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Transfer Pricing Methods: comparative analysis

It has been over six months that Section V.I of the Tax Code of the Russian Federation on transfer pricing has been introduced. In this period both officials and other experts on taxation have shared their first comments regarding the application of pricing methods for transactions with the related parties, and there are strong grounds to believe that working on a unanimous position of the law enforcement practice on this matter will be continued further. Russian taxpayers are also starting to gain experience in applying the methods of transfer pricing at the world standards.

Today our intention is not to elaborate on the practical issues of transfer pricing development in Russia, the aim is, upon presentation of a brief comparative analysis of the international methods of transfer pricing, to cover the main requirements for the application and choice thereof in various jurisdictions.

Where transfer pricing is not applicable

Residents of certain countries and territories can ignore the requirement to pay taxes on income based on market prices in the transactions between the related parties. In such jurisdictions as Angola, Bermuda, British Virgin Islands, Ghana, Guatemala, Guernsey, Jersey, the Dominican Republic, Cyprus, Malta, Namibia, Isle of Man, Panama, Sierra Leone, Uganda, the special transfer pricing rules do not apply.

However, even where a company is a resident of one of the mentioned places, it is not always right to say that it is completely safe from the respective tax authorities reconsidering the prices set by the parties to a transaction for taxation purposes. For instance, the Angolan tax authorities may change the amount of the income of certain companies as declared by a foreign entity provided that this income is different from the one an Angolan company could have received under the same conditions. Ghana tax authorities can declare an already completed transaction void and reverse it in case this transaction aims at understating of the taxable income; Sierra Leone tax bodies can re-qualify such a transaction; in Guatemala and Malta the restriction may relate to the prices in international trading transactions between the related parties. Uganda authorities have the power to make distribution of profits, withdrawals and debts between the related parties in a transaction if it is required for taxation of the received income.

Therefore, a truly unrestricted pricing in transactions between the related parties free from a possible recalculation of income to be of market value by tax authorities is possible only in the jurisdictions like Bermuda, British Virgin Islands, Guernsey, Jersey, the Dominican Republic, Cyprus, Namibia, Isle of Man, Panama. The residents of these jurisdictions do not need to rely on any transfer pricing methods.

The methods of Arm’s Length Principle

The international principles of transfer pricing have been developed by the Organization for Economic Cooperation and Development (hereinafter – the OECD) and formally adopted as the OECD Guidelines on transfer pricing – a regulatory document which is used for drafting a national tax legislation by both member-countries of the OECD and any other country for which following the OECD Guidelines is one of the mandatory terms for being accepted in future to the OECD as members or observers.

According to the OECD Guidelines, the transfer pricing methods are classified into the following categories:

  • The traditional transaction methods that are the most advantageous in their application, they include:
    - The comparable uncontrolled price method (hereinafter CUP) – this method is given priority when selecting a pricing method;
    - Resale price method (hereinafter the Resale price);
    - Cost plus method (hereinafter Cost plus).
  • The transactional profit methods are applied where such methods better reflect the nature of the transaction, for instance provided that one of the parties is in valuable or unique circumstances and where the parties are involved in close mutually advantageous cooperation, or where there is no information about similar transactions or such information is highly limited. The transactional profit methods are:
    - The transactional net margin method (hereinafter TNMM);
    - The transactional profit split method (hereinafter Profit split).

The OECD indicates that a transfer pricing method on a specific transaction must always be most appropriate one to the nature of transaction under the specific circumstances, it is not advisable to apply two or more methods to one transaction.

The methods recommended by the OECD Guidelines for application on transfer pricing have been fully integrated in the national legislation of such countries as:
  • Certain OECD countries (Australia, Austria, Belgium, Hungary, Canada, Denmark, Germany, Ireland, Italy, Luxembourg, the Netherlands, Norway, Poland, the United Kingdom, Finland, France, Czech Republic, Switzerland, Sweden, Estonia).
  • Most of the OECD observers (Argentina, Malaysia, China, Singapore, South Africa).

Certain OECD members apply the transfer pricing methods recommended by the Organization with certain peculiarities related to the priority of application, whether the priority method is available, as well as the possibility to apply other methods not provided by the law. Here is a brief summary of such peculiarities:
  • The laws of Greece and Iceland provide for transfer pricing adjustment, but the adopted methods applied for such adjustment are missing.
  • In Israel the major transfer pricing method is CUP. In case this method can not be applied, one can apply TNMM or Profit split depending on the essence of the transaction. If these methods do not reflect the essence of the transaction another method should apply, which under the circumstances will reflect most precisely the terms of the transaction under consideration and the similar transactions.
  • In Mexico for transfer pricing purposes the first method to be applied is CUP, and where it is not possible to do so, they check step by step whether they can apply the Resale price, Cost plus, Profit split, or Residual profit split method (hereinafter called Residual profit split).
  • Spain, Slovakia and Slovenia also consider CUP as the priority method, afterwards the applicable methods will be the Resale price, Cost plus, and where the mentioned methods are not applicable Profit split or TNMM shall be used.
  • The laws of Portugal provide for the application of CUP or Resale price as a priority, and where the application thereof is not possible, Profit split, TNMM or other methods will be used.
  • In Turkey three transfer pricing methods are the priority ones and it is up to a taxpayer to select the most relevant one: CUP, Resale price or Cost plus. A further use of Profit split, TNMM or a so called "Method determined by taxpayer" is possible in the hierarchy starting from the traditional methods to other methods.
  • The laws of such countries as Japan, New Zealand, South Korea authorize the tax payer to select on his own the most appropriate method from CUP, Resale price, Cost plus, TNMM and Profit split, and in South Korea also from other reasonable methods.
  • The tax authorities of Chile while adjusting the transaction prices between the related parties, in case an agency or a branch received a less profit margin than a similar agreement with a third party would receive, they apply CUP and Cost plus. In case there are no agreements with third parties they justifiably challenge the prices with the value of the international market.

Considering the national features the provisions of the OECD Guidelines have been adopted in the laws of the following OECD observers, such as Colombia (among transactional profit methods are Residual profit split, no hierarchy of methods is provided, it does not have a best method rule ), India (no identification of the traditional transaction methods and the transactional profit methods; apart from the methods provided for by the OECD Guidelines the other methods can be used, the list of which is set out by the government.)

The Russian Federation is an observer and a candidate to the OECD. As a result of introduction of Section V.I to its current Tax Code it has officially adopted the transfer pricing methods recommended by the Organization, however, it does not separate the traditional transaction methods from the transactional profit methods.

The features of the application of the transfer pricing methods by each of the mentioned countries are summarized in the below table.

The special provisions

Despite the fact that the United States of America is a member to the OECD, the transfer pricing methods adopted by the laws of this country are differ significantly from the methods recommended by the Organization and are categorized in the following manner depending on the subject of the transaction:
  • The methods applied to loans and advance payments – a method of taxpayer’s location, a based on the applicable federal tax rate, and other non-specific methods.
  • The methods applied to the transactions with the rights in rem. Such methods are CUP, Resale price, Cost plus, Profit split, TNMM and other non-specific methods.
  • The methods applied to transactions with intangible assets, including CUP, TNMM, and other non-specific methods, the method applied to main investments in accordance with the agreement for distribution of costs.
  • The methods applied to transactions related to distribution of costs (the method of reasonable expected distribution of income).
  • The methods applied to services transactions (CUP, Cost plus, Profit split, TNMM and other non-specific methods).
  • The methods applied to transactions related to major investments, such as CUP, Profit split, Cost plus, TNMM, Residual profit split and other non-specific methods.