By Pilar Barriguete & Edland Graci, Duff & Phelps, Spain
In recent years there has been a major public outcry for governments to take action to force multinational groups to pay a fair share of tax in the jurisdictions where their economic activities take place and to stop shifting profits to offshore tax havens.
Recognizing that this issue can only be meaningfully addressed on a coordinated global basis, international bodies such as the OECD, UN, and EU, among others, are trying to create an international consensus around improvements to the global system of taxation.
In doing so, they hope to restore public confidence that certain base erosion and profit shifting (BEPS) practices used historically by some MNEs will decline and that MNE profits will be taxed where economic value is created. To achieve this goal, a primary area of focus has been alignment of transfer pricing regulations so that profit allocations resulting from transfer pricing appropriately reflect value creation.
CIAT transfer pricing “Cocktail”
This is the focus of the recently published manual of the Inter-American Center of Tax Administrations (CIAT) known as “the Cocktail” which is described as “A cocktail of measures for the control of abusive transfer pricing manipulation, with a contextual focus on low-income and developing countries.”
The Cocktail seeks to propose solutions to make transfer pricing control more manageable, simple, and certain and to lower the costs of administration and compliance.
CIAT is a non-profit international public organization whose goal is to facilitate the sharing of MNE tax information among tax administrations. CIAT coordinates an international tax network, which includes participants from tax administrations, universities, the OECD, and other transnational organizations such as the World Bank.
CIAT is comprised of members from 42 countries. Of those, 32 CIAT member countries are from the Americas. There are five member countries from Europe (Spain, Portugal, Netherlands, Italy, and France), four African countries (Nigeria, Kenya, Angola and Morocco), and one Asian country (India).
While the Cocktail proposes several solutions, this article will focus on the “The Best Method Rule” (ingredient number 1).
Rule of the best method
The CIAT transfer pricing Cocktail asserts that many transfer pricing analyses lack an adequate analysis to select the best (the most appropriate) transfer pricing method.
CIAT asserts that it is common for practitioners to resort to predetermined or generic justifications to discard methods which sometimes lead to the selection of an incorrect method. CIAT asserts that often the method chosen reflects not appropriate best method considerations, but rather is governed by the ease (and expense) of applying the method, leading to overuse of the transactional net margin method.
In CIAT’s view, the transactional net margin method is a one-sided approach that only evaluates one of the counterparts in the analyzed transaction. Misapplication of the transactional net margin method may lead to outcomes where reported profits do not align to value creation because it can, in some situations, undervalue the role of the tested party.
According to the Cocktail, the correct application of the best method rule originates with a conceptual analysis of the suitability of each of the five transfer pricing methods and the possible sources of information for its application.
However, CIAT contends that the commonly-used justifications for using the transactional net margin method, such as administrative burden and the lack of access to counterpart information, cannot and should not limit the application of the best method rule.
By having a look at the generalized and systematic reasoning in selecting/ rejecting the most appropriate method, the Cocktail identified several problems.
Comparable uncontrolled price method
The comparable uncontrolled price method is commonly rejected due to lack of public information on comparable transactions, the Cocktail s states.
Nevertheless, the comparable uncontrolled price method could be the best method in a sale of goods whose prices are referenced in a recognized and transparent market. In these cases, it is possible to find reference prices that independent third parties use to agree on these operations (e.g., in the sale of raw materials).
Resale price method and cost plus method
The resale price method and cost plus method are commonly rejected based on the justification that such methods need a refined level of consistency in the cost classification and this is impossible to obtain in case of financial information reported by potential comparable companies or as part of potential comparable transactions.
However, more attention should be given to whether these methods are the most appropriate, particularly when analyzing limited risk distribution activities (purchase from related parties and sale to third parties) and contract manufacturing activities (purchase from third parties and sale to related parties), respectively.
Transactional net margin method
Transactional net margin method is a one-sided method and consequently does not analyze all the parties of an intercompany transaction; instead, it is focused merely on the profitability of the tested party and whether that profitability is within a range of returns earned by comparable companies.
Paragraph 2.65 of the OECD transfer pricing guidelines clarifies that this method is unlikely to be reliable if each party to a transaction makes unique and valuable contributions – something that CIAT clearly considers to be the case more often than the frequency of the transactional net margin method application would imply.
The Cocktail considers a detailed functional analysis and analysis of the whole business value chain critical so that the appropriateness of this method in light of the value chain can be evaluated, and so that, when it is, identification of the appropriate tested party is made.
Transactional profit split method
The transactional profit split method is generally rejected by taxpayers reasoning that multiple parties do not make unique and valuable contributions. However, there are cases where both parties make unique and valuable contributions. Thus, neither can be chosen as the tested party for the application of the transactional net margin method. In these instances, often the transactional profit split method is the most appropriate method.
Ultimately, the CIAT transfer pricing Cocktail acknowledges that the unilateral approach is practical and appropriate in some instances, but it has its limitations, especially when the analyzed entities make unique and valuable contributions.
After a full understanding of the contributions of each party to the transaction, a reliable determination of appropriate transfer pricing methodologies (and appropriate identification of tested parties for applying the transactional net margin method, when appropriate can be made, as shown in the following diagram:
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Company A (domestic) |
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Without unique and valuable contributions |
With unique and valuable contributions |
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Company B (foreign) |
Without unique and valuable contributions |
Tested entity: The less complex one (A or B) |
Tested entity: Company B |
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With unique and valuable contributions |
Tested entity: Company A |
One-sided method is unlikely to be reliable; probably, the PSM should be selected |
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Without access to the information of the company |
Tested entity: Company A (it will be never known if Company B was the least complex one) |
One-sided method is unlikely to be reliable; other methods or tools should be chosen |
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CIAT Cocktail’s best method rule proposals
The CIAT transfer pricing Cocktail proposes two main measures for clarifying the application of the “best method rule” and resolving the overuse of the unilateral approach.
The first measure is a more generic approach and the least disruptive. This proposal requires the identification and consideration of the unique and valuable contributions of each party as part of a detailed functional analysis.
In conceptual terms, unique and valuable contributions are defined as attributes that an entity has but that are not comparable with those that independent third parties are making in potentially comparable transactions, Namely, the contribution is a unique contribution and there is the expectation of generating greater future economic benefits than would be expected in its absence.
The second proposal is more specific and prescriptive. This is a measure that conceptually seeks to identify non-routine contributions through relative investments in intangible creation activity. Intangibles-creating activity within this proposal covers areas such as advertising, promotion, and R&D expenses, amongst others.
These activities are generally reflected in the taxpayers’ financial statements. Under this proposal, if the intensity in the costs identified in the financial statements of the selected tested party in a transactional net margin method analysis are significantly different from those assumed by the potential comparables, they will be considered under this approach as differences that affect the expected profitability of the comparables relative to the tested party and thus, the evaluation of their comparability.
In this regard, to encourage the correct implementation of the “best method rule”, specifically in terms of avoiding the overuse of the unilateral approach, the CIAT transfer pricing Cocktail states that when a taxpayer does not carry out an adequate comparability analysis that discards those potential comparables that maintain significant differences with respect to the valuable and unique contributions, the suitability of the conclusions under that method should be subject to question, and considerations of other methods and associated income adjustments should be considered.
This situation could practically have been avoided if the “best method rule” was correctly applied.
Transfer pricing facts and circumstances
Over the last decade, transfer pricing has become one of the most important topics in the international taxation community. International bodies are trying to develop transfer pricing rules, anti-avoidance measures, and disclosure requirements that can be reflected in domestic tax laws to combat abusive behaviors.
Transfer pricing is facts and circumstances dependent and is hardly an exact science. Taxpayers and tax authorities can have widely differing views on the appropriate implementation and testing of arm’s length pricing.
CIAT’s transfer pricing Cocktail is intended to provide measures and considerations that will help mitigate abusive behaviors and to provide more clarity on key
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