INTERNATIONAl TRANSFERPRICINGRESTRICTIONS: IMPACT ON

Administração Contábil e Financeira

Stephen T. LimbergVisiting Professor, EAESP/FGV

Professor, The University of Texas, AustinE-mail: limberg@mai/.utexas.edu

CORPORATE FINANCIAl POllCY

John R. RobinsonProfessor, The University of Texas, Austin

Raimundo l.M. ChristiansInternational Tax Partner, Price Waterhouse

São Paulo, S.P., Brazil

Professor Limberg grateful/y acknowledges the support of Philips do Brasil Ltda. and of the Genter for the Study ofWestern Hemispheric Trade at The University of Texas, in Austin.

RESUMO: Precificação de transferência é um tema muito difundido e que apresenta significativos potenciais deeconomias de impostos, sobretudo no que se refere a empresas internacionais. Em artigo anterior, os autoresabordaram os incentivos das empresas para melhor administrar os preços de transferência. Em resposta a essesincentivos, os governos têm, cada vez mais, aprovado e imposto restrições internas aos preços de transferência.Neste artigo, as atuais normas que restringem a precificação de transferência são analisadas. Os modelos deprecificação dos EUA e OECD são avaliados e as recentes aplicações desses métodos no Brasil são considera-das. Os métodos de precificação são descritos e a sua eficácia é apresentada. Concluímos por meio da descriçãodas políticas de precificação de transferência entre empresas que têm por finalidade facilitar o gerenciamentointerno e minimizar a ameaça das taxações externas.

ABSTRACT:Transfer pricing is a pervasive issue that presents significant tax savings potential concerning internationalenterprises. The authors discuss company incentives to manage transfer prices in an artic/e appearing in thepreceding issue of this journal. In response to these incentives, governments have increasingly enacted and enforceddomestic restrictions on transfer prices. In this article, contemporary norms restricting transfer pricing are analyzed.The OEGD and US pricing standards are assessed and Brazil's recent application of these standards is considered.Transfer pricing methods are described and evidence of their use is presented. We conclude by describing anintercompany transfer pricing policy intended to facilitate internaI financiaI management and minimize externaI taxthreats.

PALAVRAS-CHAVE: políticas financeiras, impostos internaticionais, preços de transferência, restrições.

KEY WORDS: financiaI policy, international tax, transfer pricing, restrictions.

28 RAE - Revista de Administração de Empresas São Paulo, v. 37, n. 3, p, 28-41 Jul./Set. 1997

INTERNATlONAl TRANSFER PRICING RESTRICTlONS

The possibility of minimizing global taxesprovides a powerful incentive formultinational enterprises to manipulatetransfer prices among related entities asdiscussed in Limberg, Robinson, andChristians.' As a result, governments areincreasingly challenging companies'practices. Challenges are based on country-specific restrictions that tend to share commoncharacteristics. The purpose of this article isto analyze the general form of theserestrictions, and to identify the basiccomponents of an intercompany transferpricing policy that facilitate internal financialmanagement and minimize successfulgovernment tax challenges. Special attentionis given to Brazil's new transfer pricingprovisions.

...............................The crifical concepf

underlyíng confemporaryfransfer pricíng guídelínes

ís fhe so-called arm'slengfh sfandard.

...............................The following analysis is relevant to

companies with interests in foreignjurisdictions that have established transferpricing roles. It also provides insights into howcountries might interpret existing standardsand develop future standards. We focus ontransfer pricing concepts and rely on the mostrecent comprehensive document, namely theOrganization for Economic Co-Operation andDevelopment (OECD) Transfer PricingGuidelinesfor Multinational Enterprises andTax Administrations (OECD Guidelines)issued in July 1995.2 Brazil recently passedtransfer pricing provisions' with the expressedintention of conforming to the roles of otherOECD countries." We assess the extent towhich this intention is realized. Reference isalso made to the OECD's influentialpredecessor, the US Treasury DepartmentRegulations on Transfer Pricing (USRegulations) issued in July 1994.5

We first analyze the arm's length standardwhich represents the fundamental principleunderlying contemporary transfer pricingrestrictions. Next, the common methods for

determining transfer prices under the arm'slength standard are assessed. Thereafter,formulary apportionment, a non-arm's lengthstandard, is considered. We summarize astudy on transfer pricing methods used in theUS. Next, administrative issues important tocompanies' transfer pricing strategies arepresented. Last, we recommend thatcompanies adopt a consistent transfer pricingpolicy and describe the basic features of suchpolicy.

Arm's length standard

The criti cal concept underlyingcontemporary transfer pricing guidelines is theso-called arm's length standard. Under thisstandard, transfer prices between relatedparties are based on prices betweenindependent parties and comparabletransactions under comparable circumstances.This standard assumes that market forcesdetermine fair prices in transactions betweenindependent parties. Therefore, these pricesshould be applied to comparable transactionsbetween related parties. Accordingly,comparability becomes a central feature ininterpreting the arm's length standard .

Some characteristics of the new Brazilianlaw adopt the arm's length standard, whileothers deviate from it. In contrast, the OECDGuidelines and US Regulations uniformlyapply the arm's length standard. They providesubstantial guidance concerning thedeterminants of comparability, as well as otherfactors for consideration. At this writing,similar elaboration has not yet occurred underthe Brazilian law, in part, because of its recentenactment. Hence, OECD and US factors maybe relevant for applying Brazilian law, as wellas a preview of potential future Brazilianguidance.

Comparability factors

Comparability considers the economicallyrelevant aspects of transactions. If comparableaspects are inexact, adjustments for differencesmay be necessary. The OECD Guidelinesspecify five factors for determining thecomparability of controlled and uncontrolledtransactions. These same factors are directlyor indirectly prescribed under the USRegulations.

© 1997, RAE - Revista de Administração de Empresas / EAESP / FGV, São Paulo, Brasil.

1. LlMBERG, sr, ROBINSON, J.R. ANOCHRISTIANS, R.L.M. Internationaltransfer pricing strategies for minimizingglobal income taxes. In: Revista deAdministraçãode Empresas,v. 37, n. 2,1997.

2. ORGANIZATlON FOR ECONOMIC CO·OPERATION ANO OEVELOPMENT.Transfer Pricing Guidelines forMu/tinationa/ Enterprises and TaxAdministrations. OECO publicationservice, July 1995.

3. Law 9430 (Oecember 27, 1996).Articles 18·24.

4. Exposição de Motivos (E.M.) N° / MFBrasília, de outubro de 1996. Paragraph12.

5. THE UNITEO STATES TREASURYOEPARTMENT. US Regulation Section1.482.

29

and extent of competition; the relativecompetitive positions of buyers and sellers;the availability of substitute goods; the levelsof overall and regional supply; consumerpurchasing power; govemment regulation ofthe market; the costs of production includinglabor, land, and capital; transportation costs;the level of the market, for example retail orwholesale; and the date and time oftransactions, among other factors. USRegulations also indicate that considerationshould be given to the relative size of andeconomic development in each market, as wellas the economic condition of the particularindustry in each market.

Fifth, a comparison of business strategiesmay be relevant to the comparability ofcontrolled and independent prices. Forexample, prices might reasonably be expectedto differ if there are distinctions amongcompanies' innovations, new productdevelopment and di versification, riskaversion, assessments of political changes andlabor laws. Also, market penetration andexpansion strategies based on short termlosses might confound the analysis.Evaluation of such strategies considers theircommon characteristics, such as low pricesand intensive advertising, and whether for acomparable independent enterprise thesestrategies are plausible at inception andwhether they are undertaken by related partiesbeyond an expected and reasonable period."

6. See US Regulalion Seclion 1.482-1(c)(iii) that elaborales on lhe relevanltactors in delermining lhe economicsubslance 01 a Iransaclion which includelhe assumplion 01 risk by lhe conlrolledlaxpayer as rellecled in lts: (a) Paliem 01conduet, (b) linancial capacity, and (c)managerial and operalional conlrol. SeeUS Regulalion Section 1.482-I(c)(iii)(C)examples (I) and (2) lor iIIuslralions.

7. See US Regulalion Seclion 1.482-1 (c).

8. A reduced price is allowed under USRegulalion Seclion 1.482-I(c) only ~Ihereis documenlalion Ihal subslanliales: (a)The conlrolled party bears lhe cost 01lheslralegy and is likely lo benefit, (b) lhereasonableness 01 lhe slralegy's limeperiod, and (c) lhe slralegy and ils lermsare established belore lhe slralegy wasimplemenled.

30

First, the characteristics of the propertytransfered should be comparable. Forexample, tangible property should havecomparable features, quality, reliability andvolume. Intangible property should becomparable regarding transaction form (forexample, leases are distinguished from sales);type (for example, patents are distinguishedfrom copyrights); duration and degree ofprotection; and the anticipated use of theproperty. Services should be comparable innature and extent.

Second, a functional analysis determinesthe comparability of the economic activitiesand responsibilities of controlled andindependent enterprises. For example,functional analysis might identify andcompare activities regarding design,manufacturing, assembly, research anddevelopment (R&D), service, purchasing,distribution, marketing, advertising,transporting, financing, and management.Transfer pricing adjustrnents should be madeto the extent these functions materially differbetween controlled and independententerprises. Adjustrnents might also arise asa result of comparing the operating assets usedby the controlled and independent entities.Moreover, consideration of various forms ofrisk is critical in the comparability ofindependent and controlled transactions. Riskanalysis might include a comparison of theparties assuming market risk, investment risk,R&D risk, financial risk such as currencyexchange risk - and credit risk, to name afew. The US Regulations indicate that risksspecified by contractual agreement will berespected if they have economic substance."

Third, contractual terms often indicatehow responsibilities, risks and benefits are tobe shared, hence they are considered whendetermining the comparability between acontrolled and independent transaction.Actual conduct, in addition to written contractterms, should also be examined since,compared to independent parties, relatedparties may be submitted to less pressure tocomply with contractual terms. The USRegulations elaborate by listing the types ofcontractual terms requiring comparison.?

Fourth, disparate economic circumstancesmay affect the comparability of transactions,and hence prices. For example, prices maybe affected by geographic location; the size

Other factors

In addition to comparability, the OECDGuidelines and the US Regulations present thefollowing other factors for considerationregarding the applying of the arm's lengthstandard. Determination of transfer prices isalmost always based on the actual transactionundertaken. Rare exceptions include, forexample, when interest on debt isrecharacterized as dividends on shares ofstock, and when a sale of intellectual propertyrights is recharacterized as a lease. Becausecontrolled enterprises can engage in morecontracts than independent enterprises andmodify, extend and suspend them morereadily, the underlying economic reality mustbe considered in establishing transfer prices.

While it is preferable that transactions betreated separately, this is sometimes

RAE • v. 37 • n. 3· Jul./Set. 1997

INTERNATlONAl TRANSFER PRIClNG RESTRICTlONS

impossible and multiple contracts are bundledtogether. When using a singlemethod or morethan one method for establishing an armslength price, sometimes a range of tenablecomparables emerges. 9 There is no generalrole for selecting a price within the range:merely, good judgment should be exercised.Multiple year data may be useful because itmight disclose intertemporal facts that affecttransfer prices, and it may reveal relevantaspects of a business cycle. Losses arepossible but should not persist beyond thosethat are logical for an independentcomparable. In other words, whileconsideration should be given to the fact thatdifferent loss strategies may exist, lossesshould be expected for a limited time only.

A company's transfer prices might beaffected by government policies, such ascontrols over prices, interest rates, paymentsfor services and management fees, royaltypayments, and currency exchange rates andamounts; subsidies to particular sectors; andanti-dumping provisions. Pricing - whengovemment policies intercede - is still basedon comparable uncontrolled transactions. Forexample, if a controlled supplier is subject togovemment costs, the abilityof an independentsupplier to pass on these costs to the customeris of relevance in establishing a comparabletransfer price. Blocking is a special problemin which governments prevent (or block)transactions, such as the payment of interest.In these situations, independent comparablessubject to similar blocking are still used todetermine a transfer price. Comparables maynot be available if independent companies willnot engage in the government affectedtransaction. Solutions to the absence ofcomparables are, for example, to consider theother means by which independent partieswould likely arrange payment in light ofgovernment restricted payments. USRegulations provide specific criteria that mustbe met before foreign legal restrictions will beconsidered.!"

Exchanging goods among controlledenterprises is also observed amongindependent enterprises. Therefore, themarket price of goods exchanged betweenindependent companies is used to determinethe transfer price for goods exchanged incomparable transactions between relatedcompanies. Customs valuations are

RAE· v. 37 • n. 3· Jul./Set. 1997

considered, but not determinative, inestablishing transfer prices. The relevanceof customs valuations in determining transferprices considers that customs valuationsoccur at the time of import, whereas pricingoccurs when contracts are concluded.Moreover, companies may have conflictingpreferences for low customs values tominimize duties and high transfer pricingvalues that minimize income taxes.

Under the arm's length standard, transferprices are determined on a case-by-case basis.Analysis using only one transfer pricingmethod may be sufficient. Multiple methodsmay also be used if they provide betterevidence.

...............................A companys fransfer prlces

mlghf be affeded bygovemmenf policies, suchas controls over prices,

inferesf rales, paymenfs forservices and managemenffees, rayalfy paymenfs, andcu"ency exchange rafesand amounfs; subsidies lo

particular sedol'S; and anfl-dumping pravlsions.

...............................Transfer pricing methods

Based on the arm's length standard, boththe OECD Guidelines and US Regulationsdescribe methods for determining transferprices. Because of their intertwinedhistories, it is no surprise that these methodsbear a striking resemblance. While Brazilalso enacted provisions that fit into thisframework, there are important distinctions.In this section, OECD, US and Braziliantransfer pricing methods are discussedseparately for tangible property, intangib1eproperty and some specia1 cases.

Tangible property

The OECD categorizes a transfer pricingmethod as either a traditional method or profitmethod as shown in co1urnn(a) of Exhibit 1,

9. Details for determining a price rangeare limited under the OECD guidelines. Incontrast, US Regulation Section 1.482-1(e) is more detailed and indicates, in part,that in determining an arm's length rangeonly one (l.e., the best) pricing method isbe used. As will be discussed in the nextsection, numerous methods fordetermining an arm's length price arepossible. Therefore, an arm's length rangeís not determined by applying two or morepricing methods to one controlledtransaction.

10. See US Regulation Section 1.482-1 (g).

31

11. The sale of invenlory is lhepredominant transacnon to whlch thesemethods are applied because inventory isthe mos! prevalen! type of intercornpanytranster. See, for axample, US INTERNALREVENUE SERVICE, Controlied foreigncorporations, 1984: An industry focus.Statistics ot tncome Bulletin, p. 3t-52 ,Fali 1989.

12, Law 9430 (Oecember 27, 1996).Article 19, Section 3.1.

13. The dlsuíbutors 9 ross profit may be.in some cases, based on an arrn's lenglhbrokerage fee, such as a percentage ofsares. Product differences are iesssignificant than with CUP because lhefocus is on comparabla gross profits, notproducts, For exarnple, many homeelectronic devices, such as toasters andblenders, may have similar rnark-ups, thuslhe nature of the produc1 is not as criticaias under CUP.

14.ln this context, the tenm "uncondítíonaldiscounts allowed" means dlscounts thatare consistent for ali customers.

32

that summarizes the transfer pricing methodsfor tangible property sanctioned by the OECD,US and Brazil.

Ex.bibit 1

TRANSFER PRICING METHODS FORTANGffiLE PROPERTY

(a) (b) (c) (d)

Categories' OECD US Brazil

Traditional CUP CUP CUP'Methods? RPM RPM RPM4

A.

CPM CPM CPMs

Other

«

Profit PSM PSMMethods" TNPM TNPM7

CUP = Comparable Uncontrolled Price MethodRPM = Retail Price MethodCPM = Cost Plus MethodPSM = Profit Split MethodTNPM = Transaction Net Profit MethodWithin the dotted boxes, methods are virtuallyidentical

I These categories derivefrom the OECD Guidelines.

2 Brazil's CUP analog for imports is called "Métododos Preços Independentes Comparados" (PIC), Law9430 (December 27, 1996), Article J 8.1. Brazil's CUPanalog for exports is called "Método do Preço deVenda nas Exportações .. (PVEx), Law 9430 (December27, 1996), Article 19, Section 3.1.

s More specifically; lhe OECD refers lo "TraditionalMethods" as "Traditional Transaction Methods."

4 Brazil's RPM analog for imports is called "Métododo Preço de Revenda menos Lucro" (PRL), Law 9430(December 27, 1996), Article 18.11. Brazil's RPManalog for wholesale exports is called "Método doPreço de Venda por Atacado no País de Destino,Diminuído do Lucro" (PVA), Law 9430 (December 27,1996), Article 19. Section 3.11. Brazil's RPM analogfor retail exports is called "Método do Preço de Vendaa Varejo no País de Destino, Diminuído do Lucro"(PW), Law 9430 (December 27, 1996), Article 19,Section 3.1lI.

5 Braril's CPM analog for imports is called "Métododo Custo de Produção mais Lucro" (CPL), Law 9430(December 27, 1996), Article 18.11I. Brazil's CPManalog for exports is called "Método do Custo deAquisição o de Produção mais Tributos e Lucro" (CAP),l.aw9430(December 27,1996), Article 19, Section3.Jv.

6 More specifically, lhe OECD refers to "ProfitMethods' as "Transactional Profit Methods."

7 The US analog to the OECD's TNPM is called the"Comparable Profit Method. "

Traditional methods. The dotted boxes inExhibit 1 indicate traditional methods that arevirtually identical. As these boxes show, CUPis universally applied, yet Brazil devi ates fromOECD and US norms in determining RPM andCPM. Exhibit 2 illustrates the basic conceptunderlying traditional methods. For simplicity,it assumes a multinational enterprise is involvedin a two-stage process using a supply companyand a distribution company. II

Under CUP, an arm's length transferprice derives directly from comparableuncontrolled sales, adjusted if necessary.Although Brazil addresses imports andexports separately, its analog to CUP bearsa strong resemblance i.n spirit and form tothe OECD and US ver s io n s of thismethod.t"

Exhibit 2

THE RELATIONSHIP AMONG THE THREETRADITlONAL TRANSACTION METHODS

A TWO-STAGE PROCESS EXAMPLE

Cost

SUl?plier { -I> Gross (!rQfit,i.e., mark-ul! } CPM

= Arm's length transíer price. ,CUP

.. { + Gross m;ofil,'i.e.. mark-UP} CPMDlstrfbutor = Sale (!rice

Under RPM, an arm's length transfer priceis estimated indirectly by working backwardsusing the formula in Exhibit 2. Namely, thefollowing calculation applies.

Sale price- Grossprofit. i,e,. mark-up= Arm's length transfer price

This approach is tenable because thedistributor's sale price derives fromindependent market forces and, under theOECD and US models, the distributor's grossprofit is based on independent (arm's length)comparable transactions which are adjustedif necessary."

While consistent in form, Brazilsimplementation of this method deviatessignificantly from the fundamentaisunderlying the OECD and US approaches.For imp011S,the average gross sales price (i.e.,the sale price) is reduced by unconditionalallowed discounts," sales related taxes, salescommissions, and a defined gross margin of

RAE· v. 37 • n. 3 • Jul./Set. 1997

INTERNATlONAL TRANSFER PRICINC RESTRICTlONS

20 percent. \5 For exports, the average grosssales price is reduced by foreign sales relatedtaxes, and a gross margin of 15 percent if theforeign affiliate is a wholesaler and 30 percentif it is a retailer." A taxpayer is safe fromchallenge, if the transfer price determined forexports is no less than 90 percent of the pricefor the same or similar products sold inBrazil'? (hereafter called the 90 percent rule)calculated according to the lowest of any ofthe methods described above. This isadvantageous to taxpayers because it enablesa transfer price variance of plus or minus tenpercent.

Specification of a gross margin and otherdeductions directly contradicts the concept ofa case-by-case arm's length standard asenvisioned by the OECD and USo Brazilrecaptures, in part, the spirit of the arm'slength standard by allowing altemative grossmargin percentages if they are supported bythe taxpayer, based on research usingintemationally adopted methods of evaluation(hereafter called the arm's length option)."In essence, when this arm's length option isexercised, it conforms the Brazilian systemto intemational norms as reflected in theOECD Guidelines and the US Regulations.

An arm's length transfer price under CPMis also indirectly determined based on theformula in Exhibit 2. Namely, the transferprice is determined as follows.

Cost+ Gross profit. i.e .. mark-up= Arm' s length transfer price

This approach is defensible because thesupplier's cost derives from independentmarket forces and, under the OECD and USmodels, the supplier's gross profit is, as underRPM, based on independent (arm's length)comparable transactions which are adjustedif necessary.'?

As with RPM, Brazil' s application of CPMdeviates in significant ways from thefundamentals underlying OECD and USnorms. Namely, the arm's length principle ismodified by application of explicit suppliercosts and mark-ups. More specifically, forimports, the foreign supplier's average costof production (i.e., the cost) is increased byrelated taxes paid in the supplier's country anda mark -up of 20 percent on calculated costs."For exports, the Brazilian supplier's averagecost of production is increased by related

RAE· V. 37 • n. 3 • Jul./Set. 1997

Brazilian taxes and a mark-up of 15 percenton these total costs." Deviation from marketgross profit norms is moderated by theavailability of an arm's length option.

As shown in Exhibit 1, other (unspecified)methods are also allowed under the USRegulations with no OECD or Braziliananalog. Under these regulations, methodsunique to tangible property other than CUP,RPM and CPM may be used to determine theprice in the case of controlled transactions.When using an unspecified method a companystill must apply the principles underlying thearm's length standard.

Profit methods. The OECD describes twoprofit methods that can be used to calculatetransfer prices, namely PSM and TNPM,although it makes clear that other methodsmay be employed. The US also describesPSM and a counterpart to TNPM which iscalled the "comparable profit method." TheBrazilian law is silent on the application ofprofit methods.

Under PSM, the arm's length profit of tworelated parties is estimated by comparing therel ative economic contribution that the twoparties make to the success of the commonventure. Therefore, not unlike a partnership,the total profit to be split between the tworelated companies is identified and profit issplit based on the contribution of eachenterprise as determined using functionalanalysis. In general, all the comparabilityfactors must be considered in implementingPSM.22 The profit split should be based onexpected profits. It is most easilyimplemented if profit splits are actually usedby the affiliated group. However, becausethis is rare, the OECD describes two profitsplit approaches while acknowledging thatothers are possible."

Under TNPM, net margin (NM) ratios ofcontrolled enterprises are determined basedon those of comparable independententerprises. Net margin equals revenuesminus direct, indirect, and operating costs.Appropriate ratio denominators include, forexample, costs, sales, and assets. Thus,controlled company ratios such as NM/costs,NM/sales, or NM/assets are equated to thoseof independent companies."

The comparability standard, withnecessary adjustments, is applied whenTNPM is used. Operating profits, hence net

15. Law 9430 (Oeeember 27, 1996). Artiele18.11.

16. Law 9430 (Oeeember 27,1996). Artiele19, Seetions 3.11and 111.

17. Law 9430 (Oeeember 27,1996). Article19.

18. Law 9430 (Oecember 27, 1996). Article21. Section 2.

19. lhe OECOGuidelines indicate thatthe costplus mark-up 01 the supplier ideally should beestablished by relerenceto lhe cost plus mark-up thatthe same supplierearns in comparableuncontrolled transactions. lhe cost plus rnark-up that would have been eamed in eomparabletransactions byan independent enterprise mayalso serve as a guide. lhe US Regulationsindicate that the appropriate gross profit iscomputed by multiplying the supplier's cost01 producing the translerred property by thegross margin earned in comparableuncontrolled transactions.

20. Law 9430 (Oecember 27,1996). Article18.111.

21. Law 9430 (Oecember 27,1996). Article19, Section 3.IV.

22. Comparability under PSM is especiallydependent on the tactors under lNPM asdeseribed in lootnote 25. In addition,comparability depends particularly on thedegree 01 similarity in the contractual terrns 01the controlled and independent eompanies.

23. So-called contribution analysis uses therelative value 01 the lunctions pertormec byeach associated enterpnse to split operatingprofits or gross profit (with deductionsspecilically identilied by entity). So-calledresidual analysis allocates a normal prolit toeach party based on independent marketreturns lrom data used in traditional methods,Ihen any residual gain or loss isallocated basedon the tacts and circurnstances. Otherapproaches suggested by the OECO ineludesetting príces so multi national enterprises eamequivalent rates 01 return on capital, whichassumes equal risk, and splitting munínanonalprolits based on comparable independenttransactions. However, lt is unlikely to lindcomparable independent transactions in caseswhere traditional transaction methods wouldnot be used.

24. Underthe US Regulations, specilied ratioscalled proíit levei indicators include, but arenot limited to, rate 01 return on capital,operating prolit to sales, and gross profrt tooperating expenses (lhe so-called Berry Ratio).lhe US Regulations elaborate by indicating Ihatthe lacts and circumstances includeconsideration ofthe relevant lines 01 business,lhe product or service markets involved, lheasseI composítíon employed (including lhenature and quanlily 01 langible assets,intangible assets and working capital), lhe sizeand seope 01 operalions, and lhe stage in abusiness or producl eycle. While lheRegulations reilerate Ihal ali 01 the generalcomparability lactors must be considered, thecomparability 01 a controlled and independentcompany under Ihis approach is particularlydependenl on a comparison 01 lhe: (1)Resources employed, (2) risks assumed, and(3) lunctions pertormec (where it ls noted Ihallhe degree oflunctional comparability requiredlo obtain a reliable result ls generally less thanthat required under RPM and CPM). OIhercomparability considerations are also noted.

33

25. Olher tactors influencing TNPM netmarclns Inelude, for exampíe, the threatof new entrants, competitive position,management efficiency, Individualstrategies, threat 01 substitute procucts,varying cost structures and businessexperience. Moreover, il is necessary loconsider the accuracy ot asset valuanonin the ealeutatlon, and whether speciliccosts should be passed throuçh, rnarkad-up, or excluded entirely to arrlve at netmargin.

26. Law 9430 (December 27, , 996). ForImports see Article 18, Section 4. Forexports see Arliele 19, Sectlon 5.

27. Law 9430 (Oeeember 27, 1996). ForImports see Article 18, Section 5. Forexports see Article t 9, secncn 6.

28. Law 9430 (Oecember 27, 1996),Artiele 18, Paragraph 9,

29.The US Regulations define Intangibleproperty as any eommercially transrerabielnterest Included In the following sixclasses of items, provided that It hassuostantíal value independent 01 tneservices of an individuai: (1) Patents,inventions, formulas, processes desícns.patterns, or know-how, (2) eopyrights andllterary, musical, ar artistic eompositions,(3) Irademarks, trade names, or brandnames, (4) tranchtses, licenses, orcontracts, (5) methods, programs,systerns, procedures, campatuns.surveys, studles, foreeasts, estlmates,eustomer üsts, or leehnical data, and (6)other similar items.

30. Very narrow exceptions lo this ruleare available. However, due to lhenumerous requlrements, lhe utility 01Ihese exceptions Is limiled.

31.STAFF DF THE US JDINT CDMMITTEEDN TAXATION, General Explanation ofthelàx Reform Act of 1986. 99th Congress,2nd Sessíon, p. 1016, 1986.

34

margins, can be significantly influenced by anumber of factors in addition to productcomparability which is so critical to CUP, andcomparable functions that are critical to RPMand CPM mark-up determinations.PBecausethere are more potential factors, TNPM netmargins may be more volatile (even ifconsistently measured) than values originatedunder traditional methods, In traditionalmethods, pricing variation amongcomparables may be elirninated by insistingon greater product and functiona1 simílarity.

The OECD prefers traditional methodsover other pricing methods because they arethe most direct means of determining price.In exceptional circumstances where data isinadequate or nonexistent, other methodsmay be considered. However, these methodsare a last resort and their use is discouragedbecause the OECD believes theyinadequately consider companies'differences and countries' lack of experiencein their application. The so-called "bestmethods rule" under the US Regulationsappears to be less judgmental by stipulatingthat there is no hierarchy of methods. Inother words, the method to be used shouldsimply be the best method, although noobjective rules are provided forimplementing this rule. However, the USRegulatíons also indicate that TNPM is amethod of last resort given adequate dataunder other methods. This puts in questionthe full force of the "best methods role" andwhether it is, in practice, distinct from theOECD Guidelines, Brazilian law does notspecify any profit methods, However, it doescreate priorities among the traditionalmethods by indicating that the method thatresults in the highest transfer price forimports and the lowest transfer price forexports should be used." For imports andexports, allowable prices are limited by theactual contract price."

Intangible assets

Exhibit 3 summarizes OECD, US andBrazilian transfer pricing guidance forintangible property,

As Exhibit 3 indicates, OECD guidelinesfor pricing the transfer (or use) of intangibleassets are pending. Brazilian transfer pricinglaw specifies that domestic deductions related

Exhibit3

TRANSFER PRICING METHODS FORINTANGffiLE PROPERTY

(a) " (b) (c)OECD US Brazil

Pendíng CU: ReferenceOther to priorlaw •

and,. PSM CUPand CPM

TNPM

CUT '"' Comparable UncontroUed TransactíonMethodPSM = Profit Split MethodTNPM = Transaction Net Profit MethodCUP = Comparable UncontroUed Price MethodCPM = Cost PIos Method

to royalties are subject to laws that predatethe new transfer pricing provisions." At thesame time, the new transfer pricing Iawindicates that CUP and CPM pricing methodsapply to imported rights. When pre-transferpricing law versus CUP and CPM methodsare applied is not clarified, In contrast, rulespertaining to intangible assets are extensiveunder the US Regulations. While there is noassurance that the US rules will be adoptedby the OECD or Brazil, they are brieflyreviewed below because they may beinstructive, for example, for companies withUS interests, in establishing or defending aposition in a country without intangibleproperty rules, and as a possible reflection ofguidelines the OECD and nonUS countriesmayadopt.

The US ruIes require that transfer pricesfor intangibles be commensurate with theincome attributable to the intangibles." Tomeet this so-called commensuration withincome requirement, transfer prices mustreflect the actual profit realized subsequentlyto an intercompany sale or Iicense.ê?Adjustments must therefore be made in theoriginal sales price or roya1ty rate to reflectunanticipated changes in the incomegenerated by the intangible." When nonUSgovernrnents will not, or cannot, make acorresponding adjustment significant issuesof double taxation may arise.

In effect, the commensuration withincome standard requires that sales andlicensing arrangements between related

RAE· v. 37 • n.3 • Jul./Set. 1997

INTERNATlONAl TRANSFER PRIClNC RESTmCTlONS

parties be treated as if they are periodicallyrenegotiated. For example, if a new patentleads to a product that tums out to be far moresuccessful than expected at the time thepatent was licensed, the affiJiates arerequired to increase the royalty payments asif the success could have been fullyanticipated. This requirement also appliesto intangibles that are sold to an affiliate fora lump-sum sales price. In such cases, thecommensuration with income standard mayrequire a recasting of the transactioo toinclude future contingent royalties orpayments of sales price. The need to makeperiodic adjustments has led some to callthese deemed payments super royalties."

Exhibit 3 indicates that, together withthe commensuration with income rule, theUS Regulations prescribe a specific pricingmethod, CUT (comparable uncontrolledtransaction method), and also permit other(unspecified) methods for determining thearms length transfer price of intangibleproperty. In addition, PSM and TNPMalready discussed under tangible property,can be applied to intangible property.

Under CUT, arm's length considerationis determined by reference to a comparableuncontrolled transaction. Similar to CUP,the "best method rule" applies and CUT isconsidered to provide the most direct andreliable measure of an arrn's length pricewhen there are only minor differencesbetween the controlled and independenttransactions. In order to considerintangibles comparable they must beproducts or processes within the samegeneral industry or market, and havesimilar profit potential. The profitpotential of an intangible is measured bythe net present value of the future profitor cost savings to be realized through theuse or subsequent tr ansfer of theintangibles, taking into consideration thecapital investment and start-up expensesrequired, the risks to be assumed, and otherrelevant considerations. The contractualterms and economic conditions in whichLhe coutrolled and uncontrolledtransactions take place must be similar."These comparability requirements may beparticularly difficult to satisfy, speciallyconsidering the unique nature of manyintangible assets.

RAE· v.37 • n.3 • Jul./Set. 1997

Special cases

Exhibit 4 identifies special cases fordeterrnining transfer prices under OECD, USand Brazilian norms.

Exbibit 4

TRANSFER PRICING METHODS- SPECIAL CASES

(a) Tb} (C)

OECD TIS, Brazil

Not specified Interest lnterestServices fees Servíces feesRents

The OECD Guidelines do not specify anyspecial cases. Therefore, the general principiesof the arm's length standard presumably applyunder the OECD Guide1ines until further notice.In contrast, under the US Regulations specialpricing applies to interest on intercompany loans,fees for intercompany services, and rents onintercompany contraets regarding tangibleproperty. Brazilian law also views interest as aspecial case and singles out technical, scientific,administrative, or similar assistance, for specialtreatment and deductions."

Each US and Brazilian special case isdiscussed below because they are relevant tocompanies frorn, or operating in thesecountries. Moreover, the discussion may bea useful reference in establishing or defendinga transfer pricing position in countries alreadyusing US or OECD-type norms, and a previewof future OECD guidelines.

Interest. Under the US Regulations,charges for interest generally are consistentwith the arm's length standard. All relevantfactors must be considered in determining thearm's length rate, including the amount andduration of loans, security involved, creditstanding of the borrower, and ínterest rateprevailing at the locations of the lender andborrower. One exception among severalallows zero interest on incurred intercompanydebt that is ou tradc rcccivablcs. 35 Determiningthe appropriate arm's length interest rate maybe difficult unless one of the affiliates is acommerciallender and therefore has expertisein the area. US Regulations provide a safeharbor rule to address this problem." A safe

32. us DEPARTMENT DF TREASURY. Asludy ot intercampany pricing. US printingoffice, p. 479, October 1988. In adopting lhecommensurate wíth Income standarrí lhe USdevated from the premise that the arm'sleng1h standard depends solely on lhe tactsexisting at the time a transaction is enteredinto (see, forexample. the US courtcase R. T.french. 60 Te 836, 1973), Nevertheless, theUS does notconsider the periodic adjustmentrequirement to be a deVlation from the arrn'slength standard because unrelated personsrarely make lonq-term Ilcenses with noprovisions 10r future adjustments. particular1ylar intangibles with high profit potental,Consistent with this view. periodicadjustments need not be made il a companycan establísh that an unconlrolied licenseagreement would not nave included anadjustment clause and any post-agreementincreases in lhe profitability of the intanglbleare attrlbutable to unanticipated eventsoccurring after the license was made (USDEPARTMENT DF TREASURY. A study ofinlercomp8J1Y pricing. US printing oflice, p.477·478, October 1988).

33. In addition 10 applying thesecomparabllity standards ano the generalprincipies diseussed under the arm's lenglhstandard, in determining comparability lheUS Regulations set forth lhe foliowing eightspecilic factors that may be particularlyrelevant in comparing controlled anduncontrolled transacnons under lhe CUTplicing method: (1) The terms o1the transfer.(2) the stageol development 01the intangible,(3) rights to receive updates, revisions. armodilications olthe intangible. (4) theuniqueness 01 the prcperív and the perlodfor which it remains unique. (5) lhe duratlon01the llcense, contract, or other agreement.and any terminatian or renegoliation rights,(6) economic and product liability risksassumed by lhe transleree. (7) the exístenceand extent of any coltateral transactions arongoing business relationships between lhetransteror and the transleree. and (8) thefunctions to be pertormad by the transterorand lhe transteree.

34. Law 9430 (December 27. 1996). Artiele22 pertalns to inlerest and Ar1icle 18,Paraqraph 9 pertalns to technieal, scientific.administrative. and similar assistance.

35. Under this exception, trade receivablesare defined as debl incurred in the ordinarycourse 01 business from saíes, leases, andserviees, so long as the debt is not evidencedby a written agreement requiring the paymentof ínterest. This exception relleets thecommon busíness practice ot not charginginterest on Ihese so-called trade receivables,and serves as an important rule ofadministra1ive ease given the larga number01these transaetons. The tnterest-free period10r intercompany trade reeeivables isgenerally IImited to between three and sixmonths.

36. Under this saía harbor, lhe interest rateon an intercompany loan is deemed equal tothe arrns length rate il il is between 100 and130 percent 01the so-called applicable federalrate. The applitable lederal rate lstne averageinterest rate (redetermined monthly) onobllgations of the US federal govemment thathave maturity dates similar to those of lheintercompany loan. For a discussion Df lhetnree sítuatíons in which a company cannotrely upon lhe safe harbor rule see USRegulation Section 1.482·2(a).37. Law 9430(Decembsr 27, t 996). A~cle 22.

35

similar services performed by or for anunrelated party. Brazilian transfer pricing lawspecifies that, similar to royalties as describedbefore, domestic deductions related totechnical, scientific, administrati ve, andsimilar assistance are subject to pre-transferpricing provisions." At the same time, the newtransfer pricing law indicates that CUP andCPM pricing methods for imports apply toservices.

Rent. Only the US characterizes rent as aspecial case. In general, an arm's length rentalmust be charged for intercompany leases oftangibleproperty,suchas real estate,machineryand equipment. The arm's length rental is therental that would have been charged for asimilar lease between unrelated parties. AlIrelevant factors must be considered indetermining the arm's length rental, inc1udingthe type of property and its condition, periodand location of the property's use, lessor'sinvestrnent in the property or rentals paid forthe property, and expenses of maintaining theproperty.

A special US role applies if the relatedlessor first leased the property from anunrelated party and then subleased it to therelated lessee. The arm's length rentaI for theseso-calIed pass-through leases is deemed equalto the rent paid to the unrelated lessor on theoriginal lease, increased by any associatedrental costs.?

37. Law 9430 (December 27, 1996).Article 22.

38. Services lor which no charge isnecessary include the lollowing. (1)Services that are ancillary to anintercompany sale or lease. Examples 01such services include installing equipmentacquired by an afliliate, and training theacquiring afliliate's personnel to operatethe equipment. This exemption serves asa rule 01 administrative ease and rellectsthe. common business practice 01impounding the costs 01ancillary servicesin the associated sale or rental price. (2)Services ifthe probable economic benelitsto the recipient are so indirect or remotethat an unrelated party would not chargelor the service. This may occur withservices lorthe joint benelit ofthe providerand afliliated recipient. (3) Some types01 supervisory services. For example,parent executives commonly visit loreignsubsidiaries in order to provide advice.Whether and how much to charge lor suchvisits is often diflicult to determine,particularly when the visits are occasionaland briel, the executives do not participatein the subsidiary's normal day-to-daybusiness activities, and the subsidiary hasits own managerial stafl. To relieve thisproblem, no charge is required tor suchservices il they merely duplicate servicesthat the subsidiary independentlyperforms lor itsell.

39. The relevant costs normally includedirect costs such as the salaries 01 theemployees performing the services, traveiexpenses, and materiais and supplies, aswell as indirect costs such as an allocableportion olthe service provider's overhead.

40. This sale narnor rule does not preventa company lrom establishing, based uponthe facts 01the case, that a diflerent chargeis more appropriate under the generalarm's length standard.

41. Law 9430 (December 27,1996).Article 18, Section 9.

42. A company is given the opportunityto show that the arm's length rental lorthe sublease diflers lrom the rentals paidunder the head lease. Otherwise, therelated lessor is treated as a mere conduitlor the lease it entered into with theunrelated lessor.

43. Evidence 01 lormulary apportionmentuse is shown in Exhibit 5 which isdiscussed in the next section. Moreover,profits 01 specilic companies may becompared on a case-by-case basls underpreviously discussed prolits methods andspecilic companies may agree to lormulaswith governments, such as the US, undermutual agreement procedures, advancepricing agreements, or other bilateral ormultilateral determinations. While lederalgovernments have not adopted lormularyapportionment, it is the primary method01 allocating prolits among the stateswithin the USo

36

harbor is, in essence, an objective rulecompanies can apply that assures they will notbe chalIenged by the tax authority.

Brazilian law goes one step beyond a safeharbor by mandating a prescribed interest rateon intercompany loans. More specificalIy,interest deductions on loans that are notregistered with the Central Bank of Brazil arelimited to the loan interbanking offered rate(Libor) for six month dollar deposits, plusthree percent annually. Notes registered withthe Central Bank of Brazil bear interest equalto the registered rate." Therefore, while theUS and OECD generally determine interestusing the arm's length standard on a case-by-case basis, Brazil uses a quantitative role for

Because of ífs sub;ecfívenafure, fhe process of

developíng an ínfercompanyfransfer prícíng policy mighfbe consídered as much arf

as scíence.

all cases not registered with the BrazilianCentral Bank. Arguably, because Liborreflects market values, the Brazilian standardbears significant components of the arm'slength standard. At the same time, because itis an objective role, it appears to be outsidethe spirit of the arm's length principle asgeneralIy envisioned by the US and OECD.

Service fees. GeneralIy a fee must becharged if one affiliate performs marketing,management, administrative, technical, orother services for another affiliate. Under theUS Regulations a separate charge may not benecessary for certain types of services." Asin the case of interest, under the USRegulations a safe harbor is provided forservices. Under this safe harbor, the transferprice can equal the costs incurred by theaffiliate for services that are not an integralpart of the business activities of eithercompany." Computing these costs is generallyadministratively easier than computing a truearm's length charge." Otherwise,intercompany services generalIy must bear anarm's length fee. The arm's length fee is theamount that would have been charged for

Non-Arm's Length Approachformulary apportionment

The most commonly discussed non-arm'slength approach to transfer pricing is globalformulary apportionment. To date, countriesinc1uding the US and Brazil, as well as theOECD,have rejected this as a general approachto international transfer pricing. However, ithas been used in specific cases." There arethree basic steps in global formularyapportionment: (1) To determine the globalenterprise to be taxed, (2) to accuratelydetermine the enterprise's global profits, and(3) to establish a formula for alIocating theenterprise's profit among its various members.

More specifically, a formulary approachallows the division of profits based on amechanical formula that weighs how manysales, assets, and/or other activities occur ineach jurisdiction. For example, consider a

RAE· v. 37 • n. 3· Jul./Set. 1997

INTERNATlONAL TRANSFER PRIClNC RESTRICTlONS

multi national company with gross sales of$40million in country A and $60 million in countryB. If the multinational's worldwide taxableincome is $20 million, it could be dividedbetween country A and B based on relativegross sales, resulting in taxable income of $844

milIion allocated to country A and $1245 millionallocated to country B. Other factors, such asthe location of operating assets andcompensation, could also be used as weightedvariables in the formula.

Advocates assert that this method isconvenient, certain, consistent witheconomic reality, and reduces compliancecosts. The OECD opposes formularyapportionment because it only works ifadopted in every jurisdiction; differentcountries are 1ikely to use differentapportionment factors; transition from theexisting system would be difficult; formulasare arbitrary; exchange rate movernents arenot accornmodated; compliance costs arehigher than proponents advocate, inc1udinginformation gathering costs andstandardization for all multinational unitsworldwide; accounting norms would need tobe standardized worldwide; there is noconsideration of important geographicdifferences, regional efficiency differences,and other factors specific to separatecompanies; disregarding specific intra-grouptransactions complicates the implementationof withholding taxes and a number ofbilateral treaty provisions; some rules stillrequire arm's length prices, such as customsduties; and, although every member of themultinational is inc1uded, separate entityrecords are sti ll necessary for non-multinational transactions.

Evidence of methods used in the US

Publicly available evidence of transferpricing methods used by companies is limited.The most recent study by the US GeneralAccounting Office provides some insightsabout US practices as shown in Exhibit 5.

Exhibit 5, Panel A, reports the transferpricing methods in 430 cases examined by theUS between 1990 and 1992. Traditionalmethods, namely CUP, RPM and CPM, wereused in only 51 percent of the cases. Panel Breflects an even less use of traditionalmethods. In 75 advanced pricing agreements

RAE· v.37 • n.3 • Jul./Set. 1997

Exhibit 5

TRANSFER PRICING METHODSUSED IN THE US

Panel A PanelBTransfer Prícíng AdvancedPricíngExaminations Agreementsq990.1992) (as of7 July 1994)

Otners COSI plus (CPM)

priceProfit measures (}tl'M)

Source: United States General Accounting Office,Report to Congressional Requesters. International

taxation: Transfer pricing and infonnation onnonpayment of tax, GAO/GGD-95-101, Apri11995,Appendix IV, Figure IV.I, p. 35.Note: Percentages do not add to 100 due torounding.

as of July 1994, 63 percent of the methodsused were not one of the three traditionalmethods, but were methods based onformulary apportionment (17 percent), otherapproaches (27 percent), OI profit measures(19 percent). As it will be discussed in thenext section, an advanced pricing agreementis an arrangement between a company and taxauthority that determines in advance anacceptable transfer pricing procedure.

Administrative issues

Govemments face a wide range of issuesin administering transfer pricing restrictions.These issues may be relevant in forming andimplementing a company's internationaltransfer pricing strategy. While administrativeissues are not yet addressed under Brazilianlaw, the US Regulations and OECD Guidelinesdiscuss various administrative issues includingadvanced pricing agreements, which wediscuss fust because of their potential impacton a companies' transfer pricing strategies.Next, we discuss other administrative issuesinc1uding mutual agreement procedures,corresponding and secondary adjustments,simultaneous examinations, and safe harborrules. These issues are addressed below byreference to the OECD Guidelines, whichclosely paraIlel the US Regulations.

44. $8 million = ($40 million ot gross salesin A)/($100 million ot warldwide grosssales) . $20 million ot worldwide taxableincome.

45. $12 million = ($60 million of grosssales in 8)/($100 million ot worldwidegross saíes) • $20 million ot worldwidetaxable income.

37

regular transfer pricing examination, andconfidential information might be misused.Last, because the APA process can beexpensive and time consuming it may not beusable by some businesses.

In general, the OECDbelieves it is too earlyto make recommendations concerning APAsbecause experience is limited to a fewcountries. One of the countries that mightprovide future information about the viabilityof APAs is the US which has a growing APAprogramo

46. The OECO Model Tax Convenlion,Article 25(3), indireclly provides for APAsIhrough compelenl aulhorilies who aredirected to endeavor to resolve difficultiesby mutual agreement. Lacking a domesticlaw aulhorizing APAs, a clause such asArticle 25(3) in a counlry's Ireaties mayprovide authority for APAs.

47. OECO COMMITTEE ON FISCALAFFAIRS. Mode/ tax convention onincome and capital. Article 9(1). OECOpublication service, March 1994, Article25.

48. Corresponding adlustrnents areaulhorized under Article 9(2) of lhe OECOModel Tax Convenlion.

38

Advanced pricing agreements

As previously noted, an advanced pricingagreement (APA)is an arrangement between acompany and the tax authority that determinesin advance an appropriate transfer pricingprocedure inc1uding,for example, the method,comparables, appropriate adjustments, andcritical assumptions about future events. AnAPA may involve a company and one taxadministration, or two or more taxadministrations."

Proponents cite numerous advantages ofAPAs. For example, for a company, theyeliminate uncertainty; they provide anopportunity for both tax administrators andcompanies to consult and cooperate in a non-adversarialsettingand spirit,prevent costly andtime-consumingexamination litigation,reducethe possibility of juridical or economic doubletax or nontax when multiple countriesparticipate, and enable tax administrators togain insight into complex multinationaltransactions.

At the same time, a number of APAdisadvantages have been cited. For example,if APAs are only unilateral, other taxjurisdictions may not agree with APAjudgments thereby increasing uncertainty andplacing in question correspondingadjustments.Moreover, an APAmay pertain to a number offuture years, therefore if predictions ofchanging market conditions are unreliable theAPA must be flexible. APAs may strain theauditresourcesof tax administrationsanddivertthese resources fromother important functions.A tendency may exist to use past APAs as thebasis for prices in future APAs. Improperlyadministered, APAprograms might seek moredetail and allow the tax administration to makea closer study of the transactions than in a

Other administrative issues

Mutual agreement procedures betweengovernments to resolve disputes areencouraged by the OECD Guidelines and area standard feature of the OECD Model TaxConvention on Income and Capital (hereaftercalled the OECD Model Tax Convention)."Such procedures may provide a mechanismfor corresponding adjustments which denotea transfer pricing adjustment made by onecountry that corresponds to the primaryadjustment made by another country." This,in turn, may justify a secondary adjustmentwhich is encouraged under the OECDGuidelines in a way that minimizes doubletaxation.

For example, assume that a $100 transferprice and payment is made for inventorysold by a parent company in country A to asubsidiary in country B. As shown inExhibit 6, if country A adjusts the transferprice to $80, purchases of the subsidiary incountry B should corresponding1y beadjusted to $80.

This corresponding adjustment may alsocause a secondary adjustment. Thesecondary adjustment in Exhibit 6 arises

Country A

Contract = ~ - 80

Country BCorrespondingadjustment:CGS~ -80

Exhibit 6

CORRESPONDING AND SECONDARY ADJUSTMENTS - AN EXAMPLE

Cash receivedAdjusted priceSecondary Adjustment

Originaladjustment:Sales i;1IQ - 80

RAE· V. 37 • n. 3 • Jul./Set. 1997

INTERNATJONAL TRANSFER PRICING RESTRICTJONS

because when the $100 transfer price isadjusted to $80, $20 of the $100 payment tothe parent should now be recharacterizedfrom sales receipts to something else. Itcould be deemed a dividend, payment forservices, interest on debt, or any other itemdepending on the facts and circumstances.

Simultaneous examinations by countriesare also encouraged by the OECD Guidelinesand authorized under the OECD Model TaxConvention (Article 26). Simultaneousexaminations refer to the exarnination of acompany's transfer prices by two or moregovemments at the same time. While theyare intended to promote cross-countrytransfer pricing coordination and identifypotential disputes at an early stage, they haveseen Jimited use, at least in the USo asindicated in Exhibit 7.

Exbibit 7

SIMULTANEOUS TRANSFER PRICING

EXAMINATIONS PROPOSED AND

ACCEPTED IN THE US

NtnnberDProposed

I Accepted20 18lS lS

1010 8 8 6S JO

1994Year

Source: United States General Accounting Office,

Report to Congressíonal Requesters. International

taxation: transfer pricing and information. 011

nonpayment OfÚlX. GAO/GGD·9S·101, April1995,

Appendix m, Figure m.l, p. 31.

It appears that there has been little changein the number of simultaneous examinationsaccepted in US cases between 1991 and1994. Overall the number is small, betweenfive (1991 and 1993) and eight (1992),despite the active role played by the US intransfer pricing challenges. This isunfortunate for companies if Lhe absence ofa simultaneous examination inhibits afavorable corresponding adjustment. Ofcourse, conversely it plays to a company'sadvantage to the extent unfavorablecorresponding adjustments are inhibited.

RAE· v. 37 • n. 3 • Jul./Set. 1997

As already indicated, safe harbors areobjective rules under which transfer pricesare automatically accepted by national taxauthorities. There are already some safeharbors applicable to specific items under theUS Regulations, sucb as previously discussedinterest on intercompany loans. Byprescribing specific interest rates on loansand mark-ups under RPM and CPM, Brazilalso has employed objective norms, althoughthey appear more as general rules than safeharbors. The OECD Guideliues do notrecommend the adoption of safe harborsbecause difficulties may arise acrossjurisdictions if safe harbors are not universallyadopted and they are viewed as artificial rulesthat present opportunities for tax avoidance.Indeed, this is precisely the situation that couldbe faced by multinational companiesconcerning for example, Brazilian inventorytransactions priced under fixed mark-up RPM01' CPM methods.

Toward a company transfer pricingpolicy

Tbere is no intemational law prescribingtransfer pricing restrictions. There are onlydomestic laws with which a company must deal.Therefore, a multinational company mayencounter as many different rules as countriesin which it is transacting. At the same time,many countries such as Brazil bave deve1oped,OI are deve1oping, transfer pricing rules based,in part, on principles underlying the OECDGuidelines and US Regulations. Not onlydo these models reflect the most developedth.inking and experience in the area, but withoutcross country harmony, asymmetrical t:reatmentmay arise hence threatening internationaldouble taxation. Therefore, a country that isout of step with international norms ispotentially less attractive to companies, thus ata comparative disadvantage in internationaltrade.

Current trends suggest that govemmentswill increasingly monitor companies'transfer pricing practices. Regular taxliabilities that result frorn unexpected transferpricing adjustments are, at best, anunexpected cost that disrupts or might evenundermine a business. In addition, suchadjustments are potentially accompanied bysignificant tax penalties and interest.

39

Moreover, even if a company successfulIydefends its transfer pricing practices, thedefense process can be extremely costly.

Potential conformity in cross boardertransfer pricing norms, increased monitoringby govemments, and the high defense costsassociated with a government challengesuggest the need for multinationals to developan intercompany transfer pricing policy, Notonly does such a policy bold potential forminimizing long term tax costs, but thepresence of a consistent, rather than ad hoc,pricing policy is a financial managementattribute tbat is important for currentoperations and effective strategic planning.The major components of a consistentintercompany transfer pricing policy aresummarized in Exhibit 8 and discussed below.

Selecting a pricing method

In general, a company's assessment oftransfer pricing methods sbould consider thefull complement of available methods.Brazilian multinationals that wish to developa global transfer pricing policy that isconsistent with US and OECD norms, canuse CUP (or CUT), or exerci se their RPM orCPM arm's length options under Brazilianlaw. However, before doing so, they shouldassess using prescribed RPM 01' CPM rnark-ups that may create advantageous pricingdiscrepancies across Brazilian and

nonBrazilian companies.In applying the arm's length standard,

transactions should be evaluated consideringthe list of OECD and US comparability factors.In addition, the OECD and US lists of otherfactors should be reviewed, along with anyotber factors a company finds relevant. Thesecomparability and other factors also providepotential guidance for companies withBrazilian activities since Brazil has not yetdeveloped detailed guidelines. Identical orsimilar transactions between a multinationalcompany and an independent party, if available,are a good starting point for establishing pricesbetween the multinational and an affiliate and,indeed, are required for exports under theBrazilian 90 percent rule. Bearing this, acompany is left to compare its controlled saleswith the sales of unrelated companies incomparable transactions. Independentquantifiable data is generally desirable and, inBrazil, called for.

Exhibit 5 indicates that, at least in the US,traditional transaction methods are frequentlyby-passed in favor of other methods, such asprofit methods. While profit methods are notcontemplated under the Brazilian law, tbeiruse elsewhere may provide cross-countrypricing differences that are advantageous to amultinational. When applying profitsmethods, many forms of the possible profitsmethods should be analyzed before the finalmethod is selected. For example, many

Exhibit 8

COMPONENTS OF A COMPANY TRANSFER PRICING POLlCY

SeIeclio.g\l pricing method · Use preferred tmditionà1 pricing me(hods to the extent they give best results,· Refer to OECn and Us. guidelines in determining comparability.· Consideronon-tradítional pricing methods to the extent they are tenable andadvantageous.,

:§j

Documentation · Keep thorongh records of the pricing method seIection processo•Maíntaíndocumentatíon of the systematíc procedures for the pricing methodselected, «

Implementatíon •Seek input from the full range of affected oompany personnel in seleoting apricing method.·11'aining sessíons facilita te the acceptance and effective use or a transferpricing mechanism.

Developed ~istory · Develop a hi'rtory Qf consisteut use of the transfer pricing policy.·",Maintainclear evídence supporting thís hístory.

40 RAE· v.37 • n. 3 • Jul./Set. 1997

INTERNATlONAl TRANSFER PRIClNG RESTRICTlONS

different types of net margin ratios underTNPM should be considered. As withtraditional methods, comparability analysisand the availability of quantifiableindependent data is relevant to profit methods.For example, only comparable companiesshould be considered when determiningcomparable net margin ratios under TNPM.Access to companies' financiaI report data,independently classified by industry,facilitates this processo Often such data isavailable in electronic form as, for example,financial reports of companies organized bystandard industrial classification (SIC) offeredby Compustat in the USo

Documentation

Relevant documentation includes a recordof the transfer pricing method selectionprocess and, for the selected method, thesystematic procedures to be consistentlyundertaken in determining transfer prices.First, evidence of the method selectionprocess should reflect the comparability andother factors assessed, including anassessment of the data sources that led toconclusions about the best method. Such arecord is a useful internaI document forreassessing transfer pricing policies in thefuture, as well as for initial transfer pricingassessments for new products or product entryinto new regions. It is also a vaIuable externaIdocument for defending tax authoritychalIenges to transfer pricing policies.

Second, documenting the proceduresunder the selected method also has internaIand external importance. InternalIy, it is avaluable management tool for systematicalIydetermining transfer pricings and facilitatingstrategic planning, especialIy to the extenttransfer pricing variables can be reasonablypredicted. The rationale for, andquantification of, adjustments made tocomparables is a relevant part of the recordoThe transfer pricing method selected shouldbe dynamic in the sense that a company'stransfer prices react to changes in thecomparability variables within the model.For example, if a company's market sharedecreases relatively to that of an independentcomparable, then transfer prices mightchange accordingly to reflect greatercompetition, relative to the preceding year.

RAE· v.37 • n.3· Jul./Set. 1997

Externally, documentation of selectedmethod procedures is important forsupporting transfer prices before taxauthorities.

Implementation

Transfer pricing is central to anorganization's decision process and typicalIyimpacts nonfinancial, as well as financiaIpersonnel. Because of its pervasive role andpriority, it is useful to involve all affectedpersonnel in the method selection andprocedures processo The involvement ofmarketing, operations, and othernonfinancial personnel may provi de valuableinput. Broad involvement through input andshort awareness sessions facilitates theinternaI acceptance and functioning oftransfer pricing mechanisms. Moreover,broad and well documented involvement inthe process provides evidence to taxauthorities of the selected method' s viability.Management approval of the process andselected method further authenticates theoutcome to intemal and external constituents.In the extreme, this suggests a board ofdirectors approval or an executive officerauthorization.

Developed history

The systematic use of the selected methodbuilds a history that is important forcontinuity and internaI planning, anddemonstrates consistency to outsideauthorities. Over time, documented periodicreviews contribute to the validity of theprocesso

CONCLUSION

Clearly, transfer pricmg requiresextensive exercise of judgment in whichreasonable minds might differ. Because ofits subjective nature, the process ofdeveloping an intercompany transfer pricingpolicy might be considered as much art asscience. Accordingly, there are noguarantees of trouble free transfer pricingpractices. At the same time, well informeddecisions and attention to the considerationsin Exhibit 8 stand to facilitate internalprocesses and minimize external hazards. D

41