Transfer Pricing
Transfer Pricing
Transfer pricing governs the pricing of transactions between related parties — ensuring that intra-group transactions reflect arm's length conditions. It is the most significant area of international tax dispute, with documentation requirements in virtually every major jurisdiction.
Arm's Length Principle
Article 9 of the OECD Model Tax Convention establishes the arm's length principle: where conditions between associated enterprises differ from those that would exist between independent enterprises, profits may be adjusted accordingly.
The principle requires that controlled transactions be priced as if the parties were unrelated, transacting at fair market conditions. This is the internationally accepted standard, endorsed by both the OECD and UN.
The Five Methods
Comparable Uncontrolled Price (CUP)
Compares the price charged in a controlled transaction to the price charged in a comparable uncontrolled transaction. The most direct method when reliable comparables exist.
Resale Price Method (RPM)
Starts with the resale price to an independent party and subtracts an appropriate gross margin. Best suited for distribution activities with limited value-add.
Cost Plus Method (C+)
Adds an appropriate mark-up to the costs incurred by the supplier. Typically applied to manufacturing, services, or semi-finished goods transactions.
Transactional Net Margin Method (TNMM)
Examines the net profit margin relative to an appropriate base (costs, sales, assets). The most commonly used method in practice due to flexibility and data availability.
Profit Split Method (PSM)
Splits combined profits from controlled transactions based on each party's relative contributions. Used for highly integrated operations or unique/valuable intangibles.
Comparability Analysis
A proper comparability analysis evaluates five factors to determine whether transactions are sufficiently comparable:
Characteristics of Property or Services
Physical features, quality, reliability, availability, and volume of goods or nature/extent of services.
Functional Analysis
Functions performed, assets used, and risks assumed by each party (FAR analysis).
Contractual Terms
Terms and conditions of the transaction, including payment terms, warranties, and volume commitments.
Economic Circumstances
Market conditions, geographic location, market size, competitive position, and regulatory environment.
Business Strategies
Market penetration strategies, innovation cycles, and risk diversification affecting pricing.
DEMPE Framework
Following BEPS Actions 8-10, the OECD introduced the DEMPE framework for intangibles analysis. Income from intangibles must be allocated to the entity performing the relevant functions:
Development
Creating the intangible
Enhancement
Improving its value
Maintenance
Preserving its value
Protection
Defending IP rights
Exploitation
Generating income
Legal ownership alone does not entitle an entity to intangible-related returns — the entity must perform the DEMPE functions, use the relevant assets, and assume and control the associated risks.
Documentation Requirements
BEPS Action 13 introduced a standardized three-tier documentation approach:
Master File
Group-level overview — organizational structure, business description, intangibles, intercompany financial activities, and financial/tax positions.
Local File
Entity-level detail — material controlled transactions, financial data, comparability analysis, and selection of transfer pricing method.
Country-by-Country Report (CbCR)
Aggregate tax jurisdiction reporting — revenue, profit, tax paid, employees, and stated capital for each jurisdiction where the group operates.
APA and MAP
Two mechanisms exist to resolve or prevent transfer pricing disputes:
Advance Pricing Agreements (APA)
Prospective agreements between taxpayers and tax authorities on the transfer pricing methodology for future transactions. Can be unilateral, bilateral, or multilateral.
Mutual Agreement Procedure (MAP)
Treaty-based dispute resolution mechanism (Art. 25) where competent authorities negotiate to eliminate double taxation resulting from transfer pricing adjustments.
Best practice
Transfer pricing documentation must be prepared contemporaneously — retroactive preparation may weaken the taxpayer's position.