The arm’s length principle treats the members of a multinational enterprise (MNE) as operating in separate entities, rather than as inseparable parts of a single, unified business. Therefore, it is required that MNEs follow the same pricing policy for intra-group and uncontrolled transactions, under comparable circumstances. Otherwise, the controlled companies shall take the necessary measures and adjust their profits by reference to the conditions, which would have obtained between independent enterprises.
In this article, we refer to the most common difficulties that MNEs face and the appropriate adjustments to be made to eliminate the effect on price. This practice is in line with OECD Transfer Pricing Guidelines which note that ‘practical considerations dictate a more flexible approach to enable the CUP method to be used’.
CUP method
The comparable uncontrolled price (CUP) method is the most direct and reliable way to apply the arm’s length principle. In particular, this method compares the price charged for property or services transferred in a controlled transaction to the price charged for the same property or services transferred in a comparable uncontrolled transaction in comparable circumstances. Any difference between the two prices may indicate that the conditions of the commercial or financial relations of the associated enterprises are not at arm’s length.
However, in the real world, it is usually difficult to find a transaction between independent enterprises that is similar enough to a controlled transaction such that no differences have a material effect on price.
Small differences: the example of coffee beans
In this section, we present an illustrative example dealing with cases where small differences exist in the product. Let us assume an independent enterprise, which is selling unbranded Colombian coffee beans of a similar type, quality, and quantity as those sold between two associated enterprises. The controlled and uncontrolled transactions occur at about the same time, at the same production stage and under similar conditions.
If the only available uncontrolled transaction involved unbranded Brazilian coffee beans, it would be appropriate to inquire whether the difference in the coffee beans has a material effect on the price. Any information obtained from commodity markets or deduced from dealer prices, may result in a reasonably accurate adjustment (premium or a discount) to approximate a comparable uncontrolled price.
If other qualitative characteristics exist, the CUP methodology may not apply. In real world, the price of the coffee beans may vary depending on the harvesting period and the quality of the plant, which both affect the aroma of the coffee, thus its wholesale price.
Transportation and delivery
Another common case is where circumstances surrounding controlled and uncontrolled sales are identical, except that the controlled sales price is a delivered price and the uncontrolled sales are made f.o.b. factory. In general, the differences in terms of transportation and insurance costs have a definite and reasonably ascertainable effect on price.
For instance, the selection of the appropriate means of transport, the distance to be covered, and other relevant factors shall be eliminated or taken into consideration to determine the arm’s length price. Therefore, to determine the uncontrolled sales price, adjustment should be made to the price for the difference in delivery terms.
Quantity and payment terms
Many companies sell their products or provide services mainly to affiliates. However, these companies may also have an independent clientele carrying out similar transactions, maybe for a lower value. For instance, a taxpayer may sell 200 tons of sugar for USD600 per ton to a related party in its group, and at the same time sell 50 tons of the same sugar for USD700 per ton to an independent enterprise. This case requires an evaluation of whether the different volumes should result in an adjustment of the transfer price.
Payment terms could also have a huge impact on the pricing of a product, which is then very difficult to justify in a scientific manner, unless there are specific pricing patterns. In that case, the best way to approach the differences is by scaling pricing depending on the payment terms and the weight the prices.
Conclusion
The CUP method is usually applied if internal comparable data are available, given that the terms and conditions governing private agreements between independent companies are not public. In addition, many commodities are traded in capital markets, therefore, the market prices may constitute a base for transfer prices determination. In real world though, transfer pricing experts are fighting to justify all these attributes to bring CUP in full effect.
The authors are senior tax advisors and partners of Transfer Pricing Experts’ hub in Cyprus. To contact the authors, please visit www.transferpricing.com.cy or dial +30 210 7245724-5.