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Transfer pricing methods
Which transfer pricing methods are used in your jurisdiction and what are the pros and cons of each method?
In line with the OECD Transfer Pricing Guidelines, the tax administrations must begin a transfer pricing examination from the perspective of the method selected by the taxpayer. Nonetheless, the taxpayer must be able to substantiate why the chosen method is the most appropriate in view of the relevant facts and circumstances. The Transfer Pricing Decree refers directly to the OECD Transfer Pricing Guidelines. In Chapter II of these guidelines the following methods are described, which can be used to substantiate arm’s-length pricing between associated enterprises.
Traditional methods The following traditional methods are regarded as the most suitable and direct means of establishing a transfer price, as the price can be traced directly:
- The comparable uncontrolled price (CUP) method compares the price charged for the transfer of property or services between associated enterprises with the price charged for comparable property or services transferred under comparable circumstances between unrelated parties, in order to find a CUP. The CUP method is particularly reliable where an independent enterprise sells the same products in the same quantity and under the same conditions as those sold between associated enterprises. Relevant data for finding a CUP is frequently not available. The CUP can also be used when a taxpayer sells products to an associated enterprise as well as to an independent enterprise. The CUP can be quite strict in its application. If products, quantities or parties involved in the transaction are not comparable from a two-sided perspective, this will possibly lead to non-acceptance. The advantage is that it is the most direct and reliable manner to find a comparable price.
- The cost-plus method increases the relevant costs incurred with an appropriate mark-up. Based on the OECD Transfer Pricing Guidelines, the cost-plus method is considered most useful where:
- semi-finished goods are sold between associated enterprises;
- associated parties have concluded joint facility agreements or long-term buy-and-supply arrangements; or
- the controlled transaction is the provision of services.
In the Netherlands, in practice the costs that are included in the cost base for applying the cost-plus method can be subjected to close scrutiny.
- The resale price method deducts an appropriate margin from the resale price to an independent third party to determine the intercompany price for a product purchased from an associated party. The margin is set in a way that enables the reseller to cover its selling and operating expenses and make an appropriate profit. According to the OECD Transfer Pricing Guidelines, the resale price method is most useful where it is applied to marketing operations. In practice, it is important to compare the selling and other operating expenses of the comparables, as this will be a good indicator of the comparability of the functions and risk profiles. It can also be useful to perform a sanity check on operating profit level, as tax authorities can argue that the resale price method is a one-sided method and the tested party should then be entitled to a routine profit.
Transactional methods The following transactional methods examine the profits that arise from transactions between associated enterprises:
- The most frequently used method is the transactional net margin method (TNMM). The TNMM compares the profits which comparable independent entities realise while performing comparable functions. The TNMM measures the profit relative to, for example, costs, sales or assets. Compared to the cost-plus method, the TNMM on costs remunerates a percentage over all costs. The TNMM has the advantage that it compares the functional profile of an entity instead of specific transactions. Therefore, it can be easier to find comparables. Another advantage is that it gives the taxpayer a degree of certainty over the corporate income tax due. In practice, this can also cause the TNMM to be a preferred method for the tax authorities when the choice for this method is in line with the functions and risk profile of the entity. To apply this method, the tested party should be considered as the least complex entity.
- The transactional profit split method divides the combined profit realised from transactions between associated enterprises based on an economically valid key on which unrelated parties could have agreed. This method is used when both entities make unique and valuable contributions, or where operations are highly integrated and a one-sided approach would not be appropriate. An advantage of applying this method is that the allocation of profits may be based on the division of functions between the entities, especially when there is no more direct evidence of how independent parties would split the profit in comparable circumstances. This means that internal company data can be used to determine an allocation key. The transactional profit split method is mostly used in bilateral or multilateral situations, as more countries then have to agree with the applied allocation key.
Multinational enterprises can also use methods not described in the OECD Transfer Pricing Guidelines, although it should then be explained why such method is considered more appropriate.
Formulary apportionment is in principle not applied in the Netherlands, as it is considered not to be in accordance with the arm’s-length principle.
Preferred methods and restrictions
Is there a hierarchy of preferred methods? Are there explicit limits or restrictions on certain methods?
There is no hierarchy of methods in the Netherlands, nor are there any restrictions. In principle, the taxpayer is free to choose any method where it reaches an arm’s-length outcome. The taxpayer must substantiate why it chose a certain method. The starting point for an examination by the tax authorities should then be the method applied by the taxpayer.
What rules, standards and best practices should be considered when undertaking a comparability analysis?
According to Chapter III of the OECD Transfer Pricing Guidelines, it is of primary importance for the taxpayer to perform a broad-based economic analysis, supplemented with a description of the market in which it operates. The taxpayer must then delineate the controlled transactions and the functions performed, assets used and risks assumed in order to choose a tested party. It should then perform a benchmark study, which demonstrates and explains to the tax authorities the various steps taken in performing the benchmark and comparable selection process. On this basis, the tax authorities should be able to assess the reliability of the comparables used.
Are there any special considerations or issues specific to your jurisdiction that associated parties should bear in mind when selecting transfer pricing methods?
There are no specific considerations where an arm’s-length outcome is reached. However, where this outcome is questionable, a critical assessment of the chosen method or the comparables may follow.
For instance, application of the CUP method can be critically assessed where the application results in profits that are not in line with the functions performed by one of the parties involved in a transaction. Then it can be assessed whether the size of the transaction, bargaining power of the parties involved in the transaction and any further relevant circumstances are closely comparable.
As for the cost-plus method, the Transfer Pricing Decree stipulates that prices will generally be determined in advance based on budgeted costs and that a higher expense as a result of inefficiency will be at the expense of the contracting party providing the performance. The reason for this is that the contracting party can influence this expenditure. Aside from this, costs which tend to be passed on to the client separately and which have the character of disbursements should be left out of the cost base for applying the cost-plus method. It can also be critically assessed whether a mark-up is applied on all relevant costs.
When applying the resale price method, a sanity check on operating profit can be useful, because comparables can be subjected to close scrutiny when taxable results are not satisfactory according to the tax authorities.
With profit-based methods (eg, TNMM and profit split), discussions will more likely concern whether the functions and risk profile of the entity are properly taken into account.
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