International Tax: Transfer Pricing


    • Transfer price is the price established in a transaction between related persons
      • The manipulation of transfer prices can be used to avoid tax: shifting income to lower tax countries; shifting income to higher tax countries when a member in that country has losses; shifting deductible expenses to higher tax countries.
      • Where those prices differ from market prices, tax authorities should have the power to adjust the transfer prices set by related persons
    • However, if a tax authority excessively uses the power to adjust the transfer prices, double taxation issues will arise
      • Example:
        • A1 produces a good with cost of 60 and sells the good to A2. Then A2 resells the good to an unrelated party at 150.
        • Total profit from the transactions is 90 (150-60)
        • The tax authority in A1’s country determines that the transfer price between A1 and A2 is 90; while sedangkan the tax authority in A2’s country aggressively determines that the transfer price is 50.
        • After adjustments: A1’s profit = 30; A2’s profit = 100; total profits = 130 (double taxation of 40)
    • Potential double taxation can be prevented if both countries have uniform rules for adjusting inappropriate transfer pricing
      • Art 9 of the OECD and UN Model Treaties: arm’s length standard
        • TP should be adjusted to reflect the prices that would have been used in the same transaction between unrelated enterprises acting independently.

    1. the OECD Transfer Pricing Guidelines
      • 2015: OECD, Base Erosion and Profit Shifting Project, 2015 Final Reports, Executive Summaries:
        • The last revision (before this 2015 report): emphasises on contractual allocations of functions, assets and risks (vulnerable to manipulation)
        • the BEPS Action Plan (Actions 8-10) required the guidance on the arm’s length principle to be clarified and strengthened
          • Revised transfer pricing guidance:
            1. careful delineation of the actual transaction between the associated enterprises by analysing the contractual relations between the parties in combination with the conduct of the parties.
            2. includes two important clarifications relating to risks and intangibles
              • Risks:
                • are defined as the effect of uncertainty on the objectives of the business.
                • risks contractually assumed by a party that cannot in fact exercise meaningful and specifically defined control over the risks, or does not have the financial capacity to assume the risks, will be allocated to the party that does exercise such control and does have the financial capacity to assume the risks
              • Intangibles:
                • Legal ownership alone does not necessarily generate a right to all (or indeed any) of the return that is generated by the exploitation of the intangible.
                • The group companies performing important functions, controlling economically significant risks and contributing assets, as determined through the accurate delineation of the actual transaction, will be entitled to an appropriate return reflecting the value of their contributions.
            3. addresses the situation where a capital-rich member of the group provides funding but performs few activities.
              • If this associated enterprise does not in fact control the financial risks associated with its funding (for example because it just provides the money when it is asked to do so, without any assessment of whether the party receiving the money is creditworthy), then it will not be allocated the profits associated with the financial risks and will be entitled to no more than a risk-free return, or less if, for example, the transaction is not commercially rational and therefore the guidance on non-recognition applies.
            4. ensures that pricing methods will allocate profits to the most important economic activities
              • It will no longer be possible to allocate the synergistic benefits of operating as a group to members other than the ones contributing to such synergistic benefits.
                • For example, discounts that are generated because of the volume of goods ordered by a combination of group companies will need to be allocated to these group companies.
      • 2017: The OECD Transfer Pricing Guidelines:
        • Arm’s length principle
          • OECD member countries continue to endorse the arm’s length principle as embodied in the OECD Model Tax Convention
        • Revisions
          1. 2010: a revision of Chapters I-III and a new Chapter IX (comparability, on transactional profit methods and on the transfer pricing aspects of business restructurings)
          2. 2013: the guidance on safe harbours was also revised in order to recognise that properly designed safe harbours can help to relieve some compliance burdens and provide taxpayers with greater certainty
          3. 2016: to reflect the clarifications and revisions agreed in the 2015 BEPS Reports on Actions 8-10 Aligning Transfer pricing
            Outcomes with Value Creation and on Action 13 Transfer Pricing Documentation and Country-by-Country Reporting
          4. Future works: the application of the transactional profit split method, the transfer pricing aspects of financial transactions, and intra-group services.
    2. UN, Practical Manual on TP for Developing Countries (generally consistent with the OECD Transfer Pricing Guidelines)
    • Transfer pricing: determining the appropriate price for a non-arm’s length transaction based on a comparable arm’s length transaction
      • Comparison: internal comparable and external comparable
      • Not necessary to identify a precise comparable as long as it is possible to make adjustments to a transaction so that it becomes comparable
    • Comparability analysis:
      • Purposes:
        1. to select the most appropriate transfer pricing method
        2. to apply the method to determine the arm’s-length price/profits
          • In traditional methods (CUP, RP, CP), to find the price in a comparable transaction between arm’s-length parties
          • In PS and TNMM, to find the profits from a comparable transaction rather than the price of a comparable transaction
      • Factors:
        1. the characteristics of the transferrred property/services
        2. a functional analysis of the parties to the transaction
          • functions performed, assets used, and risks assumed by the parties to the relevant transaction
        3. the terms of the contract
        4. the economic circumstances
        5. the business strategies pursued by the parties
    1. Comparable uncontrolled price Method
      • Establishes an arm’s length price by reference to sales of similar products made between unrelated persons in similar circumstances
      • Example 1:
        • ACo (resident in Country A) manufactures wooden chairs in Country A at a cost of 40 and sells them to unrelated foreign distributors for 47 each. It also sells nearly identical chairs to BCo (wholly owned by ACo; resident in country B). BCo resells the chairs to unrelated consumers at 70.
        • If the terms and conditions of the sales to unrelated distributors and BCo are essentially equivalent, arm’s length price for the sale of the chairs to BCo is 47
          • ACo’s profit from the intercompany sales = 7 (each)
          • BCo’s profit = 23 (each)
          • Outcome: the enterpreneurial gain/loss is allocated between ACo and BCo by reference to comparable transactions between arm’s-length parties
      • Suitable for:
        • public commodity (data on price is available)
        • manufactured goods that do not depend substantially for their value on special know-how or brand names
      • Not suitable for:
        • intermediate goods (e.g., custom-made parts that are not generally sold to unrelated parties)
        • goods that are highly dependent for their value on the trade name of the producer
    2. Resale price method
      • Sets the arm’s length price for the sale of goods between related parties by subtracting an appropriate markup from the price at which the goods are ultimately sold to unrelated parties
      • Example 2: just like example 1, with some changes:
        • ACo does not make any sales of furniture to unrelated parties -> no CUP available
        • The only activity performed by BCo is to resell the chairs in foreign markets -> RP method might be appropriate
        • Independent foreign distributors earn commissions of 20% on the purchase and sale of products comparable to the wooden chairs; BCo sells the chairs to customers for 70
          • the arm’s length price of the controlled sale between ACo and BCo = 80% x 70 = 56
          • ACo’s profit from the intercompany sales = 16 (each)
          • BCo’s profit = 14 (each)
          • Outcome: the enterpreneurial gain/loss is allocated to manufacturer (ACo); while the distributor (BCo) is guaranteed a normal profit. This is because ACo’s activities are enterpreneurial, while BCo’s activities are only ‘normal’ distributor)
      • Suitable for:
        • the sale of manufactured goods to a related party acting as distributor, followed by resale to unrelated customers without any further processing of the goods
    3. Cost-plus method
      • Uses the manufacturing and other costs of the related seller as the starting point in establishing the arm’s-length price; the seller’s costs are then multiplied by an appropriate profit percentage, and the result is added to the seller’s costs to determine the arm’s length price.
        • Profit percentage: referred to the gross profit percentage earned by 1) the seller in transactions with unrelated parties 2) OR comparable unrelated parties in similar transactions with unrelated parties
      • Example 3: just like example 2, with some changes:
        • ACo sells furniture to BCo without any brand name affixed to the furniture; BCo affixes its valuable brand name to the furniture and resells it to customers in foreign markets
          • Without spesific brand, ACo’s profit can be referred to other furniture manufacturers’ profits -> CP method
        • The standard gross profit margin practice in the furniture manufacturing industry is 25% of the cost of production; ACo’s average cost of producing furniture is 40
          • The arm’s-length price = 125% x 40 = 50
          • ACo’s profit from the intercompany sales, each = 10
          • BCo’s profit, each = 20
          • Outcome: the enterpreneurial gain/loss is allocated to BCo; ACo is guaranteed a normal profit. This is because BCo’s activities are enterpreneurial (having a brand), while ACo’s activities are only ‘normal’ manufacturing)
      • Suitable for:
        • the sale of manufactured goods to a related party, with the related party attaching its brand name to the goods and reselling them to unrelated customers
    4. Profit-split method
      • the worldwide taxable income of related parties engaging in a common line of business is allocated among the related parties in proportion to their contributions to earning the income
        • If there are more than one line of business, the PS method might be applied separately to each product line.
        • Applies to aggregate profits from a group of transactions, not to individual transactions.
      • Example 4: without routine activities
        • ACo and BCo are related companies engaged in the production and sale of pharmaceuticals.
          • ACo engages in extensive research activities, uses patented processes to manufacture the products, and sells the products to BCo. ACo incurs costs of 300 in manufacturing the products.
          • BCo repackages the products for retail sale, attaches its valuable trade name, and reselles them through an extensive marketing operation. BCo incurs costs of 100 in packaging, marketing, and selling the products. The sales proceeds from aggregate sales by BCo to unrelated customers are 600.
        • ACo does not make any sales to unrelated parties and there are no comparable sales of equivalent products by other pharmaceutical companies.
        • PS method:
          • The group’s net profit = 600-(300+100) = 200
          • ACo’s contribution to the enterprise accounts for approximately 75% of the total net profits (refers to the portion of costs, 300/400)
          • ACo’s profit = 75%x200 = 150; BCo’s profit = 50
      • Example 5: with routine activities
        • Just like example 4, with some changes:
          • ACo engages in routine production activities with gross costs of production of 300; unrelated companies engaged in comparable manufacturing activities earn gross profit margin of 20% of costs.
            • Under CP method: ACo’s routine profit = 60
          • BCo engages in routine sales activities with gross sales revenue of 600; unrelated companies engaged in similar activities earn gross profit margins of 10%.
            • Under the RP method: BCo’s routine profit = 60
          • The remaining profits = 200-60-60 = 80
            • PS method: ACo’s non-routine profits = 75%x80 = 60; ACo’s total profits = 120; BCo’s non-routine profits = 20; BCo’s total profits = 80
    5. Transactional net margin method
      • Under the TNMM the taxpayer must establish, either for itself or a related party (the tested party), an arm’s-length range of profits for a set of transactions.
        • If the tested party’s reported profits from those transactions fall within the range, its transfer pricing will be accepted by the tax authority. Otherwise, the tax authorities will adjust the transfer pricing so that the profits fall within the range (typically at the midpoint)
        • Applies to an entity’s profits (in contrast, the profit-split method applies to aggregate profits) from a group of transactions, not to individual transactions.
        • Tested party may be the taxpayer or the related party (comparables should be consistent with the tested party)
          • If tested party is the related party, then the taxpayer’s profit is determined by subtracting the related party’s profits (under the TNMM) from total profits of the two entities.
        • The tested party’s profits: established by determining the ratio of profits to some economic indicator for an unrelated person and applying that ratio to calculate the profits of the tested party
          • Ratio of profits may be the rate of return on capital employed, the ratio of operating profits to gross sales, the ratio of gross profits to operating expenses, etc.
          • Example:
            • A comparable: taxable income = 80; invested capital = 800
            • The tested party: Invested capital = 500
            • Then, the tested party’s taxable income should be 50 (i.e., (80/800) x 500)
    1. Sharing of corporate resources
      • Principle: the owner of the shared resources should charge related parties an arm’s-length fee for their use
      • Resource 1: Loan
        • Should charge: rate of interest that reflects the current cost of borrowing
        • The 2017 OECD TP Guidelines:
          • Finance companies are entitled only to a risk-free rate of return if:
            1. their only activities are advancing funds to group companies whenever requested to do so, and
            2. they do not control the financial risks arising from their intragroup loans
          • The Guidelines prevent the use of cash boxes to shift profits to low-tax countries
      • Resource 2: Performance of services
        • Should charge: an amount that an independent service provider would charge for the same services (refers to CUP or cost plus an appropriate profit)
          • However, with respect to low-value intra-group services: may use simplified method (the 2017 OECD TP Guidelines)
            • is: services provided by one group company for one or more other companies of the same group where the services are supportive, but not part of the core business of the multinational group, and do not involve the use/creation of valuable intangibles or involve significant risks for the service provider.
            • example: accounting and auditing, processing accounts, human resource activities, internal IT activities, and legal services
            • how: for each category of low-value services, total costs incurred by all group companies providing services are allocated to group companies using the services in accordance with an appropriate factor (e.g., total users for IT services, total assets or turnover for accounting services, total staff for HR activities), then a 5% markup are applied to the costs.
      • Resource 3: Tangible property (office, equipment, etc)
        • Should charge: an arm’s-length rental fee
      • Resource 4: Intangible property (patent, trademark, etc)
        • Should charge: an amount that would be charged to an unrelated person for the use of the intangible property in similar circumstances.
    2. Cost contribution arrangement
      • Context:
        • a group of corporations intends to develop valuable intangible property and share the benefits among two or more of its members. Under a cost contribution arrangement, all the prospective users of the intangible property are arranged to jointly develop that property. Without transfer of the property, they have rights to the profits generated by the property in proportion to their contribution. The group does not have to deal with transfer pricing issues.
      • The OECD Guidelines (Chapter VIII):
        • regulate cost contribution arrangement so as to be consistent with arm’s length standard.
          • The characteristics of arm’s length standard:
            1. embodied in a legally enforceable written contract
            2. the participants are only persons with a legitimate expectation of benefiting
            3. the contract should require the participants to contribute to the costs of development of the intangible property in proportion to the benefits that they might reasonably be anticipated to derive from the use of that property
              • Example 7:
                • ACo and BCo jointly develop new technology that would allow them to manufacture their products at a lower cost. The technology will be used by ACo in country A and BCo in country B. Current sales of ACo and BCo, respectively, are 400 and 600 and are expected to continue in the future
                • Therefore, costs contribution of ACo and BCo, respectively, should be 40% and 60%.
              • A revision in 2017: contribution is based on value, not cost, except if in a certain condition cost is the reliable indicator of the value of contributions.
            4. the participants should be required to keep adequate records documenting their costs and explaining how their anticipated benefits are calculated
            5. If economic circumstances change (e.g., participant A sells its right; a third party, B, becomes a new participant), then participant A should receive a payment equal to the fair market value of the rights; B should pay fair market value for the rights obtained.
          • If a cost contribution arrangement is consistent with the characteristics of arm’s length standard, then it is a bona fide (real) arrangement, the costs are deductible, the participants become co-owner of the property.
            • Example 8: just like example 7
              • Accordingly, in the development phase, Country A should permit ACo to deduct the contribution costs
              • In the exploitation phase, ACo becomes a co-owner of the intangible property
                • ACo should not be treated as paying a deemed royalty to BCo under the TP rules of Country A (i.e., the tax authority cannot deem that a royalty payment has been made with respect to the use of the intangible, because ACo is a co-owner of the intangible)
            • On the contrary, if the economic behavior is not consistent with the cost contribution arrangement, tax authorities should treat them as if they had entered into a cost contribution arrangement
              • Example 9: just like example 8, but there is no written contract of the cost contribution arrangement and ACo makes a royalty payment to BCo
                • Without an adjustment from the tax authority, the transactions would result as follows:
                  • The royalty is not subject to WHT by country A (under the tax treaty between the two countries, exclusive taxing right to the residence country of BCo)
                  • ACo would claim a deduction for the royalty payment.
    3. Disregarded transactions
      • The OECD Guidelines permit the tax authorities to ignore the actual transactions entered into by related enterprises and allocate the profits between the enterprises on a different basis where the actual transactions lack the “commercial rationality” of transactions between arm’s-length parties.
      • Example: a multinational enterprise with valuable intangible property would not sell/lease that property on a long-term basis to an unrelated enterprise without some price-adjustment mechanism allowing the transferor to share in future profits.
    4. Transfer pricing documentation
      • Transfer pricing documentation forces MNCs to establish their transfer prices in advance, preventing after-the-fact shifting of income for tax avoidance purposes.
        • Example:
          • ACo (operating in Country A; tax rate 40%) is selling goods to BCo (a related corporation; operating in Country B; tax rate 20%); they set transfer prices: small profit in Country A, large profit in Country B; then provide the documentation to Country A; then ACo discovers that it will suffer a large tax loss in Country A from some unrelated operations
          • ACo needs to change the TP method to offset the tax loss
          • The contemporaneous documentation rules may prevent such a revision in ACo’s TP method.
      • Transfer pricing documentation requirements are included in a recommendation on CbC reporting in BEPS Action 13 Final Report (Transfer Pricing Documentation and Country-by-Country Reporting)
        • MNEs must:
          1. provide the tax authorities of all countries in which they do business with a master file containing general information about their business operations and their TP practices and policies
          2. provide the tax authority of each countries with a local file containing information with respect to any related-party transactions occuring in the country
          3. provide each country in which they operate with an annual report setting out the amount of revenue, profit, and taxes accrued and paid with respect to that country
    5. Treaty aspects of transfer pricing
      1. The OECD and UN Model Treaties
        • do not deal with the TP problem in any detailed way
        • Art 9(1): adjustment may be made to the profits of an enterprise that is associated with another enterprise if “conditions are made or imposed between the two enterprises which differ from those which would be made between independent enterprises.”
          • The Art focuses on terms and conditions of controlled transactions (rather than just on the prices charged in specific transactions)
        • Art 9(2): corresponding adjustment -> if adjustments have been made by a contracting state in accordance with the arm’s length standard, the other contracting state is required to make adjustments to the TP used to compute taxable income of its taxpayers
    6. Tax policy considerations: formulary apportionment vs the arm’s length method
      • Arm’s-length standard:
        • has been criticized:
          1. by taxpayers: it often imposes unreasonable burdens of proof on them; presents them with unresolved problems of double taxation; is frequently not followed by the tax authorities during audits.
          2.  by tax authorities: tax authorities: it allows considerable under-taxation of taxpayers engaged in cross-border transactions; encourages taxpayers to take aggressive positions on their tax returns in the hope of avoiding detection or of striking a favorable bargain on audit; is extremely time consuming and expensive to enforce
          3.  by scholars: in some cases, it produces improper results because it cannot account for the profits that related corporations typically enjoy from conducting an integrated business
        • on the other hand, the advantage of arm’s length standard: it is widely accepted
          • Changing to another system will incur high costs.
      • Formulary apportionment system
        • The idea: entities engaged in a common enterprise are taxed once as if they were a single entity
        • How: the worldwide income of the enterprise is attributed by a predetermined formula among all the countries where the enterprise engages in meaningful economic activity
        • Example: if an MNE engaged in the manufacture and sale of goods
          • some part of the income of the enterprise would be apportioned among the countries in accordance with the sales in those countries; and
          • the remaining part of the income would be apportioned among the countries where the manufacturing is conducted in accordance with total manufacturing assets or the payroll of the enterprise
          • little or no income would be apportioned to any tax haven countries unless sales or manufacturing activities take place in that country
        • Has been recognized by some authorities:
          • is used in some federal countries (Canada, the US) to allocate the income of an entity among the sub-national governments
          • has been proposed for internal use within the NAFTA (North America Free Trade Agreement) and the EU
        • Problems:
          1. The predetermined formula is arbitrary -> difficult to take into account the particular circumstances of each MNE
          2. Relies heavily on access to foreign-based information
          3. Profits attributed to each member of a multinational group will differ from the income shown on its books of account, even if those books are kept in good faith and in accordance with approved accounting methods
          4. It is unlikely that countries would be able to agree on a common apportionment formula
        • Features:
          1. eliminates the tax advantages of low-tax countries without the need for complex, difficult-to-administer CFC rules
          2. avoids some of the difficult audit problems that frequently arise under the arm’s length approach
          3. does not require separate agreement on the source of gross income and deductions in order to avoid double taxation (because source rules are implicitly incorporated into the apportionment formulas)
      • Comparison:
        • Under formulary apportionment, all income (including income derived from intangibles) would be apportioned to the countries in which goods are produced and sold
        • Under the arm’s length standard, the income is allocated to the entities performing DEMPE functions or assuming DEMPE risks with respect to the intangible property -> difficult and uncertain
      • The future:
        • the arm’s-length standard is likely to continue to be the internationally accepted approach for resolving TP issues, except in special circumstances.
        • meanwhile, formulary apportionment has an undeservedly bad reputation but largely for political reasons; what is needed is a sensible discussion
        • the two approaches should be perceived as parts of a continuum of methods ranging from CUPs to predetermined formulas (arm’s length standard sometimes uses formulas, yaitu dalam PS method)


  1. Brian J. Arnold, International Tax Primer (4th ed. 2019)
  2. OECD, Base Erosion and Profit Shifting Project, 2015 Final Reports, Executive Summaries
  3. The OECD Transfer Pricing Guidelines (2017)



Hi, this article is summarised from Hi, this article is summarised from Brian J. Arnold’s “International Tax Primer”. If you wish to read the book, please click FREE PREVIEW from Amazon.

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