Transfer prices

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Significance
About 50 % of import and export of goods are between group companies
Therefore huge potential for profit transfers
In practice, however, limited:
Interference with responsibility of profit centres
Can lead to wrong management decisions
High risk due to tax audits
Risk of (economic) double taxation

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Applicable Law
National law:
Hidden profit distribution
International:
Art. 9 OECD-MA ? arm’s length principle
legal basis in contracting state necessary
If an adjustment is made by one state the other state has to make a corresponding adjustment ? but only if the first adjustment was in line with Art. 9 OECD-MA (arm’s length principle), what may be disputed by the other state
All legal rules follow the arm‘s-length-principle
Business transactions between affiliated companies have to be structured as between third parties

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Basics of arm‘s-length-principle
Partly fictitious, since transactions between affiliated companies follow other rules than those between third parties (e.g.: group backing)
Direct comparison with third party behaviour rarely possible
Therefore „notional“ comparison („what would a third party have done if…“
Functional analysis
What function is fulfilled by what company?
Functions eg:
Production
Sales
Research/ownership of intangibles
storage
Appropriate reward for functions and risks

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Methods
OECD-report 2010
Standard methods
Profit-oriented methods
Global methods
National Guidelines, eg Germany:
Administrative principles 1983
Administrative principles Cost Contribution Agreements (1999)
Administrative principles Expatriates (2001)
Administrative principles Procedures (2005)
Regulation re. documentation

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Internationally used methods:
Standard methods
Comparable uncontrolled price method (CUP)
Cost-plus method
Resale price method
Profit-oriented methods
Profit-split method
Transactional net margin method (TNMM)
Global method
Germany: Standard methods and TNMM; Russia: only standard methods
USA allows global methods, Brazil uses lump-sum standards

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Standard methods
Comparable uncontrolled price method
Direct application of arm‘s-length-principle
Comparison with transactions between third parties, between taxpayer and a third party or between affiliate of taxpayer and a third party
Intra-group deals are not “comparable” because not “uncontrolled”
State-controlled prices are not “uncontrolled”
Requires knowledge of all details of the transaction (volume, quality, freight, risk of losses, currency, payment terms, guaranties etc)
Full knowledge of details of third-party transaction in practice not available
Risk that fiscal authorities use „better knowledge of hindsight“

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Standard methods
Cost-plus-method
Remuneration for producer are costs plus (limited) profit element
Applicable for processing agreements, turn-key contracts, professional services
Apart from this hardly in line with arm‘s-length-principle
Problem: What are „costs“ (eg different depreciation regimes)? ? generally accepted accounting standards
Full costs or only variable costs?

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Standard methods
Resale-minus method
Remuneration for Marketing company are costs plus (limited) profit element
Market risk is borne by producer
Applicable, if marketing company has the role of a mere agent/ commissionaire
Not applicable, if marketing company bears full market risk/fulfills full functions of a trader
Not freely exchangeable with cost-plus-method

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Profit-oriented methods
Profit-split method
Profit of a transaction is split between seller and buyer
Transactional net margin method – TNMM
Comparison of the net margin of a transaction between affiliated companies with a margin of a third-party-transaction
Frequently used
Data banks for margin analysis available
Wrong conclusions possible if cost level of the partners differs substantially (overheads, inefficiencies)
Correctness of this method depends on the issue what factors are included in “margin”
If data banks are used, knowledge required how data are computed

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Global methods
Total profit of a group of companies is allocated to local companies according to a key
eg return on investment/capital
eg margin as percentage of proceeds
Global methods are not in line with arm‘s-length-principle, therefore not in line with Art. 9 OECD-MA
Are used by USA

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Price range
Special problem if price range exists:
Average of the prices within the range?
Argument: If the tax payer acts in line with the market the agreed prices will in medium/long run equal the average of the market prices
Prices of second and third quartile?
Argument: Prices in the first and fourth quartile are likely to be special cases and therefore not “comparable”
The price most favourable for the tax payer?
Argument: Every price in the price range is a market price and therefore a “comparable” price

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Transfer of goods
Comparable uncontrolled price method
Relevant selling market
Marketing company as risk taker or agent?
Losses of a marketing company?
Change of marketing structure „transfer of functions“
Transfer of customer relationships
Transfer of profit potential
See part 4 “Transfer of Functions”

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Services
Comparable prices rarely available (e.g. transport, insurance)
Other areas: cost plus method
Group coordination costs
Use of group name (not if trade mark)
Development of group strategy
Administration of associated companies
Corporate governance (internal audit?)
Appraisal
Benefit test

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Control- and Coordination Centres
Neither permanent establishment of parent nor of affiliated company (no transfer of mind and management)
Costs can be charged if the services are of benefit for the affiliated company
Cost-plus method incl. market-related profit element

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Intangible assets
OECD-report distinguishes:
Marketing intangibles (trade marks, customer relationships)
Trade intangibles (patents, production processes
Uncontrolled price method
Cost-plus not appropriate
Resale-minus not possible
German fiscal authorities maintain card index for royalties
Separate company for patent administration
Toll research
Risk taker
Problem: How to transfer intangible assets to the patent administration company?

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Financing
Market interests
Currency
Relevant market
Securities
Financing period
Thin capitalisation (Germany):
Interest expenses are only deductible to the amount of interest income plus 30 % of EBITDA; excess carried forward
Thin capitalisation (Russia):
Applicable if non-resident legal entity holds more than 20 % of resident company; equity-debt ration 1:3 (banks and leasing companies: 1:12,5). Excess reclassified as dicvidends

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Documentation
Internationally widely used by fiscal authorities
In principle: Tax payer has to explain what he has done and why; fiscal authorities have the burden of proof
Documentation requirements
Documentation of facts: Type and clauses of transactions
Documentation that the arm‘s-length-principle was complied with
Issues:
Has the documentation to be done immediately after the event?
Under what circumstances can the fiscal authorities ask for the documentation?
Has the documentation to be handed over immediately after the request of tax authorities

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Documentation/Sanctions – Example Germany
If documentation is not available or not useable:
Assumption that due to transfer prices profits have been reduced (change of burden of proof), and
In case of a price range: use of the most unfavourable price, and
Surcharge of 5-10 % of additional income
In case of late handover: 100 € per day, up to a maximum of 1 Mio € (per year, per transaction, per request?)

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Mutual agreement procedure:
Legal basis: Art. 25 OECD-MA
Request has to be put forward within 3 years after the measure resulting in a double taxation
Inefficient because:
Initiation of the process at the discretion of authorities
Tax payer is not involved
Risk that authorities come to a solution at the cost of the tax payer
Takes long times
Possibility to agree to disagree
DTA US-Germany: Arbitration with “first best offer”

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Arbitration procedure:
Legal basis: EC-convention
3 steps:
Information
Mutual Agreement Procedure: 2 years
Arbitration procedure: 6 months
Fiscal authorities can accept the arbitration decision or agree within 6 month to another solution
Arbitration has the character of a legal procedure
Tax payer is party to the process
A solution has to be found which avoids double taxation

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Rulings:
In OECD-states possible, however costly
Advanced Pricing Agreements (APA)
Agreement with the fiscal authorities that a certain method to calculate transfer prices is valid
Can be with more than one fiscal authority (multi-party APA)
Valid only if actual prices are calculated in accordance with APA
APA can lead to additional taxes if not followed: If APA was correct, all other methods are not suitable for the specific case ? therefore fiscal challenge
Risks:
Content of ruling can be worse than hoped
Fiscal authorities are put on the alert
Premature information of fiscal authorities

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
Controlled Foreign Companies (CFC):
Avoidance of profit transfers to companies with reduced functions
4 Steps:
Companies without economic function: abuse of law
Management in Germany: unrestricted taxation
Company with reduced function in a low-tax area: CFC rules apply
Company with full function: transfer prices
Transfer pricing rules would be sufficient

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
CFC‘s/ legal consequences - Germany:
CFC must be controlled by German residents
Passive income as defined by law
Resident in low-tax-country: tax rate less than 25 %
Income of CFC is allocated to shareholder as deemed dividend
Foreign taxes of the CFC can be deducted or credited
Tax exemption/reduction of tax base available for „normal“ dividends is not applied to „deemed dividend“ of CFC
However, dividend later actually paid by the CFC is tax-exempt.
Russia:
No CFC regulation, however currency regulations restricting domestic investors in respect of investments outside Russia have a similar effect.

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
ECJ dated 12/9/06 (Cadbury-Schweppes)
Establishment in another state with the aim at using the beneficial tax system is protected by the freedom of establishment
Discrimination since profits of a UK based affiliate are not taxed at the level of the parent company
Only possible justification is prevention of abuse of law
Establishment of an affiliate in a low tax country is no abuse of law
However, company must carry out actual and true business activities
Can be business relationships to affiliated companies

Master of International Business
21 - 23 November, 2014 St Petersburg
Transfer Prices
ECJ on CFC rules:
Criteria for abuse of law:
Material presence
Deliveries/performances on own account
Activities with added value
Standardised assumptions possible
Taxpayer must have the right to prove the contrary
German CFC-rules to a large extent not in line with EC law, therefore limited application if CFC is located in EC country