International Transfer Pricing Framework

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1 Are you ready for transfer pricing? Seminar on November 28th, 2005 Swissotel, Istanbul International Framework Marc Diepstraten, Partner, PwC Amsterdam, PwC

2 Agenda Transfer pricing environment Transfer pricing methods Transfer pricing documentation Dispute resolution Recent developments Conclusion

3 Agenda Transfer pricing environment Transfer pricing methods Transfer pricing documentation Dispute resolution Recent developments Conclusion

4 Transfer pricing environment Global trading External Pressures Global trading New entrants Demand for consistency of service and solutions Increasing price transparency Low retail margins forcing down buying price Brand rationalization Dominance of retail brands Internal Pressures Inefficient processes Need to exploit - E-Business - Strategic sourcing - Tax rate differentials Rising personnel and property costs Demands from shareholders Technology not supporting customer requirements Page 4

5 Transfer pricing environment Global trading More than 70% of global trading transactions is intercompany! Global trading has impact on traditional way of doing business principal structures, tolling, SSC Local tax authorities may as a result of global trading loose (partially) their tax base of a company Important trading partners; US, Japan and EU have introduced and executed stringent transfer pricing legislation Focus of tax authorities to get fair share of total consolidated profits => Nr. 1 tool: transfer pricing adjustments Page 5

6 Transfer pricing environment Global trading Focus on transfer pricing results in: Installation and education of transfer pricing expert teams Introduction of local documentation requirements Increase of special transfer pricing tax audits Increase in transfer pricing disputes resulting in: - risk of economic double taxation - penalty for non-compliance - secondary adjustments - exchange of information between states Page 6

7 Transfer pricing environment Why is it important? If you are doing business internationally, you are already confronted with transfer pricing It is all about being in control and managing your risk Transfer pricing part of corporate governance policy Documentation Page 7

8 Transfer pricing environment Arm s length principle OECD Model Tax convention - Article 9: [When] conditions are made or imposed between... two [associated] 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. Page 8

revisions Sets out methods for establishing arm s length transfer

9 Transfer pricing environment Legislative framework OECD Model Tax Convention (Article 9) OECD Guidelines Since 1995 including subsequent revisions Sets out methods for establishing arm s length transfer prices between related parties Endorsed by the member countries of the OECD Page 9

10 Transfer pricing environment EU Comprehensive transfer pricing regulations exist and are actively enforced in 18 of the 25 Member States of the EU: Austria Italy Cyprus Belgium Luxembourg Czech Republic Denmark Netherlands Estonia Finland Portugal Hungary France Spain Latvia Germany Sweden Lithuania Greece United Kingdom Malta Ireland Poland Slovakia Slovenia Page 10

11 Transfer pricing environment US- PATA Section 482 of the Code on arm s length dealings Surveys to examine transfer pricing methodologies under Section 482 The APA program Pacific Association of Tax Administrators (PATA) Documentation Package PATA issues guidance on Mutual Agreement Procedure and bilateral Advance Pricing Agreement processes Page 11

12 Agenda Transfer pricing environment Transfer pricing methods Transfer pricing documentation Dispute resolution Recent developments Conclusions

13 Transfer pricing methods Traditional transaction methods - Comparable Uncontrolled Price (CUP) - Cost Plus method (cost + ) - Resale Price method (resale minus) Transactional profit methods - Profit Split - Transactional Net Margin Method (TNMM) Other methods Page 13

14 Transfer pricing methods Terminology TURNOVER - COST OF GOODS SOLD Comparable Uncontrolled Price = GROSS PROFIT - OPERATING COSTS AND Resale Price Cost Plus Profit Split EXPENSES = OPERATING PROFIT / EBIT Transactional Net Margin Page 14

15 Transfer pricing methods Comparable uncontrolled price Uncontrolled transaction is comparable TP Subsidiary if; - No material differences effect the price (i.e. products, functions, contracts, economy, business strategy) Market price Third party - Reasonably accurate adjustments can be made Always the best method if comparable transactions are available Page 15

16 Transfer pricing methods Cost plus method Cost plus mark-up Transfer price Market price Costs Costs Supplier Distributor Page 16

17 Transfer pricing methods Cost plus method Transfer price is determined by cost of goods / services plus gross mark-up Mark up is determined by comparables search in light of functions and market conditions Cost base calculation problems Most useful for; - simple manufacturer - provision of services - long term supply agreements - semi finished goods Page 17

18 Transfer pricing methods Manufacturing companies - Considerations Cost plus and cost base - Type of costs to use: actual budget - by product by period - single billing entity (conversion to) - link with accounting manual - link with investment decisions Closure and relocation of manufacturing capacity Page 18

19 Transfer pricing methods Resale minus method Market price Transfer price Resale minus margin Costs Costs Supplier Distributor Page 19

20 Transfer pricing methods Resale minus method Transfer price is determined by resale price minus gross margin Gross margin is determined by comparables search in light of functions and market conditions Adjustments needed for differences in functions Most useful for; - distributor - marketing operations - finished goods or no important further processing by reseller Page 20

21 Transfer pricing methods Sales companies - Considerations Resale price minus and customer price - actual, price list and best customer - local stocks and adjustments - discounts and year-end bonus - documentation for tax audit - cost of invoicing Royalty and local marketing expenses ( Marketing intangibles ) Role of sales office Page 21

22 Transfer pricing methods Cost plus vs resale minus Product cost price 70 Market price 100 Cost plus 10% Resale margin 10% Manufacturer Distributor Customer Cost plus method: Resale minus method: Cost plus method: Resale minus method: Risks lie with distributor Risks lie with manufacturer Page 22

23 Transfer pricing methods Profit split Splits combined operating profit between related parties based upon functional risk profile Allocation of residual profit by using contribution indicators (i.e. contribution in intangible property) Based on expected rather than actual profits Most useful when no comparable prices or margins for specific transaction exist Page 23

24 Transfer pricing methods TNMM Evaluates operating profits before interest and tax by comparables search Usually results in a number of observations, and hence a range of potentially acceptable profit outcomes, typically expressed as a return on an appropriate base, such as turnover, costs or assets Commonly used because data is more readily available Number of observations Arm s length range Return % Page 24

25 Transfer pricing methods How to set the margin: Comparables Potential internal comparables Functional analysis Methods Adjustments Evaluation results reliability Potential external comparables Database studies Page 25

26 Transfer pricing methods How to set the margin: Comparables Look for; Internal comparables; i.e. transactions within the group with third parties External comparables through database search (benchmarking): TNMM approach Databases: Bureau van Dijk s AMADEUS and others Page 26

27 Transfer pricing methods OECD approach to comparability Transactional approach Transaction must be sufficiently comparable - no differences, or adjustable differences Factors in determining comparability - is it really the same product, service or intangible - contractual terms - market - differences in business strategy Assess comparability based on a functional analysis Page 27

28 Transfer pricing methods Other transfer pricing issues Intercompany services - HQ expenses / shared services Intangibles - trade name / trademarks Cost contribution / cost sharing - R&D programmes Reorganization business structures - Introduction of tollers / agents Permanent losses Page 28

29 Transfer pricing methods Other transfer pricing issues Intercompany services The low hanging fruit in transfer pricing! HQ services costs can be divided in three categories: - Direct costs - directly allocated to specific group beneficiary - Indirect costs - costs made for the group - allocated to all beneficiaries on bases of allocation yard stick - Stewardship / shareholders costs - not allocated, but are kept at central level Page 29

Transfer pricing methods Other transfer pricing issues Intercompany services Supporting contemporaneous documentation needed consisting of: - Service

30 Transfer pricing methods Other transfer pricing issues Intercompany services Supporting contemporaneous documentation needed consisting of: - Service Level Agreement - Beneficiary test - Cost allocation schedule - Functional analysis at HQ level - Documentation on mark up used - Specified invoice! Page 30

31 Agenda Transfer pricing environment Transfer pricing methods Transfer pricing documentation Dispute resolution Recent developments Conclusions

32 Transfer pricing documentation Documentation challenge Global documentation requirements Can you afford not to be in compliance? What documentation strategies should you be employing? Page 32

33 Transfer pricing documentation Complexity check Sophisticated Medium Less sophisticated Sophisticated Medium Less sophisticated AUSTRALIA AUSTRIA CHINA BELGIUM HONG KONG CZECH REPUBLIC INDIA DENMARK INDONESIA FINLAND JAPAN FRANCE KOREA GERMANY MALAYSIA GREECE NEW ZEALAND HUNGARY PHILIPPINES IRELAND SINGAPORE ITALY TAIWAN LATVIA THAILAND LITHUANIA ARGENTINA NETHERLANDS CANADA NORWAY CHILE POLAND COLOMBIA PORTUGAL MEXICO ROMANIA PERU RUSSIA UNITED STATES SOUTH AFRICA VENEZUELA SLOVAK REPUBLIC SLOVENIA SPAIN SWEDEN SWITZERLAND UKRAINE UNITED KINGDOM Page 33

34 Transfer pricing documentation Purpose Define and agree on purpose of documentation, e.g.: Tax compliance Penalty protection Local documentation requirements Risk management Support Advance Pricing Agreements Management accounting Page 34

35 Transfer pricing documentation Framework Transfer pricing policy Transfer pricing report Transfer pricing board/audit manual Legal agreements Financial analysis Transfer prices Page 35

36 Transfer pricing documentation TP Report - High Level Table of Contents 1. Introduction 2. Company profile 3. Functional analysis (location of key value drivers) 4. Selection of transfer pricing methodology 5. Economic analysis (benchmarking) 6. Financial analysis (testing) 7. Conclusion Appendix I: Appendix II: Transfer pricing policy Relevant agreements Page 36

37 Transfer pricing documentation Process approach Analyse Design Implement Document Monitor Page 37

38 Transfer pricing documentation Process approach step 1: analyse Functional analysis Value chain analysis Identification of current intercompany transactions Key tax considerations Strategic objectives What are key value drivers? Risks Functions IP Page 38

39 Transfer pricing documentation Process approach step 1: analyse Functional analysis covers: - Key value drivers and their location - Key business risks and their location - Decision makers and their location - Assets employed - Intangibles used or created - Terms of trade - Background on the industry and market - Business strategy Page 39

40 Transfer pricing documentation Process approach step 2: design What are the opportunities associated with the implementation of a (new) transfer pricing framework, e.g.: Control Compliance with regulations Reduction effective tax rate Reduction cash tax What are the risks associated with the implementation of a (new) transfer pricing framework, e.g.: Cross border shifts of profits Opening up the past IT constraints Not alignment with business structure Limited resources Page 40

41 Transfer pricing documentation Process approach step 3: implement Stakeholders who and their roles Resources available internal / external Work plan / Milestones Communication internal/external IT ERP systems and administration Legal agreements / IP and labour law issues Page 41

42 Transfer pricing documentation Process approach step 4: document Step 1: Step 2: Step 3: Step 4: Prepare one central core documentation file (per region) Decide on priority/risk countries. Factors include: - Financial size of transactions - Importance of local markets - Fluctuations in results - Structural loss-making countries - Transfer pricing documentation rules - Penalty regimes - Need of business for guidance Local country review of core file in selected countries Roll-out core file locally Page 42

43 Transfer pricing documentation Process approach step 5: monitor Check invoice is in line with policy Check whether all agreements, documentation are in place Review financial performance of transfer pricing budget (actual vs. budgets) Overall review (check whether performance transfer pricing system conform expectations) Seek proactive clearance if Advance Pricing Agreement is possible Rely on documentation to manage tax audit Page 43

Transfer pricing documentation PwC Approach: Global Core Documentation Core Document Local Document Global Core Documentation Package Coordinated international service team approach Risk assessment &

44 Transfer pricing documentation PwC Approach: Global Core Documentation Core Document Local Document Global Core Documentation Package Coordinated international service team approach Risk assessment & non-duplicative data collection Consistent functional analysis & methodology Efficiencies through specialized tools, templates & procedures Quality & cost control tool Centralize preparation of core documentation package Customization to meet country-specific requirements Different levels of documentation for different needs Page 44

45 Agenda Transfer pricing environment Transfer pricing methods Transfer pricing documentation Dispute resolution Recent developments Conclusions

46 Dispute resolution What are the tools? After double taxation may occur: - Mutual Agreement Procedures (MAP) under Treaty (i.e. Turkish treaty network) - EU Arbitration Convention - Advance Pricing Agreements (APA) as roll back facility Before double taxation may occur: - Advance Pricing Agreements (APA) as a mean of dispute resolution: unilateral, bilateral, multilateral Page 46

47 Dispute resolution Mutual agreement procedure Article 25 in the OECD Model Treaty The competent authority shall endeavor... to resolve with the competent authority of the other state No obligation to reach agreement No deadlines: normally takes a long time (average processing time within EU 20 months) Overall success rate is 85% for MAP within EU Page 47

48 Dispute resolution Mutual agreement procedure - Turkey Tax treaty network with 61 countries Competent authority: Double Taxation Agreements Division under Directorate General of Revenues No obligation for relief of double taxation 3 years filing period under most of the treaties No domestic guidelines for mutual agreement procedure No procedural requirements for mutual agreement procedure Detailed knowledge of the issue is a success factor Page 48

49 Dispute resolution EU Arbitration Convention To eliminate double taxation between member states Provides for mandatory arbitration in cases where Member States cannot reach mutual agreement If no mutual agreement between tax authorities is reached within 2 years advisory commission must arbitrate in the case Was in force for initial period 1995 until 2000 Re-entered into force on 2004 with retroactive effect from 2000 Specific deadlines provided (3 years in total) Code of Conduct published in 2004 for effective implementation Page 49

50 Dispute resolution Advance pricing agreements Paragraph OECD Guidelines (1995) Annex to the OECD Guidelines (1999) Provisions in domestic legislation (USA, Japan, Australia, UK, Spain, Belgium, The Netherlands, Canada, Mexico, China..) Possible as part of mutual agreement procedure under the treaty (bilateral) Informal agreement with tax authority (unilateral) Page 50

51 Dispute resolution Advance pricing agreements Advance Pricing Fixed period of time Future events / transactions Transfer pricing techniques and rules Products, services, IP, loans and allocation of central expenses Parents, subsidiaries and permanent establishments Entrepreneur <-> least complex entity Key value drivers Agreement Tax payer and government Unilateral / bilateral / multilateral Page 51

52 Dispute resolution First multilateral APA signed in Europe for Airbus Strong signal by EU tax authorities (France, Germany, UK, Spain) Cooperative process Finding consensus Result in reasonable timing Page 52

53 Agenda Transfer pricing environment Transfer pricing methods Transfer pricing documentation Dispute resolution Recent developments Conclusions

54 Recent developments EU Joint Forum - Master file concept OECD developments - KERT discussion EU Debate Page 54

55 Recent developments Master file concept New: Approval of code of conduct on standardised documentation in the EU November 2005 EU Documentation ( EU TPD ) is proposed Master file as a blueprint for companies and their transfer pricing systems Proposes that companies can use same documentation in all member states Will ease heavy burden on companies of different documentation requirements EU TPD is still optional Page 55

56 Recent developments Master file concept Master file a) general description of the business b) the group s organisational, legal and operational structure c) general identification of the associated enterprises engaged in controlled transactions d) general description of the controlled transactions e) general description of functions and risks f) ownership of intangibles g) inter-company transfer pricing policy h) list of Cost Contribution Agreements, APAs and Rulings i) undertaking by the taxpayer to provide additional information upon request Minimum requirement for master file Country specific documentation a) detailed description of the business and business strategy b) information on country specific controlled transactions c) comparability analysis d) explanation about the selection and application of the transfer pricing method [s] e) relevant information on internal and/or external comparables if available f) a description of the implementation and application of the group's transfer pricing policy Page 56

57 Recent developments OECD draft paper on attribution of profits to permanent establishments Income allocation between head office and PE PE treated as a notional separate entity Two step working hypothesis to determine profits attributable to PE 1- Determine the functions performed, assets used and risks assumed by the PE 2- Attribute to the PE an arm s length return for the functions performed, assets used, and risks assumed by the PE as would a comparable enterprise Page 57

58 Recent developments OECD KERT discussion Key Entrepreneurial Risk Taking Functions (KERTs) discussion: Risks follow functions Profits follow people Active decision making with regards to most important profit generators Thus: profits can be allocated to locations where relevant risks are managed. Page 58

59 Recent developments OECD KERT discussion Common principal company structure: OECD view: Head office Head office cost plus fee cost plus fee Divisional head office Principal Residual profit cost plus fee cost plus fee Operations Operations Residual profit Page 59

60 Recent developments The European Debate All EU countries apply OECD Guidelines but European Commission found significant difference per country All countries have a strong preference for CUP, resale minus and cost plus methods Although there are no public data at transactional level to support these methods Profit based methods are under discussion Page 60

61 Agenda Transfer pricing environment Transfer pricing methods Transfer pricing documentation Dispute resolution Recent developments Conclusions

62 Conclusions What are the next steps? Be aware of rapid global developments Be ready to comply with proposed Turkish TP legislation Time to act! Develop transfer pricing strategy Develop documentation Page 62

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