Transfer Pricing

Week 4 concerns itself with transfer pricing techniques used to allocate the profit made by a group of companies to the individual group members. Barnhouse et al. (2012) present a definition of transfer price as

the price an organization must charge or pay to transfer goods from one subsidiary or internal branch to another segment of the same organization.

Transfer prices are relevant for companies that operate within a single country, as they transfer products between subsidiaries, but the factors involved in transfer pricing calculations involving multinational enterprises (MNEs) involve many additional factors, since governments are entitled to adjusting the prices on international transfers according to the arm’s length principle.

According to that principle, transfers between companies belonging to a same group should be comparable to the prices the company would charge when selling groups or services to another organisation. That “arm’s length value” would then provide a fair baseline for estimating whether a company is underpricing or overpricing its intragroup operations or not, preventing companies from setting artificial prices just for reducing their taxable income.

As Barnhouse et al. (2012) point out, multinational enterprises and the countries where they operate have conflicting interests: while MNEs want to increasing the share of their income that is not subject to taxation — and, when that is not possible, shift as much income as possible to jurisdictions with lower tax rates —, the countries want to increase their tax bases. In that scenario, a “fair” process for calculating the arm’s length value of transactions will minimize the losses of each side in this game, especially as countries try to adopt definitions that allocate greater taxation to them not only at the expense of MNEs but also of the other countries involved.

In the lecture videos, Stefano Simontacchi (Transfer Pricing Reserve Center, International Tax Center, Leiden) presents a scenario where transfer pricing is used to shift income from one country to another:

Under case number 1, a manufacturer resident in country A sells finished product for an associated distributor, which is a group company resident in country B, for a price of 110. The manufacturer, having a cost of goods sold of 100, produces a profit of 10, at a corporate income tax rate of 40%. The distributor sells the finished product to its clients for 250 and has a profit of 140, taxed at a corporate income tax rate of 10%. As a consequence, the consolidated profit for the group is equal to 150. On this profit, the group pays 18 of taxes, suffering a 12% overall rate.

In case number two, the transfer pricing changes from 110 to 200. The consequence is that the manufacturer profit increases from 10 to 100, and the distributor profit decreases from 140 to 50. The consolidated profit remains 150, but the overall tax rate increases from 12% to 30%.

While this particular case of transfer pricing alteration results in an increase of paid taxes, it dramatically reduces the amount of taxes paid to country B. To avoid tax imbalances or even reductions of the overall tax rate, the OECD has adopted the arm’s length principle as a reference for setting transfer prices, but that principle can be interpreted in different ways, resulting in different methods for computing the actual transfer price.

The arm’s length principle

The arm’s length principle informally described above is given a legal formulation in Article 9 of the OECD Model Tax Convention:

  1. Where

a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or

b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State,

and in either case 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.

  1. Where a Contracting State includes in the profits of an enterprise of that State — and taxes accordingly — profits on which an enterprise of the other Contracting State has been charged to tax in that other State and the profits so included are profits which would have accrued to the enterprise of the first-mentioned State if the conditions made between the two enterprises had been those which would have been made between independent enterprises, then that other State shall make an appropriate adjustment to the amount of the tax charged therein on those profits. In determining such adjustment, due regard shall be had to the other provisions of this Convention and the competent authorities of the Contracting States shall if necessary consult each other.

The baseline for calculating the profits not actually accrued due to transfer pricing arrangements must be obtained by comparing the defined price to the conditions observed in comparable transactions done between independent parts. An intra-group transaction is internally comparable to a transaction between independent parties when one of the parties involved in the latter transaction is a third party and the other is one of the parties of the intra-group transaction. As an example, Simontacchi cites Prada, that can sell bags to its related distributors and, at the same time, to independent distributors; those two families of operations would be comparable.

An externally comparable transaction is one that happens between two independent parties, none of which is involved in the intra-group transaction in question. The lecture example is the listing price of a commodity traded between two group entities.

The OECD guidelines identify five main factors that must be taken into account when trying to establish a comparison between two transactions:

  • the properties of services or products being traded;
  • the functional role of the transaction, as the functions performed, assets used, and risks involved may generate relevant price differences;
  • the contractual terms, such as licensing terms;
  • the economic circumstances of the transaction, such as market regulations;
  • and business strategies, such as whether the operation happens between competitors.

The impact of such factors may require adjustments to the actual prices of the reference transaction before it can be actually compared to the intra-group transaction under analysis. There are two sets of methods employed for transfer price calculations: the so-called traditional transaction methods and a new set of transactional profit methods; the choice between methods is made based on the concrete cases and the approaches most adequate to them.

Traditional transaction methods

The transfer pricing methods referred by Simontacchi as “traditional transaction methods” are presented on the OECD transfer pricing guidelines. The comparable uncontrolled price method (CUP), Resale price method (RPM), and the Cost plus method (C+CP) all rely on the prices charged on the uncontrolled transaction as a baseline for adjusting the controlled transfer price.

The CUP method compares the price charged on the controlled transaction to the price charged on an comparable uncontrolled transaction, either internal or external, under similar circumstances. It is, in general, applied with internally comparable transactions, with externally comparable transactions being used only for commodities and, more rarely, licenses.

The RPM approach establishes the adequate transfer price based on the resale price obtained when the output produced thanks to the intra-group transaction is sold to an independent party. The transfer price is obtained by removing from the resale price a gross profit margin deemed as enough to allow the reseller to cover selling and operational expenses while making an appropriate profit. The appropriate margins and profit are determined through comparision with comparable transactions. This method lends itself to transfer pricing calculations involving distributors.

The C+CP method, on the other hand, starts from the manufacturing costs incurred by a manufacturer and then adds a markup that is compatible with market conditions and the nature of the services performed. This method can be applied to manufacturers and servide providers providing routine functions.

Transactional profit methods

The OECD guidelines also present two transfer pricing methods that rely on the observed profits instead of prices. Those methods may be adequate, for instance, when each of the parties in the controlled transaction provides significant unique intangibles, or when they operate in a highly integrated fashion. Transactional methods can also be useful when there’s limited reliable information available about gross margins.

The Transaction Net Margin Method (TNMM) works in a similar fashion to the resale price, substituting the gross margin with the net operating margin realised on the uncontrolled comparison in relation to an appropriate base such as costs, sales, or assets. The sales base is employed when the distributor is the simplest part on the intra-group transaction and there is not enough information for applying the RPM. For example, if an uncontrolled transaction obtains an operating profit of 15 over sales of 300, that same 5% operating profit margin should be obtained in a comparable controlled transaction over sales of 100; if the operational expenses equal 5, then we would have a transfer price of 90. In a similar way, the costs are used as the TNMM base whenever the manufacturer or service provider is the simpler part in an inter-group transaction, and it is not possible to apply the C+CP method in an adequate way.

The profit split margin method (PSM) splits the group profit among the parties engaged in the intra-group transaction based on the margins that independent companies would have agreed with under similar circumstances. Those margins are based either on comparables or internal data of the companies, such as costs or head counts, and are applied to the consolidated profit of the parties involved. This method is most appropriate when both parties to the transaction hold valuable intangibles, or when the operations are sufficiently integrated to generate economies of scale and similar advantages.

Business restructuring

Business restructuring is the cross-border redeployment of functions, assets, or risks by a multinational group. It can involve the transfer of valuable intangibles, or the termination or substantial renegotiation of existing arrangements. Those restructurings are performed to improve supply chain efficiency, to streamline business line management, and to maximize synergies and economies of scale. They may be also performed to preserve profit or limit losses in unfavourable economic scenarios, such as overproduction crises.

The example presented by Simontacchi in his lecture is the centralisation of a group’s strategic supply chain activities to a central entity, leaving local branches only with limited, low-risk activities, such as manufacture based only on items bought from the supply company itself. This centralisation can generate economies of scale and joint efficiencies, while shifting a larger share of the profit to the central supply chain company, which takes most of the risks involved. To prevent the use of restructuring operations for profit shifting, the OECD transfer pricing guidelines extend the arm’s length principle to business restructuring transactions, while requiring the taxpayer to demonstrate the existence of valid business reasons for the transaction, as opposed to a plan moved only by tax savings.

The business case of a restructuring must take such demands into account, showing the benefits at group level expected from the restructuring. Once the business case is established, it is necessary to evaluate the impact of the proposed operations on each group member, and compensation might be due whenever a group company has its profits reduced by the restructuring. This compensation is generally determined by a discounted cash flow analysis, considering the decrease on net present value of expected profits caused by the restructuring.

Transfer pricing aspects of intangibles

The Apple transfer pricing arrangements, discussed on Tang (2014) and as a lecture example, show how the uncertainty over how to treat intangible assets may be leveraged by companies to obtain significant tax savings. To address that issue, BEPS Action 8 has created standards for defining those intangible assets and correctly apply the arm’s length principle to transactions involving them.

Those rules deserve further study (which I, unfortunately, will not be able to do right now), but the lectures provide an initial, if outdated, overview, as the video on the topic was finished before the BEPS Action 8 Final Report. The OECD proposal begins from the legal rights to the intangible assets, but takes care to assign the relevant remuneration to the entities actually performing the functions, using the assets, and assuming the risks related to “the development, enhancement, maintenance, protection and exploitation of the intangibles.” Mere ownership, without performing any of the preceding functions, should be associated to a low remuneration for tax purposes. This approach does not impede outsourcing approaches such as the cost-sharing agreements used by multinationals to develop their intangibles, but places a new demand upon those agreements: to remunerate based on the control of the functions, the provision of assets, and the taking of risks related to the intangibles in question.


A. Tang. (2014) iTax - Apple’s International Tax Structure and the Double Non-Taxation Issue, British Tax Review, no. 1.

An analysis of how Apple used transfer pricing agreements with subsidiaries that operated in Ireland to significantly reduce the profits perceived by its core business. Through the use of cost-sharing agreements and advance price agreements validated by Ireland, Apple managed to pay US$ 13 million in tax to Irish authorities while avoiding to pay US$7.7 billion that would be otherwise due to the US tax authorities. Even though Irish authorities had validated the advance price agreements, the European Commission has ruled that those agreements were effectively a form of State aid.

Barnhouse, Nicole C.; Booth, Alton; Wester, Kevin (2012). Transfer Pricing. SSRN.

From the paper’s abstract:

The main focus of this paper is on the international transfer pricing issues encountered by multinational enterprises (MNE) and the countries they do business in. (…) The transfer price is the price an organization must pay to transfer goods from one subsidiary or internal branch to another segment of the same organization. This paper covers five of the most commonly used transfer pricing methods and discusses how each method affects both the MNE and the countries differently. This paper also reveals tax planning strategies that are used when applying the transfer pricing rules. (…)

OECD/CTPA (2010). Arm’s Length Range

OECD (2014). Guidance on Transfer Pricing Aspects of Intangibles, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris.

OECD (2015). Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 - 2015 Final Reports, OECD Publishing, Paris.

Researcher, Law and Artificial Intelligence

Currently researching the regulation of artificial intelligence at the European University Institute.