Transfer pricing – Analysis of transactions and arm’s length

Transfer pricing documentation in the Netherlands

The arm’s length principle is a fundamental concept in transfer pricing, ensuring that transactions between related parties are treated as if they were between independent entities. This principle prevents profit shifting and ensures fair taxation. In this article, we dive into the practical application of the arm’s length principle, covering essential steps like functional analysis and comparability analysis. We will guide you through the selection of the tested party, choosing the most appropriate transfer pricing method, and determining the arm’s length remuneration. By understanding these processes, your company can better manage compliance and avoid potential pitfalls. Want to know more about correctly applying these methods in your organization’s transfer pricing documentation? Contact our specialists directly. 

Application of the arm’s length principle 

Having briefly touched on the introduction of the arm’s length principle in a previous post, it is important to understand what it is and what its purpose is. The premise of the arm’s length principle is that related parties are presumed to be subject to the same conditions that independent parties would face, under similar circumstances. This concept was introduced to ensure that the tax profits that are derived from a related party arrangement is comparable to the tax profits that unrelated parties would earn, therefore, resulting in a scenario whereby the relevant tax jurisdictions are then allocated their fair share of tax and profits in relation to a specific intergroup transaction.  

To prove that the arm’s length principle has been adhered to in relation to a specific intercompany transaction, there are two crucial steps to be followed, which are: 

• A detailed functional analysis of the transaction; and 

• A detailed comparability analysis of the transaction. 

In the following paragraphs, we will provide an overview of each of these analyses.   

Functional analysis 

Prior to the determination of a particular price for a transaction, the economically relevant characteristics of the transaction are required to be considered. Identifying the economically relevant characteristics of the transaction will allow for a characterization of the transaction as well as to determine the conditions that comparable transactions will need to meet to be considered similar, or whether an adjustment regarding the material facts and circumstances of a comparable transaction would need to be made.  

This step is critical in developing a baseline against which the related party transaction would need to be priced or tested and involves performing an analysis of the functions performed, risks assumed, and assets employed by each of the parties to the transaction, as well as any other economically significant factors. Once the initial functional analysis is performed, a characterization of the transaction and the relevant entities can be decided upon and this functional analysis, in conjunction with the characterizations determined, can be used to inform the basis upon which the appropriate price should be set or tested.   

Comparability (economic) analysis 

Once a thorough review of the intercompany transaction has been completed, the next course of action would be to determine what the most appropriate price or range of prices would be in relation to this intercompany transaction. This can be determined through a comparability (economic) analysis.  

While the search for comparables (i.e., undertaking a benchmarking study) can be considered to be the largest and most time-consuming portion of performing a comparability analysis, it is not the only step that is required for the completion of a comprehensive comparability analysis. The OECD lists 9 main steps that can be followed in this process.  

Nine step process 

The following 9 steps constitute the typical process that can be undertaken when performing a comparability analysis. It is important to note, however, that this process is not compulsory and other search processes which lead to reliable comparables may be acceptable as well as that, although, the main steps for the typical process has been laid out, there may be additional steps within these main steps that should also be completed.  

1. Determination of years to be covered. 

2. Broad-based analysis of the taxpayer’s circumstances (the functional analysis that was previously performed can be leveraged off for this purpose). 

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. 

4. Review of existing internal comparables, if any. 

5. Determination of available sources of information on external comparables where such external comparables are needed taking into account their relative reliability. 

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). 

7. Identification of potential comparables: determining the key characteristics to be met by any uncontrolled transaction to be regarded as potentially comparable, based on the relevant factors identified in Step 3 and in accordance with the comparability factors set out in Section D.1 of Chapter I of the OECD Guidelines. 

8. Determination of and making comparability adjustments where appropriate. 

9. Interpretation and use of data collected and determination of the arm’s length remuneration. 

For this article’s purposes, we will expand on three of these steps, namely, the selection of a tested party, the most appropriate transfer pricing method and the determination of the arm’s length remuneration. We will explore the identification of potential comparables in future articles.  

The selection of a tested party

When applying certain transfer pricing methods, such as the cost plus, resale price or transactional net margin methods (described below), it is necessary to choose the party to the intercompany transaction for which a financial indicator, generally referred to as a Profit Level Indicator (“PLI”), is tested. This is due to the nature of these particular methods, being one-sided measures only requiring that the financial indicator for one of the parties is examined. Typically, the tested party would be the party for which a transfer pricing method can be applied most reliably and for which the most reliable comparables can be found and, therefore, is most often the least complex entity to the transaction, a determination which is able to be made by considering the previous functional analysis performed.  

The selection of the most appropriate transfer pricing method 

The selection of a transfer pricing method always aims at finding the most appropriate method for a particular case. For this purpose, the selection process should take account of the respective strengths and weaknesses of the OECD recognized methods; the appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis; the availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method and/or other methods; and the degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them. No one method is suitable in every possible situation, nor is it necessary to prove that a particular method is not suitable under the circumstances.  

In total, the OECD recognizes five methods, which can be split into two categories: 

Traditional transaction methods: 

• Comparable Uncontrolled Price Method (“CUP”) 

• Cost Plus Method (“CPM”) 

• Resale Price Method (“RPM”) 

Transactional profit methods:

• Transactional Net Margin Method (“TNMM”) 

• Profit Split Method (“PSM”) 

Moreover, the OECD Guidelines also allow the use of methods that are not specifically included in the OECD Guidelines, provided that the use of those methods satisfy the arm’s length principle in accordance with the OECD Guidelines. Furthermore, other methods can neither be used as a substitute for the OECD-recognized methods in cases where the OECD-recognized methods are more appropriate to use given the facts and circumstances.  

Overview of the five recognized transfer pricing methods according to the OECD  

CUP 

A CUP typically describes the transfer pricing method that compares the price for property, or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. 

A CUP can be differentiated by an internal CUP (a transaction between one of the parties involved in the transaction and a third party) or an external CUP (a transaction between two unrelated parties) and is considered to be the most appropriate method in cases where comparability is extremely similar or the same and there are no material differences and for this reason, is generally favored above the other methods, however, it is notoriously difficult to find such a situation and therefore, one of the other methods may be considered to be more appropriate or may be applied in a more reliable manner. 

CPM 

The CPM typically describes the transfer pricing method using the costs incurred by the supplier of property (or services) in a controlled transaction. An appropriate cost-plus mark-up is added to this cost, to make an appropriate profit considering the functions performed (considering assets used and risks assumed) and the market conditions. What is arrived at after adding the cost-plus mark-up to the above costs may be regarded as an arm’s length price of the original controlled transaction. 

The CPM can be applied most reliably when the controlled transaction involves the sale of semi-finished goods or the provision of services that aren’t sales related. 

RPM 

The RPM typically describes a transfer pricing method based on the price at which a product has been purchased from an associated enterprise is resold to an independent enterprise. The resale price is reduced by the resale price margin. What is left after subtracting the resale price margin can be regarded, after adjustment for other costs associated with the purchase of the product (e.g., customs duties), as an arm’s length price of the original transfer of property between the associated enterprises. 

The RPM may include differences in accounting standards between European countries make comparisons on gross profit levels unreliable. Furthermore, the RPM is more sensitive to functional differences than a TNMM. 

TNMM 

The TNMM typically describes a transactional profit method that examines the net profit margin relative to an appropriate base (e.g., costs, sales, assets) that a taxpayer realizes from a controlled transaction (or transactions that it is appropriate to aggregate under the principles of Chapter III of the OECD Guidelines). 

The TNMM, by its nature, is less affected by transactional or functional differences and for this reason, it is generally the most commonly used of the methods. 

PSM 

The PSM typically describes a transactional profit split method that identifies the relevant profits to be split for the associated enterprises from a controlled transaction (or controlled transactions that it is appropriate to aggregate under the principles of Chapter III of the OECD Guidelines) and then splits those profits between the associated enterprises on an economically valid basis that approximates the division of profits that would have been agreed at arm’s length. 

The PSM is commonly used for transactions whereby there is a requirement for each party involved to make unique and valuable contributions or, alternatively, where there is a highly integrated operation present. 

PLIs 

As briefly mentioned above, PLIs are financial indicators which typically present as a ratio of net profit to an appropriate base (sales, costs incurred, assets employed). The purpose of the PLI is to measure the relationship between the net profit and the appropriate base to provide a quantitative result to inform an arm’s length price or range of prices. Selection of an appropriate PLI depends on several factors, such as the characterization of the entities and transaction, availability of comparable data and reliability of results. The most commonly used PLIs, along with the associated transfer pricing method and characterization of transaction/entity are described in the table below. 

PLI	TP Method	Formula	Entity/Transaction characterised
Gross margin	RPM	Gross profit / sales	Primarily Distributors
Gross cost-plus margin	CPM	Gross profit / total costs	Manufacturers and/or certain Service Providers
Net cost-plus/ Mark up on total costs	TNMM	Operating profit / total costs	Manufacturers, Distributors and/or Service Provider
Operating margin	TNMM	Operating profit / net sales or net turnover	Manufacturers, Distributors and/or Service Provider
Return on Assets	TNMM	Operating profit / operating assets	Manufacturers and Asset-Intensive Service Providers
Return on Capital Employed	TNMM	Operating profit / capital employed	Manufacturers and Capital-Intensive Operations

It is important to note that while the above table represents the most typical situations in which these common PLIs are utilized, there may be other circumstances which could also be considered appropriate to employ these PLIs or others and, therefore, this would have to be evaluated on a case-by-case basis. 

Determination of the arm’s length remuneration 

As mentioned above, the process of identifying potential comparables, from which an appropriate arm’s length remuneration can be extrapolated, may differ, however, the most commonly utilized approach is the undertaking of a benchmarking study. Depending on the transfer pricing method selected and the PLI used (if necessary), a benchmarking study will typically yield a result or a range of results against which your intercompany transaction can be priced or tested.  

Once these processes discussed above are completed, your intercompany transaction can be considered sufficiently analyzed in relation to the arm’s length principle. 

Attention: If you are considering entering or already enter into any intercompany transactions, be sure to get in touch with us and we can help you evaluate what your transfer pricing needs are.