Centre for Tax Policy and Administration Organisation for Economic Co-operation and Development Auditing Multinational Enterprises 7 - Cutting Edge Comparability Analysis and Method

Summary  Cutting Edge Corporation (CE Corporation) manufactures and sells advanced and specialised electronic equipment used in diagnostic testing in hospitals.  The parent company, CE Corporation is resident in Country A, where it has an R&D facility, a manufacturing facility and a domestic sales division.  It has one subsidiary, CE (B) Ltd, resident in Country B, which carries out a sales/distribution function.  You are carrying out an audit on the 2009 return of CE Corporation, focusing on the transfer pricing of the sale of products from CE Corporation to CE (B) Ltd.  CE Corp has not maintained any formal documentation of their transfer pricing, but they do provide you with some financial data. 2

Financial data  You ask for a breakdown of CE Corporation’s turnover and you are told that is divided between: - Sales within Country A units at an average price of $133K - Sales to CE (B) units at an average price of $100K. The company tells you that sales of CE-manufactured goods within A and B carry the CE brand-name and logo. 3

Methods example  The company tells you also that CE (B) purchases products from an independent manufacturer (IndyMedical), also located in Country A, and sells the products under the independent manufacturer’s brand-name and logo.  It purchases 125 units sourced from the independent manufacturer at an average price of $ 80K. 4

CE (B)’s selling prices The company tells you that Company (B):  Sells units sources from Cutting Edge Corporation for an average of $132 K  Sells units sourced from IndyMedical for an average of $ 108K 5

Financial information You are provided with extracts from:  2009 accounts of CE Corporation  2009 accounts of CE (B) Ltd, which are provided to you by CE Corporation  2009 accounts of an independent manufacturer of diagnostic equipment in Country A, which sells units to CE (B) Ltd. These accounts are publicly available in Country A. 6

What methods may be available here?  CUP?  Cost-plus?  Resale minus?  TNMM?  Profit split? 7

Comparable uncontrolled price Cutting Edge Corporation sells goods to CE (B) for $ 100K. Potential comparables for this transaction are:  Sales by CE Corporation to domestic customers - $133K each  Sales by IndyMedical to CE (B) Ltd - $80K each. How reliable are these comparables likely to be? 8

Comparable Uncontrolled Price How reliable are the comparables?.  Are the sales into the same level of the market? CE Corporation’s sales in A 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 CE Corporation and by IndyMedical 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. 9

Cost-plus  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 CE Corporation?  Functional analysis: CE(Corp) owns 2 intangibles – brand and trade (R & D expenditure). Cost plus, which would involve testing CE 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 CE(B) Ltd. 10

Resale price method The gross margin earned by CE (B) Ltd on units purchased from the independent manufacturer is a potential comparable.  We know that, on units sourced from CE Corporation, CE (B) Ltd earns a gross profit of 24% (( )/132.)  We know that on units sourced from the independent manufacturer, the gross margin is also 26% ((108-80)/108). A comparability analysis is necessary to establish whether this a sufficiently reliable comparable. 11

Transactional Net Margin method Is TNMM available?  We know that Cutting Edge (B) earns a net margin of 10%  However we do not know how this is split between the net margin earned on goods sourced from Cutting Edge Corporation and that earned on goods sourced from Indy Medical  That is, we do not have transactional information Also..  We know the net margin earned by Cutting Edge Corporation and that earned by IndyMedical  But, again, we do not have the information available at a transactional level. So TNMM is unlikely to be reliable in this case. 12

And…Profit split method  A potential comparable would be the split of profit between the independent manufacturer and CE (B) Ltd derived from the manufacture and sale of the units produced by the independent manufacturer and sold to CE (B) Ltd.  If we used a profit split method, this would be compared to the split of profit between CE Corporation and CE (B) Ltd, from the manufacture and sale of the units produced by CE Corporation.  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. 13

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. 14

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 15

Comparability analysis You are asked to carry out a comparability analysis between the following transactions:  a) purchases of units by CE(B) from CE Corporation, and  b) purchases of units by CE(B) from IndyMedical. (See template) 16

Comparability analysis  (see key doc)  Analysis shows that there is poor product comparability between the goods sourced by CE (B) from CE Corporation and IndyMedical  But there is good functional comparability between the functions carried out by CE (B) in respect of goods sourced from CE Corporation and IndyMedical 17

Conclusions In this case, we would probably consider that there is good functional comparability between:  the functions performed by CE(B) in respect of CE Corporation sourced goods, and  The functions performed by CE (B) in respect of IndyMedical sourced goods .. and that the resale price method is likely to be sufficiently reliable  and that no transfer pricing adjustment is necessary. 18