This article wraps up what we wrote last week
The transactional net margin method
Under paragraph 16 of the Cabinet of Ministers’ Regulation No. 677, this method is applied like the resale price method or the cost plus method where comparing the gross margin of a controlled transaction or the markup on its direct and indirect costs with relevant financial indicators of unrelated parties fails to produce a sufficiently credible result based on factors affecting the transfer price.
Under generally accepted principles, this method involves comparing the net profit a taxpayer earns in a controlled transaction –
with the net profit he earns in a comparable uncontrolled transaction (an internal comparable), or
with the net profit earned by unrelated parties in comparable uncontrolled transactions (an external comparable).
Where goods or services are acquired from a related party, the net margin is calculated as follows:
Where goods or services are supplied to a related party, the net profit markup is calculated as follows:
Paragraph 4 of Annex 2 to the Cabinet Regulation illustrates how the transactional net margin method is applied.
The profit split method
Under paragraph 17 of the Cabinet Regulation, this method is applied to interdependent transactions where it is not possible to find comparable transactions between unrelated parties, or to transactions involving multiple related parties.
Under generally accepted principles, this method involves first measuring the combined profit resulting from related-party transactions and then splitting it in an economically sound manner between the related parties according to each party’s contribution to the newly created value.
Paragraph 5 of Annex 2 to the Cabinet Regulation illustrates how the profit split method is applied.
Selecting a method
Under the Cabinet Regulation, the right method for determining the arm’s length price of a transaction is selected according to the following factors:
the economic substance of a controlled transaction (meaning that the actual transaction needs identifying), which is determined by conducting a functional analysis (paragraphs 8.1 and 10);
the availability of credible information, in particular about transactions or financial indicators of unrelated parties (paragraph 8.2); and
the degree of comparability between the controlled transaction and an uncontrolled transaction or financial indicators of unrelated parties, including any comparability adjustment made in order to exclude any material differences (paragraph 8.3).
Applying the chosen method
It is important to remember that –
the arm’s length price of a controlled transaction should be determined by applying one of the methods listed in the Cabinet Regulation (paragraph 9);
an economic analysis of transactions (such as discounted cash flow analysis) can be applied as part of the methods if external statutory instruments of the related party’s country of residence permit this (paragraph 9);
publicly available information should be selected for comparability (paragraph 13.1);
methods can be combined to arrive at a more accurate arm’s length price of the transaction (paragraph 18);
the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations can be used as an auxiliary source (paragraph 19).
When determining the period for gathering information about a comparable uncontrolled transaction, we can choose –
an ex ante approach, which is based on the information that was reasonably available to the taxpayer at the time of entering into the transaction; or
an ex post approach, in which the taxpayer tests the actual results of his controlled transactions and which is usually adopted as part preparing the CIT return during the preparation of annual accounts.
Applying these methods to transactions involves conducting a comparability analysis (paragraphs 11–12), in which the results of the functional analysis and the following comparability factors are considered:
the industry sector;
a similar geographical market;
an existing independent trader;
a functionally similar transaction;
the subject matter of the transaction; and
other factors affecting the transfer price.
Comparability analysis involves drawing up a list of key economic activities (functions) and identifying relevant risks based on the functions performed. Those risks should then be compared with comparable uncontrolled transactions or a comparable unrelated party. If material differences are found between the controlled transaction and the transactions or entities being compared, then mathematical calculations or reasonably accurate financial data adjustments can be made to avoid a significant effect on comparability.
We encourage you to consider these references to the new provisions of law coming into force in 2018, and we hope they will inform your company’s commercial judgement about applying the arm’s length principle and using transfer pricing analysis.