The arm`s length approach, which is internationally accepted as the preferred basis for determining the transfer price of a transaction between associated persons, will be the basis adopted by IRBM. This is consistent with the objective of minimizing the possibility for double taxation. According to the arm's length principle, a transfer price is acceptable if all transactions between associated parties are conducted at arm's length price. Arm's length price is the price which would have been determined if such transactions were made between independent entities under the same or similar circumstances.
The arm`s length principle is stated in paragraph 1 of Article 9 of the OECD Model Tax Convention as:
" Where ... conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly."
When associated persons enter into a transaction, the element of control which one party has over the other may exist. Under this circumstance, bargaining power rarely comes into play. Unlike independent companies, multinational corporation group or multinational enterprises (hereinafter referred to as an "MNE Group") usually operate based on its own set of conditions which normally do not reflect the market forces. While independent enterprises are concerned with maximizing individual profits, by aiming for the lowest costs and highest returns, an MNE Group is concerned with overall group profits which may result in unequal distribution of profits within the group.
An example to illustrate the difference between controlled and uncontrolled transactions is as follows:
Company A purchases raw material to make furniture. Under an arm's length transaction, Company A would make the best effort to obtain its raw material at the lowest price possible in order to minimise its costs and maximise its profits. This will entail extensive bargaining between Company A and its suppliers.
However, in a controlled transaction, there usually exist elements of control that dictate the price and manner in which raw material is to be purchased. The likelihood of bargaining for the best price is minimal, and Company A may be expected to accept the price as dictated by its controlling entity. It is not impossible to witness prolonged losses in cases like Company A that has little say in the price it is willing to pay for raw material.
In essence, the application of the arm`s length principle:
(a) treats associated persons as not dealing at arm`s length and as if they operate as separate entities rather than as inseparable parts of a single unified business; and
(b) is generally based on a comparison of:
(i) prices, margins, division of profits or other indicators of controlled transactions; with
(ii) prices, margins, division of profits or other indicators of uncontrolled transactions.
CHAPTER II - THE ARM`S LENGTH PRINCIPLE
The application of the arm's length principle will mainly focus on achieving the transfer pricing outcomes that is in line with value creation by:
(a) ensuring that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or has provided capital, but align returns with value creation; and
(b) identifying circumstances in which transactions can be re-characterized.
The taxpayer need to ensure that:
(a) actual business transactions undertaken by them are identified, and transfer pricing is not based on contractual arrangements that do not reflect economic reality;
(b) contractual allocations of risk are respected only when they are supported by actual decision-making;
(c) capital without functionality will generate no more than a risk-free return, assuring that no premium returns will be allocated to cash boxes without relevant substance; and
(d) their transaction has commercial rationality and IRBM may disregard transactions when the exceptional circumstances of commercial irrationality apply.
The application of the arm's length principle is based on a comparison of the conditions in a controlled transaction with the conditions that would have been made had the parties been independent and undertaking a comparable transaction under comparable circumstances (comparability analysis). There are two key aspects in such an analysis:
(a) to identify the commercial or financial relations between the associated persons and the conditions and economically relevant circumstances attaching to those relations, in order for the controlled transaction to be accurately delineated; and
(b) 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 persons.
Identifying the commercial and financial relations
The typical process of identifying the commercial or financial relations between the associated persons and the conditions and economically relevant circumstances attaching to those relations requires:
(a) a broad-based understanding of the industry sector (e.g. mining, pharmaceutical, luxury goods) in which the associated persons operates and the factors affecting the performance of any business operating in that sector. The understanding is derived from an overview of that particular MNE Group which outlines how they respond to the factors affecting performance in the sector, including its business strategies, markets, products, its supply chain, the key functions performed, material assets used, and important risks assumed. This information shall be provided by the taxpayer in support of the taxpayer's analysis of its transfer pricing and provides useful context regarding the commercial or financial relations between members of the MNE Group.
(b) identificatioan of how each MNE operates within the group, analysis of each MNE's activities (e.g. a production company, a sales company) and identification of its commercial or financial relations expressed in transactions between them. The accurate delineation of the actual transactions between the associated persons requires analysis of the economically relevant characteristics of the transaction.
Economically Relevant Characteristics/ Comparability Factors
The economically relevant characteristics or comparability factors that need to be identified in the commercial or financial relations between the associated persons, in order to accurately delineate the actual transaction can be broadly categorised as follows:
(a) the contractual terms of the transaction;
(b) the functions performed by each of the associated persons to the transaction, taking into account assets used and risks assumed, including how those functions relate to the wider generation of value by the group to which the persons belong (such as an MNE Group), the circumstances surrounding the transaction, and industry practices;
(c) the characteristics of property transferred or services provided;
(d) the economic circumstances of the associated persons and of the market in which the associated persons operate; and
(e) the business strategies pursued by the associated persons.
A comparability analysis is a pre-requisite in the application of all transfer pricing methods that conform to the arm's length principle. This involves comparing conditions in a controlled transaction with those in an uncontrolled transaction.
A controlled transaction in a comparability analysis is the transaction that has been identified as the transaction where pricing may not be at arm's length. An uncontrolled transaction may be:
(a) a transaction between the tested party and an independent party conducted under terms and circumstances similar to the controlled transaction (internal comparable); or
(b) a transaction between two independent parties under similar terms and circumstances (external comparable).
An uncontrolled transaction is deemed comparable if the economically relevant characteristics or comparability factors identified in the commercial or financial relations (as mentioned in paragraph 2.2.5) of that transaction with that of a controlled transaction are sufficiently similar.
Where there are differences between an uncontrolled transaction and a controlled transaction, the following conditions must be met in order to be deemed comparable:
(a) none of the differences between the transactions being compared or between the enterprises undertaking those transactions could materially affect the price or cost charged or paid or the profits arising from those transactions in an open market; or
(b) reasonably accurate adjustments can be made to eliminate the material effects of such differences.
Contractual terms of the transaction
A transaction is the consequence or expression of the commercial or financial relations between the parties. Where a transaction has been formalized by the associated persons through written contractual agreements, those agreements provide the starting point for delineating the transaction between them and how the responsibilities, risks, and anticipated outcomes arising from their interaction were intended to be divided at the time of entering into the contract.
The terms of a transaction may also be found in communications between the parties other than a written contract. The written contracts alone are unlikely to provide all the information necessary to perform a transfer pricing analysis. As such, further information will be required by taking into consideration evidence of the commercial or financial relations provided by the economically relevant characteristics in the other four categories (see paragraph 2.2.5). Taken together, the analysis of economically relevant characteristics in all five categories provides evidence of the actual conduct of the associated persons. The following example illustrates the concept of clarifying and supplementing the written contractual terms based on the identification of the actual commercial or financial relations.
Company P is the parent company of an MNE Group situated in Country P. Company S, situated in Country S, is a wholly-owned subsidiary of Company P and acts as an agent for Company P's branded products in Country S market. The agency contract between Company P and Company S is silent about any marketing and advertising activities in Country S that the parties should perform. Analysis of other economically relevant characteristics and in particular the functions performed, determines that Company S launched an intensive media campaign in Country S in order to develop brand awareness. This campaign represents a significant investment for Company S.
From the example above, the characteristics of the transaction that are economically relevant are inconsistent with the written contract between the associated persons. Therefore, the actual transaction that should be delineated for purposes of the transfer pricing analysis is as per the conduct of the parties.
In transactions between independent parties, the divergence of interests between the parties ensures that contractual terms concluded reflect the interests of both parties and will ordinarily seek to hold each other to the terms of the contract. The contractual terms will be ignored or modified if it is not in the interests of both parties. However, the same divergence of interests may not exist in the case of associated persons, or any such divergences may be managed in ways facilitated by the control relationship and not solely or mainly through contractual agreements.
Therefore, it is important to examine whether the arrangements reflected in the actual conduct of the parties substantially conform to the terms of any written contract, or whether the associated persons' actual conduct indicates that the contractual terms have not been followed, or do not reflect a complete picture of the transactions, or have been incorrectly characterized or labelled by the persons, or are a sham.
Where there are material differences between contractual terms and the conduct of the associated persons in their relations with one another, such as the functions they actually perform, the assets they actually use, and the risks they actually assume, considered in the context of the contractual terms, IRBM has the right, based on the factual substance, to accurately delineate the actual transaction.
Functional Analysis of Functions Performed, Risks Assumed and Assets Employed
In transactions between two independent persons, compensation usually will reflect the functions that each person performs (taking into account assets used and risks assumed). Therefore, in delineating the controlled transaction and determining comparability between controlled and uncontrolled transactions or entities, a functional analysis is necessary. This 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. The analysis focuses on what the parties actually do and the capabilities they provide.
For this purpose, the structure and organization of the associated persons and how they influence the context in which the MNE operates must be explained, in particular, how value is generated by the group as a whole, the interdependencies of the functions performed by the associated persons with the rest of the group, and the contribution that the associated persons make to that value creation.
Similarity in product characteristics is more relevant when comparing prices than profit margins between controlled and uncontrolled transactions. Comparison of product characteristics is used to a greater extent in the application of the Comparable Uncontrolled Price (CUP) method than any other method. Characteristics that are compared should include:
Arm's length prices vary across different economic circumstances. Factors that may affect the price or margin of a transaction include:
Comparability adjustment is an important element of comparability analysis that, when applied appropriately, enhances the accuracy and reliability of comparison. Differences between the transaction of the comparable and that of the tested party must be identified and adjusted for, in order for the comparable to be useful as basis for determining the arm's length price.
Comparability adjustments are intended to eliminate the effects of differences that may exist between situations being compared and that which could materially affect the condition being examined in the methodology (e.g. price or margin). Logically, comparability adjustments should not be performed to correct differences that have no material effect on the comparison. Thus, these adjustments are neither routine nor mandatory in a comparability analysis; rather, improvements to comparability should be shown when proposing an adjustment. Comparability adjustments include accounting adjustments and function/risk adjustments.
Adjustments need to be considered with much caution, on a case-by-case basis, and should only be applied to good quality comparable in light of information available in order to improve their accuracy. The following should be avoided as they do not improve comparability:
Working capital adjustments should only be considered when the reliability of the comparable will be improved and reasonably accurate adjustments can be made. They should not be automatically made and would not be automatically accepted by IRBM. These adjustment make minor differences to the result when reliable comparable have been selected. In cases where significant difference is calculated, it will raise concern as whether the differences resulted from other issues.