OECD Tax: OECD issues draft of revised transfer pricing guidelines chapters

Following previous discussion drafts on comparability and transactional profits methods, and a public consultation in November 2009, the OECD on 9 September issued draft revised Chapters I-III of the Transfer Pricing Guidelines for a further round of consultation. The revised guidelines propose the elimination of the hierarchy of methods under which the transactional profits methods were considered methods of last resort.

Because the guidelines provide a framework for the consideration of all transfer prices between associated enterprises, any changes or clarifications are obviously extremely important.


Principal areas subject to current draft

The main areas subject to new guidance are:

- The arm's length principle itself;
- The comparability analysis; and
- The application of transactional net profit methods.
 
There are also some illustrations of issues concerning the application of transactional net profit methods, together with an example of a working capital adjustment to strengthen comparability.


The arm's length principle

All OECD members have taken the opportunity to reaffirm their belief in the arm's length principle, as opposed to alternative methods, such as global formulary apportionment, for allocating profits.

The OECD emphasizes that Article 9 is the definitive statement governing the arm's length principle, and that transfer pricing involves a review of the conditions — not only price — between the parties and a determination of the profits that would have accrued between them had they been independent enterprises.

The issue of comparability — in essence, finding comparable transactions carried out by comparable entities — remains a cornerstone of transfer pricing. The OECD outlines the concept of reasonably reliable comparables to take into account available information. The five existing comparability factors — characteristics of property or services, functional analysis, contractual terms, economic circumstances, and business strategy — continue to apply; the OECD says the relevant weight of each factor is to be considered in line with the nature of the transaction and the transfer pricing method adopted. The functional analysis remains of key importance. The draft also covers the matter of whether or not a tax administration should recognize the actual transactions undertaken. The text of this section is largely unchanged from the existing Guidelines, but is subject to the outcome of the separate "Business Restructuring" OECD work.

The OECD also considers the matter of transfer pricing methodologies, and which methodologies are preferred. There is a clear change proposed: the transactional profits methods — the profit split and transactional net margin methods — are no longer to be considered "methods of last resort." Based on the experience of OECD members since the last major revision of this part of the Guidelines, those transactional profit methods are in effect to be elevated in status to match the traditional transactional methods — comparable uncontrolled price, resale minus, and cost plus. The proposed change makes it clear that, going forward, the method that is most appropriate to the circumstances of the case can be used.


Comparability analysis

New material is proposed on the issue of comparability, and how comparability is to be determined. A recommended process for the comparability analysis is proposed: in particular, the analysis is to be carried out firmly within the context of the appropriate transfer pricing method.

The OECD recognizes that commercial databases featuring the trading results of companies are useful. The availability of only limited data does not preclude reliance on that data. There is an emphasis on the quality rather than the quantity of data. Further clarifications are presented on the interpretation of the arm's length range of results and the use of multiple-year data. Thought is given to how to treat situations in which uncertain valuations exist from the outset, and how this might affect pricing between independent enterprises.


Guidance on application of transactional profits methods

The elevation of the status of the existing transactional profits methods has also given the OECD the opportunity to provide further guidance on how those methods should be applied. It is not only choice of method that must be considered — the way the method is applied is also important.

The OECD acknowledges that the transactional profits methods can sometimes result on more reliable answers than the traditional transactional methods, particularly when "below the line" operating expenses reveal functional differences in comparable companies that might not be so apparent when looking at gross margins.

The draft revisions also recognize that it is not compulsory to use a transactional profits method to actually set prices (though it is possible.) The methods can be used after the transactions to analyze what the arm's length profit would have been. There is an emphasis on examining what third parties would have agreed to. It is important to isolate the results of the transactions under review from other trading results — Product Line Income statements will often prove useful.

For the profit split method, there is new guidance on the use of particular allocation keys — the use of assets and costs is discussed, along with the possibility of other potential keys such as incremental sales achieved, head counts, and time spent by employees.

The new guidance reflects the increased use of the transactional net margin method (TNMM) for transfer pricing purposes. The OECD states that the process for applying TNMM should not be less reliable than for other methods. However, good judgement should be accepted in case of a lack of available information. The OECD emphasizes the importance of considering the facts and circumstances of the case and gives some examples of what this means. The OECD also acknowledges the use of Berry ratios in transfer pricing.


Conclusion

The proposed changes will alter the structure of the existing Transfer Pricing Guidelines, as well as provide clarifications and perhaps changes in meaning, the ramifications of which may not be completely clear. Because transfer pricing is a high-risk area for tax administrations, it is vital that taxpayers be aware of the proposed changes and consider them carefully.