Transfer Pricing? Keep it at arm’s length! (BEPS Action #13)

If the price isn’t right, suspicion of Corporate Tax Avoidance could rise.

A discussion paper against the backdrop of OECD’s “Transfer Pricing Documentation and Country-by-Country Reporting” (BEPS Action #13).


The recent crises and some scandals shed light on the risk that a certain way of applying transfer pricing was jeopardizing the arm’s length principle itself. That’s why the OECD aims at redrafting the guidelines. Transfer pricing has become one of the main risks to be addressed and managed by MNCs.

How does this potentially affect Treasury? What are best practices? Which transfer pricing models are used? How to assess the risk of non-compliance and approach a credit risk analysis in connection with arm’s length ?


The OECD, with the backing of the G20, published a 15 points action plan in July 2013 setting out proposals to address base erosion and profit shifting (BEPS). The project has developed in response to concerns that the interaction between various domestic tax systems and double tax treaties can often lead to profits falling outside the charge to tax altogether or be subject to an unduly low rate of tax. The OECD published its final BEPS package in October 2015.

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By Norbert Braspenning

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Transfer Pricing overview – introduction

Transfer pricing for MNCs is one of the most interesting areas within international tax law. With ongoing economic globalization, intergroup cross-border transactions are becoming increasingly important, and transfer pricing is now the key issue for profits allocation among multinational group companies.

 Transfer pricing is the setting of the price for good and services sold between controlled (or related) legal entities within an enterprise.

Transfer pricing may thus be used to shift income from one country to another. How can this practice be avoided? The answer is the arms’ length principle, which is the international standard adopted by the OECD and by all relevant countries. Tax authorities globally have become much more conscious of the key role of transfer pricing in determining the taxable profit of MNCs and are more and more focusing on this area.

The arm’s length principle is the condition or the fact that the parties to a transaction are independent and on an equal footing.

For many years transfer pricing application was the responsibility of practitioners (the MNCs). The recent crises and some scandals shed light on the risk that a certain way of applying transfer pricing was jeopardizing the arm’s length principle itself. That’s why the OECD launched a few years ago many projects on transfer pricing, with the aim of redrafting the guidelines. In particular, since 2008 the OECD has issued more than ten discussion drafts on transfer pricing and more recently, four out of fifteen BEPS actions regard transfer pricing. Transfer pricing has become one of the main risks to be addressed and managed by MNCs

Treasury’s general approach

MNCs put considerable thought into their transfer pricing policies. These policies are usually an integral part of the group’s tax planning (policies to achieve tax efficiency on a group-wide basis).

Profits made by a group of companies are allocated to the individual group members through this ‘transfer pricing’. Subsequently, the country in which the designated group member is resident may tax the profits of that company. This technique is used by MNCs to shift profits from high tax jurisdictions to low tax jurisdictions.  Consequently transfer pricing can deprive governments of their fair share of taxes from global corporations and expose multinationals to possible double taxation. No country – poor, emerging or wealthy – wants its tax base to suffer because of transfer pricing. The arm’s length principle can help. 

Once you take on board the fact that more than 60% of world trade takes place within multinational enterprises, the importance of transfer pricing becomes clear.

First, however, we need to understand what exactly the arm’s length principle is and how it is applied in practice, the milestones of the arm’s length principle and, in particular, the five comparability factors.

Evolution (the rise of intercompany Treasury transactions)

Developments in international business are continuously increasing the scope and scale of the corporate treasury function within MNCs. This is due to a number of reasons. Firstly, the continued globalisation of business activities leads to increased levels of intercompany treasury activity, in particular with regard to intercompany lending, cash pooling, foreign exchange risk management, and payment and netting services. Secondly, MNCs tend to have consolidated treasury activities into global or regional treasury centres, increasing the scale, number, complexity and volume of cross-border transactions involving the treasury function. Last but not least, Treasuries are often responsible for carbon trading in response to environmental legislation.

Carbon emissions trading is a form of emissions trading that specifically targets carbon dioxide and it currently constitutes the bulk of emissions trading.

MNC’s potential Transfer Pricing exposure

Potentially all services provided by a corporate treasury to group companies give rise to an intercompany transaction that should be priced in accordance with the arm’s length principle. For a cash management perspective we typically observe

  • Intercompany funding
  • Cash pooling
  • Provision of financial guarantees
  • Asset management of surplus cash
  • Foreign exchange
  • Payments and netting services

Arm’s Length Principle – The legal framework

The arm’s length principle is the international standard adopted to deal with the issue of intragroup transactions. So what does the arm’s length principle mean? The OECD provides the definition of the arm’s length principle stating that;

when “conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly”.

The arm’s length principle is therefore based on the comparison between the terms and conditions set in intragroup transactions with the conditions that independent parties would have entered into under comparable circumstances.

 The OECD Transfer Pricing Guidelines provides the internationally agreed principles for the application of the arm’s length principle. The arm’s length principle applies to all forms of intragroup transactions, from the sale of goods and the provision of services to business restructuring.

Comparability is the core of the application of the arm’s length principle: but how can we ascertain whether a transaction is comparable to another one? The first point is that a comparable transaction must occur between independent parties (this means that in many cases a competitor cannot represent a comparable).

Secondly, comparability exists if there are no differences liable to affect the economic conditions. Where such differences exist, two transactions can be comparable only if reliable adjustments can be made. For example Prada sells a bag to its related distributors and at the same time sells the same bag to independent distributors under comparable circumstances.

The OECD guidelines identify five main comparability factors that has to be taken into account

  • Characteristics of property or services: the characteristics of the product have an impact on prices: for example, a bag made of crocodile will be far more expensive than the same bag made of standard leather.
  • Functional analysis: the functions performed, the assets used and the risks assumed by the parties of a transaction also impact the profit allocation and as a consequence the prices at which the transaction takes place. For example, a distributor suffering inventory risk should earn more than a distributor that has the right to sell back unsold products to the manufacturer.
  • Contractual terms; also contractual terms have an impact on prices. Think for example about the difference between an exclusive and a non-exclusive license.
  • Economic circumstances: for example the pharmaceutical industry where the regulations significantly impact the value chain.
  • Business strategies: a company adopting a market penetration scheme would apply for its product a price lower than the price charged for otherwise comparable products in the same market.


Non-compliance with the arm’s length principle may lead to significant penalties. Many countries require that companies prepare contemporaneous documentation to demonstrate that transactions were entered into on an arm’s length basis over the course of the year. Next to that, dealing with transfer pricing enquiries is a costly and time-consuming process for MNCs.

Transfer pricing methods

The OECD Guidelines identify five main transfer pricing methods: three are the so-called traditional transaction methods; and two are the so-called transactional profit methods.

The traditional transaction methods are (for details see footnote 1):

  • Comparable Uncontrolled Price method (CUP);
  • Resale Price Method (RPM); and
  • Cost Plus Method (CPLM).

The transactional profit methods are (for details see footnote 2):

  • Transactional Net Margin Method (TNMM); and
  • Profit Split Method (PSM).

Traditional transaction methods will compare third-party prices, or other less direct measures such as gross margins on third-party transactions, with the same measures on the transactions under review. A transactional profit method, on the other hand, examines the overall net operating profits that arise from the intercompany transactions under review. The transactional profit methods are generally less precise than the traditional transaction methods but more commonly applied as a result of practical difficulties in finding suitable information for the application of the traditional transaction methods.

Transactions between two enterprises that are associated enterprises with respect to each other, are also referred to as Controlled Transactions.

 There are certain situations when transactional profit methods are more appropriate than traditional transaction methods. An example relates to cases in which the presence of significant unique intangibles contributed by each of the parties to the controlled transaction or the engagement in highly integrated activities makes a transactional profit split more appropriate than a one-sided method. Likewise, when there is no or limited reliable information publicly available on the gross margin derived by third parties, transactional profit methods become the most appropriate.

Transfer Pricing Models for Treasury

The large majority of MNC’s Treasuries operate as cost centres, and as such charge out to affiliates. The model adopted is generally based on a mark-up (cost plus). More and more tax authorities are challenging this approach, claiming a cost plus approach only applies to services that are of low value and of routine in nature.

Many Treasuries provide (intercompany) services resembling professional external financial service providers. Though these providers charge a transaction fee for their services, these will typically not be directly linked to the costs associated with providing the service. Therefore tax authorities increasingly argue that Treasuries should be remunerated on a transactional fee basis, rather than a cost plus basis. In other words, transactions will have to be priced in a similar way to how banks might have priced the same transaction. In its turn this process may also implicate relocating the treasury function to a low-tax jurisdiction (also part of the OECD’s focus on Base Erosion and Profit Shifting).

As mentioned, in general, documenting the determination of intercompany interest rate on intercompany loans becomes important. Next to interest rates, other characteristics and terms and conditions of the intercompany loan need to be factored in. This also entails credit risk. For this purpose MNCs can decide to apply external or internal credit rating models to determine arm’s length.

Credit risk analysis

Credit risk can be expressed in three ways: i) Probability of Default, the likelihood that the borrower will default within 12 months; ii) Exposure at Default, the expected outstanding amount of a loan at the time of a default; iii) Loss Given Default, the expected loss on the intercompany loan as a percentage of the Exposure at Default, if the company defaults.

Most intercompany rating models are only based on an assessment of the Probability of Default of the counterparty.

A “best in class” approach would also entail the Exposure at Default and Loss Given Default in the assessment.

Conclusion: Transfer pricing? Keep it at arm’s length!

If you want to avoid penalties, it’s recommended to document intercompany pricing decisions contemporaneously to ensure compliance with tax rules. To obtain certainty regarding transfer prices, consider negotiating an advance pricing agreement with tax authorities to avoid any (tax) surprises down the road.

Given the increased scope of corporate treasury activities and the increase in intercompany transactions, it is recommended that MNCs regularly reassess their transfer pricing policies to ensure that they are consistent with the arm’s length principle. By doing so, MNCs can reduce the likelihood of transfer pricing enquires (and identify potential tax efficiencies).

Generally, reference interest rates and spreads (applicable to borrowers within the same industry, same credit rating, and on loans with equal or similar term and conditions) are taken into account to determine the intercompany interest rate or spread. This assessment must be documented in detail.

Recent high-profile press coverage of some large organisations’ tax strategies has shown that, for many, simply abiding by the rules and regulations is not enough to offset risk. Some have suffered reputational damage for what the public perceives to be their moral duty in respect of tax. A clear understanding of the broader impact of transfer pricing, on the risk profile of your business, should also be on the board’s agenda.

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Footnote 1: Traditional transaction methods.

Comparable Uncontrolled Price method (CUP)

The CUP method is based on a comparison between the price charged for property or services transferred in a controlled transaction and the price charged for property or services in a comparable transaction either internal or external, under comparable circumstances.

In real life, the internal CUP method is generally applied when internal comparables are available. External CUP generally only applies in case of commodities and more rarely in case of licenses.

The other two traditional methods are based on the comparison of gross margins. In this case, functional comparability becomes key. In fact, gross profit can be seen as the remuneration for the functions performed by the parties involved.

Resale Price Method (RPM)

This method is based on the price at which the product purchased from a related party is resold to an independent party. This resale price is reduced by an appropriate gross margin (gross profit / sales) which represents the amount that would enable the reseller to cover its expenses and to earn an appropriate profit margin. What is left can be regarded as the arm’s length price for the controlled transaction.

 Cost Plus Method (CPLM)

This method starts by considering the manufacturing costs incurred by the supplier of property (or services) in the controlled transaction for property transferred or services provided to a related purchaser. An appropriate mark-up is then added to this base cost, to make a profit in line with the functions performed and the market conditions. With this method a mark-up is applied to the manufacturing costs comparable to the mark-up of an independent manufacturer.

 Footnote 2: Transactional profit methods.

 Transactional Net Margin Method (TNMM)

This method works similarly to the RPM and CPLM but works at the level of operating profit margin (instead of gross margin) in relation to an appropriate base, such as costs, sales or assets. Operating profit is equal to the difference between gross profit and operating expenses. In this respect, a net profit margin analysis is found to be more reliable than a gross margin analysis, when there are material differences in functions between the tested and the uncontrolled transaction.

 Profit Split Method (PSM)

The PSM is based on the division of the total profits realised by related parties engaged in a controlled transaction. This method aims to split these profits on an economically valid basis that reflects the division of profits that would have been agreed between independent parties.

 The determination of the splitting percentage can be based on either comparables or internal data (such as costs and headcounts). PSM frequently turns to be the most appropriate method when both parties to the transactions own valuable intangibles, and when the parties are integrated with each other to generate joint efficiencies such as economies of scale.