TRANSFER PRICING WORKSHOP, KUALA LUMPUR

TRANSFER PRICING WORKSHOP, KUALA LUMPUR
Prof. Daniel N. Erasmus Assisted by Prof. Anneline Venter CA(SA) and Sebastien Gonnet NERA Economic Consultants

Index DAY 1 More notes at www.IITF.net Transfer Pricing References
Glossary of transfer pricing terms SESSION 1: Introduction to Transfer Pricing: Oil & Gas Industry Oil & Gas Primer – Annexure A Introduction – Transfer Pricing Abuses Oil & Gas organogram Intercompany Process Flows Introduction – Placing Transfer Pricing into International Perspective Country Specific Transfer Pricing Regulations DTA’s list BIT’s list Exchange of Information – OECD Exchange of Information Guidelines – Annexure B / OECD TIES’s list – Annexure C SESSION 2: Basic Principles of Transfer Pricing by Prof. A Venter Presentation in the context of oil & gas – Annexure D Bureau van Dijk TP Catalyst demonstration SESSION 3: A CASE STUDIES: (1) BRAND OIL SESSION 4: DEVELOPING APPROPRIATE DOCUMENTATION IN TRANSFER PRICING More notes at

Index DAY 2 More notes at www.IITF.net
SESSION 1: Formalizing an effective record keeping & reporting process Theory Bureau van Dijk TP Catalyst CASE STUDIES: (2) CUREMAKER (3) WIDGET WHOELSALE SESSION 2: Adopting Transfer Pricing best practices Presentation by NERA Economic Consultants – Annexure E Intellectual Property Management fees SESSION 3: Pre-empting tax audits & Handling tax controversies in a proactive manner SESSION 4: Gaining insight into different tax regulations on Transfer Pricing CASE STUDY (4): Virtual Profile Company More notes at

DAY 1 Thursday 6th of DEC 2012 More notes at

Transfer Pricing References
OECD Transfer Pricing Guidelines UN Transfer Pricing Guidelines Global Transfer Pricing Study EY 2010/11 PwC Transfer Pricing Manual More notes at

Glossary of Transfer Pricing Terms
TP = Transfer Pricing Cost plus method CUP = Comparable uncontrolled pricing RPM = Resale price method CPM = Comparable profits method TNMM = Transactional net margin method PLI = Profit level indicator CCA = Cost contribution agreement

Introduction to TP: the Oil & Gas Industry
DAY 1 Session 1 Introduction to TP: the Oil & Gas Industry More notes at

Oil & Gas Primer Refer to “Transfer Pricing in the Oil & Gas Sector: A Primer” – Annexure A More notes at

Introduction – Transfer Pricing Abuses
Through transfer pricing, a taxpayer seeks to minimize income and maximize deductible expenditures in high-tax jurisdictions and vice versa in low-tax jurisdictions. Transfer pricing mechanisms that affect revenue in the oil and gas sector are: The creative use of price hedging mechanisms involving transactions between related parties, causing great difficulty in assessing whether hedging instruments are used for transfer pricing purposes rather than to reduce risk; The provision by related parties of highly leveraged debt finance at above-market interest rates; Claiming excessive management fees, deductions for headquarter costs, or consultancy charges paid to related parties; The provision of capital goods and machinery in leasing arrangements at above-market costs charged by a related-party lessor; If the petroleum tax rate is above the standard tax rate, there may be an incentive to establish a domestic shell firm that will on-lend financing capital from related parties to the oil company giving rise to an interest deduction at a higher tax rate than is charged on the interest earnings in the shell company. Abusive transfer pricing can be very difficult to detect and prevent. SOURCE: Revenue from the Oil and Gas Sector: Issues and Country Experience, Emil M. Sunley, Thomas Baunsgaard and Dominique Simard More notes at

More notes at www.IITF.net
Home Country Tax Havens UPSTREAM Developing Countries MIDSTREAM DOWNSTREAM More notes at

Intercompany Process Flows Legal Tax Accounting Treasury Operations More notes at

Introduction – placing TP into international perspective
Country Specific Regulations (see next slide) OECD and UN guidelines ( and International law Double Tax Treaties – “DTA’s” 1 & 2 Bilateral Investment Treaties - Multilateral Treaties Constitutional & administrative law Information Exchange – TIEA’s - attached Annexures B & C More notes at

Country comparisons Country TP Regs TP Docs? Tax Return Penalties
Thailand Y Recommend Up to 200% Vietnam N Taiwan Singapore Pakistan N Anti-Av Malaysia Up to 300% Indonesia Y >Rp10m Up to 48% India Y >INR10m Hong Kong China 5% no docs Cambodia South Korea 10% More notes at

Basic principles of TP by Prof. A Venter
DAY 1 Session 2 Basic principles of TP by Prof. A Venter More notes at

Basic Principles of TP Presentation by Prof. A Venter – Annexure D
Basic principles in the context of the Oil & Gas Industry A functional analysis QA More notes at

Home Country Tax Havens UPSTREAM Developing Countries MIDSTREAM DOWNSTREAM More notes at

PetroCo Drilling Asia Explore Indonesia Vietnam Thailand Ship Refine
Home Country 100% 100% 100% Drilling Asia Tax Havens Explore Indonesia Vietnam Thailand UPSTREAM 100% Ship Developing Countries MIDSTREAM Refine DOWNSTREAM

TP Catalyst Bureau van Dijk - An introduction to TP Catalyst
IBFD Intro to Transfer Pricing More notes at

DAY 1 Session 3 A Case Study (1) More notes at

Brand A Oil Brand A Oil Brand B Oil Domestic sales to retailers
R&D, manufacturing, domestic sales UK Brand B Oil Brand A Oil K 125 80K K Domestic sales to retailers Distribution Brand A Oil (Malaysia) Diagram explained: Widget Wholesale-USA (WW-USA), is a subsidiary of a foreign manufacturer. There are only 32 other Foreign Manufacturers of widgets and no domestic (US) manufacturers WW products are specifically designed for the US market , and are not sold anywhere else on the world, although WW also manufacture products specifically designed for its domestic market WS-US does not participate in R & D WW owns the manufacturing intangibles, while WW-US developed and owns the marketing intangibles WW-USA keeps inventory and resells to various independent retailers WW-USA also sells specially designed widget models to several independent distributors in California where the widget market is most intense The independent distributors also sells normal models and also sells to retailers. None of these firms are publicly traded WW-USA are under audit over the price of imported goods shipped to it from its parent manufacturer The transferred property in question are tangible property, to which intangibles may be attached 108K Malaysia Resale under Brand B Oil 132K Resale under Brand A Oil

BRAND OIL case study More notes at

What methods may be available here?
CUP? Cost-plus? Resale minus? TNMM? Profit split? More notes at

Comparable uncontrolled price
Brand A Oil Corporation sells goods to Brand A Oil (Malaysia) for $ 100K. Potential comparables for this transaction are: Sales by Brand A Oil Corporation to domestic customers - $133K each Sales by Brand B Oil to Brand A Oil (Malaysia) - $80K each. How reliable are these comparables likely to be?

Comparable uncontrolled price
How reliable are the comparables?. Are the sales into the same level of the market? Brand A Oil’s sales in UK appear to be to end customers. The controlled transaction is to a sales/distribution company. Do they involve the same product as the controlled transaction? There appear to be marked differences between the products manufactured by Brand A Oil Corporation and by Brand B Oil It is unlikely that there is sufficient product or functional comparability to allow the comparable uncontrolled price method to be reliably used in this case.

Cost plus method The accounts of the independent manufacturer show a 66.7% mark-up on direct costs. Does this provide a comparable that can apply to the manufacturing costs of Brand A Oil Corporation? Functional analysis: Brand A Oil owns 2 intangibles – brand and trade (R & D expenditure); Cost plus, which would involve testing Brand A Oil Corporation, is unlikely to be suitable unless the independent has similar intangibles of similar value; We do not know this; We also do not know the product mix in the sales of the independent manufacturer – we need to identify the mark-up it achieves on the sale of goods to Brand A Oil (Malaysia).

Resale price method The gross margin earned by Brand A Oil Corporation on units purchased from the independent manufacturer is a potential comparable: We know that, on units sourced from Brand A Oil, Branded A (Malaysia) Ltd earns a gross profit of 24% (( )/132); We know that on units sourced from the independent manufacturer, the gross margin is 26% ((108-80)/108). A comparability analysis is necessary to establish whether this a sufficiently reliable comparable.

Transactional net margin method
Is TNMM available? We know that Brand A Oil (Malaysia) earns a net margin of 10%; However we do not know how this is split between the net margin earned on goods sourced from Brand A Oil Corporation and that earned on goods sourced from Brand B Oil; That is, we do not have transactional information Also .. We know the net margin earned by Brand A Oil Corporation and that earned by Brand B Oil; But , again, we do not have the information available at a transactional level; So TNMM is unlikely to be reliable in this case.

Profit split method A potential comparable would be the split of profit between the independent manufacturer and Brand A Oil (Malaysia) derived from the manufacture and sale of the units produced by the independent manufacturer and sold to Brand A Oil (Malaysia). If we used a profit split method, this would be compared to the split of profit between Brand A Oil and Brand A Oil (Malaysia), from the manufacture and sale of the units produced by Brand A Oil. However, we do not have the information to enable us to do this on a transactional basis. We have only whole-company information on net profit. Also, profit split is most appropriate where both of the parties to the transaction carry out non-benchmarkable functions. This would need to be tested.

conclusions The tentative conclusion might be that the resale price method is available in this case. However, we would need to carry out a comparability analysis to determine whether this method, and the chosen comparable transaction, are sufficiently reliable.

Comparability factors
A comparability analysis focuses on five factors: Nature of product Contractual terms Functional analysis (including assets used and risks assumed) Economic conditions Business strategy

Comparability analysis
You are asked to carry out a comparability analysis between the following transactions: a) purchases of units by Brand A Oil (Malaysia) from Brand A Oil (Malaysia), and b) purchases of units by Brand A Oil (Malaysia) from Brand B Oil.

Analysis shows that there is poor product comparability between the goods sourced by Brand A Oil (Malaysia) from Brand A Oil and Brand B Oil But there is good functional comparability between the functions carried out by Brand A Oil (Malaysia) in respect of goods sourced from Brand A Oil and Brand B Oil

In this case, we would probably consider that there is good functional comparability between: the functions performed by Brand A Oil (Malaysia) in respect of Brand A Oil sourced goods, and The functions performed by Brand A Oil (Malaysia) in respect of Brand B Oil sourced goods .. and that the resale price method is likely to be sufficiently reliable and that no transfer pricing adjustment is necessary.

Developing appropriate documentation in TP
DAY 1 Session 4 Developing appropriate documentation in TP More notes at

Session 1: Developing appropriate documentation in TP (1)
Examining TP documentation requirements Enabling documentation to defend TP data Implementing TP documentation to mitigate possible tax disputes

INTRODUCTION: insights to in-house TP Policy development Wolters Kluwer Developing TP Policy If a taxpayer can demonstrate that it has developed a sound transfer pricing policy in terms of which transfer prices are determined in accordance with the arm's length principle by documenting the policies and procedures for determining those prices, the Commissioner is more likely to conclude that its transfer pricing practices are acceptable and the risk of possible adjustments will be diminished.

On the other hand, preparing documentation is time-consuming and expensive. It will therefore not be expected of taxpayers to go to such lengths that the compliance costs related to the preparation of documentation are disproportionate to the nature, scope and complexity of the international agreements entered into by taxpayers with connected persons.

Documentation Guidelines: Chapter V OECD Guidelines Determined in accordance with “same prudent business management principles … evaluating a business decision of a similar level of complexity and importance” Commissioner expects retained documentation in accordance with this principle Demonstrate compliance with arm’s length principles Will require some form of functional analysis and info gathering of relevant entities Determine appropriate method then apply relevant data to determine arm’s length ….Unfortunately, it is not possible to specify a comprehensive pre-defined set of documentation requirements that meet the requirements of all taxpayers, because appropriate documentation depends on each taxpayer's specific facts and circumstances. This Practice Note can, therefore, do no more than set out factors that should be considered by taxpayers in determining an appropriate level of documentation for their specific circumstances.

Commissioner expects process to be documented contemporaneously to justify why transfer prices are arm’s length Commissioner will rely on documents created in ordinary course of business and of setting a transfer price, addressing following issues: Identification of affected transactions Copies of international agreements Description of nature & terms of all affected transactions Functional analysis and appraisal of comparatives of affected transactions…

Continued.. Reason why choice of method considered most appropriate Explanation of the process used to select and apply the method used and why consistent with the arm’s length principle Information relied upon at arriving at arm’s length: Commercial agreements with 3rd parties Financial information Budgets Forecasts Details of any special circumstances influencing pricing

At TP review Commissioner expects taxpayer to identify: Which goods/services most comparable Its major competitors Competitors considered most comparable Methodologies used & why appropriate for taxpayer Where inadequate contemporaneous doc’s of arm’s length international dealings, between connected parties, difficult to convince Commissioner of arm’s length Availability of information for comparative purposes: Data from Asia, Australia, UK, US, but assess impact of geographical differences and other factors on price For example, data may be available to indicate that the gross margin paid to distributors of a particular product in the United Kingdom is 20 per cent. This does not mean that 20 per cent will necessarily be an appropriate gross margin for South African distributors. There are a number of factors which may indicate an alternative gross margin to be more appropriate. For example: a)Consumer preferences may result in different retail prices for a product in the two countries. This raises the question of which party to the transaction should capture any premium in price. b)Higher transport costs may be associated with one of the markets. The relative gross margins may be affected by who bears this cost. c) The relative competitiveness of the distribution industries in South Africa and the United Kingdom may differ. This could result in lower gross margins being paid in the more competitive market. d) There may be differences in accounting standards that, if not adjusted for, could distort the relative margins of the parties being compared.

Conclusion Taxpayers establish transfer prices comply with the arm’s length principle and prepare documentation to evidence that compliance Commissioner likely to determine prima facie that the taxpayers’ transfer pricing practices represent a lower tax risk In contrast, taxpayers who give inadequate consideration to their transfer pricing practices are likely to receive greater scrutiny from the Commissioner

A summary of the broad guidelines suggested: establish economic justification before the transaction is entered into; be satisfied that the consideration is an arm’s length consideration; prepare and retain contemporaneous documentation to support the above matters and the assessment of market conditions at the time when the pricing decisions were made; justify the choice of method; and establish and consistently follow a systematic process for setting arm’s length international transfer prices.

DAY 2 Friday 7th of DEC 2012 More notes at

DAY 2 Session 1 Formalising an effective record keeping and reporting process More notes at

SESSION 1: Formalising an effective record keeping and reporting process (1)
Analysing organisation structure so as to have conducive methods of document development and storage Standardising means of collating information and documentation in a manner that will reduce costs and duplication Backing up of documentation for efficient record recall Conducting reviews of documentation and inter-company agreements to reduce exposures to tax penalties

SESSION 1: Formalising an effective record keeping and reporting process (Functional Analysis) (2)
The preparation of a functional analysis is an important tool that can assist in ensuring that an arm’s length consideration is determined in accordance with internationally accepted principles A functional analysis can be performed with varying levels of detail and can serve a variety of purposes. The scope of the analysis will be determined by the nature, value and complexity of the matters covered by international dealings and the nature of the taxpayer’s business activities. These include the strategies that the enterprise pursues and the features of its products or services

Also, factors such as the pricing method that is used and availability of data will affect the extent to which the analysis can be conducted. By determining the relevant functions to be priced, the functional analysis can assist in the selection of a transfer pricing method. It can also assist in the analysis of the level of comparability present in controlled and uncontrolled dealings and in an assessment of the relative contribution of the parties when a profit-split method is used.

It is important, however, not to confuse the use of functional analysis with the determination of a transfer price. Functional analysis is not an alternative to searching for comparables. It is a means to establish what sort of comparables should be sought. Annexure B sets out a four-step practical approach for determining transfer prices. The discussion in that annexure further considers functional analysis in a practical context.

SESSION 1: Formalising an effective record keeping and reporting process (Four step practical approach) (5) Step 1: Understand the cross-border dealings between connected parties in the context of the business The taxpayer and the Commissioner will have to understand the nature and extent of the dealings between the taxpayer and connected parties in the context of the taxpayer's business. It is important for a taxpayer to be able to explain: how the international connected-party dealings of the enterprise are undertaken; the purpose or object of the dealings; what the taxpayer obtains from its participation in the dealings (for example products, services or strategic relationships); the significance of the dealings to the taxpayer's overall business activities and to those of the multinational. At this stage of the process the taxpayer should, therefore, prepare some documentation that outlines these considerations. The insight developed in this process will assist in determining the extent of any functional analysis that might be necessary for an analysis of comparability in applying the arm's length principle. The taxpayer should also develop a preliminary functional analysis to consider the broad functions performed by the relevant members of the multinational. This will assist in determining an appropriate pricing method in step 2 of the process. The functional analysis should not be comprehensive at this stage. As will be discussed in step 3 of the process, the detail included in a functional analysis is affected by a taxpayer's choice of pricing method. At this stage, the aim of the functional analysis should be to determine which method (or methods) is/are likely to be appropriate to the taxpayer's circumstances. The nature of the information that will be required to apply that method should also be determined. Location of comparables: A taxpayer should also, at this stage, begin to assess potential sources of information on which to base its analysis. These comparables may be identified internally within the group (if a member of the multinational transacts with an independent external party), or by reference to transactions between independent external parties. If internal comparables can be located, it is likely that they will be more reliable than external comparables. This is because: they are more likely to "fit" the affiliated transaction as they occur within the context of the group's business; more information about the comparable situation should be readily available; one representative internal comparable may be sufficient to support a defence of the transaction under review, whereas a wider base of support may be required if external comparables are used. It should be noted, however, that internal transactions may not provide reliable comparables for determining an arm’s length price if they do not occur on normal arm's length terms. For example, internal transactions are unlikely to provide reliable comparables for determining an arm's length price if: they are not made in the ordinary course of business; or one of the principle purposes of the uncontrolled transaction is to establish an arm's length price to be used as a comparable for the controlled transaction.

SESSION 1: Formalising an effective record keeping and reporting process (Four step practical approach) (6) Step 2: Select the pricing method or methods In terms of the OECD Guidelines, the choice and resultant application of a method or methods for calculating an arm's length price should be made and documented, having regard to: the degree of comparability between the uncontrolled transactions used for comparison and the controlled transactions of the taxpayer; the completeness and accuracy of the data relied on; the reliability of all assumptions; the sensitivity of any results to possible deficiencies in the data and assumptions. The application of these criteria will depend on the quality of the information available to the taxpayer. Thus, at this stage of the process, the taxpayer will need to make an assessment of the quality of the data it has available. This assessment should be made for the purpose of determining which pricing method (or methods) is likely to provide the greatest consistency with the factors mentioned above and result in the most reliable measure of the arm's length price required under section 31. To this end, the information obtained in step 1 can assist with the: determination of comparability, when traditional transaction methods are appropriate; and/or determination of comparability between enterprises, when pricing methods using profit comparisons are appropriate; and/or allocation of the consideration between the enterprises, when a profit split method is applicable.

SESSION 1: Formalising an effective record keeping and reporting process (Four step practical approach) (7) Step 3: Application of the pricing method or methods Once a pricing method (or methods) has been chosen, the preliminary functional analysis prepared in step 1 can be extended to reflect that choice of method. If a pricing method involving external benchmarking with independent enterprises is being used, the functional analysis assists in determining the comparability of the multinational’s dealings with uncontrolled dealings of the independent parties. The main purpose of this is to establish the degree of comparability. It is, therefore, not necessary to value the functions, assets and risks of each of the enterprises separately. However, it is essential to ensure that, if there are differences in the significance of the functions, assets and risks to each of the businesses, these differences are taken into account. The functional analysis can be performed with varying levels of detail and can serve a variety of purposes. The analysis may be applied on a product, a divisional basis for individual transactions, or on all levels up to corporate group level. The scope of the analysis will be determined by the nature, value and complexity of the matters covered by international dealings. It will also be determined by the nature of the taxpayer's business activities, including the strategies that the enterprise pursues and the features of its products or services.

SESSION 1: Formalising an effective record keeping and reporting process (Four step practical approach) (8) Step 4: Arriving at the arm's length amount and introducing processes to support the chosen method The taxpayer will be required to document and demonstrate how its data has been used in the application of its chosen pricing method to determine an arm's length amount. Adherence to the process up to this stage should result in a taxpayer having an objective, documented and considered review of the available material and possible choices for arriving at an arm's length outcome. However, the nature of the arm's length principle is such that there are a number of practical problems in its application. Transfer pricing will always require an element of judgment and taxpayers and the Commissioner need to bear this in mind in undertaking their transfer pricing analysis. It should also be noted that transfer pricing does not end with the initial analysis. Taxpayers will need to implement appropriate processes to: ensure the availability of data for subsequent review analyses; and allow for changes in the choice and application of a pricing method, to reflect changes in their circumstances or market conditions, or if the process followed does not result in a commercially realistic outcome.

SESSION 1: Formalising an effective record keeping and reporting process (Steps in comparability - intangibles) (9) Pursuant to the recent modifications to the OECD Guidelines, the steps to be undertaken in connection with a comparability analysis are: Step 1: Determination of years to be covered Step 2: Broad-based analysis of the taxpayer’s circumstances (e.g., industry, competition, economic factors)

SESSION 1: Formalising effective record keeping and reporting process (Steps in comparability - intangibles) (10) 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

SESSION 1: Formalising effective record keeping and reporting process (Steps in comparability - intangibles) (11) 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)

SESSION 1: Formalising effective record keeping and reporting process (Steps in comparability - intangibles) (12) 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 Step 8: Determination of and making comparability adjustments where appropriate Step 9: Interpretation and use of data collected; determination of the arm’s length remu tion 62 See OECD Guidelines ¶¶ 3.29 – 3.46. 63 See id. at ¶ 3.46. 64 Id. at ¶ 3.57. 65 Id. at ¶ 3.75.

SESSION 1: Formalising effective record keeping and reporting process (Steps in comparability - intangibles) (13) The updated Guidelines also address the selection and rejection of comparables in detail, & use of commercial databases. The key point articulated is that such searches must be “transparent, systematic, and verifiable.” The OECD Guidelines recognize that, in circumstances where a range of results includes a sizeable number of observations, statistical tools that take account of central tendency to narrow the range (e.g., the interquartile range) may help to enhance the reliability of the analysis. 62 See OECD Guidelines ¶¶ 3.29 – 3.46. 63 See id. at ¶ 3.46. 64 Id. at ¶ 3.57. 65 Id. at ¶ 3.75.

SESSION 1: Formalising effective record keeping and reporting process (Steps in comparability - intangibles) (14) The OECD Guidelines recognize that multiple year data may improve reliability, particularly in cyclical industries. 62 See OECD Guidelines ¶¶ 3.29 – 3.46. 63 See id. at ¶ 3.46. 64 Id. at ¶ 3.57. 65 Id. at ¶ 3.75.

SESSION 1: Formalising effective record keeping and reporting process (Bureau van Dijk demonstration) (15) Bureau van Dijk DEMONSTRATION Case Studies: CUREMAKER WIDGET WHOLESALE

CASE STUDY 2: Feinschreiber Transfer Pricing Handbook (1)
CUREMAKER Transfer Pricing Handbook, 2 Volume Set, editor Robert Feinschreiber (available in Amazon.com Kindle) Location 2409 Context: The example in Feinschreiber is given in the context of finding and applying arm’s-length comparables under the Comparative Profits Method(CPM) The reason we want to use this example in the context of “developing appropriate documentation”, is because the application CPM is a good example where both taxpayers and Revenue Officials make use of short-cuts, in that they only choose the SIC (Standard Industrial Classification) code, and then use a database to find companies with the same SIC code to use as comparables. This short cut approach ignores whether the SIC classification is correct for the company or its comparables, functional analysis, risks, contract terms economic conditions; as well as the nature of the entity being tested. This short cut approach deviates most strongly from the TP regulations resulting in invalid approaches and results, and therefore insufficient and inappropriate documentation. So lets work through this example to demonstrate the type of comprehensive analysis that should form part of the TP documentation, instead of only stating the SIC code and the report of database comparables. Background: Curemaker is an integrated manufacturer and wholesaler of pharmaceutical products, and is registered in the USA. Curemaker developed sophisticated cancer technology. This patented product is widely sold throughout the world. Curemaker produces several products, and has integrated functions, such as manufacturing, marketing, distribution and research More notes at

Exports final product to CM-US Independent wholesalers
AP1 Integrated functions CM -US AP2 Independent Contractor Cost +15% Imports ingredients Exports final product to CM-US Royalty 5% Diagram explained: CM-US has established a foreign subsidiary in Europe: Curemaker Europe (CM-EU), in a small principality where no tax will be assessed for 25 years. CM-US has transferred intangibles (patent rights) to the subsidiary for a royalty payment of 5% to cover research and development costs CM-EU performs only manufacturing functions, and imports ingredients from the US; process them to final assembly(according to practices established by the parent, than resells final product back to the Parent, and to wholesalers in other European countries CM-EU industrial plant is the most modern in the world CM-US manufactures the same product in two who wholly owned assembly plants (no rights to intangibles), no charge for use of intangibles (produce several products) All functions are integrated and reported as such on tax return CM-US also uses the services of an independent manufacturer, by contract. Independent contractor charges CM-US cost plus 15% for manufacturing services. Received ingredients from CM-US (no possession), resells final product to CM-US. Does no research, receives no special technology, pays no royalties. IRS: proposed this third-party contract as an comparable adjustable transaction CM-US under audit: price of transferred products and intangibles to CM-EU In year under audit: CM-EU reported substantial profits, while CM-US showed smaller profit margins CM-US has at least 10 major competitors Industry in EU has higher profit margins than the industry in US. CM-EU Independent wholesalers Manufacturing

Diagram explained: CM-US has established a foreign subsidiary in Europe: Curemaker Europe (CM-EU), in a small principality where no tax will be assessed for 25 years; CM-US has transferred intangibles (patent rights) to the subsidiary for a royalty payment of 5% to cover research and development costs; CM-EU performs only manufacturing functions, and imports ingredients from the US; process them to final assembly (according to practices established by the parent) than resells final product back to the Parent, and to wholesalers in other European countries; CM-EU industrial plant is the most modern in the world; CM-US manufactures the same product in two wholly owned assembly plants (no rights to intangibles), no charge for use of intangibles (produce several products); All functions are integrated and reported as such on tax return; CM-US also uses the services of an independent manufacturer, by contract. Independent contractor charges CM-US cost plus 15% for manufacturing services. Received ingredients from CM-US (no possession), resells final product to CM-US. Does no research, receives no special technology, pays no royalties; IRS: proposed this third-party contract as an comparable adjustable transaction; CM-US under audit: price of transferred products and intangibles to CM-EU; In year under audit: CM-EU reported substantial profits, while CM-US showed smaller profit margins; CM-US has at least 10 major competitors; Industry in EU has higher profit margins than the industry in US.

EXAMPLE 1: Feinschreiber Transfer Pricing Handbook (2)
Classification: Identify the issue under investigation: income of US taxpayer CM-EU income comes under scrutiny: receives intangibles from US taxpayer and had higher profit margins than the Parent CM-EU classified as drug manufacturer (SIC #2833)

Finding Comparables CM-EU: Direct comparables: may possibly be CM-US assembly plants or independent contractor used CM-US Indirect comparables: possibly other large integrated drug companies or smaller contract manufacturers Functions are closer to contract manufacturers, but incurs the costs and risks of operating in a foreign market place. Investigators will have to look at the number of alternatives to approach this research question n as to the direction of the comparability analysis

Finding Comparables: Direct comparables (transaction based) Assembly plants of CM-US: various product lines and integrated functions, difficult to separate one product line for comparison. Independent contractor: differences: Patent rights: reduce COS with royalty payment Market risks: no contract guarantee, foreign market: difficult to quantify Advanced physical facilities: difficult to identify which operating expenses to add back Economic function of CM-EU are very different to that of the Independent Manufacturer, in that it owns intangibles, incurs substantial market risk and owns sophisticated facilities. Transaction methods: greater product comparability needed, no other comparables, since it is a product under patent (unique)

Finding Comparables: Indirect comparables (profit based)(public data needed) Integrated drug companies: owns intangibles and incurs risks like these companies, but do not have integrated functions Independent contract manufacturers: independent manufacturing, but not guaranteed by contract and owns intangibles.

Method used CPM: more than one type of transaction, with no direct comparables as to similar transactions Intangibles transferred with effect on profitability Profit methods reflects reasonableness Transaction method used to ascertain appropriate royalty rate

Arm’s length range Profit Level Indicator (PLI) range: high-end of large companies’ PLI’s and low end on contract manufacturer’s PLI’s. Adjust royalty rate to an arm’s length rate, by doing market research, scrutinizing third party contracts and independent transaction. This indicated that a proper rate should be increased to 25%

PLI’s used Gross profit to operating expenses Operating income on sales Return on operating assets: good indicator for manufacturers, but assets may vary quite extensively. Good PLI for CM-EU which owns intangibles and state of the art plant and equipment with one product for allocation purposes. Not so good for parent with various product lines, and previous investment in assets. Document PLI from public data obtained, as well as the method of obtaining this data

Return on assets Royalty changed from 5 % to 25%

Must be done for other ratios as well

CASE STUDY 3: Feinschreiber Transfer Pricing Handbook (1)
Widget Wholesale Transfer Pricing Handbook, 2 Volume Set, editor Robert Feinschreiber (available in Amazon.com Kindle) 11.3 WIDGET WHOLESALE (Kindle Location 2550). Kindle Edition. Background: Widget Wholesale-USA (WW-USA), is a subsidiary of a foreign manufacturer, and is engaged in importing, marketing and distribution of widgets Widgets are highly sophisticated motorized robots for use in home. The widgets, being new technology evolve dramatically from year to year in terms of features – a three year old widget would be considered obsolete. The selling price for a widget is between $ to $15000 WW-USA imports the final product, and does no manufacturing or servicing, only distribution. The market exhibits substantial brand name loyalty, making marketing innovative competitive and very costly The widget market is characterized by substantial entry barriers. To enter the market enormous costs would have to be incurred to develop and maintain the product, to distribute and to win over customers from other established brands. WW-USA had a 15% market share, and is the third largest distributor of widgets in the US It has been in business for 20 year and never reported a profit. More notes at

Independent distributors
FM1 Manufacturing WW FM2 FM3 Imports widgets from WW Independent distributors CA WW-US Distribution Diagram explained: Widget Wholesale-USA (WW-USA), is a subsidiary of a foreign manufacturer. There are only 32 other Foreign Manufacturers of widgets and no domestic (US) manufacturers WW products are specifically designed for the US market , and are not sold anywhere else on the world, although WW also manufacture products specifically designed for its domestic market WS-US does not participate in R & D WW owns the manufacturing intangibles, while WW-US developed and owns the marketing intangibles WW-USA keeps inventory and resells to various independent retailers WW-USA also sells specially designed widget models to several independent distributors in California where the widget market is most intense The independent distributors also sells normal models and also sells to retailers. None of these firms are publicly traded WW-USA are under audit over the price of imported goods shipped to it from its parent manufacturer The transferred property in question are tangible property, to which intangibles may be attached Other Retailers Retailers CA

Diagram explained: Widget Wholesale-USA (WW-USA), is a subsidiary of a foreign manufacturer; There are only 32 other Foreign Manufacturers of widgets and no domestic (US) manufacturers; WW products are specifically designed for the US market, and are not sold anywhere else on the world, although WW also manufacture products specifically designed for its domestic market; WS-US does not participate in R & D; WW owns the manufacturing intangibles, while WW-US developed and owns the marketing intangibles; WW-USA keeps inventory and resells to various independent retailers; WW-USA also sells specially designed widget models to several independent distributors in California where the widget market is most intense; The independent distributors also sells normal models and also sells to retailers; None of these firms are publicly traded; WW-USA are under audit over the price of imported goods shipped to it from its parent manufacturer; The transferred property in question is tangible property, to which intangibles may be attached.

Classification: Identify the issue under investigation: income of US taxpayer Payments made to foreign parent for purchased goods will be investigated The question is whether an independent company would be willing to pay the same prices for the goods, as WW-US is paying the foreign parent Business classification: WW-US is a pure importer/distributor

Classification (continued) Import consideration: in order to earn a profit importers need to limit costs and expenses, such as purchase price of goods; shipping and transport, import duties, storage , advertising and selling expenses Import contract: when dealing with independent manufacturer, the importer will negotiate a contract covering various issues Wholesale Relationship: wholesaler imports large quantities and makes profit from high turnover of products. Usually has a large marketing investment. Issues covered in contract: Product design Quality control Packaging Delivery How to handle rejects Grievance procedures Exclusivity of sales Method of payment etc

Finding Comparables No independent importers of widgets Numerous importers of other durable goods with publicly available information Widgets do not have separate SIC code Wholesale trade category Comparables: distributors of consumer durables with motorised and electronic technology, used in the home (perceived product similarity) 100 companies over 5 years Method used by Dr. Charles Berry in the case E.I Dupont de Nemours v The Unites States

Method used WW-USA needs to be adjusted to reflect arm’s length purchase price for goods imported Logic: distributors would not buy at prices it could not sell profitably. Only possible comparable for the transaction: resale of independent California Distributors, adjusted for differences for conditions of sale, models, market level, services provided etc. The Resale Price Method (RPM) can then be used to determine an arm’s lengthy price. CPM: reflects the effectiveness of applying the arm’s length price

PLI’s used Gross profit to operating expenses Operating income on sales Return on operating assets Document PLI from public data obtained, as well as the method of obtaining this data

Gross profit on operating expenses reflecting adjustment of purchase price

Must be done for other ratios as well

CUREMAKER & WIDGET WHOLESALE case studies
More notes at

Adopting transfer pricing best practices
DAY 2 Session 2 Adopting transfer pricing best practices More notes at

SESSION 2: Adopting transfer pricing best practices for streamlined and efficient tax activities
NERA Economic Consulting - Case Study – Sebastian Gonnet and a colleague. Presentation - ANNEXURE E More notes at

Intangibles – VI OECD GUIDELINES p 191
More notes at

Starting point: legal and financial information (but…)
Intangibles can be protected or not Examples: patent / know-how They can be on the balance sheet or not Examples: acquired / created and capitalised / created and expensed They can be remunerated or used free of charge by other group companies (often in good faith) Where they are not protected and not on the balance sheet, identification and determination of ownership can be difficult

Identify intangibles, thorough functional analysis
It is not sufficient to rely on the balance sheet It is not sufficient either to rely on the P&L accounts (in case the taxpayer omits to charge some valuable intangibles used by related parties): Risk assessment forms which are filed with tax returns in some countries often prove insufficient in this respect

Identify intangibles: thorough functional analysis
Interviews Historical background of the company Financial information released for investors (e.g. IPOs)

Where intangibles are used in controlled transactions: take into account
In the functional analysis (functions performed taking account of assets used and risks assumed): In the selecting of transfer pricing methods Comparable controlled price One-sided methods: cost plus, resale price, TNMM;

Where intangibles are used in controlled transactions: take into account
“Two-sided” methods: profit split e.g. if both parties use unique, valuable intangibles): In the selection of the “tested party” for a one- sided method: the less complex party to the transaction Comparable controlled price In the selection of uncontrolled transactions that can be used as comparables (comparable means: no material difference or differences can be adjusted in a reasonably accurate manner

How to determine ownership:
Economic vs. Legal ownership Centralized vs. Distributed ownership

Ownership: legal vs. economic
Legal ownership for registered intangibles (e.g. registered patent, trademark, copyright) Economic ownership: who is entitled to the economic benefits? For transfer pricing purposes, a party that bears the costs and risks of developing an intangible should be entitled to a corresponding beneficial interest, even if it is not the legal owner of the intangible.

Reasons for taxpayers to segregate legal and beneficial ownership: Handle all intangible registrations centrally Cost Contribution Arrangement (CCA) where economic ownership is shared but legal ownership cannot be under multiple names (para OECD TP Guidelines) Taxpayer must provide sufficient documentation.

The OECD TP Guidelines recognise the difference between legal and economic ownership, and provide specific comments in this respect in relation to marketing intangibles (marketing activities performed by a party that does not own the trademark).

In the treaty context, useful (although different) notion of beneficial ownership For the purposes of determining treaty benefits, a conduit company cannot normally be regarded as the beneficial owner if, though the formal owner, it has, as a practical matter, very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties.

Ownership:centralised vs. distributed
Centralised ownership Single company in the group owns the intangibles, both beneficially and legally. License agreements with other group entities need to determine arm´s length price Opportunity for tax planning 97

Ownership: centralised vs. distributed
Distributed ownership A number of companies (operating companies) would share ownership of intangibles on a pre- determined basis (e.g. geographic territory or product application) It always involves shared beneficial ownership Usually take the form of CCA Less tax driven

conclusion Multinational enterprises have the freedom to fund and organise the development of intangible property, subject to: the legal form of the arrangement to be consistent with the substance of the transaction, and the arrangements, viewed in their totality, to be arm’s length (see in particular whether consistent with functional analysis and whether achieves an arm’s length allocation of risks) Legal and economic ownership are increasingly disconnected from the location where R&D is performed. The location of legal and economic ownership of intangibles developed have huge transfer pricing consequences. This is a policy issue for fiscal attractiveness.

conclusion Decision where to locate R&D activities is generally based mainly on non-tax factors (e.g. skilled personnel), although tax factors (specific tax breaks for R&D activities) might help.

Locating IP ownership: tax factors to consider
Depreciation, amortisation of developed or acquired intangible Deduction of license fees Treaty network Withholding tax on inbound (and outbound) royalties Tax rate on benefits from exploitation (business profits or royalties) Repatriation of earnings to shareholders Future disposal of intangibles (exit scenarios) Others (VAT, registration duties…)

INTRA-GROUP SERVICES – VII OECD GUIDELINES p 205
More notes at

Session 3 DAY 2 More notes at www.IITF.net
Pre-empting tax audits & Handling tax controversies in a proactive manner More notes at

What is tax admin administration?
Core activities of a Tax Administration are centered around the implementation and enforcement of tax legislation and tax regulations.

Voluntary compliance The objective of Tax administrations is to achieve the highest possible level of voluntary compliance with the laws, at minimal cost. Why “voluntary” compliance? - Tax administrations cannot enforce compliance from each & every taxpayer; they don’t have the resources. - Governments will not provide more resources, which are both costly and intrusive. - Voluntary compliance is the cheapest & most efficient means of administering a tax system.

Barriers to achieving Voluntary compliance
Taxpayers’ ignorance of the law: I did not know! You did not tell me what I needed to do!

Tax laws are often complex – I made an error!

Tax laws & rules may put a high compliance burden on taxpayers- Its too costly / difficult to comply!

There are many barriers to achieving voluntary compliance (…continued) Some taxpayers have poor/ no records –They don’t know how to keep good records or can’t be bothered.

There are many barriers to achieving voluntary compliance (…continued) Some citizens and business are not prepared to comply- They deliberately don’t comply & are prepared to take a risk of being caught.

Taxpayer services Effective taxpayer services help achieve voluntary compliance by: - Improving taxpayers’ understanding of the law - Making it easier and less costly to comply - Informing taxpayers on what they need to do to properly comply - Discouraging taxpayers from non-compliance

Classification of determinants of tax compliance
Political perspective (fiscal policy) Tax system (complexity, tax rates, etc) Social psychological perspective Mental (social) representations Tax knowledge and mental concepts Attitudes: beliefs and evaluations Norms: Personal norms Social norms and identity Societal norms

Classification of determinants of tax compliance (…CONTINUED)
Mental (social) representations (2) Perceived opportunity to evade Fairness perceptions: Distributive fairness Procedural fairness Retributive fairness Motivation to comply Motivational postures Tax morale

Classification of determinants of tax compliance (…CONTINUED)
Decision making perspective Rational decision making Audit probability, fines, tax rate and income Psychological aspects of decision making Sequence of audits: learning processes Heuristics, biases, frames Withholding phenomena Self-employment (paying out of pocket) Interaction between tax authorities and taxpayers (Cops against robbers versus service for clients perspective)

INTERACTION WITH TAXPAYERS: THE CRUCIAL VARIABLE THAT DETERMINES TAX CLIMATE
Tax authorities who perceive taxpayers as robbers rather then as clients are likely to establish a command and control climate with taxpayers engaging in escaping the authorities by taking extensive (rational) decisions. Tax behaviour depends on audit probability and fines Tax authorities who perceive taxpayers as clients and governments committed to responsive regulation are likely to establish a climate of cooperation and trust. Voluntary compliance depends on the taxpayers’ social representations of taxation.

IMPROVEMENT OF COMPLAINCE
Simple and understandable legislation Transparent and clear procedures Fast efficient processes Low compliance costs Treatment of the taxpayer as a client Taxpayer service (assistance, information) Visible supervision and fraud detection Use of third party information (banks etc.) Enforcement communication

PUBLIC CONFIDENCE Rights and obligations of the taxpayers
Clear guidance in dealing with the Tax Administration Ethical standards and rules of conduct Confidentiality of information Professional staff Feedback from stakeholders Performance measurement

TAXPAYER RIGHTS AND OBLIGATIONS
Explanation and protection of rights Explanation why information is asked Disclosure of information only on legal basis Professional service Representation Payment of only the correct amount of Tax

Emergence of taxpayers’ rights
Increasing acknowledgment that taxpayers have rights, as well as obligations. Examples of (basic) rights: - to be informed, heard, and assisted; - to pay no more than the correct amount of tax due; - to appeal decisions of the tax body; and - to have certainty, privacy, and confidentiality Examples of (advanced) “rights” - Services are comprehensive, easily accessible, low cost to taxpayer, & timely.

taxpayers’ rights Basic rights may be stated in countries legislation
Many tax administrations set out taxpayers’ rights in formal charters/ statements that are made public. Charters reflect tax administrations’ vision for service delivery (e.g. services are comprehensive, accessible, fair, & timely). Many tax administrations set service performance standards with time-bound objectives that are made public

SESSION 3: Pre-empting tax audits (1)
Eliminating possible issues that could prompt an audit Determining the appropriate documentation needed to address an audit Preparing defence to tax audit for and responding to tax authorities’ transfer pricing audits Identifying possible impacts from the proposed transfer pricing legislation amendments that could lead to an audit Review E&Y Global TP survey 2010/11

Eliminating possible issues that could prompt an audit Keep TP policies up-to-date Don’t deviate from policies without amending Control Exchange of Information via tax authorities Beware of other country TP audits Revisit offshore center intermediary SubCo’s Where is the sensitive information kept?

Determining the appropriate documentation needed to address an audit Where is the sensitive information kept? TP policy document – updated? What documents must you bring in from other jurisdictions? Association clause in DTA Mutual Assistance clause in DTA Exchange Information clause in DTA

Preparing defense to tax audit for and responding to tax authorities’ transfer pricing audits Presentation on preparing for tax audits – An emerging market perspective

SESSION 3: Handling tax controversies in a proactive manner (1)
Structuring your company to be able to address potential controversies Examining Intangible Property, Intragroup Services, Cost Contribution Arrangements, and Thin Capitalisation policies Considering Mutual Agreement Procedures (MAPs) and Advance Pricing Agreements (APAs) to reduce your tax risk Overcoming potential penalties and costly litigation arising from transfer pricing adjustments Enforcing a defensible model to safeguard against tax audits and disputes

Structuring your company to be able to address potential controversies Tax Intelligence Book 7 Habitual Tax Mistakes made by Companies The summary book

Considering the following to reduce your tax risk: Mutual Agreement Procedures (MAPs) – very slow and outside control of taxpayer Advance Pricing Agreements (APAs) – not relevant in Africa GATT, GATS, State Responsibility and other sundry procedures Other - such as monitoring ATAF

Overcoming potential penalties and costly litigation arising from transfer pricing adjustments Up-to-date TP policy documents Contemporaneous with tax returns Control audits & exchange of information Letters of findings Opinions to mitigate interest & penalties

Enforcing a defensible model to safeguard against tax audits and disputes Tax team Regular tax risk meetings Regular communication intra-group Remember FEDEX info survey model

Gaining insight into different tax regulations on TP
DAY 2 Session 4 Gaining insight into different tax regulations on TP More notes at

SESSION 5: Gaining insight into different tax regulations
Categorising groups of similar taxation laws Assessing these different tax regulations group by group Highlighting documentation requirements in various regions Exploring best practices to address transfer pricing operations More notes at

Country comparisons Country TP Regs TP Docs? Tax Return Penalties
Thailand Y Recommend Up to 200% Vietnam N Taiwan Singapore Pakistan N Anti-Av Malaysia Up to 300% Indonesia Y >Rp10m Up to 48% India Y >INR10m Hong Kong China 5% no docs Cambodia South Korea 10% More notes at

Country Summaries REFER to various country summaries download at More notes at

Home Country Tax Havens UPSTREAM Developing Countries MIDSTREAM DOWNSTREAM

CASE STUDY 4: Virtual Profile Company
More notes at

VIC VPC Ltd Third Party VPC (M) On-Line Clients Wholesalers
Manufacturing costs: $ 2500 GP: $ 2 500 SP: $ 5 000 Manufacturing costs: $ 1 000 GP: $ 2 500 SP: $ 3 500 VPC Ltd Third Party Purchase: $ 5 000 Distribution cost: $500 GP: $2 000 SP: $ 7 500 Purchase: $ 3 500 Distribution costs: $300 GP: $ 3 700 SP: $ 7 500 VPC (M) On-Line Clients Wholesalers 15 countries SP: $ to end-user

Evaluation of methods CUP: Cost Plus: Resale Price Method:
Branded product, not comparable to VIC brand Cost Plus: Manufacturing intangible present, cannot compare to manufacturing intangible of VIC brand (no info available for VIC) Resale Price Method: VPC (M) sells to wholesalers, while Cayman Third Party sells to end-user

Evaluation of methods TNMM: Profit Split: all that is left
Would be difficult to find companies that are similar to RSA entity: R&D, Manufacturing, on-line selling, integrated company, owning a very unique brand TNMM would not be appropriate Profit Split: all that is left Used by taxpayer Based on cost contribution: development, manufacturing and distribution (good objectively verifiable basis) Parent: manufacturing and R&D: $2 500 Sub: distribution cost: $500 Total cost: $3 000 Profit split: Parent: 83% (2500/3000); Sub: 17% (500/3000)

CONCLUSION Contact Details: Prof D N Erasmus +1 561 568 7115
More notes at

TRANSFER PRICING WORKSHOP, KUALA LUMPUR

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