Transfer Pricing Strategy as a Tool for Group Tax Planning

Transcription

1 Mendel University in Brno Faculty of Business and Economics Transfer Pricing Strategy as a Tool for Group Tax Planning Diploma Thesis Supervisor: Doc. Ing. Danuše Nerudová, Ph.D. Bc. Jan Cienciala Brno 2011

2 Declaration I hereby confirm that I prepared this diploma thesis Transfer pricing strategy as a tool for group tax planning independently and on my own, by exclusive reliance on the literature written in the list of sources and my supervisor s assistance of Mrs. Doc. Ing. Danuše Nerudová, Ph.D. Brno, 13 th May Bc. Jan Cienciala

3 Acknowledgement I wish to express thanks to Mrs. Doc. Ing. Danuše Nerudová, Ph.D. my supervisor for this diploma thesis for her effort and professional approach in guiding me through the elaboration of this work in the course of my master s studies. Sincere thanks belong also to Mrs. Ing. Veronika Solilová, Ph.D. for her valuable advices regarding practical part of this thesis.

4 Abstract The goal of this diploma thesis is to suggest optimal transfer pricing strategy leading to group tax optimisation. Partial goal of this work is to analyze the legal aspects concerning transfer pricing in the Czech Republic. This work is divided into two parts. The first part is focused on explanation of terms and analysis of legal aspects of transfer pricing applied in the Czech Republic. In the second part on the basis of empirical analysis and data from AMADEUS databasis optimal transfer pricing strategy for group of companies is provided. Keywords: transfer pricing, income tax, OECD Guidelines for Multinational Enterprises, functional analysis, double taxation elimination

5 Abstrakt Cílem této diplomové práce je navrhnout optimální transfer pricingovou strategii vedoucí k optimalizaci daně pro skupinu podniků. Dílčím cílem této práce je prozkoumat právní aspekty týkající se transferových cen v rámci České republiky. Tato práce se skládá ze dvou částí. První část práce je zaměřena na historii, základní pojmy a podrobně analyzuje jednotlivé metody používané k určení převodních cen. Ve druhé části práce na, základě empirické analýzy a dat z databáze AMADEUS, je navržena optimální transfer pricingová strategie pro skupinu podniků. Klíčová slova: transfer pricing, daň z příjmů, směrnice OECD, funkční analýza, zamezení dvojího zdanění

6 Content 1. Introduction Objectives of the thesis Methodology and Outline of the Thesis History of Transfer Pricing Contributions of International Organizations History of Transfer Pricing related to the Czech Republic Growing Importance of Transfer Pricing in the Czech Republic Legal Aspects of Transfer Pricing in the Czech Republic Act on Income Tax Decrees Issued by the Ministry of Finance Decree D Decree D Decree D Factors Determining Comparability Characteristics of Property or Services Functional Analysis Identification of Areas for Possible Tax Optimization Related to Functions of Particular Companies of MNE Contractual Terms Economic Circumstances Business Strategies Recognition of the Actual Transactions Undertaken Losses Transfer Pricing Methods Comparable Uncotrolled Price Method (CUP) Resale Price Method (RPM) Cost Plus Method (CPM) Transactional Net Margin Method (TNMM) Transactional Profit Split Method (TPSM) OECD Model Tax Convention on Income and on Capital Convention on Elimination of Double Taxation in Connection with the Adjustment of Profits of Associated Enterprises (Arbitration Convention) OECD Concept of Advance Pricing Agreements EU Joint Transfer Pricing Forum Guidelines for Advance Pricing Agreements within the EU Practical part Model example Selection Procedure in Amadeus Databasis

7 7.1.2 Removing of Associated Companies from the Selection Determination of an Arm s Length Range Analysis of Producers Profit Margin Year Analysis of Producers Profit Margin Year Analysis of Producers Profit Margin Year Analysis of Producers Profit Margin Year Analysis of Producers Profit Margin Year Analysis of Producers Profit Margin Suggestion of Transfer Pricing Strategy Limitations of This Suggestion Sources Appendices BvDEP Independence Indicator

8 1. Introduction Since the beginning of 1990 th there is a global trend of growing globalization. There is no doubt that the most significant trend in today s world economy is the globalization i.e. great expansion of trade, integration of markets and economies accompanied by acculturation. Globalization has affected almost all spheres of human activities however most of the new opportunities arise in the business and entrepreneurial sphere. Especially in the last two decades a large number of multinational enterprises has been created and their importance is still growing. It became much easier to establish subsidiary, affiliate, joint venture, special purpose entity or trust in favourable geographical location and to take advantage of low taxes and subsidies. Simultaneously with this effect intercompany transactions across borders started to grow rapidly and become much more complex. The price charged for intercompany transactions as transfers of goods, services and intangibles across borders is called "transfer price". Due to the fact that transfer pricing has significant impact on income tax it cannot be set in the same way as for unrelated entities i.e. transfer pricing rules, methods and regulatory provisions must be followed. Even if special guidelines exist it is still complicated to find correct transfer price. If the transfer price is set at too low a level then the "seller" from the multinational enterprise thereinafter only MNE may suffer from depressed profit and moreover cuts the tax revenue for the respective national budget. On the other hand if the transfer price is set at too high a level then the "seller" from MNE gains more profit but on the expense of the buyer. If the income tax rate differs within the states where related entities of the MNE are located then the correct setting of the transfer price may help to increase corporate tax efficiency. This could be done by setting transfer prices at levels which encourage profits in low tax-rate countries, and restricting them in high tax-rate countries. Off course, the tax authorities in the high tax-rate country will be especially concerned to ensure that the tax revenue loss does not result from such action. If the tax administrator will prove that it is so the retrospective assessment of the tax will be made and penalty will be imposed

9 1.1 Objectives of the thesis Because of unquestionably growing importance of transfer pricing as explained already in the introduction and considerably low consciousness I am finding this topic very interesting and up-to-date. Therefore I decided to work out this thesis dealing with transfer pricing oriented on practice. The aim of this work is to suggest the optimal transfer pricing strategy leading to group tax optimisation while keeping to transfer pricing rules, methods and regulatory provisions. This main goal does include series of partial goals that can be separately defined as follows: Recognize the development of transfer pricing by study of Czech and mostly foreign literature sources as books, bulletins, presentations, studies, guidances, guidelines, regulations, etc. regarding this topic Analyze the most important contributions of international organizations to the transfer pricing legislation Describe the transfer pricing methods accepted by OECD and identify the differences between them Describe the process of setting transfer price according to OECD Guidelines for Multinational Enterprises Analyze legislation concerning transfer pricing in the Czech Republic Identify possible ways to prevent tax disputes concerning transfer pricing Point out possible ways how to optimize group tax With the help of Amadeus databasis select comparable companies and determine arm s length range for the particular branch of industry Work out practical example and show possible tax saving 1.2 Methodology and Outline of the Thesis This work is divided into eight chapters and into theoretical and practical part. First chapter is named introduction and explains briefly the basics and principles of transfer pricing. In the second chapter there is described the origin of transfer pricing and historical development. The most important milestones are mentioned. I read a lot of books about transfer pricing nevertheless I found the best - 9 -

10 information about the history on internet mainly on websites of HMRC 1 and UN. In the subchapter 2.1 I focused on the contributions of international organization to the area of transfer pricing and the most important steps of OEEC 2, OECD and UN are described. In this part I also utilized valuable information from the textbook International taxation by Mrs. Doc. Ing. Danuše Nerudová, Ph.D. At the end of this subchapter I mentioned also information about the Transfer Pricing Documentation Code of Conduct published by one of the consultancy firms on the internet. Subchapter 2.2 deals with the history of transfer pricing related to the Czech Republic. I used information from Communication D-258, D-292 and D-293 issued by the Ministry of Finance. In the subchapter 2.3 I created a graph showing growing number of MNE s in the Czech Republic based on Mr. Ing. Francírek s dissertation thesis. Chapter no. 3 deals with legal aspects of transfer pricing particularly in the Czech Republic. Income tax act no. 586/1992 Coll. with regard to the transfer pricing is analyzed. I worked with an internet source zakony-online (up to date version in Czech) and with paragraphs of this act in English published in Communications D as already mentioned. Subchapters analyze Communications D issued by the Ministry of Finance. I worked with both the older versions in English still available on the internet site of the Czech tax administration 3 and up to date version in the Czech language published in the bulletin Finanční zpravodaj. Chapters no. 4 and 5 were written after the study of the English book OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. This book represents the latest revision of transfer pricing guidance published by the OECD. Because of the importance of comparability analysis whole chapter 5 deals with this proposition. In order to provide necessary insight I put together the information from Communication D-332 with the OECD guidelines. Later I did my best to describe the possible ways of tax optimization in connection with functions. This was the most difficult from the theoretical part of this thesis. Although I read a lot of books and articles on the internet concerning transfer pricing practical examples on tax savings I was hardly able to find. Nevertheless I hope that I took down the most important. In the subchapters of chapter no. 5 I analyzed factors determining comparability, characteristics of property or services, functional analysis, contractual terms, economic 1 Her Majesty's Revenue and Customs-is a non-ministerial department of the UK Government responsible for the collection of taxes and the payment of some forms of state support. HMRC was formed by the merger of the Inland Revenue and Her Majesty's Customs and Excise which took effect on 18 April 20 2 Organisation for European Economic Co-operation-the predecessor of OECD

11 circumstances, business strategies, recognition of the actual transactions undertaken and losses. More space is devoted to transfer pricing methods. I tried to describe the principles and differences between them and also types of applications where they are used at most. Thanks to the advice of my supervisor I incorporated in this thesis also the guidances and commentaries from OECD Model Tax Convention on Income and on Capital. In the subchapter 5.8 I worked also with the Czech translation of the book OECD Model Tax Convention on Income and on Capital translated by Danuše Nerudová and Kristýna Šimáčková. The Czech translation helped me with understanding of a lot of complicated provisions. Subchapter 5.9 deals with so called arbitration convention which can help in solving international disputes. Subchapter 5.10 on the other hand describes the possibility to prevent disputes by establishing Advance Pricing Agreement. I focused on APA also later in the text because the EU Joint Transfer Pricing Forum prepared special guidelines for applying APA within the Member states of the EU. Chapter no. 6 describes the most important steps of the EU in the transfer pricing. It is also answered why the EU became involved in transfer pricing policy. In the subchapter 6.1 the EU Joint Transfer Pricing Forum is described and its most significant achievements are mentioned. At the end of chapter no. 6 I mentioned Guidelines for Advance Pricing Agreements and I provide brief insight to the situation in the Czech Republic. Practical part of this thesis begins with chapter no. 7. My intention was to provide a clear example where by correct setting of transfer price it is possible to take advantage of tax saving. For finding comparable companies I used Amadeus databasis created by Belgian company Bureau van Dijk. This kind of databasis contains comprehensive information on over 18 million companies across Europe. It enables searches for individual companies, searches with specific profiles and also analysis. This databasis is used also by Czech tax administration and therefore we can consider that as a reliable source of information. It enables searches for individual companies, searches with specific profiles and also analysis. At first I wanted to analyze the arm s length range by companies brewing beer in the Czech Republic. Unfortunately after the selection procedure in Amadeus databasis only 13 companies remained and moreover these were not independent. So I was trying to find another branch in the industry producing very similar products with higher number of companies. Finally, I succeded with dairy industry where I found 37 companies. Because of missing BvDEP independence indicator I had to manually remove from selection associated companies. I worked with annual reports and other official statements

12 from Company register downloaded from the server Justice.cz. In order to have statistically significant sample I removed from the selection only companies which participate directly in the management, control, or capital of an enterprise of other state. This step of manual removing of associated persons was very time consuming and difficult. But after having a sample of comparable companies I was able to calculate the interquartile range and median for each particular year of my analysis. Based on the results I proposed transfer pricing strategy and I prepared an example showing possible tax saving. The main sources of data are primary and secondary materials. Primary sources include guidelines, guidances, regulations, international conventions and domestic legislation. Secondary sources include, presentations, data from Amadeus databasis, bulletin articles, books, textbooks and data from dissertation thesis. Internet sources are used where they provide information that is otherwise not available in primary sources and where they provide current information and data

13 2. History of Transfer Pricing The history of transfer pricing began in the United Kingdom by the start of the 20 th century. At that time United Kingdom had one of the world's most developed economies and possibly the most comprehensive tax system. Quite a few UK companies had overseas operations (both subsidiaries and branches). Rates of tax tended to be slightly higher in the UK and additional levies had to be imposed during wartime. Manipulation of transfer prices had started to cause a few problems before the First World War ( ) and remedial legislation was first attempted in Specific transfer pricing provision with an international focus were introduced during World War I in the United States as well. These provisions should prevent from profit shifting by associated companies through under or over-pricing of cross-border transactions. 5 Result of these eventual transactions was that the total profit of the associated companies was significantly affected. For this and other reasons multinational companies effectively used transfer pricing as a mean to avoid taxes. This was done bearing in mind that avoiding tax is tolerated i.e. by taking the advantage of shortcomings in tax law within legal boundaries. Absence of transfer pricing provisions in many countries meant that companies found it relatively easy to reduce their tax burdens. In the subsequent years, the anti-avoidance provisions in the United Kingdom, the United States and other countries that followed the trend, presented a risk of double taxation for the taxpayer on the same income or profits. The risk of double taxation could either be, economic double taxation where the same amount is taxed more than once in the hands of different parties or, juridical (legal) double taxation where the same income is taxed more than once by way of different taxes or in an international context by different authorities. The risk was enhanced by an increasing concern by tax authorities to get satisfactory tax contribution from the enterprise operating in or from their jurisdiction. The countries did so by enacting transfer pricing legislation which resulted in unilateral solutions to the problem. 4 Her Majesty's Revenue and Customs (HMRC) [online] [retrieved ]. What is transfer pricing all about? < 5 Ad Hoc Group of Experts on International Cooperation in Tax Matters Tenth meeting, Geneva, 2001: Transfer Pricing History C State of the Art C Perspectives. Paper prepared by the United Nations Secretariat [retrieved ]. Available at: <

14 Further, there was a common conflict of interest among the countries to collect tax at the expense of the companies being doubled taxed hence leading to increased operational costs, decreased profits and uneven competition internationally. 6 Therefore it was essential to found an international consensus on transfer pricing and cross-border transactions. 2.1 Contributions of International Organizations These efforts begun by the League of Nations 7 and pursued in the Organisation for European Economic Co-operation (OEEC) (now known as the Organisation for Economic Co-operation and Development - OECD) and in regional forums, as well as in the United Nations, have in general found concrete expression in a series of model or draft model bilateral tax conventions. Substantial progress towards the elimination of double taxation has been made through unilateral relief measures and more particularly through bilateral tax conventions, which have emerged since the However, until 1965, only a relatively small number of treaties had been concluded between developed and developing countries. 8 It is worth of mentioning the formulation of the arm s length principle, because nearly all systems for setting transfer price require that prices be tested according to this standard. It means that a price is considered appropriate if it is within a range of prices that would be charged by unrelated parties dealing at arm s length. This is generally defined as a price that an unrelated buyer would pay an unrelated seller for an identical item under identical terms and conditions. In a multilateral context the arm s length principle was formulated for the first time in Article 6 of the League of Nations draft Convention on the Allocation of Profits and Property of International Enterprises in This article is substantially similar to Article 9 of the 1963 OECD Draft Convention and Article 9, paragraph 1 of the present OECD and UN Model tax treaties. 9 6 ALLAN, Onsando. The OECD Transfer Pricing Guidelines: An Analysis of their Application in the South Africa Legal Regime. Cape Town, p. Research dissertation. University Of Cape Town. Available at: < 7 League of Nations is the precursor to the United Nations, it was founded in 1919 in Paris 8 United Nations Model Double Taxation Convention between Developed and Developing Countries. 1st. New York : United Nations, p. Available at: < 9 Ad Hoc Group of Experts on International Cooperation in Tax Matters Tenth meeting, Geneva, 2001: Transfer Pricing History C State of the Art C Perspectives. Paper

15 The general difference between the OECD and UN model of double taxation elimination treaty is in the place where most of the incomes are taxed. The OECD model of double taxation elimination treaty is usually concluded between advanced countries and the incomes are taxed in the country where the taxpayer is resident. The UN model of double taxation elimination treaty is usually concluded between developing countries and the incomes are taxed in the country of its source. (NERUDOVÁ, 2007) Before 1979 administrative guidance on the application of legal provisions relating to transfer pricing was scarcely available. Because of the increase in the number of MNEs and the increase of transactions within MNEs since the sixties the Member States of the OECD considered it necessary to produce guidelines for their respective tax administrations on how to deal with transfer pricing. It was also considered useful to elaborate on Article 9 of the Model Treaty and its Commentary. 10 Since one of the two main goals was the avoidance of double taxation, the multilateral framework of the OECD was chosen for developing a consensus on the matter of transfer pricing. Working Party No. 6 which is a subgroup of the Committee on Fiscal Affairs of the OECD, produced an authoritative report by the end of the seventies. The 1979 OECD Report "Transfer Pricing and Multinational Enterprises" was not intended to establish a detailed standard of transfer pricing, but rather to set out the problems and the considerations to be taken into account and to describe which methods and practices were acceptable from a tax point of view in determining transfer prices. Although the recommendation has no immediate legal force, the fact that all Ministries of Finance of the OECD Member States have adopted the 1979 Report without reservations gives it a high level of authority. There is a more than moral obligation for tax authorities not to deviate from the Report in their domestic administrative regulations. In several countries judges look upon the report as binding on the tax administration concerned unless pertinent legislation deviates from it. Without such a common approach it is extremely difficult to reach an agreement under mutual agreement procedures on transfer pricing matters. The unfortunate result may be double taxation. 11 prepared by the United Nations Secretariat [retrieved ]. Available at: < 10 Ad Hoc Group of Experts on International Cooperation in Tax Matters Tenth meeting, Geneva, 2001: Transfer Pricing History C State of the Art C Perspectives. Paper prepared by the United Nations Secretariat [retrieved ]. Available at: < 11 Ad Hoc Group of Experts on International Cooperation in Tax Matters Tenth meeting, Geneva, 2001: Transfer Pricing History C State of the Art C Perspectives

16 Due to growing importance of transfer pricing besides OECD and UN also the European Union started to be active in this matters. Because of proliferation of transfer pricing documentation requirements the administrative burden of MNEs substantially increased. Therefore European Commission prepared Transfer Pricing Documentation Code of Conduct which was approved by the European Council on 27 June History of Transfer Pricing related to the Czech Republic The history of transfer pricing in the Czech Republic is relatively short, it started after the fall of iron curtain in The domestic transfer pricing arrangements are closely related to the international ones, namely the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. The principles of the Guidelines have not been directly implemented in tax laws nor there is any direct reference to them in the Czech tax laws. However its binding effect arises from the fact that the Czech Republic is a signatory to multilateral Vienna Convention on Law of Contracts from Czech Republic is a member of the OECD since The arm s length principle was introduced into the Czech law already in The Czech translation of the OECD Guidelines has been published in the bulletin of Ministry of Finance Finanční zpravodaj in two parts, first in FZ no. 10/1997 and second in FZ no. 6/1999. The recommendations and principles from OECD guidelines and EU Transfer Pricing Documentation Code of Conduct were implemented into the Czech law within years as decrees D-258, D-292 and D-293 issued by the Ministry of Finance. Later I will describe them in more details including updates. Paper prepared by the United Nations Secretariat [retrieved ]. Available at: < 12 EU Transfer Pricing Documentation : A uniform EU-wide approach to documentation in line with a wider global approach. PricewaterhouseCoopers. [online]. 1st: 2006 [retrieved ]. Available at: < Ref 2006BHM Czech Republic. Guidance D 332 : Communication by the Ministry of Finance in respect of international standards application in taxation of transactions between associated enterprises transfer pricing. In Communication D. 2010, p Available at: < 0>

17 Total number of registered subsidiaries of MNEs in CR 2.3 Growing Importance of Transfer Pricing in the Czech Republic Based on the data from the dissertation thesis of Mr. František Francírek, PhD. I created this chart on which is clearly visible the development of number of subsidiaries of MNEs in the Czech Republic. Number of registered subsidiaries of MNEs in the Czech Republic Years Chart no. 1 Number of registered subsidiaries of MNEs in the Czech Republic, source: Source: Francírek, 2003; graph elaboration by author

18 3. Legal Aspects of Transfer Pricing in the Czech Republic The income tax act no. 586/1992 Coll., as amended regulates the tax for both legal entities and natural persons. In this act we can find the basic regulation of transfer pricing. In addition to this the Czech Ministry of Finance issued three guidelines. Now we will look in more detail on the above mentioned laws. 3.1 Act on Income Tax With transfer pricing deals above all s. 23, par. 7, where is defined the arm s length principle. In the Czech conditions we can say that this concerns using the usual prices for income tax base definition as stipulated in our tax laws. The definition is as follows: If the prices agreed between enterprises associated in economic or personnel sense or between otherwise associated enterprises differ from prices which would be agreed effected between independent enterprises in usual business relations under the same or similar conditions, and if the difference is not reasoned in a satisfactory manner, the tax administrator shall adjust the taxpayer s tax base applying the difference The sense of this enactment lies in the right of the tax administrator to adjust the tax base of the inspected taxable unit in case when given transfer prices does not satisfy the market prices for comparable transactions. Inspected transactions can be transfers of physical goods or intangible property, providing services, cost contribution arrangements etc. 14 It is worth of mentioning that in the Act on Income Tax there is also defined the term "associated persons". From 2004 the definition of associated persons is more precise and transparent and for deep understanding I provide exact definition. a. capitally associated persons means 1. if one person is directly involved in capital or right to vote of another person, or if one person is directly involved in capital or right to vote of more persons, and person s share represents at least 25% of registered capital or 25% of right to vote, all the persons concerned are the capital associated persons, 14 A CCA is a framework agreed among enterprises to share the costs and risks of developing, producing, or obtaining assets, services, or rights, and to determine the nature and extent of the interests of each participant in the results of the activity of developing, producing, or obtaining those assets, services, or rights-source OECD,

19 2. if one person is indirectly involved in capital or right to vote of another person, or if one person is directly or indirectly involved in capital or right to vote of more persons, and person s share represents at least 25% of registered capital or 25% of right to vote, all the persons concerned are the capital associated persons, b. persons associated in a different way, namely 1. when one person in engaged in management or control of another person, 2. when the same persons or persons next of kin are engaged in management or control of other persons, these other persons are associated persons 3. controlling and controlled persons, and also persons controlled by the same controlling person 4. persons next of kin 20c) 5. persons which established legal relation mainly for the purpose of tax base reduction or tax loss increase Decrees Issued by the Ministry of Finance In consideration to the development in the field of transfer pricing the Ministry of Finance issued three guidelines D-258, D-292 and D In view of the 2010 amendments to the OECD Transfer Pricing Guidelines and changes in the area of tax administration the Czech Ministry of Finance has issued new updated guidelines D-332, D-333 and D-334. From 1 st January 2011, new guidelines replaced old ones Decree D-332 Decree D-332 replaces older Decree D-258 and has been issued to ensure a uniform procedure when taxing transfers of goods, intangible assets and services within multinational enterprises, considering both tax administrations and tax entities. It does not aim at detailed description of the whole wide matter of transfer pricing issues or at substitution or reformulating of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, but it strives to deal with the application of the basic 15 Czech Republic. Act on Income Tax. In Collection of Law. 1992, as amended, s. 23 par. 7. Available at: <

20 principles in the tax administration under the conditions of the Czech Republic. 16 The new instruction changes the existing procedure when choosing a suitable method for setting transfer prices. In accordance with the new OECD Transfer Pricing Guidelines (July 2010), the Decree prescribes that when choosing a method it is no longer necessary to follow the pre-set order of methods but the most suitable method should be selected. In addition, Point 1.5 of the Instruction provides that the OECD Guidelines should also be used when evaluating domestic transactions. The appendix, with illustrative examples, forms an integral part of the Instruction. Compared with the previous decree, the Decree leaves out detailed information about transfer pricing documentation Decree D-333 Decree D-333 replaces existing Decree D-292 and relates to the application of the binding consideration in cases of so called transfer pricing. The possibility to request binding consideration was introduced since January 1 st, The binding consideration takes over principles of advance pricing agreements in the sense of OECD Guidelines (paragraphs ) and other international standards, and adjusts them to the conditions of the Czech tax law. The binding consideration provides the taxpayers the possibility to verify in advance whether the method for setting up the transfer price is complying with the arm s length principle for the purposes of tax base definition as provided for in Article 9 Associated enterprises of the Double Taxation Treaty, as well as in s. 23 par. 7 of AIT. Upon a request by a taxpayer, a tax authority shall decide whether the taxpayer selected transfer pricing method leading to appropriate allocation of incomes and expenditures between associated enterprises. Such consideration shall mean a certain degree of certainty for the taxpayer in respect of the way, how the tax authority assesses the transfer pricing method by the taxpayers for the purposes of tax base 16 Czech Republic. Finanční zpravodaj. In Sdělení k uplatňování mezinárodních standardů při zdaňování transakcí. 2010, 44th, 6, pages Available at: < ISSN MOUČKA, Lubomír; DRAŠAR, Tomáš. Instructions regarding transfer prices between related parties. KPMG : Financial Update [online]. January 2011, [retrieved ]. Available at: < Update/Documents/KPMG_Financial-Update-January-2011.pdf>

21 definition. If in the period for which the binding consideration was issued the taxpayer meets all the conditions based on which the tax authority took the decision, and if the facts and circumstances effecting the transfer pricing method do not change in principle, the tax authority shall consider the prices determined in this way as a usual prices under s. 23 par. 7 of AIT during a tax audit or other way of evidence collection and tax assessment. Nevertheless, in principle the binding consideration in the form of new guidance has not changed significantly. There are only minor changes. The administrative charge paid for the application for a binding consideration remains CZK 10,000. Originally, before 31 st December 2008 the fee for submission of an application for binding consideration (APA) was CZK 50, Decree D-334 Decree D-334 replaces existing Decree D-293 and includes recommendations of the Ministry of Finance in respect of the documentation that should be provided when setting transfer prices between related parties. This communication aims at publishing standards of documenting appropriateness of transfer pricing to make it compliant with s. 23 par. 7 of the Act no. 586/1992 Coll., on income taxes, as amended (hereinafter AIT ) and Article 9 of most of the Double Taxation Treaties, so compliant with arm s length principle specified in Chapter 1 of OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. Further in the Decree there is described the concept of EU Transfer Pricing Documentation which Czech Republic and also other EU member states decided to implement. Briefly this concept consists of two main elements: The masterfile (contain common standardized information relevant for all EUgroup members of a multinational enterprise such as a general description of the business and business strategy, a general description of the transactions involving associated enterprises in the EU and the enterprise's transfer pricing policy.), and Country-specific documentation (consist of a set standardized documentation for each of the specific Member State involved. Each set of country-specific documentation would contain information relevant to that country only such as amounts of 18 Czech Republic. Finanční zpravodaj. In Sdělení k uplatňování mezinárodních standardů při zdaňování transakcí. 2010, 44th, 6, pages Available at: < ISSN

22 transaction flows within that country, contractual terms and the particular transfer pricing methods used). 19 Nevertheless the companies may decide themselves whether to process Masterfile for whole group or prepare transfer pricing documentation independetly. The new instruction compared to the previous does not include any significant changes. I will focus in more detail on the EU TPD later in the chapter EU and its Contribution to the Transfer Pricing. 4. OECD approach to the Transfer Pricing As you already read in the introduction and in the chapter of Legal aspects of transfer pricing manytimes I reffered to the OECD Transfer Pricing Guidelines for Multinational Enterprises. This document and its principles are followed not only by the Czech tax administration but also other OECD member states and a great number of non-member states too. Because of these facts I would like to follow these Guidelines and start analyzing and explaining them. First chapters of OECD Guidelines are related to the introduction, the arm s lenth principle and non-arm s length methods. The arm s length principle I mentioned already and the non-arm s length methods as theoretical alternative due to several disadvantages should be rejected. Therefore I will not deal anymore with the non-arm s length methods and I will continue with guidance for applying the arm s length principle. 5. Comparability Analysis The procedure of finding the most appropriate transfer price which satisfies the arm s length principle is based on a comparison of the price, margin or profits from particular controlled transaction with the price, margin or profits from comparable uncontrolled transaction. 19 Guidance D : Communication by the Ministry of Finance in respect of the scope of transfer pricing documentation. In Communication D. 2005, 39/ / , Available at: < >

23 Compa ny A Controlled transaction (sale or purchase) Compa ny A Unrelated company B Picture no. 1 Comparable transactions Source: Daňové prostředí České republiky roku 2006, Seminar of Ministy of Finance and CzechInvest. [retrieved ].Available at: Many methods exist how to determine the transfer price. In each particular case it should be aimed to select the most appropriate method. For selecting the most appropriate method it is of crucial importance to identify potential comparables. However it is only rarely possible to find fully comparable transaction in respect of conditions under which these transactions are performed. In most cases it is necessary to make adjustments so that the identified differences will be eliminated. According to the decree D-332 the transaction could be considered as comparable when one of the following criteria is maintained: a. none of the differences between the controlled and comparable transaction should influence a condition (factor) being assessed, i.e. possible differences identified may be considered as insignificant and unimportant, or b. there is a possibility to implement relevant adjustments so that the influence of the identified differences may be eliminated Czech Republic. Finanční zpravodaj. In Sdělení k uplatňování mezinárodních standardů při zdaňování transakcí. 2010, 44th, 6, pages Available at: < ISSN

24 At present no compulsory process exist for performing comparability analysis. For better understanding bellow is a typical process that can be followed when performing comparability analysis: Step 1: Determination of years to be covered. Step 2: Broad-based analysis of the taxpayer s circumstances. Step 3: Understanding the controlled transaction(s) under examination, based in particular on a functional analysis, in order to choose the tested party (where needed), the most appropriate transfer pricing method to the circumstances of the case, the financial indicator that will be tested (in the case of a transactional profit method), and to identify the significant comparability factors that should be taken into account. Step 4: Review of existing internal comparables, if any. Step 5: Determination of available sources of information on external comparables where such external comparables are needed taking into account their relative reliability. Step 6: Selection of the most appropriate transfer pricing method and, depending on the method, determination of the relevant financial indicator (e.g. determination of the relevant net profit indicator in case of a transactional net margin method). Step 7: Identification of potential comparables: determining the key characteristics to be met by any uncontrolled transaction in order to be regarded as potentially comparable, based on the relevant factors identified in Step 3 and in accordance with the comparability factors set forth at paragraphs Step 8: Determination of and making comparability adjustments where appropriate. Step 9: Interpretation and use of data collected, determination of the arm s length remuneration. (OECD, 2010) From tax administrator point of view it is necessary to find a benchmark. Prices among related companies should be as close to the benchmark as possible. The benchmark is usually identified through a database. Tax administrators and some international companies use for this purpose the Amadeus database. This database is created the by Belgian company Bureau van Dijk. Czech tax administration has purchased this databasis in October In practical part of my work I will work with and describe in details this database and possible utilization. It is worth of mentioning that this new 2010 OECD Guidelines much more emphasise the importance of a comparability analysis compared to the previous version from This above mentioned nine-step process which is considered to be good practice was newly added as a part of the chapter III

25 5.1 Factors Determining Comparability It is useful to mention that according to the OECD Guidelines five factors may be important when determining comparability. These comparability factors include the characteristics of the property or services transferred, functions performed by the parties (usually analysed in functional analysis), the contractual terms, the economic circumstances of the parties and the business strategies followed by the parties Characteristics of Property or Services When performing comparability analysis it is very useful to take into account following factors: in respect of things (e.g. goods, real estates etc.), their physical features, quality, reliability, market availability, market offer volumes must be assessed; in respect of the property of intangible nature, it is necessary to concentrate attention on the form of transaction (e.g. whether it concerns licensing or sale), property type (e.g. patent, trade mark, know-how), duration and level of protection, expected profit from intangible property use/enjoyment; in respect of services provided, the nature and scope of the services must be considered Functional Analysis In order to correctly determine whether controlled and uncontrolled transactions are comparable it is necessary to perform so called functional analysis. Functional analysis is used for identification and comparison of economically significant activities and responsibilities undertaken, assets used and risk assumed by the parties of the transactions. It is possible that one party may provide a large number of functions compared to the other one. As function it is considered e.g. design, manufacturing, assemling, research and development, servicing, purchasing distribution, marketing, advertising, transportation, financing and management. The functions carried out by the parties determine to some extent the risk that each party bears. Risks that need to be considered while determining the degree of comparability between controlled and uncontrolled transactions include for example 21 Czech Republic. Finanční zpravodaj. In Sdělení k uplatňování mezinárodních standardů při zdaňování transakcí. 2010, 44th, 6, pages Available at: < ISSN

26 product liability risks, credit and collection risks etc. In an open market higher risk is usually offset by higher income from the transaction and in case of controlled transactions this is usually reflected in an arm s length price Identification of Areas for Possible Tax Optimization Related to Functions of Particular Companies of MNE It is both wise and legal to profitably allocate the functions between the companies within MNE. For example suppose that there is MNE having two subsidiaries one manufacturing company located in low-tax jurisdiction and one distribution company located in high-tax jurisdiction. The scope of business will be for example manufacturing and sale of shoes. In this case it is much more efficient to assign more functions, and therefore risks to the manufacturing company. The more functions and risks are performed by each particular company the higher price could be charged at arm s length. The risks that could be assigned to the manufacturing company are for example risk of the success or failure of investment in research and development, transportation risks, currency exchange rate risks, inventory risk and so forth. In case of currency exchange rate risk hedging arrangements, forward contracts, put and call options, swaps are common. There are also other ways how to optimize the tax burden for associated group of companies arrising from functions. Advantageous structuring of intangible property between companies within MNE is another possibility. According to PricewaterhouseCoopers from tax point of view intellectual property 22 offers significant opportunities for legitimate modular result planning. Particular transfer pricing techniques can be applied to achieve tax optimisation and defend your company s IP strategy. Unrecognised and unexploited IP clearly means losing out on a competitive advantage Intellectual property (IP) is a term referring to a number of distinct types of creations of the mind for which a set of exclusive rights are recognized and the corresponding fields of law. [1] Under intellectual property law, owners are granted certain exclusive rights to a variety of intangible assets, such as musical, literary, and artistic works; discoveries and inventions; and words, phrases, symbols, and designs. Common types of intellectual property include copyrights, trademarks, patents, industrial design rights and trade secrets in some jurisdictions. Intellectual property. In Wikipedia : the free encyclopedia [online]. St. Petersburg (Florida) : Wikipedia Foundation, 16 October 2001, last modified on 4 April 2011 [retrieved ]. Available at: < 23 RASCHLE, Norbert; MARTI, Armin; BONVIN, Nicholas. Structuring Intangible Property. In PricewaterhouseCoopers. Transfer Pricing : Tax solutions that meet your

27 The thing is that the valuation of intellectual property is more difficult. It is because the value of some intangible asset can fluctuate significantly over time and even though the cost of creating the the intangible asset was low the value can be high or vice versa. Another complication is that comparable intangible assets and therefore corresponding royalty rates are often difficult to identify. Another areas for example intra-group services especially management fees offers also a small space for tax optimization. 5.2 Contractual Terms Based on the contractual terms and conditions, it is possible to find out how the responsibilities and risks or revenues of transactions executes should be allocated (refer also to the previous point). Contractual terms and conditions may be also identified in correspondence or other documents Economic Circumstances Economic circumstances clearly play an important role when deciding about market comparability of the transactions. In order to achieve comparability it requires that the markets in which the independent and associated enterprises operate do not have differences that have a material effect or that appropriate adjustments can be made. Economic circumstances include the geographic location; the size of the markets; the extent of competition; the extent of competition in the markets and the relative competitive positions of the buyers and sellers; the availability of substitute goods and services; the levels of supply and demand in the market as a whole and in particular regions; consumer purchasing power; the nature and extent of government regulation of the market; costs of production including the costs of land, labour, and capital; transport costs; the level of the market (e.g. retail or wholesale), the date and time of transactions, and so forth. (OECD 2010) business needs [online]. 1st. Switzerland : PricewaterhouseCoopers, 2008 [retrieved ]. Available at: < >. 24 Czech Republic. Finanční zpravodaj. In Sdělení k uplatňování mezinárodních standardů při zdaňování transakcí. 2010, 44th, 6, pages Available at: < ISSN

28 5.4 Business Strategies Business strategies followed by particular companies should be taken into account when determining comparability of controlled and uncontrolled transactions. The reason is that if for example some company is expanding its market share it might temporarily charge a price for its product that is lower than the price charged for otherwise comparable products in the same market. Furthermore the company might temporarily incur higher costs (e.g. due to increased marketing efforts) and hence achieve lower profit compared to other companies operating in the same market. For this and for other reason when deciding about comparability it is necessary to analyse the business strategy. It is also reasonable to take into account that tax administrations could examine the conduct of the parties to determine if it is consistent with the purported business strategy. For example, if a manufacturer charges its associated distributor a below-market price as part of a market penetration strategy, the cost savings to the distributor may be reflected in the price charged to the distributor's customers or in greater market penetration expenses incurred by the distributor. (OECD, 2010) 5.5 Recognition of the Actual Transactions Undertaken For the tax administration several reasons exists for assessing whether the transfer prices have been set up in accordance with the arm s length principle. If economic substance of a transaction differs from its form. Form and substance of the transaction are the same, the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner and the actual structure practically impedes the tax administration from determining an appropriate transfer price. In these above mentioned cases the character of the transaction may derive from the relationship between the parties rather than be determined by normal commercial conditions and may have been structured by the taxpayer to avoid or minimise tax. Associated enterprises are able to make a much greater variety of contracts and arrangements than can independent enterprises because the normal conflict of interest which would exist between independent parties is

29 often absent. Therefore the tax administrations may want to determine what underlying reality is behind a contractual agreement in applying the arm s length principle. 5.6 Losses There are some specific situations when associated enterprise realizes long-term losses while the MNE group as a whole is profitable. Obviously in such a case the transfer pricing should be examined. The reason is that the loss enterprise may not be receiving adequate compensation from the MNE group i.e. transfer price may not be set up in accordance with arm s length principle. Recurring losses for a reasonable period may be justified in some cases by a business strategy however if the pricing strategy continues beyond a reasonable period, a transfer pricing adjustment may be appropriate. (OECD, 2010) 5.7 Transfer Pricing Methods In general I can say that when setting up transfer price whatever method can be used which is consistent with the arm s length principle. According to the circumstances of the case the most appropriate transfer pricing method should be selected. OECD recognized 2 kinds of transfer pricing methods: traditional transaction methods and transactional profit methods. For better orientation bellow I provide graphical scheme, see picture no

30 Comparable Uncotrolled Price Method (CUP) Traditional transactional methods Resale Price Method (RPM) Cost Plus Method (CPM) Transactional profit methods Profit Split Method (PSM) Transactional Net Margin Method (TNMM) Picture no. 2 Division of Transfer Pricing Methods Source: OECD, 2010; own graphical processing Traditional transaction methods are regarded as the most direct means of determining an arm s length price. Therefore if there is a situation that a traditional transaction method and a transactional profit method can be applied in an equally reliable manner, the traditional transaction method is preferable to the transactional profit method. On the contrary there are situations where transactional profit methods are found to be more appropriate than traditional transaction methods. For example, cases where each of the parties makes valuable and unique contributions in relation to the controlled transaction, or where the parties engage in highly integrated activities, may make a transactional profit split more appropriate than a one-sided method. (OECD, 2010) In order you to have an overview which method suits best each particular transaction I provide short analysis of all five methods. The basic principle of each method is also desribed in the Decree D-332 issued by the Ministry of Finance Comparable Uncotrolled Price Method (CUP) The comparable uncotrolled price method (CUP) offers of course the most direct way of determining an arm s length price. It compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. Under the U.S. regulations, the CUP method applies only to transfers of tangible property. (FEINSCHREIBER, 2004)

31 An uncontrolled transaction is comparable to a controlled transaction (i.e. it is a comparable uncontrolled transaction) for purposes of the CUP method if one of two conditions is met: a) none of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions could materially affect the price in the open market; or, b) reasonably accurate adjustments can be made to eliminate the material effects of such differences. Where it is possible to locate comparable uncontrolled transactions, the CUP method is the most direct and reliable way to apply the arm's length principle. (OECD, 2010) However in practice, this method is very often difficult to apply as it is unusual for multinational companies to have access to suffcient details of appropriately comparable third-party transactions. Transfer pricing regulations in most countries allow CUPs to be adjusted if differences between the CUP and the related party transaction can be valued and have a reasonably small effect on the price. Examples of adjustments that are commonly allowed include differences in: The terms of the transaction (for example, credit terms); The volume of sales; and The timing of the transaction. Differences in respect of which adjustments are difficult or impossible to make include the: Quality of the products; Geographic markets; Level of the market; and Amount and type of intangible property involved in the sale Resale Price Method (RPM) Resale price method seems to be a little bit more complicated than comparable uncontrolled price method. The resale price is the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise. This price is then reduced by an appropriate gross margin on this price (the resale price margin ). What is left after subtracting the gross margin can be 25 PricewaterhouseCoopers. Comparable uncontrolled price method. International Transfer Pricing 2011 [online]. 2010, 12, 1, [retrieved ]. At 38. Available at: <

32 regarded, after adjustment for other costs associated with the purchase of the product (e.g. customs duties), as an arm s length price for the original transfer of property between the associated enterprises. This method is probably most useful where it is applied to marketing operations. Where uncontrolled and controlled transactions are comparable in all characteristics other than the product itself, the resale price method might produce a more reliable measure of arm s length conditions than the CUP method, unless reasonably accurate adjustments could be made to account for differences in the products transferred.(oecd, 2010) In other words the closer the comparability of products between controlled and uncontrolled transaction the better the result of this method Cost Plus Method (CPM) Cost plus method determines the arm s length price by suming up costs incurred by the supplier of property or services in a controlled transaction and adding appropriate markup. The cost plus mark up of the supplier in the controlled transaction should ideally be established by reference to the cost plus mark up that the same supplier earns in comparable uncontrolled transactions ( internal comparable ). In addition, the cost plus mark up that would have been earned in comparable transactions by an independent enterprise may serve as a guide ( external comparable ). It is important to note that the transferred goods under the comparable transaction need not be physically similar to the goods transferred under the controlled transaction. It is necessary also to consider several issues when evaluating a comparable transaction. Especially capacity, technology owned by manufacturer, volume and geographic market. These differences between controlled and uncontrolled transaction may have a considerable effect on the on the size of mark up. Therefore certain adjustments should be made. This method probably is most useful where semi finished goods are sold between associated parties, where associated parties have concluded joint facility agreements or long-term buy-and-supply arrangements, or where the controlled transaction is the provision of services. (OECD,2010) Transactional Net Margin Method (TNMM) The transactional net margin method works in the similar way as the resale price method or cost plus method. It means that it compares financial indicators related to the controlled transaction with the

33 financial indicators related to a comparable independent transaction. A functional analysis of the controlled and uncontrolled transactions is required to determine whether the transactions are comparable and what adjustments may be necessary to obtain reliable results. A transactional net margin method is unlikely to be reliable if each party to a transaction makes valuable, unique contributions. This method has off course certain strengths as for example is less adversely affected by differences in products than is the comparable uncontrolled price method and less adversely affected by differences in functions performed than are resale price and cost plus methods. This is because net profit indicators also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, this may lead to a wide range of gross profit margins but still broadly similar levels of net operating profit indicators. Another practical strength of the transactional net margin methodis that, as with any one-sided method, it is necessary to examine a financial indicator for only one of the associated enterprises (the tested party). As a weakness OECD considers the requirement of information on uncontrolled transactions that may not be available at the time of the controlled transactions. However multiple year data can be used as stated in article (OECD, 2010) According to PricewaterhouseCoopers 26 in practice profit-based methods are widely used largely because of the availability of comparable data at the net profit level based on the published financial statements of independent companies Transactional Profit Split Method (TPSM) This method determines the transfer price on the basis of division of total profit between associated enterprises according to contribution to that profit. The transactional profit split method first identifies the profits to be split for the associated enterprises from the controlled transactions in which the associated enterprises are engaged (the combined profits ). References to profits should be taken as applying equally to losses. It then splits those combined profits between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm s length. 26 PricewaterhouseCoopers. Comparable uncontrolled price method. International Transfer Pricing [online]. 2011, 12, 1, [retrieved ]. At 44. Available at: <

34 The main strength of the transactional profit split method is that it can offer a solution for highly integrated operations for which a onesided method would not be appropriate and in cases where both parties to a transaction make unique and valuable contributions (e.g. contribute unique intangibles) to the transaction, because in such a case independent parties might wish to share the profits of the transaction in proportion to their respective contributions. On the other hand, a transactional profit split method would ordinarily not be used in cases where one party to the transaction performs only simple functions and does not make any significant unique contribution (e.g. contract manufacturing or contract service activities in relevant circumstances). A weakness of the transactional profit split method relates to difficulties in its application. On first review, the transactional profit split method may appear readily accessible to both taxpayers and tax administrations because it tends to rely less on information about independent enterprises. However sometimes can be difficult to access the information from foreign affiliates and moreover also to measure combined revenue and costs for all the associated enterprises participating in the controlled transactions because it requires adjustments in accounting practices and currencies. (OECD, 2010) 5.8 OECD Model Tax Convention on Income and on Capital In order to have a more detailed view on the transfer pricing it is very useful to mention article 9 Associated Enterprises of the Model Tax Convention on Income and on Capital. This Article deals with adjustments to profits that may be made for tax purposes where transactions have been entered into between associated enterprises (parent and subsidiary companies and companies under common control) on other than arm s length terms. (OECD, 2010) Article 9, paragraph 1 says: 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,

35 may be included in the profits of that enterprise and taxed accordingly. (OECD, 2010) In other words the tax administration can in terms of correct setting of transfer prices include into the profit of the enterprise profit of other associated enterprise which was already taxed in other country. Obviously this leads to juridical double taxation. For this reason there is paragraph no. 2 which says: 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. (OECD, 2010) However The Czech Republic and Hungary reserve the right not to insert paragraph 2 in their conventions but are prepared in the course of negotiations to accept this paragraph and at the same time to add a third paragraph limiting the potential corresponding adjustment to bona fide cases. (OECD, 2010) 5.9 Convention on Elimination of Double Taxation in Connection with the Adjustment of Profits of Associated Enterprises (Arbitration Convention) In order to prevent problems of juridical double taxation arising from transfer pricing adjustments (earlier mentioned) with the effect from 1 October 2006, the Czech Republic ratified 90/436/EEC "Convention on elimination of double taxation in connection with the adjustment of profits of associated enterprises". 27 The origin of the Arbitration Convention was the Commission's 1976 proposal for a directive to eliminate double taxation in the case of transfers of profits between associated enterprises in different Member States and the White Paper of 1985 on the completion of the Internal Market. After long negotiations in the Council, the Commission proposal was transformed from a Directive into an inter-governmental 27 Czech Republic Ratifies the EU Arbitration Convention. Deloitte : Tax & Legal News [online]. October 2006, [retrieved ]. Par. 1 at 1. Available at: < CzechRepublic/Local%20Assets/Documents/cz(en)_tax_legal_news_ pdf>

36 Convention and it was signed on 23 July The Arbitration Convention was in force from 1 January 1995 until 31 December 1999 for an initial period of five years. Several months before the expiration of the first five-year application period of the Arbitration Convention, the Council adopted a Protocol to the Arbitration Convention that provides for an automatic extension of the Convention by periods of five years unless a Contracting State opposes. This Protocol of 25 May 1999 amends the Convention of 23 July 1990 on the elimination of double taxation in connection with the adjustment of profits of associated enterprises. This Protocol was, in spite of its timely signature, only ratified in August 2004 by all 15 prior EU Member States. The EU Arbitration Convention therefore re-entered into force, with retroactive effect from 1 January 2000, on 1st November With the enlargement of the EU the Arbitration Convention was extended on three occasions in 1995, in 2004 and in As a result the Arbitration Convention will generally apply amongst EU Member States. 28 The main objective of this Convention is to adjust processes applied in resolving disputes, which may arise from transfer pricing adjustments made by tax authorities on transaction between related parties in the EU, thus preventing double taxation. Disputes arising during the taxation of controlled transactions had been previously dealt with by tax treaties whereby tax authorities reached mutual agreement on individual cases. However, tax treaties do not oblige tax authorities to reach an agreement and do not determine any time limit for concluding a case. 29 On the contrary this Convention states that: If the competent authorities concerned fail to reach an agreement that eliminates the double taxation referred to in Article 6 within two years of the date on which the case was first submitted to one of the competent authorities in accordance with Article 6 (1), they shall set up an advisory commission charged with delivering its opinion on the elimination of the double taxation in question. The advisory commission 28 European Commission : Taxation and Customs Union [online]. 19/01/2010, 12/11/ :51:42 [retrieved ]. Transfer Pricing and the Arbitration Convention. Available at: < tration_convention/index_en.htm>. 29 Czech Republic Ratifies the EU Arbitration Convention. Deloitte : Tax & Legal News [online]. October 2006, [retrieved ]. Par. 1 at 1. Available at: < CzechRepublic/Local%20Assets/Documents/cz(en)_tax_legal_news_ pdf>

37 referred to in Article 7 shall deliver its opinion not more than six months from the date on which the matter was referred to it. 30 In this way it is assured that the final solution related to a disputed case must be reached within 3 years. How this all works? I will try to describe briefly the process. At first the taxpayer requests to initiate a mutual agreement procedure (MAP). The competent authority informs the competent authorities of the other States involved in the case attaching a copy of the taxpayer s request. In order to minimize costs and delays caused by translation the mutual agreement procedures are mostly conducted in English. Then the competent authority decides whether the requests are justified, if it can itself arrive at a satisfactory solution or has to resolve the case by mutual agreement with competent authority of any other State concerned. As soon as the competent authority of some state involved considers a case to be well founded, it has to initiate the mutual agreement procedure by informing the competent authority of the other State of its decision. The State sends a position paper to the competent authorities of the other states, its view of the merits of the case, e.g. why it believes that double taxation has occurred and how the case might be resolved. The other competent authority will respond not later than six months after receipt of the position paper. If the States do not find a compromise by these MAP during two years an advisory commission has to be established. The opinion of the advisory commission has to be finalized within six months. The states have to find a compromise within six months after the opinion was delivered by the advisory commission. The most interesting is that the compromise of the states may deviate from the opinion of the advisory commission unless it avoids double taxation. From my point of view this is quite good Convention in favour of the companies. It is clearly defined and its application is costeffective and efficient. In practice the tax payers just had to transmit the documents, which were prepared for the preceding tax audit Official Journal of the European Union L 225, 20/08/1990 P VOEGELE, Alexander; FORSTER, Florence. The Arbitration of Transfer Prices in Europe : The EU Arbitration Convention in Practice. In WorldTrade Executive Inc. Practical European Tax Strategies : Report on Tax Planning for International Companies Operating in Europe [online]. 1st. Concord : World Trade Executive Inc., 2006 [retrieved ]. p Available at: <

38 5.10 OECD Concept of Advance Pricing Agreements In order to eliminate uncertainty and avoid possible disputes considering transfer pricing the possibility for Advance Pricing Agreement has been established. Because of the fact that the Czech Decree D-333 issued by the Ministry of Finance comes out from this OECD arrangement and I described this decree already in the previous chapter I would like just to point out the most important things. The concept of Advance Pricing Agreements is defined by OECD as follows: An advance pricing arrangement ( APA ) is an arrangement that determines, in advance of controlled transactions, an appropriate set of criteria (e.g. method, comparables and appropriate adjustments thereto, critical assumptions as to future events) for the determination of the transfer pricing for those transactions over a fixed period of time. An APA is formally initiated by a taxpayer and requires negotiations between the taxpayer, one or more associated enterprises, and one or more tax administrations. APAs are intended to supplement the traditional administrative, judicial, and treaty mechanisms for resolving transfer pricing issues. They may be most useful when traditional mechanisms fail or are difficult to apply. (OECD, 2010) Finally I would like to point out that with this topic deals also the EU Joint Transfer Pricing Forum and worked out Guidelines for Advance Pricing Agreements within the EU. I will briefly describe these guidelines in following chapters. 6. EU Approach to the Transfer Pricing Although regulations of transfer pricing of each EU country are based on or at least inspired by OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations each country has its particularities. This results definitely in uncertainty over certain transfer pricing issues and moreover it increases compliance costs for multinational companies. Therefore, cross border transfer pricing issues can be considered as obstacles to the smooth functioning of the internal market of the European Union. Furthermore, the different interpretations, approaches and points of view of the tax authorities increase the risk of double taxation arising from transfer pricing adjustments. Therefore the need of taxpayers and tax administrations to be able to obtain preferably bilateral and multilateral advance pricing arrangements (APAs) in a smooth and cost effective way is essential. However, current procedures remain complex, time consuming and costly. Given the fact that transfer pricing remains a difficult matter, avoiding double taxation in all cases by means of APAs will not be

39 feasible. Tax authorities and taxpayers therefore also need effective dispute resolution procedures. In order to try to resolve the above stated problems, the European Commission found that closer cooperation between the tax administrations and the business community within the European Union was essential and that coordination between the EU member states had to improve. For this reason in June 2002 European Commission established the EU Joint Transfer Pricing Forum EU Joint Transfer Pricing Forum In this chapter I would like to describe in more detail the EU Joint Transfer Pricing Forum and also to sum up its achievements. The forum is made up of one expert from the tax administrations of each Member State plus 15 experts from business and is chaired by an independent chairman. Additionally, representatives from applicant countries (namely Croatia, Turkey and the Former Yugoslav Republic of Macedonia) and the WP6 OECD Secretariat attend as observers. 33 The representative of the Czech Republic in EU JTPF is currently Mr. Ing. Michal Roháček from General Financial and Tax Directorate. Up to this day the EU Joint Transfer Pricing Forum issued three communications. The first was a Code of Code of Conduct on the Convention for the elimination of double taxation (the Arbitration Convention). This work I will describe in the next chapter. The second communication was a Code of Conduct on transfer pricing documentation for associated enterprises in the EU. This Code of Conduct is also implemented in the Czech legislation as Decree D This decree was also already described in my work. Finally in February 2007 the third communication was adopted by the EU Commission-Guidelines for Advance Pricing Agreements. This is a 25-page document and I will briefly describe its aim in the next chapter KPMG : Belgium [online]. 14/01/2010 [retrieved ]. EU Joint Transfer Pricing Forum. Available at: TransferPricingForum.aspx>. 33 European Commission : Taxation and Customs Union [online]. 2002, 08/04/ :45:39 [retrieved ]. Transfer Pricing Forum. Available at: < m/index_en.htm> 34 European Commission : Taxation and Customs Union [online]. 04/03/2010, 08/04/2011 [retrieved ]. At Commission Communication ( COM(2007)71. Transfer Pricing Forum. Available at:

40 6.1.1 Guidelines for Advance Pricing Agreements within the EU An APA is an agreement between tax administrations over the way in which certain transfer pricing transactions between taxpayers will be taxed in the future. Hence an APA often prevents the need for a dispute between tax administrations over the transactions included in the APA. APAs are an exemplary method of dispute avoidance. The JTPF examined the pros and cons of APAs in depth and concluded that there were significant advantages for taxpayers and tax administrations that can arise from APAs. First amongst these are the certainty over the taxation treatment of the transactions in the APA a certainty enjoyed by both the tax administrations (which no longer have to conduct an audit to establish the correct transfer pricing; it is only the correct application of the APA that has to be checked) and the taxpayers (who know how to establish the correct transfer pricing since this has been agreed between the tax administrations involved.) 35 In other words Advance Pricing Agreements (APAs) within the EU aims to prevent transfer pricing disputes and associated double taxation from arising in the first place by laying down how an efficient APA process should work. An APA will provide in advance certainty concerning the transfer pricing methodology and therefore simplify or prevent costly and time-consuming tax examinations into the transactions included in the APA; this should lead to savings for all parties involved in an APA, lead to a reduction of compliance costs, and provide more consistency in transfer pricing within the EU. This approach should reduce tax obstacles to cross-border economic activities in the internal market. The Guidelines set out the framework for the over-all procedure and also provide details of how some specific problems could be resolved. They also provide examples of the necessary time frame and the types of areas which would need to be covered by the APA /transfer_pricing/com(2007)71_en.pdf>. 35 European Commission : Taxation and Customs Union [online]. 04/03/2010, 08/04/2011 [retrieved ]. At Commission Communication ( COM(2007)71.. Transfer Pricing Forum. Available at: < x/transfer_pricing/com(2007)71_en.pdf>. 36 EU Joint Transfer Pricing Forum : Over the next year the JTPF will examine transfer pricing in SMEs. Transfer Pricing International Journal [online]. 2010, 01, [cit ]. Available at: < BNA%20-EUJTPF-KPMG-Van%20Stappen.pdf>. ISSN

41 In order you to have an overview about the situation in the Czech Republic I provide following information. The option to apply for binding consideration (Advanced pricing agreement) is being used by a growing number of taxpayers. From the moment the provisions of 38nc of the Act on Income Taxes came into force until the end of 2009, there were 60 tax subjects who utilized this measure to find out in advance whether the tax administrator would confirm the method applied in pricing transactions between associated entities. This represents a growing trend, since in 2009 there were 25 requests compared to 13 requests in the It is necessary to add that in many cases requests are incomplete and the time of processing is thus prolonged by the time needed to complete all the details, despite the fact that the tax administrators managed to process the request within 8 months Výroční zpráva české daňové správy [online]. 1st. Prague : Ministerstvo financí - Ústřední finanční a daňové ředitelství, 2010 [retrieved ]. Available at: < ISBN

42 7. Practical part In the theoretical part I mentioned and analyzed the transfer pricing rules, methods and provisions. Now in this part part I would like to suggest transfer pricing strategy for company from particular industry branch in the Czech Republic that lead to group tax optimization. I will perform a comparability analysis on a sample of companies from dairy industry. Basically similar procedure is used also by the Czech tax administration to determine transfer price when the taxpayer requests for binding consideration (APA) or by audit. I will work with real data from the Amadeus databasis. On the basis of comparability analysis it is possible to find an arm s length range i.e. to find out whether the price methodology is correct and appropriate for a company from this particular branch of industry. 7.1 Model example Task: Suggest transfer pricing strategy leading to tax optimization for independent company focused on milk processing located in the Czech Republic. The basic principle of transfer pricing strategy is to assign the functions and risks with respect to the tax rules in respective countries in a way that the highest portion of income of the group of companies will be taxed in country with lowest corporate tax rate. Properly set transfer pricing strategy enables to assign the functions and connected risks within the group of companies to lower the tax burden off course by keeping to the valid rules and regulations. For this reason it is necessary to set the transfer price within the arm s length range Selection Procedure in Amadeus Databasis As I already mentioned for finding arm s length range for specific type of products it is necessary to find appropriate comparables. Therefore I will follow the deductive approach i.e. I will start with a search from the Amadeus databasis. The advantage of this approach is that the deductive approach compared to the additive is more reproducible and transparent. After, I will manually remove from the selection enterprises which participate directly in the management, control, or capital of an enterprise of other state. Amadeus databasis is of regional coverage and contains comprehensive information on over 18 million companies across Europe. It is published by Belgian company Bureau van Dijk and is provided as a paid service. The owners of the databasis are mostly

43 financial institutions and big companies. The advantage of this databasis is the wide coverage and also possibility of sophisticated easy searching and analyzing. 38 In order to find meaningful comparables reasonable selection criteria has to be used in each particular case. In my search I applied following selection criteria: 1. Geographic - selection is restricted only to companies located in Czech Republic 2. Type of accounts selection is restricted only to companies with unconsolidated accounts 3. Active companies are selected 4. Industry selection is again restricted only to companies with primary codes 1551 Operation of dairies and cheese making according to NACE Rev Finally selection is restricted to companies employing over 50 employees. 38 Bureau van Dijk : Company information and business intelligence [online]. 2011, 21/02/2011 [retrieved ]. Amadeus. Available at: < 39 NACE is a Statistical Classification of Economic Activities developed in the European Community. NACE is an acronym derived from the French title 'Nomenclature générale des Activités économiques dans les Communautés Européennes'. A number of different versions of NACE have been used since the original version NACE 70 was introduced in NACE 70 was replaced by NACE Rev. 1 in 1990 which in turn under went a minor update in 2002 to establish NACE Rev

44 Picture no. 3 Selection Procedure in Amadeus Databasis Source: Amadeus Bureau van Dijk Electronic publishing