Most countries, the OECD and the United Nations transfer pricing guidelines have all built in a degree of flexibility into their approaches, allowing other methods to be used in specific cases, provided that they approximate an arm’s length result and are acceptable to all the parties involved – that is acceptable to the tax administration, the taxpayer and to the treaty partner in cases where a Double Tax Agreement comes into play.
The OECD Transfer Pricing Guidelines describes five basic transfer pricing methods. These methods are incorporated in the transfer pricing rules of nearly every country that has adopted the transfer pricing rules. Kenya in its Income Tax Act CAP 470 Revised 2021 adopted Transfer Pricing Rules, 2006 under legal notice number (Ln) 67/2006.
The first four transfer pricing methods have a fundamental characteristic in common. They all look to the market to establish arm’s length pricing which is the basis for comparability analysis. The profit split method often relies on economic analyses to determine a division of profit between related parties. This is because comparable transactions, or data on the split of profit in comparable transactions, is often not available.
The selection of the most appropriate method for the circumstances depends on {OECD TP Guidelines 2022};
- The strengths and weaknesses of each method
- Nature of the transaction
- Availability of reliable information on comparability
- Degree of comparability and reliability of comparability adjustments
If the selection criteria result in more than one equally reliable method, then the CUP is preferred over all other methods and traditional methods are preferred over transactional profit methods.
However, situations where transactional profit methods may nonetheless be preferred are: where each party makes valuable and unique contributions; where activities are highly integrated; and where there is limited public gross margin information and no internal comparable.
Selecting the most appropriate method does not require an in-depth analysis of all methods. Other methods could be used if the taxpayer shows why the OECD methods were less appropriate than the chosen method. Further, any method acceptable to all enterprises and tax administrations involved should be permitted.
When evaluating the possible application of the methods, the following approach may provide a sensible basis but before delving in it is prudent to understand the transfer pricing methods proposed both in OECD model and Kenya Income Tax. They include but not limited to;
Traditional Methods
The Comparable Uncontrolled Price (CUP) Method: CUP involves a comparison of the prices charged in the controlled transactions with the prices charged for comparable goods or services – including the provision of finance and intangible property- in uncontrolled transactions. Actual Prices which are the financial indicator under examination is derived from uncontrolled transactions.
It can be expected that even minor differences between the product and functions relating to controlled transactions and those in uncontrolled transactions may have a material impact on those prices. In this regard, the required standard of comparability for applying the CUP method is generally considered to be very high relative to the other transfer pricing methods.
When applying the CUP methods, the key issues will always be product comparability. More often than not it will be extremely difficult to identify a reliable CUP. In case of concerns regarding the comparability, a secondary will be helpful.
Therefore, when applying CUP method, the following steps could form as a guide;
- Are we looking at a commodity transaction?
- If yes, then identify a quoted price, double check comparability but remember timing issues are sensitive to commodities and lastly conduct adjustment payments.
- If no, acknowledge that conducting a reliable external CUP for non-commodity transaction will be difficult. However, you need to keep following the decision tree by examining an internal CUP.
- Can we identify an internal CUP?
- If yes, first, clearly delineate the tested transactions. However, note that closely linked transactions will be difficult to evaluate with CUP. Secondly, evaluate a broad range of relevant comparability factors and perform adjustment calculations.
- If no, then you may need to summarize your reasons for rejecting the CUP for documentation purposes.
- Can we apply the CUP as a secondary method?
- If yes, try to make it work by adopting a flexible approach in line with OECD guidelines paragraph 2.17.
- If no, find a reliable method.
The Resale Price Method (RPM): Gross Profit Margin data derived from buy/sell transactions undertaken between uncontrolled entities. The method is most useful for marketing operations (OECD GL paragraph 2.27). The market compensation for similar functions tends to equalize across activities, but not so for products. The resale price method gives the compensation for a particular function (e.g., marketing).
From the tax perspective, the focus on the resale price margin provides the opportunity to explicitly link the pricing mechanism to the functional and risk analysis.
However, the following factors could affect comparability and thus an adjustment would be necessary;
- Differences between the compared enterprises, e.g., regarding management and operational efficiency. These will affect profits and thus the comparability of the margins.
- Differences in functions will require adjustments.
- If the reseller contributes substantially to the product physically or through intangibles (e.g., trademarks).
- Short turnover periods are better as they reduce differences in risks on inventory or currency.
- Fewer activities produce smaller margins (e.g. forwarding agents vs. fully fledged distributors). Some activities may require separate compensation under another method (e.g. high marketing volumes under a cost plus).
- A reseller carrying on substantial additional commercial activity employing e.g. intangibles, cannot be compared to one who does not, without adjustments.
- It may be relevant to look at companies further up and down a distribution chain to see who assume economically significant risks or value increasing functions.
- Exclusivity may affect profit margins and or reseller effort, which requires examination.
- Different accounting practices, e.g., treating R&D as an operating cost, or as costs of sales.
When applying RPM, the key issue will always be;
- Functional comparability.
- In practice a suitable method for price setting especially for non-routine distributors
- Often comparable financial data on gross profit margins will not be available
- Reliability is limited when tested party performs additional functions to the distribution
Therefore, when applying RPM method, the following steps could form as a guide;
- Can we identify the tested party exhibiting a routine function after conducting functional and risk analysis?
- If yes, then the tested party is not expected to share the in the residual profits and should generally exhibit small but comparable stable profits.
- If no, then you will have to substantiate the economic activity of the tested party in detail. The share of tested party in residual profit will depend on the value contributions and significant risks assumed to warrant that.
- The other question we ask is, can we identify sufficient comparability reliable data?
- If yes, then you will have to provide a detailed documentation on the performed adjustment calculation. Note that this applies for internal and external comparable.
- However, if no, due to the lack of public available data on gross margins in commercial databases, OECD GL acknowledges that RPM in most cases only be applicable on internal comparable which tend to be readily available.
In conclusion, the main caveat of applying the RPM is that the level of activity performed by the reseller, whether minimal or substantial, would need to be well supported by relevant evidence when evaluating the relationship between gross margin and functional profile of the tested party
Author: Edwin Opiyo