wholesalers
CM-EU
Manufacturing:
Modern industrial
plant
AP1
AP2
Manufacturing
functions
CM –US
Jupiter
Drinks
Technology for
5% Royalty
Contract
Manufacturer
Cost +15%
Imports ingredients
From CM-US
Distributors
CM-Nigeria
Fully-fledged
manufacturer
Independent wholesalers
in Nigeria
Feinschreiber
Transfer Pricing Handbook (1)
 A summary of the broad guidelines suggested:
 establish economic justification before the transaction




is entered into;
be satisfied that the consideration is an arm’s length
consideration;
prepare and retain contemporaneous documentation to
support the above matters and the assessment of market
conditions at the time when the pricing decisions were
made;
justify the choice of method; and
establish and consistently follow a systematic process for
setting arm’s length international transfer prices.
Feinschreiber
Transfer Pricing Handbook (2)
1. Classification:
 Identify the issue under investigation: income of US
taxpayer
 CM-EU income comes under scrutiny: receives
intangibles from US taxpayer and had higher profit
margins than the Parent
 CM-EU classified as drug manufacturer (SIC #2833)
Feinschreiber
Transfer Pricing Handbook (3)
2. Finding Comparables
 CM-EU:



Direct comparables: may possibly be CM-US
assembly plants or independent contractor used CMUS
Indirect comparables: possibly other large integrated
drug companies or smaller contract manufacturers
Functions are closer to contract manufacturers, but
incurs the costs and risks of operating in a foreign
market place.
Feinschreiber
Transfer Pricing Handbook (4)
2. Finding Comparables: Direct comparables
(transaction based)


Assembly plants of CM-US: various product lines and
integrated functions, difficult to separate one product line
for comparison.
Independent contractor: differences:
 Patent rights: reduce COS with royalty payment


Market risks: no contract guarantee, foreign market:
difficult to quantify
Advanced physical facilities: difficult to identify
which operating expenses to add back
Feinschreiber
Transfer Pricing Handbook (5)
2. Finding Comparables: Indirect comparables (profit
based)(public data needed)


Integrated drug companies: owns intangibles and incurs
risks like these companies, but do not have integrated
functions
Independent contract manufacturers: independent
manufacturing, but not guaranteed by contract and owns
intangibles.
Feinschreiber
Transfer Pricing Handbook (6)
3. Method used




CPM: more than one type of transaction, with no direct
comparables as to similar transactions
Intangibles transferred with effect on profitability
Profit methods reflects reasonableness
Transaction method used to ascertain appropriate royalty
rate
Feinschreiber
Transfer Pricing Handbook (7)
4. Arm’s length range


Profit Level Indicator (PLI) range: high-end of large
companies’ PLI’s and low end on contract manufacturer’s
PLI’s.
Adjust royalty rate to an arm’s length rate, by doing market
research, scrutinizing third party contracts and
independent transaction. This indicated that a proper rate
should increased to 25%
Feinschreiber
Transfer Pricing Handbook (8)
5. PLI’s used



Gross profit to operating expenses
Operating income on sales
Return on operating assets: good indicator for
manufacturers, but assets may vary quite extensively.
Good PLI for CM-EU which owns intangibles and state
of the art plant and equipment with one product for
allocation purposes. Not so good for parent with various
product lines, and previous investment in assets.
Feinschreiber Transfer
Pricing Handbook (9)
40%
35%
30%
25%
Contr Man
CM-EU
20%
CM-US
15%
Drug Co's
10%
5%
0%
Mean
Maximum
Minimum
TP Methods
TRANSACTIONAL PROFIT METHODS
Transactional Profit Split Method:
 Starting point: identifies combined profits to be split
between associated enterprises.
 Some cases: total profits from controlled transactions
 Other cases: residual profit that cannot be readily
assigned to a specific party, from the application of
other TP methods, such as profits from intangibles
(may even be a loss).
 Division of anticipated profits on economically valid
basis
TP Methods
TRANSACTIONAL PROFIT METHODS
Transactional Profit Split Method:
 Economically valid basis:
 may be supported by independent market data (division
ratios of uncontrolled transactions)
 may also be (most often) internal data
 Internal data: depends on the facts an circumstances
(sales, R & D expenditure, assets, operating expenses)
 Splitting factor: should reflect respective contribution of
parties to generating of income from controlled
transactions
 Must be based on objective data, rather than remuneration
from controlled transactions.
TP Methods
TRANSACTIONAL PROFIT METHODS
Transactional Profit Split Method:
Associated Enterprise A
Associated Enterprise B
Contribution by
A to controlled
transaction: x%
Contribution by
B to controlled
transaction: y%
Controlled Transaction Profit
Profit share
attributable to A:
X%
Profit share
attributable to b:
Y%
Description
Amount Percentage
Currently
Percentage
Cost contributed to ZE
Zambia
1 028
82,18%
Cost contributed to ZE
Botswana
223
17,82%
Total costs
1 251
100%
Total Profit
2 248
100%
2 248
100%
Profit allocated to ZE Z
1 848
82,18%
257
11,44%
Profit allocated to ZE B
401
17,82%
1 991
88,56%
New GP% on
transaction for ZEB
11.44%
Price to ZEZam
2 876
New GP% on
transaction for ZEZam
based on new price
64.24%
Selling Price
57%
20%
Selection of TP Methods
Selecting the Appropriate Method:
 Four criteria:
 Strengths and weaknesses of OECD TP methods
 Results of functional analysis
 Availability of reliable information
 Degree of comparability between controlled and
uncontrolled transactions
Selection of TP Methods
Selecting the Appropriate Method:
STRENGTHS AND WEAKNESSES OF OECD TP METHODS
 CUP:
 most direct and reliable method
 high product similarity needed, not always available in
practice
 Resale Price Method:
 most useful for marketing operations
 fewer adjustments needed for product differences,
functions based
Selection of TP Methods
Selecting the Appropriate Method:
STRENGTHS AND WEAKNESSES OF OECD TP METHODS
 Cost Plus Method:
 useful for transfer of semi-finished goods, manufacturing and
services
 functions base: fewer adjustments for product differences
 Challenges: cost determination and accounting inconsistencies
 TNMM:
 Less affected by transactional differences, more tolerable for
functional differences (reflected in operating expenses)
Selection of TP Methods
Selecting the Appropriate Method:
STRENGTHS AND WEAKNESSES OF OECD TP METHODS
 TNMM (…continued):
 Useful for integrated transactions, or when difficult to
obtain info on one of the parties
 Weaknesses: difficulty establishing comparability
(transactional level)
 Timing of transaction: net profit info usually not yet
available (multiple year data may be a solution)
 Difficulty establishing corresponding adjustment
Selection of TP Methods
Selecting the Appropriate Method:
STRENGTHS AND WEAKNESSES OF OECD TP METHODS
 Profit Split Method:
 Solution for highly integrated operations
 Solution for when unique and valuable contributions are made
 Not used when one of the parties does not make a significant
contribution
 Comparables data can support split ratio, otherwise internal
data can be used
 Flexibility in unique circumstances and facts
 Both parties tested: very fair method
 Weakness: difficulty in application when info of foreign affiliate
not readily available.
Selection of TP Methods
Selecting the Appropriate Method:
FUNCTIONAL ANALYSIS
 Method should be consistent with functions performed
by “tested party”:
 Cost plus method: seller is tested party
 Resale price method: buyer is tested party
 TNMM or CUP: either seller or buyer is tested party
 Profit Split method: both parties are tested
Selection of TP Methods
Selecting the Appropriate Method:
AVAILABLE RELIABLE INFORMATION
 CUP method when uncontrolled transactions are highly
comparables
 Availability of gross or net profit information will
determine whether traditional or profits methods are
used.
DEGREE OF COMPARABILITY
 Data with a high level of comparability will be a priority
when the appropriate method is selected.
 Keep in mind that comparables are very rarely perfect or
complete: professional judgment will be involved
Selection of TP Methods
Selecting the Appropriate Method:
 Don’t have to proof other methods are not suitable
 Traditional methods preferred over transactional profit methods
 Where CUP preferred over other methods, if both can be applied
equally reliable manner
 Situations where Profits Methods more appropriate than
Traditional methods
 Profit Methods only accepted it compatible with Article 9:
comparability
 May use “other methods”
 More than one method may be used, but is not mandatory
 See Illustration on page 16 OECD document on TP Methods July
2010
Selection of TP Methods
Source:
 OECD Guidelines: Chapter 2
 UN TP Manual for Developing Countries: Chapter 5
 ATAF: TP for Policy Makers: Session 1: “TP Methods”
by OECD (PDF)
 Transfer Pricing Handbook, 2 Volume Set, editor
Robert Feinschreiber (available in Amazon.com Kindle)
 IBFD TP Database: “Introduction to Transfer Pricing”
 BNA Transfer Pricing International Journal “CUPs
and Profit Splits – when and how to use”

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