1. European and International Taxation
Transfer Pricing and thin capitalization
© Jean Monnet Module: Managing the EU: Taxation, Governance and Economics
The content does not represent the view of the Erasmus+ project nor the European Commission but only of the author
Jean Monnet Module: Managing the EU: Taxation, Economics and Governance
Cluj-Napoca

2. Agenda of the lecture European and International Taxation
1. Introduction to transfer pricing
2. Main features of transfer pricing legislation
3. OECD Model Article 9: associated enterprises
4. Advance pricing agreements (“APAs”)
5. The OECD transfer pricing guidelines

3. European and International Taxation
Introduction
“transfer” - transactions between related parties, both domestic and cross-border
“pricing” - commercial relationships/terms of trade between related parties
Transfer pricing regulations - a major consideration in trading relationships between related companies because of tax consequences
OECD – guidelines followed by authorities when judging transfer pricing transactions across borders between enterprises in different countries

4. Introduction: Arm’s length principle
European and International Taxation
Introduction:
Arm’s length principle
”price that might have been expected if the parties to a commercial understanding or transaction had been independent persons dealing at arm’s length with each other in a normal commercial manner unaffected by any special relationship between them”
Why?
unrelated parties involved - maximize their revenues or minimize their costs
related parties involved - profit attribution between them, profit shifting at free will

5. Introduction to transfer pricing
European and International Taxation
Introduction to transfer pricing
Overview
arm’s length” approach - identify the terms of trade that would be obtained on the same transactional relationships between unrelated parties in the same commercial circumstances.
OECD “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” (the OECD TP Guidelines”)
incorporation of the arm’s length concept within domestic tax legislation
short history of the OECD TP Guidelines:
issued in 1979
updated in 1995
Updated July published in September 2010

6. European and International Taxation
The WIND GROUP is the parent company of a wind turbine manufacturer. The company
has two subsidiaries: Dutch Parts - manufactures circuit boards for the turbines in the
Netherlands and Turbines UK - produces and assembles the turbines.
SHIFTING PROFITS FROM UK TO NL: YEAR 1: 100 EUR per board
YEAR 2: 150 EUR per board

7. European and International Taxation
Transfer Pricing dispute: GSK vs. IRS – US tax authority
For 14 years, GlaxoSmithKline (GSK) and its predecessor companies had disagreed with
the IRS about the transfer prices the U.S. subsidiary of GSK paid its U.K. parent for
several different drugs. The dispute primarily involved the appropriate pricing method for
GSK’s Zantac, a product designed to treat stomach ailments and ulcers.
The primary issue in the GSK case was the transfer price at which the U.K. parent,
GlaxoSmithKline PLC, sold drugs (primarily Zantac) to its U.S. subsidiary. In a parent-
subsidiary transaction such as this, the transfer price does not affect the overall profit of
the group, but it does affect the overall taxes paid by the group.
Resolution: GSK and the IRS agreed to a $3.4 billion settlement, the largest in IRS history.

8. Introduction to transfer pricing
European and International Taxation
Introduction to transfer pricing
Unitary taxation / global formulary apportionment
alternative approach to arm’s length principle
formula to allocate profits between countries by considering different factors
not an approved method of the OECD
USA – application of the unitary taxation because of the state tax rates
common consolidated corporate tax base (CCCTB) initiatives project in EU – formulary
apportionment to fight against profits shifting in the EU
in practice: consolidated profits of the group are allocated/apportioned to a state based on sales,
payroll, property, etc
Disadvantages:
Not a valid concept for many countries
Not an accepted method for computing profits
Impact on different accounting implications from country to country

9. European and International Taxation
Arm’s length principle
main objective of transfer pricing documentation – identify third party comparables => benchmark price
Comparables are:
internal - those experienced by one of the related parties in its dealings with third parties, or
external - those transactions or commercial relations between third parties which are in the
public domain and can be pointed to as a direct comparison.
Any resulting independent prices obtained by this method are referred to as a “comparable
uncontrolled prices” (“CUPs”) => ideal way of benchmarking.

10. European and International Taxation
In order to identify appropriate comparable data, the initial groundwork needs to be
undertaken. This involves understanding:
1. the functions that the business performs in relation to the commercial relationship under
consideration “functional analysis” – e.g. distribution, manufacturing, R&D
2. the nature of the asset (tangible or intangible) or service, including quality, quantity, reliability
and name recognition;
3. the risks attaching to the functions and activities – e.g. FX currency risk
4. the contractual terms of any arrangement, whether in writing or by inference to the actions of
the parties – e.g. payment terms, delivery terms, guarantee terms
5. business policies, projections, forecasts and strategies; and
6. economic background, including geographic location, market performance and competition.

11. Transfer pricing of Permanent establishments
European and International Taxation
Transfer pricing of Permanent establishments
profits attributable to a permanent establishment…”which it might be expected to make if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions”
important to establish the functions, the key entrepreneurial risks of the PE and its underlying assets

12. Main features of TP legislation
European and International Taxation
1. Methods to analyze TP
 CUP, resale method and cost plus – wide spread around the world
2. Documentation and compliance issues
 Some countries – specific tax returns in respect of TP (e.g. USA, Australia)
 generally – tax audit procedures
 Widespread – documentation requirement to demonstrate that prices are at arm’s
length
3. Tax audit and penalties
All countries have imposed penalties and adjustment of profits
Some differences from country to country
Main features of TP legislation

13. Main features of TP legislation
European and International Taxation
Main features of TP legislation
4. Thin capitalisation
- Issue of excessive debt from related parties
-Methods to avoid such cases
5. APAs
-unilateral or bilateral agreements
-based on MAP of the OECD
-validate price cross-border arrangements

14. OECD MODEL ARTICLE 9: ASSOCIATED ENTERPRISES
European and International Taxation
OECD MODEL ARTICLE 9: ASSOCIATED ENTERPRISES
Double tax treaties and transfer pricing
! 4 main areas where tax treaties follow the OECD Model related to transfer pricing:
1. The associated enterprises article (Article 9 OECD Model) - TP adjustments
2. Article 11 OECD Model - denies treaty benefits when “the amount of the interest…exceeds
the amount which would have been agreed upon by the payer and the beneficial owner in the
absence of such relationship”
3. Royalty article (Article 12(4) OECD Model) - similar in effect to that of the interest article
4. The mutual agreement procedure (“MAP”) (Article 25 OECD Model) - enables transfer
pricing disputes to be resolved

15. OECD MODEL ARTICLE 9: ASSOCIATED ENTERPRISES
European and International Taxation
OECD MODEL ARTICLE 9: ASSOCIATED ENTERPRISES
Article 9 Associated Enterprises (OECD Model Treaty)
permits a country to make an upward adjustment to the profits of a local enterprise
permits the other state to make a corresponding/compensating adjustment
MAP procedures to be used
“Associated enterprises” are defined in two ways:
i. either one enterprise “participates directly or indirectly in the management, control or
capital” of another enterprise in the other state, or
ii. both enterprises have the same persons participating in the management, control or
capital.

16. ADVANCE PRICING AGREEMENTS (“APAs”)
European and International Taxation
ADVANCE PRICING AGREEMENTS (“APAs”)
the advantage => enable local companies to enter into APAs where there is a need to
overcome complex transfer pricing issues with overseas related parties.
-2 APA methods:
Bilateral APAs
2 countries/tax authorities involved based on a MAP of a treaty
multilateral APA – in theory, possible to be obtained as an extension of a bilateral APA
- In practice, very difficult to be achieved

17. ADVANCE PRICING AGREEMENTS (“APAs”)
European and International Taxation
ADVANCE PRICING AGREEMENTS (“APAs”)
2. Unilateral APAs
-which are those agreed with local tax authorities without reference to another authority
Important:
-domestic legislation in place in order to initiate APA
-country without specific APA legislation - MAY be a party to a bilateral APA as a result of
another country’s APA regulations and the existence of a tax treaty with a MAP
! IN ROMANIA – 2 UNILATERAL APAs
What is in practice an APA?
-written agreement between tax paying company and local revenue authority
-enjoys overseas tax authority and related overseas company

18. THE OECD TRANSFER PRICING GUIDELINES
European and International Taxation
THE OECD TRANSFER PRICING GUIDELINES
OECD Guidelines content
1. The arm’s length principle (Chapter I of the Guidelines);
2. Transfer pricing methods; traditional transaction methods (Chapter II): CUP, resale
price, cost plus, profit split, transaction net margin methods;
3. Comparability analysis (Chapter III);
4. Administrative approaches to avoiding and resolving transfer pricing disputes
(Chapter IV);
5. Documentation (Chapter V);
6. Intangible property (Chapter VI);
7. Intra-group services (Chapter VII); and
8. Cost contribution arrangements (Chapter VIII).

19. THE OECD TRANSFER PRICING GUIDELINES
European and International Taxation
THE OECD TRANSFER PRICING GUIDELINES
Methodologies and their application
1. Comparable Uncontrolled Price (“CUP”)
-the most objective method
-price = the one which would be charged in a similar transaction with an unconnected party
-types of CUPs:
1. the CUP between two unconnected parties
2. the CUP that the enterprise would charge when dealing with an unconnected third party
An uncontrolled transaction can be said to be comparable to a controlled transaction if:
• there are no differences between the transactions being compared or between the enterprises
entering into the transactions which could materially affect the price charged in the open
market
• where there are differences, reasonably accurate adjustments could be made to eliminate their
effect.

20. THE OECD TRANSFER PRICING GUIDELINES
European and International Taxation
THE OECD TRANSFER PRICING GUIDELINES
Example of CUP
A manufacturer sells heaters to a number of companies in different countries, who
distribute the goods to the end user.
In country X, the climate is unusually mild all year round and therefore the associated
distributor has to incur a lot of marketing cost to shift any units.
In country Y, the climate is cold all year round; the heaters sell as soon as the
independent distributor can stock them. No marketing is required.

21. European and International Taxation
Implications on illustration:
 the first distributor has a much lower margin than the second.
 country X distributor might negotiate a lower price with the manufacturer, related to its
additional marketing costs
 impact on arm’s length – differences in the markets might affect the price paid for the
same goods, at the same number and at the same time

22. European and International Taxation
2. Resale price
 specific for marketing or distribution operations, manufacturing operations
 involves the enterprise constructing the arm’s length price.
 it uses known resale price margins either from the company’s own transactions with
third parties or from transactions between unconnected parties
 the transfer price is constructed

23. European and International Taxation
Example of the resale price method
the case of goods coming into the UK from a connected party, the transfer price would be
constructed as follows:
UK selling price
Transport costs
Advertising
Other costs
Resale price Margin*
Known
(X)
____________________________
Arm’s length price X

24. European and International Taxation
3. Cost plus method (C+)
-used for contract manufacturing and provision of services
-how? It takes the costs incurred - direct and indirect - and adds an agreed mark up.
4. Profit split method – transactional method
-used to resolve the more complex transfer pricing exercise
-related to highly integrated activities
-how? It looks at the overall profit made on the transaction and seeks to split it between the
different parts of the enterprise on the same basis as it would be split between unconnected
parties
5. Transaction net profit margin (TNMM) – transactional method
-commonly used in the US and may be used where other methods prove difficult
-how? Computation of the profit net margin derived by an entity as a result of its transactions
with related parties compared with an estimation of this margin at the level that entity would
have obtained in transactions with non-related entities or with profit net margin derived from
independent party transactions

25. European and International Taxation
Intra-group services
-many group services that may be subject to transfer pricing - for example marketing, IT,
finance or human resources.
How to analyze these types of services
1. Have the services been supplied?
2. An independent enterprise would have been prepared to pay for such services?
3. An independent enterprise would have needed to perform them in house?
If all answers are yes => a service has been provided
such services should be recharged at an arm’s length price