U.S. TRANSFER PRICING UPDATE ESTABLISHING THE TRANSFER PRICE FOR SALES OF TANGIBLE PROPERTY
By Giovanna T. Sparagna, Partner
The Council for International Tax Education (CITE)
ESTABLISHING THE TRANSFER PRICE FOR SALES OF TANGIBLE PROPERTY
I.Introduction to the Pricing of Tangible Property
A. Benefits of Developing a Worldwide Corporate Transfer Pricing Policy
Companies that develop transfer pricing (TP) policies solely in reaction to governmental action are at risk of:
- increasing exposure to double taxation and loss of foreign tax credits;
- relying on a TP position that is inconsistent with the form of its business operations;
- relying on a TP position that is difficult to defend because it is inconsistent with contractual relations and legal documentation;
- documenting a TP position that demonstrates a TP exposure in another jurisdiction; and
- missing opportunities to rationalize their TP transactions and minimizing foreign taxes.
B. Tactics for Developing a Workable Worldwide Policy
1. Commonality of local TP rules with U.S. TP rules.
The arm's length standard is the fundamental basis of worldwide transfer pricing regulations. Countries with (or proposed) TP rules and documentation requirements U.S., Mexico, Brazil, Canada, Australia United Kingdom Most of these countries impose penalties (or have proposed penalties) based on lack of documentation or a "reasoned" TP analysis.
Comparison of acceptable methodologies for the intercompany sale of tangible property:
United States Methods OECD Methods:
Comparable Uncontrolled Comparable Uncontrolled
Price (CUP) Price (CUP)
Resale Price Method Resale Price Method
Cost-Plus Cost-Plus
Comparable Profits Transactional Net Margin
Method (CPM) Method (TNMM)
Profit Split Method Profit Split Method
Unspecified Methods
Priority of Methods Priority of Methods
CUP slightly preferred Transactional Methods preferred;
TNMM last resort
2. "Labeling" Counts
The title attached to any particular method may be very significant in acquiring local tax authority approval.
The CPM vs. TNMM debate.
The CPM clothed as a cost-plus analysis or a resale price method.
3. Taxpayers may realign functions and risks where necessary to create simpler transfer pricing analyses E.g., foreign currency risk.
4. Consistency in worldwide TP policies, where appropriate, assists in securing multiple government approval.
5. Limit exceptions to the TP policy.
6. Document all exceptions to TP policies. E.g., market share strategies
C. Key Elements in Conducting a Functional Analysis
1. Functional analysis of the controlled party for the purposes of determining an appropriate transfer pricing methodology became prominent in the 1988 White Paper.
2. The functional analysis involves a review of all functions performed and resources employed that are economically significant in terms of capital, labor, and economic risk exposure.
3. A functional analysis should identify the value added chain.
- Profit Opportunity and Risks
- Marketing Intangibles
- Trademarks & Tradenames
- Sales & Distribution
- Product & Market Risks
- Corporate Services
- Manufacturing
- Product R&D
4. Important elements to be identified in a functional analysis:
What type of product is being sold? This factor will indicate profit margin on product.
- (i) general use, specialty use, or commodity products
- (ii) life cycle of the product
What are the contractual terms between the related parties? Generally, the contractual relationships establishes the risk shifting between related parties.
- (i) form of consideration charged/paid
- (ii) sales or purchase volume
- (iii) scope and terms of warranties provided
- (iv) rights to updates, revisions, modifications
- (v) duration of relevant license, contract, other agreements, and
- (vi) termination or renegotiation rights
- (vii) collateral transactions or ongoing relationship between buyer and seller, including arrangements for the provision of ancillary or subsidiary services
- (viii) extension of credit or payment terms
What are the risks assumed by each party: market risks, risks of loss associated with investment, risks of success or failure of research and development, financial risks, credit risks, etc.
What are the economic conditions surrounding sales of products?
- (i) level of actual/potential competition in the geographic market
- (ii) demand elasticity
- (iii) bargaining positions of buyers vs. sellers
- (iv) Who are the key competitors in the industry? What are their relative market shares?
- (v) How do expenses differ from those of competitors?
What are the assets utilized by the parties? This factor indicates the amount of capital needed to operate business and the necessary minimum margin.
What is the size of the company being tested?
Identify all unrelated party transactions that are comparable to the related party transactions.
5. Economic substance of transaction is determining factor.
Inventory Risk - For example, a buy/sell subsidiary that only purchases goods from a related subsidiary after an order is placed with a 3rd party customer does not have any inventory risk.
Convoluted structures should be analyzed on the effect of the "multiple transactions" and "multiple contracts."
6. A functional analysis has several basic objectives
- To identify the best transfer pricing method as well as the appropriate comparable transactions or comparable companies.
- To uncover the factors resulting in adding value to the product or services delivered to third parties.
- To develop the adjustments to the financial statements of the tested party and comparables required to increase comparability.
- To develop the adjustments required to explain impact of unforeseen market conditions on profitability of the tested party.
- To support the relationship between the facts and the economic analysis employed by the taxpayer.
7. The importance of attorney-client privilege should be emphasized in the initial phase of the investigation when various TP exposures are being explored.
D. Determining Who is the Tested Party
1. The tested party should be the least complex participant in the transaction. Example: (Treas. Reg. 1.482-5(e)) A U.S. subsidiary of publicly traded foreign company imports assembled product and distributes it within the United States at the wholesale level under the foreign parent's name. The U.S. subsidiary would be the least complex participant in the transaction. The tested party should be the entity for which it is easiest to find comparable companies. Multiple function entities may be reduced into separate, less complex operations.
2. The tested party should not have valuable intangible property/unique assets to distinguish it from potential uncontrolled comparables.
3. The tested party should be the company whose operating profit can be reviewed using the most reliable data and requiring the fewest and most reliable adjustments.
Manufacturers are expected to have normal, routine operating intangibles such as non-unique process intangibles.
Distributors would normally have routine distribution intangibles such as customer relationships.
II. The Transactional Methods - Comparable Uncontrolled Price, Resale Price and Cost-Plus Methods
A. In General
1. Although the three transactional methods have less priority under the 1994 regulations than they did under the 1968 regulations, the methods are described and restated in Treas. Reg. 1.482-3 with relatively minor changes.
2. The regulations provide that, given adequate data, methods such as CUP and RPM will achieve a higher degree of comparability and reliability than CPM.
3. However, any method chosen must be selected in accordance with:
- the Best Method Rule described in Treas. Reg. 1.482-1(c)
- the comparability analysis described in Treas. Reg. 1.482-1(d)
- the arm's-length range principles of Treas. Reg. 1.482-1(e)
4. Transactional methods such as CUP, RPM and Cost-Plus are generally preferred over profit-based methods under the OECD guidelines.
B. The Comparable Uncontrolled Price (CUP) Method
1. The CUP Method evaluates whether the amount charged in a sale between the tested party and a controlled party is arm's length by reference to the amount charged in a comparable uncontrolled transaction.
2. The CUP Method was traditionally the preferred method for pricing of tangible property, prior to the 1994 regulations. It remains the preferred method where there are uncontrolled transactions with relatively minor differences for which reliable adjustments can be made.
3. The CUP Method provides an administrative advantage to many multinational companies because it is the method of choice in many countries. However under U.S. principles, the comparability standard can rarely be met. In addition, unless there are internal sales, data of comparable uncontrolled transactions are generally unavailable.
4. Comparability Factors
The CUP Method results are viewed as the most direct and reliable measure of an arm's length price for a controlled transaction if an uncontrolled transaction has no differences that would affect price, or if there are only minor differences that have a definite and reasonably ascertainable effect on price and for which appropriate adjustments are made.
The CUP Method is not a reliable method where there are product differences for which reliable adjustments cannot be made.
In practice, comparability may hinge on the availability of quantifiable market data or expert testimony regarding physical or functional differences.
5. Under the CUP Method, adjustments are required to account for the following differences between controlled and uncontrolled transactions:
Quality of product (The examples demonstrate that adjustments can and should be made for minor product differences.)
- Contractual terms
- Level of the market (whether it is wholesale or retail, etc.)
- Geographic Market -- The examples provide that if differences are material but can be reliably ascertained, the CUP Method will be appropriate.
- Date of the transaction
- Intangible property associated with sale (this usually refers to market intangibles)
Example: A valuable trademark is only affixed to property sold in controlled transactions. Because the effect on price cannot be reliably estimated, the CUP Method is not likely to provide an arm's-length result.
- Foreign currency risks
- Alternatives available to buyer and seller
6. Where application of the CUP Method is based on at least two uncontrolled transactions, each of which establishes an arm's length price, price data from all comparable uncontrolled transactions may be used to create an arm's length range.
7. The 1994 regulations provide that indirect evidence of comparable uncontrolled data may be used. Thus, CUP data may be derived from public exchanges or quotation media under the following circumstances.
Data is widely and routinely used in the ordinary course of business to negotiate sales prices in the industry. Controlled and uncontrolled parties utilize data in the same manner. The amount charged in the controlled transaction is adjusted to reflect differences affecting price in the same way that uncontrolled parties would make the adjustment. There are no extraordinary market conditions.
Example : War breaks out in major oil countries, causing significant instability in world petroleum markets. Prices listed on quotation medium are no longer a reliable measure of an arm's-length result.
C. The Resale Price Method (RPM)
1. The RPM involves a comparison of the gross profit margin of tested and comparable uncontrolled transactions. The gross profit margin is equal to the gross profit on resale as a percentage of the resale price.
2. RPM is useful for measuring the value of functions performed, particularly in cases involving purchase and resale where the reseller has not added substantial value to the tangible goods by physically altering the goods.
3. RPM is not appropriate if: Substantial value is added to goods by physical alteration before resale. (Packaging, labeling and minor assembly are not considered to add up to physical alteration.) Intangible property adds substantial value to the product
4.Comparability factors: Since a reseller's gross profit provides compensation for a reseller's functions e.g., investment of capital and assumption of risks, factors that will determine the comparability of potential comparable companies are:
- Functions performed
- Risks borne
- Contractual terms
Example: A lack of information regarding the provision of warranties and the payment terms of uncontrolled parties may render RPM unreliable. Other factors: cost structures, business experience, management efficiency
5. Some comparability factors are less important when using RPM than when using other methods:
Close physical similarity of products is not critical. Products should, however, be "of the same general type" (e.g., consumer electronics). The examples demonstrate that the addition of value from an intangible (e.g., a trademark) can affect the reliability of the comparison.
6. With RPM, adjustments to gross profit margins may be required to account for differences between the tested party and the comparables with respect to:
- Inventory levels and turnover rates
- Contractual term
- Sales, marketing, and advertising
- Level of the market: wholesale or retail
- Foreign currency risks
7. If reasonably reliable adjustments can be made between the controlled and uncontrolled parties, even large differences should not preclude the use of this method. Minor differences, however, could render this method inappropriate if reliable adjustments cannot be made.
8. Application of method: Gross profit margin data from comparable companies is adjusted for above factors to determine the "appropriate gross profit." This profit is deducted from the resale price to determine the arm's length range of prices that would have been paid by the distributor.
9. The regulations require a consideration of operating expenses because the level of such expenses may be an indication of the comparability of the functions performed and risks assumed.
10. Consistency in accounting affects reliability:
Consistency is also required in the treatment of discounts, returns, rebates, transportation costs, insurance and packaging. Difficulty in ascertaining accounting conventions of uncontrolled parties enhances the reliability of internal resale data, but limits the use of public resale data. Ultimately, a lack of detailed information regarding accounting methodology may indicate that RPM is inappropriate and CPM should be used.
Example: Adjustments should be made to account for a controlled U.S. subsidiary's treatment of discounts and insurance as operating expenses where uncontrolled distributors treated these items as cost of goods sold.
D. Cost-Plus Method
1. The Cost-Plus Method evaluates whether the amount charged in a controlled transaction is arm's-length by reference to the gross profit markup realized in comparable uncontrolled transactions.
2. The Cost-Plus Method is generally appropriate in cases involving manufacturing, assembly, or other production of goods sold to related parties. In addition, this method is appropriate for service providers such as a commissionaire, trading company, etc.
3. Methodology:
Gross Profit = cost of producing property, plus a gross profit markup (expressed as a percentage of cost)
4. Comparability with the Cost-Plus Method:
Functional comparability:
(i) A producer's gross profit involves compensation for the performance of production functions. The gross profit should also be sufficient operating profit to compensate the producer for its investment of capital and assumption of risks
(ii) Comparability Factors: similarity of functions performed, risks borne, and contractual terms
Other comparability factors:
- (i) Although close physical similarity is less important with the Cost-Plus method, particularly when compared to the CUP Method, it is preferable to compare goods within the same product category.
- (ii) Again, the impact of intangibles on the value of the goods may have an impact on the reliability of the measure of comparability between controlled and uncontrolled parties under the Cost-Plus Method.
- (iii) Gross profit may be affected by factors that have less of an impact on price such as: Cost structures (age of plant and equipment) Business experience (whether the business is in start-up phase or is mature) Management efficiency (expanding or contracting sales or executive compensation over time)
Adjustments to comparables required under the Cost-Plus method:
- (i) Consideration of operating expenses associated with the functions performed and risks assumed. (This typically includes the cost of capital.)
- (ii) The effect of the difference in functions performed on gross profit may not necessarily be equal to the differences in the amount of related operating expenses.
Comparability Factors relevant to this method include:
- (i) Complexity of manufacturing or assembly
- (ii) Manufacturing, production, and process engineering
- (iii) Procurement, purchasing, and inventory control activities
Example: A controlled party uses materials consigned by its subsidiary while uncontrolled parties carry inventory risk. The regulations require an adjustment to compensate for this difference.
- (iv) Testing functions
- (v) Selling, general and administrative expenses
- (vi) Foreign currency risks
- (vii) Contractual terms
III. The CPM
A. In General
1. The OECD analog to CPM is the transactional net margin method (TNMM). The OECD has, however, expressed a clear preference for transactions-based methods over profit-based methods such as CPM.
2. The arm's length result is the amount of operating profit that the tested party would have earned on related party transactions if its profit level indicator (PLI) were equal to that of an uncontrolled comparable.
3. Method: Apply the PLI from the uncontrolled comparable to the financial data for the tested party's relevant business activity. This should be the most narrowly identifiable business activity for which data incorporating the business transaction is available.
Data should be derived from a sufficient number of years to reasonably measure returns that accrue to uncontrolled comparables.
Data from public databases (Compustat, Compact Disclosure, etc.) may require significant adjustments to account for inconsistent reporting and other inconsistencies.
4. The extent to which particular PLI will produce a reasonable determination of an arm's-length result.
5. PLI alternatives:
Return on Capital or Operating Assets: ratio of operating profit to operating assets
- (i)This PLI is emphasized in regulations as the preferred PLI.
- (ii)Reliability increases as the role of operating assets in generating profits increases (e.g. manufacturers).
- (iii)Difficulties in valuing assets, particularly intangible assets, pose challenges in applying this PLI.
Financial Ratios
(i) Financial ratios measure relationships between profit and costs or sales revenue.
(ii) They are more sensitive to functional differences than the rate of return on capital employed.
(iii) Closer comparability is required for financial ratios than for a rate of return on capital as a PLI because financial ratios do not directly relate operating profit to the level of investment and risk in a trade or business.
(iv) Reliability of financial ratios is dependent on functional similarities of parties as well as the degree to which the composition of the parties' operating expenses is similar.
(v) Types of financial ratios: Operating profit/sales (operating profit margin); often used for distributors. Berry ratio: gross profit/operating expenses; acceptable PLI if the composition of operating expenses for the tested party and the comparable parties are substantially the same
(vi) PLIs based solely on internal data may not be used because they are not objective measures of profitability derived from operations of uncontrolled taxpayers engaged in similar business activities under similar circumstances.
B. Arm's Length Range
1. Typically the arm's length range in the CPM is derived from a sample of public companies derived from a specific industry or SIC (e.g., contract manufacturers).
2. To increase the reliability of the sample, many practitioners eliminate companies in the sample that demonstrate a history of losses in the relevant period under review.
3. The statistical range most often employment to increase the reliability of the CPM data is the interquartile range. Others may be applied as well.
C. Comparability Issues
1. Comparability Factors
When using external benchmarks the reliability of the results are increased as the comparability of the tested party and uncontrolled party increases.
Relevant comparability facts and circumstances include:
- (i) Relevant lines of business
- (ii) Product or service markets involved
- (iii) Asset composition employed (nature and quantity of tangible assets, intangible assets and working capital)
- (iv) Size and scope of operations, and
- (v) Stage in a business or product cycle
Nevertheless, the degree of functional comparability required under CPM is generally less than that required under the RPM or Cost-Plus methods. Taxpayers performing different functions may have very different gross profit margins but earn similar levels of operating profit.
CPM is not as dependent upon product similarity as the RPM and the Cost-Plus Method are.
The reliability of PLIs based on net profit is adversely affected by factors that have less effect on results under CUP, RPM or the Cost-Plus Method:
- (i) Cost structures (age of plant and equipment)
- (ii) Business experience (whether the business is in start-up phase or is mature)
- (iii) Management efficiency (expanding or contracting sales or executive compensation over time)
The reliability of operating profit and PLIs will be affected by the allocation of costs, income and assets between the relevant business activity of the tested party or comparable parties and other business activities.
D.Adjustments to Comparables
Accounts payable/receivable: where there are material differences between the tested and comparable parties, an imputed interest charge may be used to adjust the operating profit of the parties.
Example: A U.S. manufacturer has a significantly lower level of accounts receivable than the uncontrolled manufacturers. Each uncontrolled manufacturer's operating assets is reduced by the amount (relative to sales) by which they exceed the U.S. manufacturer's accounts receivable. In addition, each uncontrolled comparable's operating profit is adjusted by deducting imputed interest income from the excess accounts receivable. The imputed interest income is calculated by multiplying the uncontrolled comparable's excess accounts receivable by an interest rate appropriate for short term debt.
Adjustments should also be made to account for extraordinary events that significantly impact the company's market share. Examples include:
- (i)Technological developments
- (ii)Changes in supplier relationships
- (iii)Financial distress of established customers
- (iv)Unanticipated economic instability
IV. Transfer Pricing Strategies
A. Embedded Royalties or Not
Often taxpayers can structure an intercompany sale of tangible property to include a payment for any intangibles or exclude the intangible value and charge the related reseller a royalty. Different tax consequences can flow from both structures that should be considered including any withholding taxes on the royalty, any duties on the cross border sale, etc.
B. Commissionaire Structure
Taxpayers can often reduce income in high tax jurisdictions by realigning the functions of the foreign entities operating in such jurisdiction. The commissionaire arrangement has been used for reducing the income on selling activities.
C. Central Regional Manufacturer
Many taxpayers are faced with excess capacity within a region. In addition, varying costs structures for manufacturing in a region can result in varying prices for finished goods. The central manufacturing structure has been used to neutralize both problems. Under this structure, a central manufacturing entity controls, managers, produces (or hires Contract Manufacturers to produce) a central supply for goods distributed in a region. Although the ameliorates the business concerns described above, the subpart F implications must be evaluated.
D. Aggregation of Product Lines
Often taxpayers can have results (ranges) under the above described TP methods which differ according to different groupings of products.
E. IRS Strategies in Tangible Goods Pricing
The IRS has developed variations of the TP methods described above to price tangible goods, including a berry ratio adjustment to the Cost-Plus Method, and a residual profit method to arrive at tangible product pricing where a manufacturer also licensed intangible property. I have seen both methods challenged at IRS Appeals.
This article is intended to provide the reader with general information and should not be considered a substitute for specific legal advice or opinion. Readers are advised not to act upon this information without seeking professional counsel.
For further information please contact:
Giovanna T. Sparagna Sutherland Asbill & Brennan LLP 1275 Pennsylvania Avenue, NW Washington, DC 20004-2415 Phone (202) 383-0183 Fax (202) 637 3573 E-mail: Click Contact Link Visit the Sutherland Asbill & Brennan LLP website at Click Contact Link