As explained in my previous publications on Transfer Pricing (TP), to determine a desirable price for the exchange, sale or transfer of goods or services between and among persons in a controlled relationship which meets the arm’s length principle, there are series of activities that a taxpayer is required to undertake to price its controlled transactions. This article sets out the broad activities and processes required in the determination of a transfer price which satisfy the arm’s length principle.
- Identifying the commercial or financial relations
To commence the whole analysis, one must understand the commercial or financial relationship between the associated enterprises and the conditions and economically relevant circumstances attached to those relations. A broad-based understanding of the industry and sector in which the Multination Enterprise (MNE) group operates – e.g., mining, pharmaceutical, telecom, banking – and of the factors affecting the performance of any business operating in that sector. The understanding is derived from an overview of the particular MNE group which outlines how the MNE group responds to the factors affecting performance in the sector, including its business strategies, markets, products, its supply chain, critical success factor, and the key functions performed, assets employed, and important risks assumed.
The process then narrows to identify how each entity within that MNE group operates and provides an analysis of what each entity does – e.g., production, marketing, sales, procurement, R&D – and identifies its commercial or financial relations with associated enterprises as expressed in the transactions between them. The analysis seeks to identify the commercial or financial relations between the associated enterprises and the conditions and economically relevant circumstances attached to those relations in order for the controlled transaction to be accurately delineated, and to compare the conditions and the economically relevant circumstances of the controlled transaction as accurately delineated with the conditions and the economically relevant circumstances of comparable transactions between independent enterprises.
2. Functional analysis
In transactions between two independent enterprises, compensation will usually reflect the functions that each enterprise performs, considering assets used and risks assumed. Therefore, in delineating the controlled transaction and determining comparability between controlled and uncontrolled transactions, a functional analysis is necessary. The functional analysis seeks to identify the economically significant activities and responsibilities undertaken, assets used or contributed, and risks assumed by the parties to the transactions. Allocation of cost or revenue from the arrangement should be done in accordance with the functions performed by the parties to the arrangement. While one party may provide a large number of functions relative to that of the other parties to the transaction, it is the economic significance of those functions in terms of their frequency, nature, and value to the respective parties to the transactions that is important. Analysis of risk in the commercial or financial relations is a key activity required to determine the appropriate reward for material risk assumed by parties in arrangements. There are many definitions of risk, but in a transfer pricing context, it is appropriate to consider risk as the effect of uncertainty on the objectives of the business.
Controlled transactions should be accurately delineated during the functional analysis to identify the substance of the commercial or financial relations between the parties, and will have accurately delineated the actual transaction by analysing the economically relevant characteristics. In performing the analysis, the actual transaction between the parties will have been deduced from written contracts, email exchanges, and the conduct of the parties. Formal conditions recognised in contracts will have been clarified and supplemented by analysis of the conduct of the parties and the other economically relevant characteristics of the transaction. Where the characteristics of the transaction that are economically significant are inconsistent with the written contract, then the actual transaction will have been delineated in accordance with the characteristics of the transaction reflected in the conduct of the parties.
3. Transfer pricing methods
There are five generally accepted TP methods recognised by OECD and UN as adopted by our local legislation (LI 2412). Any of the five methods is appropriate and no method is superior to the other; however, we are enjoined to choose the method which provides the most appropriate outcome in the circumstances under consideration. The methods have been classified into two main categories as ‘Traditional transaction methods’ and ‘Transactional profit methods’. Traditional transaction methods are the Comparable Uncontrolled Price Method (CUP method), the Resale Price Method, and the Cost-Plus Method while the transactional profit methods are the Transactional Net Margin Method (TNMM) and the Transactional Profit Split Method. By the permission of the Commissioner-General, any other method can be used if it gives a better outcome than any of the five afore-mentioned methods.
The method selection process should take into account the respective strengths and weaknesses of the five recognised methods; the appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis; the availability of reliable information – in particular on uncontrolled comparables – needed to apply the selected method and/or other methods; and the degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them.
4. Comparability analysis
In the comparability analysis, a distinction is made between internal and external comparables. Internal comparables are comparable transactions which the investigated entity (tested party) enters with unrelated parties while external comparables are comparable transactions which are entered between two unrelated parties. In internal comparables, the information is present in the administration of the tested party, whereas for external comparables, data in the public domain should be sought for comparison with the tested party. External comparables are usually found in commercial databases which collect a lot of corporate financial data.
For the identification of the external comparables, two main types of identification are recognised in the OECD guidelines. The first method is additive approach; this consists of drawing up a list of potentially comparable companies, such as the taxpayer’s competitors. And the second method is the deductive approach, which starts with a wide set of companies operating in the same sector, using domestic or international databases. The main criteria when creating the list of potentially comparable companies from the database in the benchmarking studies of companies are: independence, date of incorporation, available financial statements in last 3–5 years, activities, geographic market, industry screening, revenues, number of employees, etc.
Despite the search process carried out, the conclusion must sometimes be drawn that not enough reliable comparables can be found. It then depends on the facts and circumstances to guide what should be done. Sometimes it may be decided to broaden the search by also looking at, for example, slightly different geographical markets or to search for activities in a comparable industry or sector. In doing so, the effects on the reliability of the data must always be considered, and a very critical attitude is necessary.
5. Comparability adjustments and arm’s-length range
Rarely will it be possible, on the basis of the comparability analysis, to set a single price that is reliable enough to be considered the arm’s-length price. If the reliability of the various comparables differs, the less reliable comparables should be eliminated. The remaining comparables should have a comparable reliability. The OECD Guidelines note that, in principle, any value within the range satisfies the arm’s-length principle. If, on the other hand, it is possible to identify a point within the range that best matches the facts and circumstances of the controlled transaction in question, the adjustment should be made up to that point. If there are imperfections in the construction of the range, the OECD considers that there is a case for using a statistical method to establish the point. For example, the median, the mean, the weighted average, or Interquartile range can be employed.
Since it’s practically difficult to find a party which is totally comparable to the tested party in every aspect of measurement, adjustments are sometimes required to align areas where material deviation is identified between the comparable parties through the use of comparability adjustments to restore either party to the same level with the tested party. Different comparability adjustments can be made. Adjustments can be made because of the different reporting rules. In addition, adjustments regularly occur as a result of differences in functions, assets and risks. The OECD explicitly warns that comparability adjustments should not be applied automatically if it remains uncertain whether the adjustments would lead to a better comparable outcome.
6. TP documentation and reporting
The crown jewellery activity of taxpayers and tax practitioners on TP activity is the compilation of documentation on activities leading to the determination of the transfer price to prove that the price chosen meets the arm’s length principle. TP documentation requirements can differ per jurisdiction; but in general, the keeping of contemporaneous documentation is required and serves the importance outlined as follows:
a) To ensure that taxpayers consider transfer pricing requirements in establishing prices and other conditions for transactions between associated enterprises and in reporting the income derived from such transactions in their tax returns.
b) To provide tax administrations with the information necessary to conduct an informed transfer pricing risk assessment.
c) To provide tax administrations with useful information to employ in conducting an appropriately thorough audit of the transfer pricing practices of entities subject to tax in their jurisdiction, although it may be necessary to supplement the documentation with additional information as the audit progresses.
Various documents on TP are expected to be filed by taxpayers with tax authorities. In Ghana, taxpayers who are subject to TP are expected to file on an annual basis a TP return, Local file, and Master file. In addition to the three returns afore-mentioned, when the total annual revenue of the MNE group exceeds GH¢2.9billion, then the ultimate parent entity is expected to file a Country-by-country report (CbCr).
Conclusio
From the forgoing, it’s evidenced that the process in arriving at the arm’s length price requires highly methodical activities which MNEs and parties in controlled relationship are expected to follow to ensure that their controlled transactions satisfy the ALP, and they ultimately meet the TP legislative requirements of their jurisdiction.
This series of articles is my contribution to tax literacy in Ghana as a professional tax practitioner in the discharge of my duties as a Ghanaian citizen who seeks the success of Ghana. The next edition will be on function, assets and risk (FAR) analysis.
Reference is made from the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, local laws, and other sources.
The author is a Chartered Tax Practitioner, a member of ICAG and a member of the Chartered Institute of Taxation Ghana.
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