Presented By: Anneline Venter CA(SA)

Arm’s length Principle And Introduction to Comparability Arm’s length Principle And Introduction to Comparability

Introduction If prices do not reflect arm’s length prices tax it will distort: Tax liabilities of associated enterprises Tax revenues of host countries Other factors than tax considerations may also distort commercial and financial relations between associated enterprises: Customs valuations Exchange or price controls Cash flow requirements of enterprises Arm’s Length Principle

Introduction (…continued) Adjustment to arm’s length price sometimes needed irrespective of: Contractual obligation to pay a particular price Intention of the parties to minimize tax Tax authorities should not automatically assume MNEs have sought to manipulate profits. Arm’s Length Principle

Statement of arm’s length principle Article 9 OECD Model Tax Convention: “[Where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.” Arm’s Length Principle

Justification for use of arm’s length principle Puts associated enterprises and independent enterprises on a more equal footing for tax purposes, thereby promoting trade. Adopts as benchmark the normal operations of the market No realistic or legitimate alternative exists: Global formulary apportionment would not be acceptable in theory, implementation or practice Arm’s Length Principle

Application of the arm’s length principle Comparability analysis is at the heart of the application of the arm’s length principle (par 1.6) Significance of Comparability analysis and meaning of “comparable’. Arm’s Length Principle

Internal and External Comparable Transactions Arm’s Length Principle Internal Comparable External Comparable Co A Controlled Transaction Controlled Transaction Uncontrolled Transaction Uncontrolled Transaction Co A Co B Controlled Transaction Controlled Transaction Uncontrolled Transaction Uncontrolled Transaction

Factors affecting Comparables Characteristics or Property/Services Functional Analysis Contractual Terms Economic Circumstances Business Strategies

Tangible Property: physical features; quality and reliability, availability and volume of supply Services: nature (shareholder or stewardship) and extent Intangible Property: Form of transaction: licensing or sale Type of property: patent, trademark, know-how Duration and degree of protection Anticipated benefits Characteristics of Property or Services Factors affecting Comparables

Main category of type of transaction: Distributor, wholesaler, retailer Fully fledged or contract manufacturer Fully fledged or contract marketing Sub-functions: Manufacturing, material purchasing, Packaging, storage of inventory, shipping Quality control, negotiation, admin Functional Profile Factors affecting Comparables

Functional Analysis Contract ManufacturerFull- Fledged Manufacturer Functions Research & Development√ Purchasing√√ Manufacturing√√ Assembling and Packaging√√ Warehousing and Logistics√√ Engineering√√ Quality Control√√ Labour Management, Training√√ Marketing√ Sales & Distributions√ After Sales Services√ Risks Business risks√ Market risks√(volume)√ Manufacturing risk√√ Foreign exchange risk?√ Inventory risk√√ Credit risk√√ Research & Development risk√ Warranty risk√ Assets Product intangibles√ Manufacturing intangible??

27 Full-Fledged Manufacture r Manufacturing + R&D + Regional/global marketing + All risks Simple (Low) Integrated (High) Functions/Risks/ Assets Employed Low _ + High Expected Profit Profit expectation follows functions, risks and assets Loss possible Contract Manufacture r

Define how risks, benefits and responsibilities are divided Analyse terms whether written or oral, explicit or implied Independent parties will hold one another to terms and only rarely will modify Less incentive to do so in controlled transaction: therefore examination necessary Analysis: whether the actual conduct of the parties is consistent with terms of contract Contractual Terms Factors affecting Comparables

Prices vary across different markets even for similar products Essential to identify relevant market(s) related to transaction Whole variety of factors to take into account: Location, size, competitive position, availability of substitute goods/services, level of supply and demand, purchasing power, regulation and local costs, level of market (retail or wholesale), date and time of transactions etc. Economic Circumstances Factors affecting Comparables

1,67% 1,38% 1,71% 7,65% 11,45%

2,22% 1,28% 3,50% 6,85% 8,30%

Business strategies may include start up (entering a new market) marketing strategy to increase of market share; Business strategy may sacrifice current for anticipated profits What happens if anticipated profits are not in fact realized? evaluate position critically to see if strategy is credible: e.g. look for consistent behaviour and see who bears costs and is intended to reap rewards would independent enterprise have entered into such a scheme and would it have continued long after anticipated profits have not materialized? Business Strategies Factors affecting Comparables

Recognition of actual transactions undertaken Be careful of restructuring of transactions Circumstances were restructuring will appropriate: Economic substance differs from the form “…(T)he 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….” Arm’s Length Principle

Losses Situation: one group entity experience consistent losses while overall group is profitable. Legitimate business reasons may exist: heavy start-up costs, unfavourable economic conditions or inefficiencies. Independent enterprises would not tolerate losses indefinitely. Loss enterprise may not be receiving adequate compensation. Example Arm’s Length Principle

Other issues The effect of government policies Government interventions (interest rate controls, control over royalty payments etc.) should be treated as normal market conditions. Use of customs valuations May not be aligned with OECD TP methods May provide valuable contemporaneous information Taxpayers may have competing incentive in setting prices for customs valuations and tax purposes Arm’s Length Principle

Source: OECD Guidelines: Chapter 1 UN TP Manual for Developing Countries: Chapter 1 (section 4) ATAF: TP for Policy Makers: Session 1: “Arm’s length range” by OECD (PDF) Arm’s Length Principle