Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations « TAXATION
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- 1. TAXATIONTransfer PricingGuidelines forMultinationalEnterprises and TaxAdministrations
2. Transfer Pricing Guidelinesfor Multinational Enterprisesand Tax AdministrationsORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT 3. ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENTPursuant to Article 1 of the Convention signed in Paris on 14th December 1960,and which came into force on 30th September 1961, the Organisation for EconomicCo-operation and Development (OECD) shall promote policies designed: to achieve the highest sustainable economic growth and employment and a rising standard of living in Member countries, while maintaining financial stability, and thus to contribute to the development of the world economy; to contribute to sound economic expansion in Member as well as non-member countries in the process of economic development; and to contribute to the expansion of world trade on a multilateral, non- discriminatory basis in accordance with international obligations. The original Member countries of the OECD are Austria, Belgium, Canada,Denmark, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, theNetherlands, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the UnitedKingdom and the United States. The following countries became Memberssubsequently through accession at the dates indicated hereafter: Japan(28th April 1964), Finland (28th January 1969), Australia (7th June 1971), NewZealand (29th May 1973), Mexico (18th May 1994), the Czech Republic(21st December 1995), Hungary (7th May 1996), Poland (22nd November 1996),Korea (12th December 1996) and the Slovak Republic (14th December 2000). TheCommission of the European Communities takes part in the work of the OECD(Article 13 of the OECD Convention).Publi en franais sous le titre : PRINCIPES APPLICABLES EN MATIRE DE PRIX DE TRANSFERT A LINTENTION DES ENTREPRISESMULTINATIONALES ET DES ADMINISTRATIONS FISCALES OECD 2001Permission to reproduce a portion of this work for non-commercial purposes or classroomuse should be obtained through the Centre franais dexploitation du droit de copie (CFC),20, rue des Grands-Augustins, 75006 Paris, France, tel. (33-1) 44 07 47 70, fax (33-1) 46 34 67 19,for every country except the United States. In the United States permission shouldbe obtained through the Copyright Clearance Center, Customer Service, (508)750-8400,222 Rosewood Drive, Danvers, MA 01923 USA, or CCC Online: www.copyright.com. All otherapplications for permission to reproduce or translate all or part of this book should be madeto OECD Publications, 2, rue Andr-Pascal, 75775 Paris Cedex 16, France. 4. FOREWORDThese Guidelines are a revision of the OECD Report Transfer Pricingand Multinational Enterprises (1979). They were approved by the Committeeon Fiscal Affairs on 27 June 1995 and by the OECD Council for publication on13 July 1995. These Guidelines will be supplemented with additional chaptersaddressing other aspects of transfer pricing and will be periodically reviewedand revised on an ongoing basis.July 1995iii OECD 5. TABLE OF CONTENTSPreface ....................................................................................................................P-1Glossary ................................................................................................................. G-1 Chapter I The Arms Length PrincipleA. Introduction .....................................................................................................I-1B. Statement of the arms length principle ..........................................................I-3 i) Article 9 of the OECD Model Tax Convention .....................................I-3 ii) Maintaining the arms length principleas the international consensus.................................................................I-6C. Guidance for applying the arms length principle ..........................................I-7 i) Comparability analysis............................................................................I-7 a) Reason for examining comparability ...............................................I-7 b) Factors determining comparability.................................................. I-9 1. Characteristics of property or services ........................................I-9 2. Functional analysis.......................................................................I-9 3. Contractual terms ...................................................................... I-12 4. Economic circumstances........................................................... I-12 5. Business strategies .................................................................... I-13 ii) Recognition of the actual transactions undertaken ............................. I-15 iii) Evaluation of separate and combined transactions ............................. I-17 iv) Use of an arms length range................................................................ I-19 v) Use of multiple year data .................................................................... I-20 vi) Losses ................................................................................................... I-21 vii) The effect of government policies ...................................................... I-22 viii) Intentional set-offs................................................................................ I-24 ix) Use of customs valuations.................................................................... I-26 x) Use of transfer pricing methods........................................................... I-27August 1997v OCDE 6. OECD TRANSFER PRICING GUIDELINES Chapter IITraditional Transaction MethodsA. Introduction ................................................................................................... II-1B. Relationship to Article 9 .............................................................................. II-1C. Types of traditional transaction methods ..................................................... II-2 i) Comparable uncontrolled price method .............................................. II-2 ii) Resale price method ............................................................................. II-5 iii) Cost plus method................................................................................. II-11D. Relationship to other methods .................................................................... II-17Chapter IIIOther MethodsA. Introduction .................................................................................................. III-1B. Transactional profit methods ....................................................................... III-1 i) Profit split method................................................................................ III-2a) In general........................................................................................ III-2b) Strengths and weaknesses.............................................................. III-3c) Guidance for application................................................................ III-4 ii) Transactional net margin method ........................................................ III-9a) In general........................................................................................ III-9b) Strengths and weaknesses............................................................ III-10c) Guidance for application ............................................................. III-12 1. The comparability standard to be applied to the transactional net margin method................................. III-12 2. Other guidance....................................................................... III-14 iii) Conclusions on transactional profit methods .................................... III-16vi August 1997 OCDE 7. TABLE OF CONTENTSC. A non-arms-length approach:global formulary apportionment............... III-19 i) Background and description of method............................................. III-19 ii) Comparison with the arms length principle...................................... III-20 iii) Rejection of non-arms-length methods............................................. III-24 Chapter IV Administrative Approaches to Avoiding and Resolving Transfer Pricing DisputesA. Introduction ..................................................................................................IV-1B. Transfer pricing compliance practices ........................................................IV-2 i) Examination practices ..........................................................................IV-3 ii) Burden of proof ....................................................................................IV-4 iii) Penalties................................................................................................IV-7C. Corresponding adjustments and the mutual agreement procedure: Articles 9 and 25 of the OECD Model Tax Convention...........................IV-10 i) The mutual agreement procedure ......................................................IV-10 ii) Corresponding adjustments:Paragraph 2 of Article 9 .......................IV-11 iii) Concerns with the procedures............................................................IV-13 iv) Recommendations to address concerns .............................................IV-15a) Time limits ...................................................................................IV-15b) Duration of mutual agreement proceedings ................................IV-17c) Taxpayer participation .................................................................IV-19d) Publication of applicable procedures ..........................................IV-20e) Problems concerning collection of tax deficienciesand accrual of interest ..................................................................IV-21 v) Secondary adjustments.......................................................................IV-22August 1997 vii OCDE 8. OECD TRANSFER PRICING GUIDELINESD. Simultaneous tax examinations. ...............................................................IV-26 i) Definition and background.................................................................IV-26 ii) Legal basis for simultaneous tax examinations.................................IV-27 iii) Simultaneous tax examinations and transfer pricing ........................IV-28 iv) Recommendation on the use of simultaneous tax examinations .....IV-31E. Safe harbours..............................................................................................IV-31 i) Introduction ........................................................................................IV-31 ii) Definition and concept of safe harbours............................................IV-32 iii) Factors supporting use of safe harbours ............................................IV-33a) Compliance relief.........................................................................IV-33b) Certainty.......................................................................................IV-33c) Administrative simplicity ............................................................IV-34 iv) Problems presented by use of safe harbours......................................IV-34a) Risk of double taxation and mutual agreement procedure difficulties ....................................................................................IV-36b) Possibility of opening avenues for tax planning .........................IV-38c) Equity and uniformity issues .......................................................IV-39 v) Recommendations on use of safe harbours .......................................IV-40F. Advance pricing arrangements ..................................................................IV-41 i) Definition and concept of advance pricing arrangements.................IV-41 ii) Possible approaches for legal and administrative rulesgoverning advance pricing arrangements..........................................IV-45 iii) Advantages of advance pricing arrangements...................................IV-46 iv) Disadvantages relating to advance pricing arrangements .................IV-48 v) Recommendations ..............................................................................IV-52a) In general......................................................................................IV-52b) Coverage of an arrangement........................................................IV-52c) Unilateral versus bilateral (multilateral) arrangements ..............IV-52d) Equitable access to APAs for all taxpayers.................................IV-53e) Developing working agreements between competent authorities and improved procedures ..........................................IV-53G. Arbitration ................................................................................................IV-53viii August 1997 OCDE 9. TABLE OF CONTENTS Chapter VDocumentationA. Introduction ................................................................................................... V-1B. Guidance on documentation rules and procedures ...................................... V-2C. Useful information for effective transfer pricing audits .............................. V-6D. General recommendations on documentation.............................................. V-9Chapter VI Special Considerations for Intangible PropertyA. Introduction ..................................................................................................VI-1B. Commercial intangibles ...............................................................................VI-1 i) In general ..............................................................................................VI-1 ii) Examples: patents and trademarks.....................................................VI-4C. Applying the arms length principle ............................................................VI-6 i) In general ..............................................................................................VI-6 ii) Identifying arrangements made for the transferof intangible property...........................................................................VI-7 iii) Calculation of an arms length consideration ......................................VI-8 iv) Arms length pricing when valuation is highly uncertainat the time of the transaction..............................................................VI-11D. Marketing activities undertaken by enterprises not owning trademarks or tradenames ..........................................................................VI-13August 1997ix OCDE 10. OECD TRANSFER PRICING GUIDELINES Chapter VII Special Considerations for Intra-Group ServicesA. Introduction .................................................................................................VII-1B. Main issues..................................................................................................VII-2 i) Determining whether intra-group services have been rendered ........VII-2 ii) Determining an arms length charge ...................................................VII-7 a) In general.......................................................................................VII-7 b) Identifying actual arrangements for charging for intra-group services.......................................................................VII-7 c) Calculating the arms length consideration ............................... VII-10C. Some examples of intra-group services................................................... VII-13Chapter VIII Cost Contribution ArrangementsA. Introduction ..........................................................................................VIII-1B. Concept of a CCA.................................................................................VIII-2 i) In general.......................................................................................VIII-2 ii) Relationship to other chapters .......................................................VIII-3 iii) Types of CCAs ..............................................................................VIII-3C. Applying the arms length principle .....................................................VIII-4 i) In general.......................................................................................VIII-4 ii) Determining participants ...............................................................VIII-5 iii) The amount of each participants contribution .............................VIII-6 iv) Determining whether the allocation is appropriate .......................VIII-7 v) The tax treatment of contributions and balancing payments ........VIII-9xAugust 1997 OCDE 11. TABLE OF CONTENTSD. Tax consequences if a CCA is not arms length .................................VIII-10 i) Adjustment of contributions ........................................................VIII-10 ii) Disregarding part or all of the terms of a CCA ...........................VIII-11E. CCA entry, withdrawal, or termination ..............................................VIII-12F. Recommendations for structuring and documenting CCAs ...............VIII-15APPENDIX: Recommendation of the OECD Council ...........................................A-1ANNEXESGuidelines for Monitoring Procedures on the OECD Transfer PricingGuidelines and the Involvement of the Business Community.......................AN-1Examples to Illustrate the Transfer Pricing Guidelines.................................AN-9Application of the Residual Profit Split Method .................................AN-11Intangible Property and Uncertain Valuation .....................................AN-15Guidelines for Conducting Advance Pricing ArrangementsUnder The Mutual Agreement Procedure ("MAP APAs")..........................AN-19October 1999 xi OECD 12. PREFACE1.The role of multinational enterprises (MNEs) in world trade hasincreased dramatically over the last 20 years. This in part reflects the increasedintegration of national economies and technological progress, particularly inthe area of communications. The growth of MNEs presents increasinglycomplex taxation issues for both tax administrations and the MNEs themselvessince separate country rules for the taxation of MNEs cannot be viewed inisolation but must be addressed in a broad international context.2. These issues arise primarily from the practical difficulty, for bothMNEs and tax administrations, of determining the income and expenses of acompany or a permanent establishment that is part of an MNE group thatshould be taken into account within a jurisdiction, particularly where the MNEgroups operations are highly integrated.3. In the case of MNEs, the need to comply with laws and administrativerequirements that may differ from country to country creates additionalproblems. The differing requirements may lead to a greater burden on anMNE, and result in higher costs of compliance, than for a similar enterpriseoperating solely within a single tax jurisdiction.4. In the case of tax administrations, specific problems arise at bothpolicy and practical levels. At the policy level, countries need to reconciletheir legitimate right to tax the profits of a taxpayer based upon income andexpenses that can reasonably be considered to arise within their territory withthe need to avoid the taxation of the same item of income by more than one taxjurisdiction. Such double or multiple taxation can create an impediment tocross-border transactions in goods and services and the movement of capital.At a practical level, a countrys determination of such income and expenseallocation may be impeded by difficulties in obtaining pertinent data locatedoutside its own jurisdiction.5. At a primary level, the taxing rights that each country asserts dependon whether the country uses a system of taxation that is residence-based,source-based, or both. In a residence-based tax system, a country will includein its tax base all or part of the income, including income from sources outsidethat country, of any person (including juridical persons such as corporations)July 1995 P-1 OECD 13. OECD TRANSFER PRICING GUIDELINESwho is considered resident in that jurisdiction. In a source-based tax system, acountry will include in its tax base income arising within its tax jurisdiction,irrespective of the residence of the taxpayer. As applied to MNEs, these twobases, often used in conjunction, generally treat each enterprise within theMNE group as a separate entity. OECD Member countries have chosen thisseparate entity approach as the most reasonable means for achieving equitableresults and minimising the risk of unrelieved double taxation. Thus, eachindividual group member is subject to tax on the income arising to it (on aresidence or source basis).6.In order to apply the separate entity approach to intra-grouptransactions, individual group members must be taxed on the basis that they act atarms length in their dealings with each other. However, the relationship amongmembers of an MNE group may permit the group members to establish specialconditions in their intra-group relations that differ from those that would havebeen established had the group members been acting as independent enterprisesoperating in open markets. To ensure the correct application of the separateentity approach, OECD Member countries have adopted the arms lengthprinciple, under which the effect of special conditions on the levels of profitsshould be eliminated.7.These international taxation principles have been chosen by OECDMember countries as serving the dual objectives of securing the appropriate taxbase in each jurisdiction and avoiding double taxation, thereby minimizingconflict between tax administrations and promoting international trade andinvestment. In a global economy, coordination among countries is better placedto achieve these goals than tax competition. The OECD, with its mission tocontribute to the expansion of world trade on a multilateral, non-discriminatorybasis and to achieve the highest sustainable economic growth in Membercountries, has continuously worked to build a consensus on international taxationprinciples, thereby avoiding unilateral responses to multilateral problems.8.The foregoing principles concerning the taxation of MNEs areincorporated in the OECD Model Tax Convention on Income and on Capital(OECD Model Tax Convention), which forms the basis of the extensive networkof bilateral income tax treaties between OECD Member countries and betweenOECD Member and non-Member countries.These principles also areincorporated in the Model United Nations Double Taxation Convention betweenDeveloped and Developing Nations.P-2July 1995 OECD 14. PREFACE9.The main mechanisms for resolving issues that arise in the applicationof international tax principles to MNEs are contained in these bilateral treaties.The Articles that chiefly affect the taxation of MNEs are: Article 4, whichdefines residence; Articles 5 and 7, which determine the taxation of permanentestablishments; Article 9, which relates to the taxation of the profits of associatedenterprises and applies the arms length principle; Articles 10, 11, and 12, whichdetermine the taxation of dividends, interest, and royalties, respectively; andArticles 24, 25, and 26, which contain special provisions relating to non-discrimination, the resolution of disputes, and exchange of information.10.The Committee on Fiscal Affairs, which is the main tax policy body ofthe OECD, has issued a number of reports relating to the application of theseArticles to MNEs and to others. The Committee has encouraged the acceptanceof common interpretations of these Articles, thereby reducing the risk ofinappropriate taxation and providing satisfactory means of resolving problemsarising from the interaction of the laws and practices of different countries.11.In applying the foregoing principles to the taxation of MNEs, one of themost difficult issues that has arisen is the establishment for tax purposes ofappropriate transfer prices. Transfer prices are the prices at which an enterprisetransfers physical goods and intangible property or provides services to associatedenterprises. For purposes of this Report, an "associated enterprise" is anenterprise that satisfies the conditions set forth in Article 9, sub-paragraphs 1a)and 1b) of the OECD Model Tax Convention. Under these conditions, twoenterprises are associated if one of the enterprises participates directly orindirectly in the management, control, or capital of the other or if "the samepersons participate directly or indirectly in the management, control, or capital" ofboth enterprises (i.e. if both enterprises are under common control). The issuesdiscussed in this Report also arise in the treatment of permanent establishmentsand will be dealt with subsequently. Some relevant discussion may also be foundin the OECD Report Model Tax Convention: Attribution of Income to PermanentEstablishments (1994) and in the OECD Report International Tax Avoidance andEvasion (1987).12.Transfer prices are significant for both taxpayers and taxadministrations because they determine in large part the income and expenses,and therefore taxable profits, of associated enterprises in different taxjurisdictions. Transfer pricing issues originally arose in dealings betweenassociated enterprises operating within the same tax jurisdiction. The domesticJuly 1995P-3 OECD 15. OECD TRANSFER PRICING GUIDELINESissues are not considered in this Report, which focuses on the internationalaspects of transfer pricing. These international aspects are more difficult to dealwith because they involve more than one tax jurisdiction and therefore anyadjustment to the transfer price in one jurisdiction implies that a correspondingchange in another jurisdiction is appropriate. However, if the other jurisdictiondoes not agree to make a corresponding adjustment the MNE group will be taxedtwice on this part of its profits. In order to minimise the risk of such doubletaxation, an international consensus is required on how to establish for taxpurposes transfer prices on cross-border transactions.13. These Guidelines are intended to be a revision and compilation ofprevious reports by the OECD Committee on Fiscal Affairs addressing transferpricing and other related tax issues with respect to multinational enterprises. Theprincipal report is Transfer Pricing and Multinational Enterprises (1979) (the"1979 Report") which elaborated on the arms length principle as set out in Article9. Other reports address transfer pricing issues in the context of specific topics.These reports are Transfer Pricing and Multinational Enterprises -- ThreeTaxation Issues (1984) (the "1984 Report"), and Thin Capitalization (the "1987Report").14.These Guidelines also draw upon the discussion undertaken by theOECD on the proposed transfer pricing regulations in the United States [see theOECD Report Tax Aspects of Transfer Pricing within Multinational Enterprises:The United States Proposed Regulations (1993)]. However, the context in whichthat Report was written was very different from that in which these Guidelineshave been undertaken, its scope was far more limited, and it specificallyaddressed the United States proposed regulations.15.OECD Member countries continue to endorse the arms length principleas embodied in the OECD Model Tax Convention (and in the bilateralconventions that legally bind treaty partners in this respect) and in the 1979Report. These Guidelines focus on the application of the arms length principle toevaluate the transfer pricing of associated enterprises. The Guidelines areintended to help tax administrations (of both OECD Member countries and non-Member countries) and MNEs by indicating ways to find mutually satisfactorysolutions to transfer pricing cases, thereby minimizing conflict among taxadministrations and between tax administrations and MNEs and avoiding costlylitigation. The Guidelines analyse the methods for evaluating whether theconditions of commercial and financial relations within an MNE satisfy the armsP-4 July 1995 OECD 16. PREFACElength principle and discuss the practical application of those methods. They alsoinclude a discussion of global formulary apportionment.16. OECD Member countries are encouraged to follow these Guidelines intheir domestic transfer pricing practices, and taxpayers are encouraged to followthese Guidelines in evaluating for tax purposes whether their transfer pricingcomplies with the arms length principle. Tax administrations are encouraged totake into account the taxpayers commercial judgement about the application ofthe arms length principle in their examination practices and to undertake theiranalyses of transfer pricing from that perspective.17. These Guidelines are also intended primarily to govern the resolution oftransfer pricing cases in mutual agreement proceedings between OECD Membercountries and, where appropriate, arbitration proceedings. They further provideguidance when a corresponding adjustment request has been made. TheCommentary on paragraph 2 of Article 9 of the OECD Model Tax Conventionmakes clear that the State from which a corresponding adjustment is requestedshould comply with the request only if that State "considers that the figure ofadjusted profits correctly reflects what the profits would have been if thetransactions had been at arms length". This means that in competent authorityproceedings the State that has proposed the primary adjustment bears the burdenof demonstrating to the other State that the adjustment "is justified both inprinciple and as regards the amount." Both competent authorities are expected totake a cooperative approach in resolving mutual agreement cases.18. In seeking to achieve the balance between the interests of taxpayers andtax administrators in a way that is fair to all parties, it is necessary to consider allaspects of the system that are relevant in a transfer pricing case. One such aspectis the allocation of the burden of proof. In most jurisdictions, the taxadministration bears the burden of proof, which may require the tax administra-tion to make a prima facie showing that the taxpayers pricing is inconsistent withthe arms length principle. It should be noted, however, that even in such a case atax administration might still reasonably oblige the taxpayer to produce itsrecords to enable the tax administration to undertake its examination of thecontrolled transactions. In other jurisdictions the taxpayer may bear the burden ofproof in some respects. Some OECD Member countries are of the view thatArticle 9 of the OECD Model Tax Convention establishes burden of proof rulesin transfer pricing cases which override any contrary domestic provisions. Othercountries, however, consider that Article 9 does not establish burden of proofJuly 1995 P-5 OECD 17. OECD TRANSFER PRICING GUIDELINESrules (cf. paragraph 4 of the Commentary on Article 9 of the OECD Model TaxConvention). Regardless of which party bears the burden of proof, an assessmentof the fairness of the allocation of the burden of proof would have to be made inview of the other features of the jurisdictions tax system that have a bearing onthe overall administration of transfer pricing rules, including the resolution ofdisputes. These features include penalties, examination practices, administrativeappeals processes, rules regarding payment of interest with respect to taxassessments and refunds, whether proposed tax deficiencies must be paid beforeprotesting an adjustment, the statute of limitations, and the extent to which rulesare made known in advance. It would be inappropriate to rely on any of thesefeatures, including the burden of proof, to make unfounded assertions abouttransfer pricing. Some of these issues are discussed further in Chapter IV.19. This Report focuses on the main issues of principle that arise in thetransfer pricing area. The Committee on Fiscal Affairs intends to continue itswork in this area and so has decided to issue these Guidelines in a looseleafformat. Future work will address such issues as the application of the armslength principle to transactions involving intangible property, services, costcontribution arrangements, permanent establishments, and thin capitalization.The Committee intends to have regular reviews of the experiences of OECDMember and selected non-Member countries in the use of the methods used toapply the arms length principle, with particular emphasis on difficultiesencountered in the application of transactional profit methods (as defined inChapter III) and the ways in which these problems have been resolved betweencountries. The Committee will also expect a regular reporting back on thefrequency with which transactional profit methods are used. On the basis of thesereviews and reporting the Committee may find that it needs to issuesupplementary guidelines on the use of these methods.P-6 July 1995 OECD 18. GLOSSARYAdvance pricing arrangement ("APA")An arrangement that determines, in advance of controlled transactions, anappropriate set of criteria (e.g. method, comparables and appropriate adjustmentsthereto, critical assumptions as to future events) for the determination of thetransfer pricing for those transactions over a fixed period of time. An advancepricing arrangement may be unilateral involving one tax administration and ataxpayer or multilateral involving the agreement of two or more taxadministrations .Arms length principleThe international standard that OECD Member countries have agreedshould be used for determining transfer prices for tax purposes. It is set forth inArticle 9 of the OECD Model Tax Convention as follows: where "conditions aremade or imposed between the two enterprises in their commercial or financialrelations which differ from those which would be made between independententerprises, then any profits which would, but for those conditions, have accruedto 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".Arms length range A range of figures that are acceptable for establishing whether theconditions of a controlled transaction are arms length and that are derived eitherfrom applying the same transfer pricing method to multiple comparable data orfrom applying different transfer pricing methods.February 1998 G-1 OECD 19. OECD TRANSFER PRICING GUIDELINESAssociated enterprisesTwo enterprises are associated enterprises with respect to each other if oneof the enterprises meets the conditions of Article 9, sub-paragraphs 1a) or 1b) ofthe OECD Model Tax Convention with respect to the other enterprise.Balancing paymentA payment, normally from one or more participants to another, toadjust participants proportionate shares of contributions, that increases thevalue of the contributions of the payer and decreases the value of thecontributions of the payee by the amount of the payment.Buy-in payment A payment made by a new entrant to an already active CCA forobtaining an interest in any results of prior CCA activity.Buy-out paymentCompensation that a participant who withdraws from an alreadyactive CCA may receive from the remaining participants for an effectivetransfer of its interests in the results of past CCA activities.Commercial intangible An intangible that is used in commercial activities such as theproduction of a good or the provision of a service, as well as an intangible rightthat is itself a business asset transferred to customers or used in the operation ofbusiness.Comparability analysisA comparison of a controlled transaction with an uncontrolled transactionor transactions. Controlled and uncontrolled transactions are comparable if noneof the differences between the transactions could materially affect the factorbeing examined in the methodology (e.g. price or margin), or if reasonablyaccurate adjustments can be made to eliminate the material effects of any suchdifferences.G-2 February 1998 OECD 20. GLOSSARYComparable uncontrolled price (CUP) methodA transfer pricing method that compares the price for property or servicestransferred in a controlled transaction to the price charged for property or servicestransferred in a comparable uncontrolled transaction in comparablecircumstances.Compensating adjustmentAn adjustment in which the taxpayer reports a transfer price for taxpurposes that is, in the taxpayers opinion, an arms length price for a controlledtransaction, even though this price differs from the amount actually chargedbetween the associated enterprises. This adjustment would be made before thetax return is filed.Contribution analysisAn analysis used in the profit split method under which the combinedprofits from controlled transactions are divided between the associatedenterprises based upon the relative value of the functions performed (taking intoaccount assets used and risks assumed) by each of the associated enterprisesparticipating in those transactions, supplemented as much as possible by externalmarket data that indicate how independent enterprises would have divided profitsin similar circumstances.Controlled transactions Transactions between two enterprises that are associated enterprises withrespect to each other.Corresponding adjustmentAn adjustment to the tax liability of the associated enterprise in a secondtax jurisdiction made by the tax administration of that jurisdiction, correspondingto a primary adjustment made by the tax administration in a first tax jurisdiction,so that the allocation of profits by the two jurisdictions is consistent.February 1998 G-3 OECD 21. OECD TRANSFER PRICING GUIDELINESCost contribution arrangement (CCA)A CCA is a framework agreed among enterprises to share the costsand risks of developing, producing, or obtaining assets, services, or rights, andto determine the nature and extent of the interests of each participant in theresults of the activity of developing, producing, or obtaining those assets,services, or rights.Cost plus mark up A mark up that is measured by reference to margins computed after thedirect and indirect costs incurred by a supplier of property or services in atransaction.Cost plus method A transfer pricing method using the costs incurred by the supplier ofproperty (or services) in a controlled transaction. An appropriate cost plus markup is added to this cost, to make an appropriate profit in light of the functionsperformed (taking into account assets used and risks assumed) and the marketconditions. What is arrived at after adding the cost plus mark up to the abovecosts may be regarded as an arms length price of the original controlledtransaction.Direct-charge methodA method of charging directly for specific intra-group services on aclearly identified basis.Direct costs Costs that are incurred specifically for producing a product or renderingservice, such as the cost of raw materials.G-4February 1998 OECD 22. GLOSSARYFunctional analysis An analysis of the functions performed (taking into account assets usedand risks assumed) by associated enterprises in controlled transactions and byindependent enterprises in comparable uncontrolled transactions.Global formulary apportionment methodA method to allocate the global profits of an MNE group on aconsolidated basis among the associated enterprises in different countries on thebasis of a predetermined formula.Gross profits The gross profits from a business transaction are the amount computed bydeducting from the gross receipts of the transaction the allocable purchases orproduction costs of sales, with due adjustment for increases or decreases ininventory or stock-in-trade, but without taking account of other expenses.Independent enterprises Two enterprises are independent enterprises with respect to each other ifthey are not associated enterprises with respect to each other.Indirect-charge methodA method of charging for intra-group services based upon costallocation and apportionment methods.Indirect costsCosts of producing a product or service which, although closely related tothe production process, may be common to several products or services (forexample, the costs of a repair department that services equipment used to producedifferent products).February 1998G-5 OECD 23. OECD TRANSFER PRICING GUIDELINESIntra-group serviceAn activity (e.g. administrative, technical, financial, commercial, etc.)for which an independent enterprise would have been willing to pay or performfor itself.Intentional set-offA benefit provided by one associated enterprise to another associatedenterprise within the group that is deliberately balanced to some degree bydifferent benefits received from that enterprise in return.Marketing intangible An intangible that is concerned with marketing activities, which aidsin the commercial exploitation of a product or service and/or has an importantpromotional value for the product concerned.Multinational enterprise group (MNE group)A group of associated companies with business establishments in two ormore countries.Multinational enterprise (MNE) A company that is part of an MNE group.Mutual agreement procedure A means through which tax administrations consult to resolve disputesregarding the application of double tax conventions. This procedure, describedand authorized by Article 25 of the OECD Model Tax Convention, can be used toeliminate double taxation that could arise from a transfer pricing adjustment.G-6February 1998 OECD 24. GLOSSARYOn call services Services provided by a parent company or a group service centre,which are available at any time for members of an MNE group.Primary adjustment An adjustment that a tax administration in a first jurisdiction makes to acompanys taxable profits as a result of applying the arms length principle totransactions involving an associated enterprise in a second tax jurisdiction.Profit split method A transactional profit method that identifies the combined profit to be splitfor the associated enterprises from a controlled transaction (or controlledtransactions that it is appropriate to aggregate under the principles of Chapter I)and then splits those profits between the associated enterprises based upon aneconomically valid basis that approximates the division of profits that would havebeen anticipated and reflected in an agreement made at arms length.Resale price margin A margin representing the amount out of which a reseller would seek tocover its selling and other operating expenses and, in the light of the functionsperformed (taking into account assets used and risks assumed), make anappropriate profit.Resale price methodA transfer pricing method based on the price at which a product that hasbeen purchased from an associated enterprise is resold to an independententerprise. The resale price is reduced by the resale price margin. What is leftafter subtracting the resale price margin can be regarded, after adjustment forother costs associated with the purchase of the product (e.g. custom duties), as anarms length price of the original transfer of property between the associatedenterprises.February 1998G-7 OECD 25. OECD TRANSFER PRICING GUIDELINESResidual analysis An analysis used in the profit split method which divides the combinedprofit from the controlled transactions under examination in two stages. In thefirst stage, each participant is allocated sufficient profit to provide it with a basicreturn appropriate for the type of transactions in which it is engaged. Ordinarilythis basic return would be determined by reference to the market returns achievedfor similar types of transactions by independent enterprises. Thus, the basicreturn would generally not account for the return that would be generated by anyunique and valuable assets possessed by the participants. In the second stage, anyresidual profit (or loss) remaining after the first stage division would be allocatedamong the parties based on an analysis of the facts and circumstances that mightindicate how this residual would have been divided between independententerprises.Secondary adjustment An adjustment that arises from imposing tax on a secondary transaction.Secondary transactionA constructive transaction that some countries will assert under theirdomestic legislation after having proposed a primary adjustment in order to makethe actual allocation of profits consistent with the primary adjustment. Secondarytransactions may take the form of constructive dividends, constructive equitycontributions, or constructive loans.Shareholder activityAn activity which is performed by a member of an MNE group(usually the parent company or a regional holding company) solely because ofits ownership interest in one or more other group members, i.e. in its capacityas shareholder..G-8 February 1998 OECD 26. GLOSSARYSimultaneous tax examinations A simultaneous tax examination, as defined in Part A of the OECD ModelAgreement for the Undertaking of Simultaneous Tax Examinations, means an"arrangement between two or more parties to examine simultaneously andindependently, each on its own territory, the tax affairs of (a) taxpayer(s) in whichthey have a common or related interest with a view to exchanging any relevantinformation which they so obtain".Trade intangibleA commercial intangible other than a marketing intangible.Traditional transaction methods The comparable uncontrolled price method, the resale price method, andthe cost plus method.Transactional net margin method A transactional profit method that examines the net profit margin relativeto an appropriate base (e.g. costs, sales, assets) that a taxpayer realizes from acontrolled transaction (or transactions that it is appropriate to aggregate under theprinciples of Chapter I).Transactional profit methodA transfer pricing method that examines the profits that arise fromparticular controlled transactions of one or more of the associated enterprisesparticipating in those transactions.Uncontrolled transactionsTransactions between enterprises that are independent enterprises withrespect to each other.February 1998 G-9 OECD 27. Chapter IThe Arms Length PrincipleA.Introduction1.1This Chapter provides a background discussion of the arms lengthprinciple, which is the international transfer pricing standard that OECD Membercountries have agreed should be used for tax purposes by MNE groups and taxadministrations. The Chapter discusses the arms length principle, reaffirms itsstatus as the international standard, and sets forth guidelines for its application.1.2When independent enterprises deal with each other, the conditions oftheir commercial and financial relations (e.g. the price of goods transferred orservices provided and the conditions of the transfer or provision) ordinarily aredetermined by market forces. When associated enterprises deal with each other,their commercial and financial relations may not be directly affected by externalmarket forces in the same way, although associated enterprises often seek toreplicate the dynamics of market forces in their dealings with each other, asdiscussed in paragraph 1.5, below. Tax administrations should not automaticallyassume that associated enterprises have sought to manipulate their profits. Theremay be a genuine difficulty in accurately determining a market price in theabsence of market forces or when adopting a particular commercial strategy. It isimportant to bear in mind that the need to make adjustments to approximate armslength dealings arises irrespective of any contractual obligation undertaken by theparties to pay a particular price or of any intention of the parties to minimize tax.Thus, a tax adjustment under the arms length principle would not affect theunderlying contractual obligations for non-tax purposes between the associatedenterprises, and may be appropriate even where there is no intent to minimize oravoid tax. The consideration of transfer pricing should not be confused with theconsideration of problems of tax fraud or tax avoidance, even though transferpricing policies may be used for such purposes.1.3 When transfer pricing does not reflect market forces and the armslength principle, the tax liabilities of the associated enterprises and the taxrevenues of the host countries could be distorted. Therefore, OECD Membercountries have agreed that for tax purposes the profits of associated enterprisesmay be adjusted as necessary to correct any such distortions and thereby ensureJuly 1995I-1 OECD 28. OECD TRANSFER PRICING GUIDELINESthat the arms length principle is satisfied. OECD Member countries consider thatan appropriate adjustment is achieved by establishing the conditions of thecommercial and financial relations that they would expect to find betweenindependent enterprises in similar transactions under similar circumstances.1.4 Factors other than tax considerations may distort the conditions ofcommercial and financial relations established between associated enterprises.For example, such enterprises may be subject to conflicting governmentalpressures (in the domestic as well as foreign country) relating to customsvaluations, anti-dumping duties, and exchange or price controls. In addition,transfer price distortions may be caused by the cash flow requirements ofenterprises within an MNE group. An MNE group that is publicly held may feelpressure from shareholders to show high profitability at the parent company level,particularly if shareholder reporting is not undertaken on a consolidated basis.All of these factors may affect transfer prices and the amount of profits accruingto associated enterprises within an MNE group.1.5It should not be assumed that the conditions established in thecommercial and financial relations between associated enterprises will invariablydeviate from what the open market would demand. Associated enterprises inMNEs commonly have a considerable amount of autonomy and often bargainwith each other as though they were independent enterprises. Enterprises respondto economic situations arising from market conditions, in their relations with boththird parties and associated enterprises. For example, local managers may beinterested in establishing good profit records and therefore would not want toestablish prices that would reduce the profits of their own companies. Taxadministrations should bear in mind that MNEs from a managerial point of viewhave an incentive to use arms length prices to be able to judge the realperformance of their different profit centres. Tax administrations should keepthese considerations in mind to facilitate efficient allocation of their resources inselecting and conducting transfer pricing examinations. Sometimes, it may occurthat the relationship between the associated enterprises may influence theoutcome of the bargaining. Therefore, evidence of hard bargaining alone is notsufficient to establish that the dealings are at arms length.I-2 July 1995 OECD 29. ARMS LENGTH PRINCIPLEB. Statement of the arms length principle i) Article 9 of the OECD Model Tax Convention1.6 The authoritative statement of the arms length principle is found inparagraph 1 of Article 9 of the OECD Model Tax Convention, which forms thebasis of bilateral tax treaties involving OECD Member countries and anincreasing number of non-Member countries. Article 9 provides:"[When] conditions are made or imposed between ... two [associated]enterprises in their commercial or financial relations which differ fromthose which would be made between independent enterprises, then anyprofits which would, but for those conditions, have accrued to one of theenterprises, but, by reason of those conditions, have not so accrued, may beincluded in the profits of that enterprise and taxed accordingly."By seeking to adjust profits by reference to the conditions which would haveobtained between independent enterprises in comparable transactions andcomparable circumstances, the arms length principle follows the approach oftreating the members of an MNE group as operating as separate entities ratherthan as inseparable parts of a single unified business. Because the separate entityapproach treats the members of an MNE group as if they were independententities, attention is focused on the nature of the dealings between thosemembers.1.7 There are several reasons why OECD Member countries and othercountries have adopted the arms length principle. A major reason is that thearms length principle provides broad parity of tax treatment for MNEs andindependent enterprises. Because the arms length principle puts associated andindependent enterprises on a more equal footing for tax purposes, it avoids thecreation of tax advantages or disadvantages that would otherwise distort therelative competitive positions of either type of entity. In so removing these taxconsiderations from economic decisions, the arms length principle promotes thegrowth of international trade and investment.1.8 The arms length principle has also been found to work effectively in thevast majority of cases. For example, there are many cases involving the purchaseand sale of commodities and the lending of money where an arms length priceJuly 1995I-3 OECD 30. OECD TRANSFER PRICING GUIDELINESmay readily be found in a comparable transaction undertaken by comparableindependent enterprises under comparable circumstances. Nevertheless, there aresome significant cases in which the arms length principle is difficult andcomplicated to apply, for example, in MNE groups dealing in the integratedproduction of highly specialized goods, in unique intangibles, and/or in theprovision of specialised services.1.9 The arms length principle is viewed by some as inherently flawedbecause the separate entity approach may not always account for the economiesof scale and interrelation of diverse activities created by integrated businesses.There are, however, no widely accepted objective criteria for allocating theeconomies of scale or benefits of integration between associated enterprises. Theissue of possible alternatives to the arms length principle is discussed in SectionC of Chapter III.1.10A practical difficulty in applying the arms length principle is thatassociated enterprises may engage in transactions that independent enterpriseswould not undertake. Such transactions may not necessarily be motivated by taxavoidance but may occur because in transacting business with each other,members of an MNE group face different commercial circumstances than wouldindependent enterprises. For example, an independent enterprise may not bewilling to sell an intangible (e.g. the right to exploit the fruits of all futureresearch) for a fixed price if the profit potential of the intangible cannot beadequately estimated and there are other means of exploiting the intangible. Insuch a case, an independent enterprise may not want to risk an outright salebecause the price might not reflect the potential for the intangible to becomeextremely profitable. Similarly, the owner of an intangible may be hesitant toenter into licensing arrangements with independent enterprises for fear of thevalue of the intangible being degraded. In contrast, the intangible owner may beprepared to offer terms to associated enterprises that are less restrictive becausethe use of the intangible can be more closely monitored. There is no risk to theoverall groups profit from a transaction of this kind between members of anMNE group. An independent enterprise in such circumstances might exploit theintangible itself or license it to another independent enterprise for a limited periodof time (or possibly under an arrangement to adjust the royalty). However, thereis always a risk that the intangible is not as valuable as it seems to be. Therefore,an independent enterprise has to make the choice between selling the intangibleand so diminishing the risk and safeguarding the profit, andI-4July 1995 OECD 31. ARMS LENGTH PRINCIPLEexploiting the intangible and taking the risk that the profit will vary from theprofit which could be gained by selling the intangible. Where independententerprises seldom undertake transactions of the type entered into by associatedenterprises, the arms length principle is difficult to apply because there is little orno direct evidence of what conditions would have been established byindependent enterprises.1.11 In certain cases, the arms length principle may result in anadministrative burden for both the taxpayer and the tax administrations ofevaluating significant numbers and types of cross-border transactions. Althoughan associated enterprise normally establishes the conditions for a transaction atthe time it is undertaken, at some point the enterprise may be required todemonstrate that these are consistent with the arms length principle. (SeeChapter V on Documentation). The tax administration may also have to engagein this verification process perhaps some years after the transactions have takenplace. The tax administration would then attempt to gather information aboutsimilar transactions, the market conditions at the time the transactions took place,etc., for numerous and varied transactions. Such an undertaking usually becomesmore difficult with the passage of time.1.12Both tax administrations and taxpayers often have difficulty inobtaining adequate information to apply the arms length principle. Because thearms length principle usually requires taxpayers and tax administrations toevaluate uncontrolled transactions and the business activities of independententerprises, and to compare these with the transactions and activities of associatedenterprises, it can demand a substantial amount of data. The information that isaccessible may be incomplete and difficult to interpret; other information, if itexists, may be difficult to obtain for reasons of its geographical location or that ofthe parties from whom it may have to be acquired. In addition, it may not bepossible to obtain information from independent enterprises because ofconfidentiality concerns. In other cases information about an independententerprise which could be relevant may simply not exist. It should also berecalled at this point that transfer pricing is not an exact science but does requirethe exercise of judgment on the part of both the tax administration and taxpayer.July 1995 I-5 OECD 32. OECD TRANSFER PRICING GUIDELINES ii) Maintaining the arms length principle as the international consensus1.13While recognizing the foregoing considerations, the view of OECDMember countries continues to be that the arms length principle should governthe evaluation of transfer prices among associated enterprises. The armslength principle is sound in theory since it provides the closest approximationof the workings of the open market in cases where goods and services aretransferred between associated enterprises. While it may not always bestraightforward to apply in practice, it does generally produce appropriatelevels of income between members of MNE groups, acceptable to taxadministrations. This reflects the economic realities of the controlledtaxpayers particular facts and circumstances and adopts as a benchmark thenormal operation of the market.1.14A move away from the arms length principle would abandon thesound theoretical basis described above and threaten the internationalconsensus, thereby substantially increasing the risk of double taxation.Experience under the arms length principle has become sufficiently broad andsophisticated to establish a substantial body of common understanding amongthe business community and tax administrations. This shared understanding isof great practical value in achieving the objectives of securing the appropriatetax base in each jurisdiction and avoiding double taxation. This experienceshould be drawn on to elaborate the arms length principle further, to refine itsoperation, and to improve its administration by providing clearer guidance totaxpayers and more timely examinations. In sum, OECD Member countriescontinue to support strongly the arms length principle. In fact, no legitimate orrealistic alternative to the arms length principle has emerged. The globalformulary apportionment approach, sometimes mentioned as a possiblealternative, would not be acceptable in theory, implementation, or practice.(See Chapter III, Part C, for a discussion of the global formulary apportionmentmethod.)I-6July 1995 OECD 33. ARMS LENGTH PRINCIPLEC. Guidance for applying the arms length principle i) Comparability analysis a) Reason for examining comparability1.15 Application of the arms length principle is generally based on acomparison of the conditions in a controlled transaction with the conditions intransactions between independent enterprises. In order for such comparisons tobe useful, the economically relevant characteristics of the situations beingcompared must be sufficiently comparable. To be comparable means that noneof the differences (if any) between the situations being compared could materiallyaffect the condition being examined in the methodology (e.g. price or margin), orthat reasonably accurate adjustments can be made to eliminate the effect of anysuch differences. In determining the degree of comparability, including whatadjustments are necessary to establish it, an understanding of how unrelatedcompanies evaluate potential transactions is required. Independent enterprises,when evaluating the terms of a potential transaction, will compare the transactionto the other options realistically available to them, and they will only enter intothe transaction if they see no alternative that is clearly more attractive. Forexample, one enterprise is unlikely to accept a price offered for its product by anindependent enterprise if it knows that other potential customers are willing topay more under similar conditions. This point is relevant to the question ofcomparability, since independent enterprises would generally take into accountany economically relevant differences between the options realistically availableto them (such as differences in the level of risk or other comparability factorsdiscussed below) when valuing those options. Therefore, when making thecomparisons entailed by application of the arms length principle, taxadministrations should also take these differences into account when establishingwhether there is comparability between the situations being compared and whatadjustments may be necessary to achieve comparability.1.16All methods that apply the arms length principle can be tied to theconcept that independent enterprises consider the options available to them and incomparing one option to another they consider any differences between theoptions that would significantly affect their value. For instance, beforepurchasing a product at a given price, independent enterprises normally would beexpected to consider whether they could buy the same product at a lowerJuly 1995I-7 OECD 34. OECD TRANSFER PRICING GUIDELINESprice from another party. Therefore, as discussed in Chapter II, the comparableuncontrolled price method compares a controlled transaction to similaruncontrolled transactions to provide a direct estimate of the price the partieswould have agreed to had they resorted directly to a market alternative to thecontrolled transaction. However, the method becomes a less reliable substitutefor arms length dealings if not all the characteristics of these uncontrolledtransactions that significantly affect the price charged between independententerprises are comparable. Similarly, the resale price and cost plus methodscompare the gross profit margin earned in the controlled transaction to grossprofit margins earned in similar uncontrolled transactions. The comparisonprovides an estimate of the gross profit margin one of the parties could haveearned had it performed the same functions for independent enterprises andtherefore provides an estimate of the payment that party would have demanded,and the other party would have been willing to pay, at arms length for performingthose functions. Other methods as discussed in Chapter III are based oncomparisons of profit rates or margins between independent and associatedenterprises as a means to estimate the profits that one or both of the associatedenterprises could have earned had they dealt solely with independent enterprises,and therefore the payment those enterprises would have demanded at arms lengthto compensate them for using their resources in the controlled transaction. In allcases adjustments must be made to account for differences between the controlledand uncontrolled situations that would significantly affect the price charged orreturn required by independent enterprises. Therefore, in no event can unadjustedindustry average returns themselves establish arms length conditions.1.17 As noted above, in making these comparisons, material differencesbetween the compared transactions or enterprises should be taken into account.In order to establish the degree of actual comparability and then to makeappropriate adjustments to establish arms length conditions (or a range thereof),it is necessary to compare attributes of the transactions or enterprises that wouldaffect conditions in arms length dealings. Attributes that may be importantinclude the characteristics of the property or services transferred, the functionsperformed by the parties (taking into account assets used and risks assumed), thecontractual terms, the economic circumstances of the parties, and the businessstrategies pursued by the parties. These factors are discussed in more detailbelow.I-8 July 1995 OECD 35. ARMS LENGTH PRINCIPLE1.18The extent to which each of these factors matters in establishingcomparability will depend upon the nature of the controlled transaction and thepricing method adopted. For a discussion of the relevance of these factors for theapplication of particular pricing methods, see the consideration of those methodsin Chapters II and III.b) Factors determining comparability1.Characteristics of property or services1.19Differences in the specific characteristics of property or services oftenaccount, at least in part, for differences in their value in the open market.Therefore, comparisons of these features may be useful in determining thecomparability of controlled and uncontrolled transactions. In general, similarityin the characteristics of the property or services transferred will matter most whencomparing prices of controlled and uncontrolled transactions and less whencomparing profit margins. Characteristics that it may be important to considerinclude the following: in the case of transfers of tangible property, the physicalfeatures of the property, its quality and reliability, and the availability and volumeof supply; in the case of the provision of services, the nature and extent of theservices; and in the case of intangible property, the form of transaction (e.g.licensing or sale), the type of property (e.g. patent, trademark, or know-how), theduration and degree of protection, and the anticipated benefits from the use of theproperty.2. Functional analysis1.20 In dealings between two independent enterprises, compensation usuallywill reflect the functions that each enterprise performs (taking into account assetsused and risks assumed). Therefore, in determining whether controlled anduncontrolled transactions or entities are comparable, comparison of the functionstaken on by the parties is necessary. This comparison is based on a functionalanalysis, which seeks to identify and to compare the economically significantactivities and responsibilities undertaken or to be undertaken by the independentand associated enterprises. For this purpose, particular attention should be paid tothe structure and organisation of the group. It will also be relevant to determinein what juridical capacity the taxpayer performs its functions.July 1995 I-9 OECD 36. OECD TRANSFER PRICING GUIDELINES1.21The functions that taxpayers and tax administrations might need toidentify and compare include, e.g., design, manufacturing, assembling, researchand development, servicing, purchasing, distribution, marketing, advertising,transportation, financing, and management. The principal functions performedby the party under examination should be identified. Adjustments should bemade for any material differences from the functions undertaken by anyindependent enterprises with which that party is being compared. While one partymay provide a large number of functions relative to that of the other party to thetransaction, it is the economic significance of those functions in terms of theirfrequency, nature, and value to the respective parties to the transactions that isimportant.1.22It may also be relevant and useful in identifying and comparing thefunctions performed to consider the assets that are employed or to be employed.This analysis should consider the type of assets used, such as plant andequipment, the use of valuable intangibles, etc., and the nature of the assets used,such as the age, market value, location, property right protections available, etc.1.23It may also be relevant and useful in comparing the functionsperformed to consider the risks assumed by the respective parties. In the openmarket, the assumption of increased risk will also be compensated by an increasein the expected return. Therefore, controlled and uncontrolled transactions andentities are not comparable if there are significant differences in the risksassumed for which appropriate adjustments cannot be made. Functional analysisis incomplete unless the material risks assumed by each party have beenconsidered since the assumption or allocation of risks would influence theconditions of transactions between the associated enterprises. Theoretically, inthe open market, the assumption of increased risk must also be compensated byan increase in the expected return, although the actual return may or may notincrease depending on the degree to which the risks are actually realised.1.24The types of risks to consider include market risks, such as input costand output price fluctuations; risks of loss associated with the investment in anduse of property, plant, and equipment; risks of the success or failure of investmentin research and development; financial risks such as those caused by currencyexchange rate and interest rate variability; credit risks; and so forth.I-10 July 1995 OECD 37. ARMS LENGTH PRINCIPLE1.25 The functions carried out (taking into account the assets used and therisks assumed) will determine to some extent the allocation of risks between theparties, and therefore the conditions each party would expect in arms lengthdealings. For example, when a distributor takes on responsibility for marketingand advertising by risking its own resources in these activities, it would beentitled to a commensurately higher anticipated return from the activity and theconditions of the transaction would be different from when the distributor actsmerely as an agent, being reimbursed for its costs and receiving the incomeappropriate to that activity. Similarly, a contract manufacturer or a contractresearch provider that takes on no meaningful risk would be entitled to only alimited return.1.26 In line with the discussion below in relation to contractual terms, it maybe considered whether a purported allocation of risk is consistent with theeconomic substance of the transaction. In this regard, the parties conduct shouldgenerally be taken as the best evidence concerning the true allocation of risk. If,for example, a manufacturer sells property to a related distributor in anothercountry and the distributor is claimed to assume all exchange rate risks, but thetransfer price appears in fact to be adjusted so as to insulate the distributor fromthe effects of exchange rate movements, then the tax administrations may wish tochallenge the purported allocation of exchange rate risk.1.27 An additional factor to consider in examining the economic substanceof a purported risk allocation is the consequence of such an allocation in armslength transactions. In arms length dealings it generally makes sense for partiesto be allocated a greater share of those risks over which they have relatively morecontrol. For example, suppose that Company A contracts to produce and shipgoods to Company B, and the level of production and shipment of goods are to beat the discretion of Company B. In such a case, Company A would be unlikely toagree to take on substantial inventory risk, since it exercises no control over theinventory level while Company B does. Of course, there are many risks, such asgeneral business cycle risks, over which typically neither party has significantcontrol and which at arms length could therefore be allocated to one or the otherparty to a transaction. Analysis is required to determine to what extent each partybears such risks in practice. When addressing the issue of the extent to which aparty to a transaction bears any currency exchange and/or interest rate risk, it willordinarily be necessary to consider the extent, if any, to which the taxpayer and/orthe MNE group have a business strategy which deals with the minimisation orJuly 1995 I-11 OECD 38. OECD TRANSFER PRICING GUIDELINESmanagement of such risks. Hedging arrangements, forward contracts, put andcall options, etc, both "on-market" and "off-market", are now in common use.Failure on the part of a taxpayer bearing currency exchange and interest rate riskto address such exposure may arise as a result of a business strategy of the MNEgroup seeking to hedge its overall exposure to such risks or seeking to hedge onlysome portion of the groups exposure. This latter practice, if not accounted forappropriately, could lead to significant profits or losses being made which arecapable of being sourced in the most advantageous place to the MNE group.3. Contractual terms1.28In arms length dealings, the contractual terms of a transaction generallydefine explicitly or implicitly how the responsibilities, risks and benefits are to bedivided between the parties. As such, an analysis of contractual terms should be apart of the functional analysis discussed above. The terms of a transaction mayalso be found in correspondence/communications between the parties other than awritten contract. Where no written terms exist, the contractual relationships ofthe parties must be deduced from their conduct and the economic principles thatgenerally govern relationships between independent enterprises.1.29In dealings between independent enterprises, the divergence of interestsbetween the parties ensures that they will ordinarily seek to hold each other to theterms of the contract, and that contractual terms will be ignored or modified afterthe fact generally only if it is in the interests of both parties. The samedivergence of interests may not exist in the case of associated enterprises, and it istherefore important to examine whether the conduct of the parties conforms to theterms of the contract or whether the parties conduct indicates that the contractualterms have not been followed or are a sham. In such cases, further analysis isrequired to determine the true terms of the transaction.4. Economic circumstances1.30Arms length prices may vary across different markets even fortransactions involving the same property or services; therefore, to achievecomparability requires that the markets in which the independent and associatedenterprises operate are comparable, and that differences do not have a materialeffect on price or that appropriate adjustments can be made. As a first step, it isessential to identify the relevant market or markets taking account of availablesubstitute goods or services. Economic circumstances that may be relevant toI-12 July 1995 OECD 39. ARMS LENGTH PRINCIPLEdetermining market comparability include the geographic location; the size of themarkets; the extent of competition in the markets and the relative competitivepositions of the buyers and sellers; the availability (risk thereof) of substitutegoods and services; the levels of supply and demand in the market as a whole andin particular regions, if relevant; consumer purchasing power; the nature andextent of government regulation of the market; costs of production, including thecosts of land, labour, and capital; transport costs; the level of the market (e.g.retail or wholesale); the date and time of transactions; and so forth. 5. Business strategies1.31Business strategies must also be examined in determiningcomparability for transfer pricing purposes. Business strategies would take intoaccount many aspects of an enterprise, such as innovation and new productdevelopment, degree of diversification, risk aversion, assessment of politicalchanges, input of existing and planned labour laws, and other factors bearingupon the daily conduct of business. Such business strategies may need to betaken into account when determining the comparability of controlled anduncontrolled transactions and enterprises. It will also be relevant to considerwhether business strategies have been devised by the MNE group or by a memberof the group acting separately and the nature and extent of the involvement ofother members of the MNE group necessary for the purpose of implementing thebusiness strategy.1.32Business strategies also could include market penetration schemes. Ataxpayer seeking to penetrate a market or to increase its market share mighttemporarily charge a price for its product that is lower than the price charged forotherwise comparable products in the same market. Furthermore, a taxpayerseeking to enter a new market or expand (or defend) its market share mighttemporarily incur higher costs (e.g. due to start-up costs or increased marketingefforts) and hence achieve lower profit levels than other taxpayers operating inthe same market.1.33 Timing issues can pose particular problems for tax administrationswhen evaluating the legitimacy of a taxpayers claim that it is following abusiness strategy that distinguishes it from potential comparables. Some businessstrategies, such as those involving market penetration or expansion of marketshare, involve reductions in the taxpayers current profits in anticipation ofJuly 1995 I-13 OECD 40. OECD TRANSFER PRICING GUIDELINESincreased future profits. If in the future those increased profits fail to materializebecause the purported business strategy was not actually followed by thetaxpayer, legal constraints may prevent re-examination of earlier tax years by thetax administrations. At least in part for this reason, tax administrations may wishto subject a taxpayers claim that it is following such a business strategy toparticular scrutiny.1.34When evaluating a taxpayers claim that it was following a businessstrategy that temporarily decreased profits in return for higher long-run profits,several factors should be considered. Tax administrations should examine theconduct of the parties to determine if it is consistent with the professed businessstrategy. For example, if a manufacturer charges its related distributor a below-market price as part of a market penetration strategy, the cost savings to thedistributor may be reflected in the price charged to the distributors customers orin greater market penetration expenses incurred by the distributor. A marketpenetration strategy of an MNE group could be put in place by the manufactureror by the distributor acting separately from the manufacturer (and the resultingcost borne by either of them). Furthermore, unusually intensive marketing andadvertising efforts would often accompany a market penetration or market shareexpansion strategy. Another factor to consider is whether the nature of therelationship between the parties to the controlled transaction would be consistentwith the taxpayer bearing the costs of the business strategy. For example, inarms length dealings a company acting solely as a sales agent with little or noresponsibility for long-term market development would generally not bear thecosts of a market penetration strategy. Where a company has undertaken marketdevelopment activities at its own risk and enhances the value of a product througha trademark or tradename or increases goodwill associated with the product, thissituation should be reflected in the analysis of functions for the purposes ofestablishing comparability.1.35An additional consideration is whether there is a plausible expectationthat following the business strategy will produce a return sufficient to justify itscosts within a period of time that would be acceptable in an arms lengtharrangement. It is recognised that a business strategy such as market penetrationmay fail, and the failure does not of itself allow the strategy to be ignored fortransfer pricing purposes. However, if such an expected outcome wasimplausible at the time of the transaction, or if the claimed business strategy isunsuccessful but nonetheless is continued beyond what an independent enterpriseI-14 July 1995 OECD 41. ARMS LENGTH PRINCIPLEwould accept, the taxpayers claim may be doubtful. In determining what periodof time an independent enterprise would accept, tax administrations may wish toconsider evidence of the commercial strategies evident in the country in whichthe business strategy is being pursued. In the end, however, the most importantconsideration is whether the strategy in question could plausibly be expected toprove profitable within the foreseeable future (while recognising that the strategymight fail), and that a party operating at arms length would have been prepared tosacrifice profitability for a similar period under such economic circumstances andcompetitive conditions.ii) Recognition of the actual transactions undertaken1.36 A tax administrations examination of a controlled transactionordinarily should be based on the transaction actually undertaken by theassociated enterprises as it has been structured by them, using the methodsapplied by the taxpayer insofar as these are consistent with the methods describedin Chapters II and III. In other than exceptional cases, the tax administrationshould not disregard the actual transactions or substitute other transactions forthem. Restructuring of legitimate business transactions would be a whollyarbitrary exercise the inequity of which could be compounded by double taxationcreated where the other tax administration does not share the same views as tohow the transaction should be structured.1.37However, there are two particular circumstances in which it may,exceptionally, be both appropriate and legitimate for a tax administration toconsider disregarding the structure adopted by a taxpayer in entering into acontrolled transaction. The first circumstance arises where the economicsubstance of a transaction differs from its form. In such a case the taxadministration may disregard the parties characterisation of the transaction andre-characterise it in accordance with its substance. An example of thiscircumstance would be an investment in an associated enterprise in the form ofinterest-bearing debt when, at arms length, having regard to the economiccircumstances of the borrowing company, the investment would not be expectedto be structured in this way. In this case it might be appropriate for a taxadministration to characterise the investment in accordance with its economicsubstance with the result that the loan may be treated as a subscription of capital.The second circumstance arises where, while the form and substance of thetransaction are the same, the arrangements made in relation to the transaction,July 1995I-15 OECD 42. OECD TRANSFER PRICING GUIDELINESviewed in their totality, differ from those which would have been adopted byindependent enterprises behaving in a commercially rational manner and theactual structure practically impedes the tax administration from determining anappropriate transfer price. An example of this circumstance would be a saleunder a long-term contract, for a lump sum payment, of unlimited entitlement tothe intellectual property rights arising as a result of future research for the term ofthe contract (as previously indicated in paragraph 1.10). While in this case it maybe proper to respect the transaction as a transfer of commercial property, it wouldnevertheless be appropriate for a tax administration to conform the terms of thattransfer in their entirety (and not simply by reference to pricing) to those thatmight reasonably have been expected had the transfer of property been thesubject of a transaction involving independent enterprises. Thus, in the casedescribed above it might be appropriate for the tax administration, for example, toadjust the conditions of the agreement in a commercially rational manner as acontinuing research agreement.1.38In both sets of circumstances described above, the character of thetransaction may derive from the relationship between the parties rather than bedetermined by normal commercial conditions and may have been structured bythe taxpayer to avoid or minimise tax. In such cases, the totality of its termswould be the result of a condition that would not have been made if the partieshad been engaged in arms length dealings. Article 9 would thus allow anadjustment of conditions to reflect those which the parties would have attainedhad the transaction been structured in accordance with the economic andcommercial reality of parties dealing at arms length.1.39Associated enterprises are able to make a much greater variety ofcontracts and arrangements than can unrelated enterprises because the normalconflict of interest which would exist between independent parties is often absent.Associated enterprises may and frequently do conclude arrangements of aspecific nature that are not or are very rarely encountered between unrelatedparties. This may be done for various economic, legal, or fiscal reasonsdependent on the circumstances in a particular case. Moreover, contracts withinan MNE could be quite easily altered, suspended, extended, or terminatedaccording to the overall strategies of the MNE as a whole and such alterationsmay even be made retroactively. In such instances tax administrations wouldhave to determine what is the underlying reality behind a contractual arrangementin applying the arms length principle.I-16July 1995 OECD 43. ARMS LENGTH PRINCIPLE1.40In addition, tax administrations may find it useful to refer toalternatively structured transactions between independent enterprises todetermine whether the controlled transaction as structured satisfies the armslength principle. Whether evidence from a particular alternative can beconsidered will depend on the facts and circumstances of the particular case,including the number and accuracy of the adjustments necessary to account fordifferences between the controlled transaction and the alternative and the qualityof any other evidence that may be available.1.41The difference between restructuring the controlled transaction underreview which, as stated above, generally is inappropriate, and using alternativelystructured transactions as comparable uncontrolled transactions is demonstratedin the following example. Suppose a manufacturer sells goods to a controlleddistributor located in another country and the distributor accepts all currency riskassociated with these transactions. Suppose further that similar transactionsbetween independent manufacturers and distributors are structured differently inthat the manufacturer, and not the distributor, bears all currency risk. In such acase, the tax administration should not disregard the controlled taxpayerspurported assignment of risk unless there is good reason to doubt the economicsubstance of the controlled distributors assumption of currency risk. The factthat independent enterprises do not structure their transactions in a particularfashion might be a reason to examine the economic logic of the structure moreclosely, but it would not be determinative. However, the uncontrolledtransactions involving a differently structured allocation of currency risk could beuseful in pricing the controlled transaction, perhaps employing the comparableuncontrolled price method if sufficiently accurate adjustments to their pricescould be made to reflect the difference in the structure of the transactions.iii)Evaluation of separate and combined transactions1.42Ideally, in order to arrive at the most precise approximation of fairmarket value, the arms length principle should be applied on a transaction-by-transaction basis. However, there are often situations where separate transactionsare so closely linked or continuous that they cannot be evaluated adequately on aseparate basis. Examples may include 1. some long-term contracts for the supplyof commodities or services, 2. rights to use intangible property, and 3. pricing arange of closely-linked products (e.g. in a product line) when it is impractical toJuly 1995I-17 OECD 44. OECD TRANSFER PRICING GUIDELINESdetermine pricing for each individual product or transaction. Another examplewould be the licensing of manufacturing know-how and the supply of vitalcomponents to an associated manufacturer; it may be more reasonable to assessthe arms length terms for the two items together rather than individually. Suchtransactions should be evaluated together using the most appropriate arms lengthmethod or methods. A further example would be the routing of a transactionthrough another associated enterprise; it may be more appropriate to consider thetransaction of which the routing is a part in its entirety, rather than consider theindividual transactions on a separate basis.1.43While some separately cont
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