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Frequently Asked Questions

Transfer pricing is the area of taxation that deals with the pricing of transactions between enterprises under common ownership or control (so called ‘associated enterprises’). Transactions are for example the sale of goods, the provision of services, the use of intellectual property or the provision of financial transactions. The price for such transactions between associated enterprises must be comparable to what independent enterprises would agree upon.

The arm’s length principle prescribes that transactions between associated enterprises should occur against market conditions, i.e. such transactions should be priced as if they had been carried out by independent enterprises under comparable circumstances.

Transfer pricing methods are used to establish an arm’s length transfer price for intercompany transactions. The methods are used to examine whether the conditions imposed in the commercial or financial relations between group enterprises are consistent with the arm’s length principle. The following five transfer pricing methods can be distinguished:

Comparable uncontrolled price method (CUP)

The CUP method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. A comparable uncontrolled transaction may either be internal (between an associated enterprise and an independent enterprise) or external (between two independent enterprises).

Resale price method

The resale price method starts with the price at which a product that has been purchased from a related party is resold to an unrelated party. This price is then reduced by an appropriate gross margin representing the amount out of which the reseller would seek to cover its selling and other operating expenses and make an appropriate profit.

Cost plus method

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

Transactional net margin method (TNMM)

The TNMM examines the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realises from a controlled transaction.

Transactional profit split method

The profit split method determines the division of profits that independent enterprises would have expected to realize from engaging in the transaction or transactions. It first identifies the profit to be split for the associated enterprises from the transactions in which the associated enterprises are engaged. It then splits those profits between the associated enterprises on an economically valid basis.

Multinational Enterprises (“MNEs”) set up subsidiaries abroad to cater to local markets and capitalize on their brands. Such subsidiaries are entrusted with various functions ranging from licensed manufacturing to selling and distributing the products. The intellectual property rights (“IPR”) in products as well as the brands lies with the parent entities. The subsidiaries are generally engaged in marketing the products manufactured or imported by them and incur certain expenses, which are popularly known as advertisement, marketing and sale promotion expenditure (“AMP expenses”).

The revenue authorities, on several occasions in past, have contended that AMP expenses give rise to IPR of the subsidiaries for which they ought to be remunerated. Being an international transaction, it needs to be tested for Arm’s Length Price (“ALP”). To test that whether the transaction is at ALP or not, Revenue Authorities’ have adopted the Bright Line Test (“BLT”), as per which for the amount of AMP expenses incurred above the similar amount incurred by comparable is considered as non-routine AMP expense.

Transfer prices affect three managerial accounting areas. First, transfer prices determine costs and revenues among transacting divisions, affecting the performance of each division.

Second, transfer prices affect division managers’ incentives to sell goods either internally or externally. If the transfer price is too low, the upstream division may refuse to sell its goods to the downstream division, potentially impairing the company’s profit-maximizing goal.

Finally, transfer prices are especially important when products are sold across international borders. The transfer prices affect the company’s tax liabilities if different jurisdictions have different tax rates.

Transfer pricing is relevant for each transaction between associated enterprises, mainly in a cross border context. Such transactions could include i) supply of products, ii) rendering of services, iii) provision of funding or iv) providing access to intangible property. In most countries substantiation of the arm’s length conditions of such transactions is required by tax law.

Cash pooling can be used to manage the multinational group’s cash position on a consolidated basis and concentrate the group’s cash in one place. A cash pool is normally administered by a group company which is to be referred as the cash pool leader.

Cash pooling arrangements

There are two main types of cash pooling arrangements: notional cash pooling and physical cash pooling. A notional cash pool allows the multinational group to net off the balances of various bank accounts across jurisdictions. The cash is not physically transferred to a cash pool leader’s bank account. In a physical cash pool the cash is periodically (daily, weekly or monthly) transferred from the individual group company’s bank account to a cash pool leader’s bank account. The cash pool leader becomes the owner of the cash and any deposit with a third party bank will turn into a loan to the cash pool leader in the group.

Transfer Pricing

From a transfer pricing perspective, the key question is how the benefits from the cash pooling arrangement should be allocated between the participating group companies. Notwithstanding the cash pooling arrangement is concluded with a third party bank, the responsibility to use at arm’s length interest rates remains within the multinational group. These internal interest rates will most likely differ from the external bank rate.

Determining an arm’s length price is a complex task and highly depends on the specific facts and circumstances. To apply the arm’s length principle to the cash pool transactions, the functions, assets and risk of each of the parties of the arrangement should be considered and subsequently the most appropriate transfer pricing method can be chosen. Since the facts and circumstances (like the solvency of a participating company) can change during the year, the preparation of a cash pooling policy is highly recommended.  A description of the relevant facts and circumstances in a cash pooling agreement will strongly support the at arm’s length nature of your intercompany interest rates.

Our cash pooling agreement

Our cash pooling agreement describes a ‘zero balancing’ cash pool arrangement, whereby funds are transferred on a daily basis to/from the cash pool leader, the group entity that manages the pool (usually a treasury operation or the parent company). The cash pooling arrangement includes multiple countries and currencies. The currencies used in this template cash pooling agreement are Euro and US Dollar. Further the template agreement assumes that i) an operating account, a ii) secondary account and a concentration account are operated.

DEMPE was first introduced in the final Actions 8–10 report of the Transfer Pricing Aspects of Intangibles (‘Aligning Transfer Pricing Outcomes with Value Creation’), released on October 5th 2015. The reports were published by the Organisation for Economic Co-operation and Development (OECD) under its base erosion and profit shifting (BEPS) initiative.

DEMPE stands for Development, Enhancement, Maintenance, Protection and Exploitation. DEMPE is designed to help both taxpayers (including multinational enterprises or ‘MNEs’) and tax authorities achieve an accurate assessment of intangible asset transactions to help with the determination of appropriate transfer pricing. By identifying the entities that perform DEMPE functions in a transaction, MNEs and taxpayers in general can ensure that they are complying with the OECD’s BEPS guidelines.

There are three factors to consider when determining who is performing what function, which are:

  1. control,
  2. funding, and
  3.  

Per DEMPE function it should be determined: who has control, who is funding, and who is incurring the risks related to the function. The determination of the functions performed and the consideration of the factors are combined in a DEMPE analysis. Such a DEMPE analysis should be prepared on a case-by-case basis and should be substantiated by objective documents such as annual reports, board meeting notes or any other internal documents that could provide further substantiation.

After having performed a DEMPE analysis, it can be determined which entity is entitled to the profits resulting from an intangible asset. However, it can also be concluded that multiple entities perform considerable DEMPE functions. In that case, multiple entities are entitled to the profits resulting from an intangible asset. The OECD Guidelines set out that the Profit Split Method is the most appropriate method for allocating the profits in such circumstances.

What are the implications of DEMPE for MNEs?

Before the DEMPE concept was introduced, the legal owner of an intangible was entitled to essentially all the returns generated by that particular intangible (e.g. intangible asset, such as a brand name or logo). This meant that, in practice, the owner of a brand could set up their company in a country (say country A), but also register their trademark in a low-tax environment so that they could charge royalties to the business in country A for any income related to the intangible asset registered in the low-tax environment. With the old model, the intangible asset owner would be entitled to the income effectively generated by the business in country A.

Now, however, any income that is generated as a result of that intangible asset is owned by all the parties that perform the DEMPE functions. This for example implies that for transfer pricing purposes, legal ownership of intangibles, by itself, does not confer the right to retain returns derived by the MNE group from exploiting the intangible. As a result of the contractual arrangement between the MNE entities, these returns may initially accrue to the legal owner of the intangible assets. However, if the legal owner performs no DEMPE functions, but acts only as a holding entity, the legal owner will not be entitled to any portion of the returns, other than compensation for the holding activities, if any.

DEMPE has significantly changed the way in which MNEs should determine arm’s length conditions for controlled intangible asset transactions between related parties. Appropriate compensation of entities that have performed DEMPE functions that contribute towards the profit generating value of an intangible is now a key consideration in establishing arm’s length transfer pricing.

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