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Introduction to Transfer Pricing Transfer pricing is an area of tax law that has significantly expanded over the last decades. With the globalization of business activities, the threat of international double taxation, and the need for States to monitor transfer prices to avoid the illegitimate erosion of their tax base, transfer pricing has become a key question for multi­ national enterprises and tax administrations.

Introduction to Transfer Pricing provides a general overview on the fundamentals of transfer pricing from an OECD perspective.

The book also illustrates the fundamentals of transfer pricing with concrete examples based on the structures often used by multi­ national enterprises when entering into cross-border intercompany transactions.

Jérôme Monsenego | Introduction to Transfer Pricing

Dr. Jérôme Monsenego teaches tax law at the University of Uppsala and is a tax lawyer with PwC in Stockholm.

Introduction to

Transfer Pricing

Introduction to Transfer Pricing is primarily addressed to students reading international tax courses, but may also be of use to tax professionals in matters pertaining to transfer pricing.

Art.No 37764

Jérôme Monsenego

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COPYING PROHIBITED

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Art. No 37764 ISBN 978-91-44-09270-6 First edition 1:1 Š The author and Studentlitteratur 2013 www.studentlitteratur.se Studentlitteratur AB, Lund Cover design: Francisco Ortega Cover illustration: Somchaij/shutterstock.com Printed by Eurographic Danmark A/S, Denmark 2013

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CONTENTS

Foreword 7 Preface 9 Introduction 13 Abbreviations 15 Chapter 1

The key to understanding transfer pricing: the arm’s length principle 17

1.1 1.2 1.3 1.3.1 1.3.2 1.4

Introduction 17 The arm’s length principle in theory 21 The arm’s length principle in practice 26 The functional analysis 27 The comparability analysis 29 The tax arbitrage resulting from intercompany pricing: the distinction between acceptable and unacceptable tax planning 33 The OECD Guidelines 35

1.5 Chapter 2

The transfer pricing methods recognised by the OECD Guidelines 39

2.1 2.2

Introduction 39 Traditional transaction methods 40

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Contents

2.2.1 2.2.2 2.2.3 2.3 2.3.1 2.3.2 2.4

The CUP method 41 The resale price method 43 The cost plus method 46 Transactional profit methods 48 The transactional net margin method 49 The transactional profit split method 58 The combined use of several transfer pricing methods 60

Chapter 3

Transfer pricing models 63

3.1 3.2 3.3 3.3.1 3.3.2 3.3.3 3.3.4 3.3.5 3.3.6 3.3.7

Introductory remarks on standardised transfer pricing models 63 Intercompany transactions involving intangibles 65 Common types of intercompany transactions and transfer pricing models 69 Research and development 70 Manufacturing 73 Distribution 78 Intercompany services 80 Financial transactions 86 Cost contribution arrangements 89 The centralized entrepreneur model 91

Chapter 4

Cross-border business restructurings 95

4.1 4.2

Introduction 95 Frequent cross-border business restructurings implying a centralization of functions, risks and/or assets 97 Should a cross-border business restructuring give rise to the payment of compensation between the restructured entities? 99 Has something of value been transferred from one company to another company? 100 Does the business restructuring involve the termination or the substantial renegotiation of existing arrangements? 104

4.3 4.3.1 4.3.2

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Contents Chapter 5

The substance requirement from a transfer pricing perspective 107

5.1 5.2

The purpose of the substance requirement 107 The determination of whether or not an intercompany transaction is supported by sufficient substance 109 Introduction 109 The substance requirement applied to functions 110 The substance requirement applied to risks 111 The substance requirement applied to assets 112 The substance requirement applied to cross-border business restructurings 112

5.2.1 5.2.2 5.2.3 5.2.4 5.3

Chapter 6

The attribution of profits to permanent establishments 115

6.1 6.2

Introduction – what is a permanent establishment? 115 Background on the attribution of profits to permanent establishments and former principles recommended by the OECD 117 The authorised OECD approach 121 The applicability of the authorised OECD approach 121 Rationale of the authorised OECD approach 123 The functional and factual analysis 125 Introduction 125 Analysis of the functions attributable to a permanent establishment 126 Analysis of the risks attributable to a permanent establishment 126 Analysis of the assets attributable to a permanent establishment 127 Analysis of the rights and obligations arising from transactions with separate enterprises that are attributable to a permanent establishment 128 Analysis of the funding attributable to a permanent establishment 129 The comparability analysis 133

6.3 6.3.1 6.3.2 6.3.3 6.3.3.1 6.3.3.2 6.3.3.3 6.3.3.4 6.3.3.5

6.3.3.6 6.3.4

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Contents Chapter 7

The prevention and the resolution of transfer pricing disputes 135

7.1 7.2 7.2.1 7.2.2 7.2.3 7.3 7.3.1 7.3.2 7.4 7.4.1 7.4.2 7.4.3

Introduction 135 Advance pricing arrangements 138 The purpose of an advance pricing arrangement 138 The different types of advance pricing arrangements 140 The procedure to obtain an advance pricing arrangement 142 Mutual agreement procedures 143 The purpose of a mutual agreement procedure 143 The different steps of a mutual agreement procedure 145 Arbitration 149 Introduction 149 Arbitration in tax treaties 149 The EU arbitration convention 153

List of sources 157 Articles of doctrine and books 157 Other sources 161

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FOREWORD

by prof. M ich a e l L a ng Transfer pricing is an area of international tax which has become more and more important, and an increasing number of highly specialized experts are making their living from using their expertise in this area. Still, the market needs even more specialists who have sufficient skills to solve transfer pricing cases in practice. Therefore, it is extremely important for universities and similar institutions to offer courses on transfer pricing and provide students with the necessary training. The academic institutions of a large number of countries have started to offer such training. However, there has long been a gap in the literature: there are primers on European tax law and tax treaties on the one hand, and there is highly specialized literature on transfer pricing on the other hand. Nevertheless, an introductory book on transfer pricing has been missing so far.

Dr. Jérôme Monsenego has filled this gap by providing students and beginners in practice with an excellent introduction to the topic. Those of us who have been authoring or editing tax books know how tempting it is to write big books with a lot of details, and how difficult it is to write a small book which provides the basic knowledge. Jérôme has managed to deal with this challenge and resisted going into all the details (although he definitely would be the expert to do this and has shown that on several occasions).

Academics who run courses in the area of transfer pricing now really have a book they can recommend to their students without feeling that they are demanding too much of them. If students read this book when they register for a transfer pricing class they will be excellently prepared. The same is

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Foreword

true for tax practitioners who want to become familiar with transfer pricing issues. Therefore, I am really confident that this book, which has long been awaited by the transfer pricing community, will be very well received.

Michael Lang Professor, Institute for Austrian and International Tax Law, WU Vienna

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PREFACE

I would like to thank Prof. Bertil Wiman, Prof. Mattias Dahlberg, Prof. Hugh Ault, Ass. Prof. Jan Bjuvberg, and Ida Larsson for their invaluable feedback on an earlier draft of this book. I am also thankful to the Uppsala Center for Tax Law, a research foundation supported by Deloitte, Ernst & Young, KPMG, Mannheimer Swartling, PwC and Skeppsbron Skatt (Taxand), for the financial support it provided to this book project.

My primary objective when writing this book was to introduce transfer pricing to students and practitioners in an educational way, in particular through relying on examples and concrete explanations of transfer pricing principles. I found the need for such a book when teaching transfer pricing and hope to receive feedback from students, teachers, and practitioners with different national backgrounds, as such feedback would greatly contribute to future editions of this book. Comments are therefore most welcome and may be sent to jerome.monsenego@jur.uu.se This book takes into account the legal developments up to 31 July 2013.

Jérôme Monsenego Stockholm, 1 October 2013

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To Liv and Axel

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INTRODUC TION

Transfer pricing is an area of tax law that has significantly expanded over the last few decades. This is partly explained by the globalization of business activities: enterprises are getting more global to reach new markets and make their organization more efficient. Another reason is related to the tax planning opportunities that are made possible through cross-border controlled transactions, something that States are willing to monitor so as to avoid the illegitimate erosion of their national tax base. The focus on transfer pricing has also amplified during recent years as States are under pressure to levy taxes to reduce their public deficits, which increases the risks of double taxation for multinational enterprises. Consequently, transfer pricing has become a key question for multinational enterprises and tax administrations.

Introduction to transfer pricing has a twofold purpose. First, it intends to provide a general introduction to the fundamentals of transfer pricing from the perspective of the recommendations issued by the OECD.1 Given the breadth and the complexity of this discipline, only the key principles necessary to understand transfer pricing are dealt with in this book. Also, the connection between transfer pricing and other areas of tax law is outside the scope of this book.2 Second, it intends to illustrate the fundamentals of transfer pricing by concrete examples, together with the tax planning or risk mitigating aspects that may be considered by multinational enterprises and that need to be monitored by tax administrations.

1 Although domestic laws, the various wordings of tax treaties, and the views of organizations other than the OECD are outside the scope of this book, references to such sources are made occasionally to illustrate certain differences with the recommendations of the OECD. 2 In particular corporate income taxation, value-added taxation and customs duties, although connected to transfer pricing, are outside the scope of this book.

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Introduction

This book is divided into the following chapters: Chapter 1 The key to understanding transfer pricing: the arm’s length

principle Chapter 2 The transfer pricing methods recognised by the OECD

Guidelines Chapter 3 Transfer pricing models Chapter 4 Cross-border business restructurings Chapter 5 The substance requirement from a transfer pricing

perspective Chapter 6 The attribution of profits to permanent establishments Chapter 7 The prevention and the resolution of transfer pricing disputes

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ABBREVIATIONS

The following abbreviations are used throughout the book: APA

Advance pricing arrangement Base erosion and profit shifting CCA Cost contribution arrangement CCCTB Common consolidated corporate tax base COGS Cost of goods sold CUP Comparable uncontrolled price EU European Union IT Information technology OECD Guidelines OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 2010 OPEX Operating expenses Para.

Paragraph R&D Research and development TNMM Transactional net margin method UN United Nations BEPS

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C HAP T E R 3

Transfer pricing models

The purpose of this chapter is to present certain common types of intercompany transactions and describe the transfer pricing models applicable to these transactions, together with their implications from a tax planning perspective.

This is done through following a typical series of steps throughout the value chain of a multinational enterprise (3.3). Before presenting these transfer pricing models, some introductory remarks are made on the advantages and drawbacks of applying standardised transfer pricing models (3.1) as well as on transactions involving intangibles (3.2).

3.1 Introductory

pricing models

remarks on standardised transfer

Although each intercompany transaction may have unique features, the value chain of multinational enterprises often includes intercompany transactions related to certain typical business activities such as R&D, manufacturing, or distribution. Multinational enterprises and tax administrations tend to follow certain standardised transfer pricing models for setting the prices of such intercompany transactions depending on how they are structured, i.e. with regard to the way functions, risks and assets are attributed to each party to a transaction. “Standardised transfer pricing models” does not refer to the transfer prices or profit margins but rather to the transfer pricing methodology applied to a given intercompany transaction. However, in certain situations, a range of profit margins applied to a certain standardised

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transfer pricing model may also be determined in advance,1 thus constituting a safe harbour.2 Applying standardised transfer pricing models has both advantages and drawbacks. Setting transfer prices according to certain standardised models may enhance the legal certainty, both for tax administrations and for multinational enterprises. That is, both tax administrations and multinational enterprises may be used to certain transfer pricing models, something that may mitigate tax controversies and thereby risks of double taxation or risks of illegitimate erosion of the tax base. Also, standardised transfer pricing models may be useful to mitigate the administrative burden put on tax administrations and multinational enterprises. On the other hand, a shortcoming of standardised transfer pricing models is the more or less automatic way according to which transfer prices may be set. This tends to associate intercompany transactions with certain transfer pricing models without necessarily performing a sufficiently thorough analysis, something that may leave little room for dividing the profits (or the losses) of a multinational enterprise as closely as possible to the way independent enterprises would.3 However, despite the drawbacks of standardising the setting of transfer prices according to commonly used transfer pricing models, this approach is still connected to the business reality of a multinational 1 An example is the 5 % profit mark-up for low value-adding services suggested by the EU Joint Transfer Pricing Forum: see COM(2011) 16 final, Communication from the Commission to the European Parliament, the Council and the European Economic and Social Committee on the work of the EU Joint Transfer Pricing Forum in the period April 2009 to June 2010 and related proposals 1. Guidelines on low value adding intra-group services and 2. Potential approaches to non-EU triangular cases, 25 January 2011, para. 65. It can be observed that this Communication from the European Commission has been endorsed by the Council of the European Union: see 3088th Economic and Financial Affairs Council meeting, Brussels, 17 May 2011.

2 In the transfer pricing context, safe harbours refer to the possibility of knowing in advance the way a given intercompany transaction should be priced. By meeting the requirements of a safe harbour, taxpayers may benefit from the certainty that intercompany prices are at arm’s length. Safe harbours may be granted on a unilateral, bilateral, or multilateral basis. In certain cases the use of safe harbours is encouraged by the OECD Guidelines (see OECD, Revised section E on safe harbours in chapter IV of the transfer pricing Guidelines, 16 May 2013, para.

4.93 to 4.122).

3 On the need to avoid too automatic approaches see OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 120. It is important to emphasise that this document is only a discussion draft, i.e. the view of the OECD may be amended before chapter 6 of the OECD Guidelines is finalised.

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enterprise thanks to relying on a functional analysis. Also, the arm’s length principle inherently implies some level of approximation.4 This is why such standardised transfer pricing models are commonly applied in practice.

Consequently, although it is important to be cautious when using standardised transfer pricing models, the advantages of this approach may, in certain situations, outweigh its drawbacks.

3.2 Intercompany

transactions involving intangibles

Intangible property is one of the most valuable aspects of a business.5 Indeed, an end-customer often purchases a product or service due to aspects connected to intangible property such as a product’s design or name. Since intangibles are closely linked to the creation of value (and thus to the earning of income and the payment of taxes), it is central for transfer pricing purposes to take into account the intangibles owned by a group when determining the transfer prices of cross-border intercompany transactions. Therefore, the consideration of intangibles is crucial, whether intangibles are part of a transaction involving the transfer of goods or services,6 or are subject to a specific intercompany transaction.7 The OECD has issued particular recommendations when it comes to intangibles.8 This guidance is currently being reviewed and will be updated

4 In this respect, the OECD Guidelines emphasise that transfer pricing is not an “exact science”: see para. 1.13, 3.55, 4.8 and 8.3 of the OECD Guidelines.

5 See Toshio Miyatake, General Report, Cahiers de droit fiscal international, Volume 92a, Transfer pricing and intangibles, 2007, p. 19; see also Isabel Verlinden and Yoko Mondelaers, Transfer pricing aspects of intangibles: at the crossroads between legal, valuation and transfer pricing issues, International Transfer Pricing Journal, January/February 2010, p. 49.

6 For example, the price of the goods sold by a fully-fledged manufacturer to its distributor includes a part that is related to the intangibles or the rights in intangibles that are owned by the manufacturer. When intangibles are part of a transaction involving the transfer of goods or services, the OECD refers to transactions involving the use of intangibles (see OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 122 to 124).

7 That would be the case when an intangible is sold or licensed to an associated enterprise.

When intangibles are subject to a specific intercompany transaction, the OECD refers to transactions involving the transfer of intangibles (see OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 106 to 121).

8 See chapter 6 of the OECD Guidelines.

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in the near future.9 The OECD revised discussion draft on the transfer pricing aspects of intangibles recommends defining and identifying intangibles that are used or transferred between associated enterprises, as it is indeed necessary to first identify the possible existence of intangibles before assessing their consequences for transfer pricing purposes. To that end, the OECD proposes a broad definition of intangibles that is particular to the field of transfer pricing: intangibles are defined in the revised discussion draft as “something which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances”.10 Therefore, for transfer pricing purposes, although one may take into account other definitions of intangibles such as definitions for legal or accounting purposes,11 it is first and foremost the transfer pricing definition that should be used.12 Once an intangible has been identified, the next step consists in identifying the parties entitled to the return attributable to the intangible upon the use or transfer of the intangible, assuming such a return exists. As with other transfer pricing issues,13 the starting point consists in analysing the existing 9 See OECD, Revision of the special considerations for intangibles for chapter 6 of the OECD transfer pricing guidelines and related provisions, 6 June to 14 September 2012; see also OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013.

10 See OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 40. It is important to emphasise the requirement of ownership or control contained in this definition, which distinguishes intangibles from other circumstances that may influence transfer prices without being owned or controlled by a company (e.g. the presence of competitors on a market, or group synergies that do not derive from specific actions of associated enterprises).

11 Such definitions indeed provide an indication as to whether or not a company may own intangible property. For example, an intangible asset may be recorded on the balance sheet of a company. Another example is the situation where a company has registered a patent. These examples, which indicate that an intangible may exist for transfer pricing purposes, are only indicative: an intangible asset for legal or accounting purposes does not necessarily result in an intangible for transfer pricing purposes, and, conversely, an intangible for transfer pricing purposes is not necessarily recognised for legal or accounting purposes.

12 This is consistent with the substance-over-form principle, i.e. irrespective of the form (in this case legal agreements, patent registrations, assets being registered – or not – on the balance sheet and being attributed a certain value, etc.), substance (in this case identifying parties owning or using an intangible for transfer pricing purposes) prevails.

13 See particularly para. 1.48, 1.52, 1.62, 9.11, 9.13 to 9.16, 9.34, and 9.170 of the OECD Guidelines. See also chapter 5 of this book.

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legal registrations and contractual arrangements.14 However, although legal registrations or contractual arrangements may entitle a party to the return on certain intangibles,15 such a return should not necessarily be relevant from a transfer pricing perspective. Therefore, an analysis of the substance of the transactions involving an intangible should be performed in any case.16 In other words, the substance of transactions involving an intangible, as revealed by a functional analysis, ultimately determines the parties entitled to the return attributable to the intangible.17 In some situations it is clear which party should be entitled to the return attributable to an intangible.18 However, functions, risks or costs may be spread between two or more parties, something that raises the issue of which company(ies) should be entitled to the return attributable to an intangible, and if so to what extent.19 Although the OECD works on providing guidance in that respect,20 entitlement to the return attributable to an intangible is a 14 On the recommendations of the OECD to start a transfer pricing analysis by examining the existing contractual arrangements (i.e. the legal form), see para. 1.64 and 9.11 of the OECD Guidelines. See also OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 67.

15 This is the case for example when a copyright is registered; the party owning the copyright is entitled both to legal protection and to the revenues that are related to the copyright.

16 That is, whether or not there are legal registrations or contractual arrangements that entitle a party to the return attributable to an intangible.

17 See particularly OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 73, where it is referred to the contributions made to the value of intangibles through the functions performed, assets used, and risks assumed.

18 This would be the case when a company designs and controls a research and development programme, performs the actual research and development activities, supports all the costs related to such activities, and owns the legal rights to the intangibles developed through the research and development.

19 There may indeed be several companies that are entitled to the return attributable to an intangible. This could be the case when two or more companies have been involved in activities resulting in intangibles, for example by sharing functions, risks and costs as part of a cost contribution arrangement.

20 See OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, particularly para. 65 to 103. The OECD emphasises primarily the need to control the development, enhancement, maintenance and protection of the intangible (this is particularly relevant when functions related to an intangible have been outsourced to an associated enterprise or a third party), the need to perform certain important functions, the need to bear and control the risks and costs related to developing and enhancing the intangible, as well as the need to bear and control risks and costs associated with maintaining and protecting a company’s entitlement to the return attributable to an intangible. The lack of one or more of these criteria is likely to preclude a full entitlement to the return attributable to the intangible: →

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difficult issue that often gives rise to disagreements between multinational enterprises and tax administrations.

The way a transaction involving intangibles is priced may vary widely depending on the circumstances. In certain cases the transfer price of goods or services already includes a part corresponding to the return attributable to the intangible, in which case the intangible may not need to be priced separately. Let us illustrate this by an example: Example: the transfer price of goods or services already includes a part corresponding to the return attributable to the intangibles A parent company acts as an entrepreneur and performs research and development, manufacturing, as well as key management functions, while selling goods to a buy/sell distributor. The buy/sell distributor will often be considered as a tested party and, irrespective of the transfer pricing method applied (e.g. the CUP, the resale price method, or the TNMM), the profits earned by the entrepreneur after selling the goods to the distributor will include a part that is related to the intangibles. In this case there is no separate pricing for the intangibles, as the entrepreneur receives the return attributable to the intangibles through the profits made on the sale of goods to the distributor.

In other cases a transaction may relate specifically to an intangible, thus requiring a particular pricing of this transaction. This is illustrated below: Example: an intercompany transaction involves the transfer of an intangible through a parent company licensing a patent to its manufacturing subsidiary A parent company owns a patent that its manufacturing subsidiary needs to use. The parent company does not want to sell the patent for example, if certain strategic functions are performed by company A while some risks are controlled and financially borne by company B, entitlement to the return attributable to the intangible is likely to be divided between companies A and B. In such situations the profit split method may be the only transfer pricing method that correctly reflects the fact that functions, risks and costs associated with intangibles are divided between two or more companies. The way such functions, risks and costs are split between the companies is likely to lay the basis for determining which profits (or losses) should be split, as well as how such profits (or losses) should be split.

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because it is needed in other areas of the business. Therefore, the parent company lets its subsidiary use the patent in exchange for the payment of a license fee. This is a transaction involving solely an intangible and needs to be priced as such.

When setting a transfer price for a transaction involving intangibles, any of the transfer pricing methods recognised in the OECD Guidelines may be applicable.21 In certain cases it may also be useful to perform a valuation of intangibles or rights in intangibles, for example when an intangible is sold between two associated enterprises. The OECD is working on providing guidance in that respect, particularly with regard to the valuation of future cash flows attributable to an intangible.22 In any case the OECD puts strong emphasis on the comparability requirement and provides examples of criteria that may be taken into account to assess comparability and possibly adjust transfer prices for transactions involving intangibles.23 The intercompany transactions and transfer pricing models described below may involve the use or the transfer of intangibles to different extents.

3.3 Common

types of intercompany transactions and transfer pricing models

The most common types of intercompany transactions and transfer pricing models are described hereunder. This is done through following a typical series of steps throughout the value chain of a multinational enterprise involving research and development (3.3.1), manufacturing (3.3.2), and distribution 21 In practice the methods used most frequently in relation to the transfer of intangibles are the CUP method (for example for determining license fees charged by the owner of an intangible) and the profit split method (for example in order to share the return attributable to an intangible when several parties together own such an intangible): see OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 163.

22 See chapter 6 of the OECD Guidelines and OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 175 to 196. See also Jens Wittendorff, Valuation of intangibles under income-based methods – part I, International Transfer Pricing Journal, September/October 2010, pp. 323–335; Jens Wittendorff, Valuation of intangibles under incomebased methods – part II, International Transfer Pricing Journal, November/December 2010, pp.

383–401. The valuation of intangibles is outside the scope of this book.

23 See OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 134 to 148.

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(3.3.3). In addition, intercompany services (3.3.4), financial transactions (3.3.5), and cost contribution arrangements (3.3.6) are also touched upon, followed by a description of the centralized entrepreneur model frequently used in practice to centralize functions, risks, and assets (3.3.7).

In any case, as a consequence of the substance-over-form principle, it is important to underline that transfer prices should not be determined on the basis of the terminology describing a certain transfer pricing model, but on the basis of the outcome of a comprehensive analysis including a functional analysis and a comparability analysis.24 3.3.1 RESEARCH AND DEVELOPMENT

From a transfer pricing perspective, there are two main types of research and development activities, depending on which party is considered as the owner of the intangibles for transfer pricing purposes.

The possible ownership of intangibles results from the combination of performing the important functions25 and assuming the relevant risks26 in relation to the research and development activities. As a consequence of an entity performing such functions and assuming such risks, the intangible that may result from the research and development activities will – for transfer pricing purposes – be owned by this entity, something that entitles it to the return attributable to the intangible. If this company also performs the very research and development activities, thus being responsible for the 24 See para. 9.133 of the OECD Guidelines, and OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 36.

25 See OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 79. This paragraph provides the following examples of such important functions: “design and control of research and marketing programmes, management and control of budgets, control over strategic decisions regarding intangible development programmes, important decisions regarding defence and protection of intangibles, and ongoing quality control over functions performed by independent or associated enterprises that may have a material effect on the value of the intangible”. Other functions may be outsourced, as long as the control over such functions is kept by the party claiming the return attributable to the intangible (see OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 80).

26 The relevant risks could for example consist in supporting the full costs of a research and development project, assuming the consequences if the project fails, and being liable to the end-customers if the product is flawed: see OECD, Revised discussion draft on transfer pricing aspects of intangibles, 30 July 2013, para. 85 to 88.

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3 Transfer pricing models

whole chain of research and development, it may be described for transfer pricing purposes as a fully-fledged researcher.

On the other hand, an entity executing research and development activities on behalf of another entity, which performs the important functions and assumes the relevant risks, will normally not own the intangible that may be created by the research and development activities. Such an entity is often referred to as a contract R&D, when it performs research and development activities on a contractual basis, and on behalf of a principal which performs the important functions and assumes the risks related to the research and development activities.27 The researcher would then act as a service provider,28 and be remunerated accordingly.29 In this respect, the OECD Guidelines indicate that the cost plus method may be an appropriate method to remunerate a researcher that does not own valuable intangibles,30 if the CUP method is not applicable.

From a tax planning perspective, multinational enterprises may be tempted not to have the return attributable to intangibles subject to a high corporate income tax rate, particularly when the intangibles give rise to significant profits. At the same time, a multinational enterprise may wish to carry out its research and development activities in a country that may be a high-tax jurisdiction, for example when qualified labour force is located there. In principle, a separation between the performance of the very research and development activities and the taxation of the return attributable to the intangibles may be achieved, through properly applying the OECD 27 It is important to emphasise that a contract R&D may own other intangibles than the ones connected to the outcome of the research and development activities. That would for example be the case of a contract R&D that develops valuable know-how by providing services to the company acting as principal.

28 The services consist in the research and development that is carried out on behalf of the principal.

29 The remuneration takes into account the fact that the contract R&D normally supports limited risks, while more significant risks are supported by the principal. Therefore, the transfer prices applied between the principal and the contract R&D should limit the exposure of the contract R&D to the profits or losses of the research and development activities, unlike the principal which should be exposed to the outcome of these activities. However, it is important to emphasise that even if an entity is characterized as a contract R&D, the transfer prices will still depend on the functions it performs, the risks it assumes, and the assets it owns or uses.

30 See e.g. para. 2.55 of the OECD Guidelines.

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Introduction to Transfer Pricing Transfer pricing is an area of tax law that has significantly expanded over the last decades. With the globalization of business activities, the threat of international double taxation, and the need for States to monitor transfer prices to avoid the illegitimate erosion of their tax base, transfer pricing has become a key question for multi­ national enterprises and tax administrations.

Introduction to Transfer Pricing provides a general overview on the fundamentals of transfer pricing from an OECD perspective.

The book also illustrates the fundamentals of transfer pricing with concrete examples based on the structures often used by multi­ national enterprises when entering into cross-border intercompany transactions.

Jérôme Monsenego | Introduction to Transfer Pricing

Dr. Jérôme Monsenego teaches tax law at the University of Uppsala and is a tax lawyer with PwC in Stockholm.

Introduction to

Transfer Pricing

Introduction to Transfer Pricing is primarily addressed to students reading international tax courses, but may also be of use to tax professionals in matters pertaining to transfer pricing.

Art.No 37764

Jérôme Monsenego

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