Tugas Akuntansi Internasional 3

“META ANALISIS”

TRANSFER PRICING OF INTANGIBLE ASSETS IN THE US, THE OECD

AND AUSTRALIA: ARE PROFIT – SPLIT METHODOLOGIES THE WAY

FORWARD?

Michelle Markham

2004

In the 21 st century, the number one international tax issue of interest to multinational

enterprises (MNEs) is undoubtedly transfer pricing. The reason for this is that as

global trade increases, so too does the uncertainty of the tax treatment of inter-

affiliate transactions across national boundaries and the spectre of double taxation.

The Australian Deputy Commissioner of Taxation has outlined the concept of

transfer pricing as follows: 'Broadly, transfer pricing relates to the setting of prices by

multinationals for the goods and services that they supply to related parties. It also

covers the structuring of transactions and financial relationships, and how innovation

The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax

Administrations (the OECD Guidelines) make it clear that the concept of transfer

pricing should not be confused with that of tax fraud, or of tax avoidance, even

though transfer pricing transactions may be utilised for such purposes. A number of

international tax specialists have also stressed that incorrect references to transfer

pricing as 'income-shifting' obfuscate a clear analysis.

A paper prepared by the United Nations Secretariat in 2001 has described transfer

pricing as 'probably the most important tax issue in the world'. Referring to the fact

that over 60 percent of international trade is carried out within MNEs, the paper also

refers to the impact which intangible property has had on this trade. Both US and

Australian tax practitioners have acknowledged that some of the most difficult

transfer pricing issues have always been in the area of intangible property. The tax

treatment of intangible assets therefore warrants particular attention in the transfer

In the United States, for purposes of section 482 of the final regulations, the term

'intangible' refers to any item included in one of six broad categories specified in the

regulations, provided the item has substantial value independent of the services of any

individual. These categories of intangible property include:

 Patents, inventions, formulas, processes, designs, patterns or know-how;

 Copyrights and literary, musical, or artistic compositions;

 Trademarks, trade names, or brand names;

 Franchises, licenses, or contracts;

 Methods, programs, systems, procedures, campaigns, surveys,

studies, forecasts, estimates, customer lists, or technical data; and

 Any other similar item that derives its value from its intellectual

content rather than its physical attributes.

For the purposes of Chapter VI of the OECD Guidelines, 'intangible property'

includes rights to use industrial assets, such as patents, trademarks, trade names,

designs or models, literary and artistic property rights, and intellectual property such

as know-how and trade secrets. Australian Taxation Rulings generally refer to the

OECD definitions of intangible assets.

The internationally accepted arm's length principle demands that MNEs charge

transfer prices in their controlled transactions that are consistent with the prices that

would have been charged for the same uncontrolled transaction taking place between

unrelated, independent enterprises under the same circumstances. To this end, transfer

pricing methodologies are utilised by MNEs in order to establish an arm's length

outcome. The transfer pricing methodology adopted by an MNE consequently

constitutes a pivotal component of a determination of the arm's length consideration

attributable to a transaction involving the intragroup transfer of intangible property.

As identical transactions between unrelated enterprises are rare, transfer pricing

methodologies tend to focus on comparable rather than identical transactions. So-

called 'transactional' methodologies have been espoused by revenue authorities as the

most direct way of establishing whether arm's length conditions exist between

associated enterprises. These methodologies are reliant on finding either identical

transactions, or, where these are not available, similar comparable transactions. There

has been a growing realisation that where intangible assets are concerned, there are

grave problems in determining even a comparative analysis. This paper will explore

the consequent shifting focus to newer, non-traditional methodologies, especially

profit-split methodologies, in the US and Australia, and to a lesser extent by the

OECD. These methodologies tend to rely in whole or in part on internal data rather

than on data derived from comparable uncontrolled transactions.

The US final section 482 regulations, the OECD Guidelines and the Australian

transfer pricing rulings all permit MNEs to select an appropriate transfer pricing

methodology for their inter-affiliate transfers of intangible assets. Different

methodologies may be selected under different circumstances. It is necessary to

assess a number of variables in determining the correct methodology for a particular

transaction. These variables may change over time, necessitating a reconsideration of

the methodology to be utilised.

Although there are marked similarities in the US, OECD and Australian approaches

to choosing a transfer pricing methodology for intangible property transfers, there are

also some important differences. While the official position of the US is that its final

transfer pricing regulations are consistent with the OECD Guidelines, some OECD

member countries disagree. This has had the unfortunate result that MNEs risk

antagonising certain revenue authorities if they undertake what appears to be a US

transfer pricing approach. Multinational taxpayers are therefore compelled 'to account

for multiple and sometime[s] disparate rules when setting, documenting, and

defending cross-border transfer prices.

Allocate income to routine contributions

The first step involves using other methods to estimate market returns to routine

functions and then to allocate them to the parties that performed them. Routine

contributions may be described as contributions that are of the same or similar kind to

those made by uncontrolled taxpayers taking part in similar business activities, for

which it is possible to identify market returns. These ordinarily include contributions

of tangible property, services and intangibles that are generally owned by

uncontrolled taxpayers engaged in similar business activities. Thus comparables still

The residual profit that remains after income has been allocated to routine

contributions is then allocated between the parties on the assumption that this residual

amount is attributable to nonroutine intangible property contributed to the activity by

the controlled taxpayers. The second step therefore refers to the apportionment of

residual profit, which remains after the income allocation where valuable nonroutine

intangibles are owned by the controlled group but similar items are not owned by the

uncontrolled taxpayers utilised to determine market returns in the first step. This

second step does not involve the use of comparables.

Three methods of apportionment of such residual profit are provided in the

regulations. Firstly, the relative value of such intangible property may be measured

by external market benchmarks that reflect the fair market value of such intangible

property. The IRS acknowledges that such fair market value may not usually be

readily ascertainable, and that consequently other measures of the relative values of

intangible property can be used.

Here the profits from the controlled transactions would be divided between the

associated enterprises according to the relative value of the functions performed by

each associated enterprise. If possible, external data is used to provide an independent

comparability measure. The operating profit is generally used to determine the profit

split under the contribution analysis, thus taking into account both the income and

expenses of the MNE with respect to the relevant associated enterprise. In certain

circumstances a split of gross profit may be utilised, followed by a deduction of the

expenses incurred in or attributable to each relevant enterprise.

There may be difficulties in accurately determining such a contribution analysis,

which may vary from case to case. A percentage of the profits may be allocated to an

associated enterprise on the basis of a relative comparison of the nature and degree of

each party's contribution, supplemented by relevant external data.

The OECD suggests a two-step approach, similar to that adopted by the US. The first

step allocates each associated enterprise with a basic return relevant to the

transactions it has engaged in, referring to market returns received by independent

enterprises for similar transactions. This first step would generally not account for

any unique or high value intangible assets held by the participants. In the second step,

any residual profit or loss would be allocated between the associated enterprises,

taking into account any contributions of intangible property as well as the relative

bargaining positions of the enterprises. This would involve an analysis of the facts

and circumstances that might indicate how this residual would have been divided

between independent enterprises. It is here that practical difficulties arise in

discovering suitable comparables involving similar unique, high-value intangible

assets. While the US residual profit split method may be deemed less reliable at this

second stage, as it relies on internal rather than external data, it is at the same time of

more practical application. The Guidelines place strong emphasis on the relative

bargaining positions of the associated enterprises in this second step, along with a

comparative analysis of such positions. Yet they also acknowledge the difficulties

involved in finding sufficiently comparable transactions and the fact that even where

such comparable transactions exist, adequate information on these transactions may

not be readily available either to MNEs or to tax administrations.

Although the OECD has shown great reluctance to accept all variations of the profit

split method, the Guidelines now explicitly state that the profit split method may be

acceptable in the case of highly valuable intangibles for which no comparable

uncontrolled transactions can be found. (It is in fact generally acknowledged that

transactions between unrelated entities involving a high-profit intangible are

extremely rare – indeed, the Tax Executives Institute has described them as 'almost

non-existent', with the result that profit split methods may often be the only reliable

method in such cases.) The Guidelines do, however, still anticipate practical problems

in applying a profit split method, possibly because of their insistence on using

comparable data in its application.

The United States: choosing the 'Best Method'

The ‘Best Method Rule has been adopted by the US final regulations for all

intercompany transactions. In contrast to the rigid hierarchical system that had

previously applied, the final regulations now require a taxpayer to select the pricing

method that provides the most reliable measure of an arm’s length result, relative to

the reliability of other applicable methods, bearing in mind the facts and

circumstances surrounding the particular transaction under review. Taxpayers are

thus given more freedom to choose the methodology most appropriate to their

The transfer pricing regulations allow companies to examine and test different

methods to determine which method provides the most reliable result. There is no

strict priority of methods under the regulations, and no method is considered

invariably more reliable than another. The greater flexibility of the final regulations is

also indicated by the fact that the taxpayer is allowed to establish an arm’s length

amount through the use of a method (properly documented) other than those specified

There appears to be an underlying assumption that taxpayers will test a variety of

methods before selecting the one that best suits their particular transaction. The

regulations provide that in choosing a particular methodology it is not necessary to

establish the inapplicability of another method. However, if another method is

subsequently shown to produce a more reliable measure of an arm's length result,

such other method must be used.

The US regulations designate certain allowable transfer pricing methods for a

determination of taxable income in connection with a transfer of intangible property.

Unspecified methods are also allowed, as long as they provide the most reliable

measure of an arm's length result under the principles of the best method rule.

MNEs should select the method that provides the greatest degree of comparability,

which will be determined not only by the accuracy of the underlying data, but also by

the extent of the information – eg the period of time on record. A functional analysis

will determine whether the economically significant activities of the controlled and

uncontrolled transactions are sufficiently similar.

From a practical point of view, it may be difficult to choose the best method for an

interaffiliate transfer of intangible property. Greater flexibility is generally

acknowledged to be a positive outcome of the final regulations, but there is a warning

here that a corollary may be less certainty in reaching a satisfactory transfer price, and

a greater burden on taxpayers to meet nebulous requirements. There is therefore a

need for more adequate advice and direction to be available to taxpayers.

The OECD: a flexible approach

The OECD Guidelines do not refer to a 'Best Method' rule, but rather recommend that

taxpayers select a transfer pricing methodology that is able to provide the best

estimation of an arm’s length price, taking into account the facts and circumstances of

the case, the mix of evidence available and the relative reliability of the various

methods under consideration. In contrast to the US approach, the OECD Guidelines

state quite explicitly that the arm's length principle does not require the application of

more than one method, as this may give rise to a significant administrative burden for

taxpayers. The OECD appears to be aware of the fact that collecting external data on

a number of different methods is not only onerous for taxpayers, but also for tax

administrations, and therefore requires neither party to perform analyses under more

The Guidelines also demonstrate flexibility regarding the use of transfer pricing

methods, in that MNE groups are given the freedom to apply methods other than

those described in the OECD Report to establish prices, provided those prices satisfy

the arm’s length principle. Unlike the US regulations, the Guidelines do not designate

certain specific methods as applicable to transfers of intangible assets.

They even provide for the use of a combination of methodologies in difficult cases

where no one approach appears conclusive.

Under the Guidelines, comparisons with uncontrolled transactions can only be

relevant where the economically relevant characteristics of the situations undergoing

comparison are sufficiently comparable. While the Guidelines make it clear that

taxpayers should base their controlled transfer prices on a sound analysis and should

document the basis on which such prices are set, 'the amount of effort called for by

the Guidelines is markedly less than what U.S. regulations would require to avoid a

tax penalty on a large transfer pricing adjustment.

Australia: a modified OECD approach

The Australian Taxation Office (ATO) seeks to adopt the most appropriate or best

suited transfer pricing methodology, bearing in mind all the circumstances of the

In Australia, the methodology must, on an objective basis, produce the most accurate

arm's length calculation. No preference for a particular methodology is prescribed – a

novel methodology may be utilised, providing it achieves an arm's length result. The

ATO has stated that in Australia it is possible to go beyond the OECD Guidelines, by

resolving transfer pricing issues using indirect methods, while still remaining true to

their fundamental principle of evaluating transactions according to what truly

independent enterprises acting independently would probably have done in the

Division 13 of the Australian Income Tax Assessment Act 1936 (ITAA) does not refer

to the methodologies to be utilised in calculating an arm's length price – these are only

referred to through public taxation rulings. The Commissioner generally seeks to

apply methods given international endorsement, adopting the method best suited to

the circumstances of the particular case. It is recommended that a taxpayer document

the reasons for their choice of method at the time of its adoption.

The Comparable Profit Split Method

This method depends on discovering the profit on comparable transactions between

two unrelated enterprises. The regulations explain that a comparable profit split is

derived by combining the operating profit of uncontrolled taxpayers whose

transactions and activities are similar to those of the controlled taxpayers in the

relevant business activity. Each uncontrolled taxpayer's percentage of the combined

operating profit or loss then serves to allocate the combined operating profit or loss of

the relevant business activity. In other words, the uncontrolled split is used as a

benchmark for the profit split between the controlled parties.

The Comparable Profit Split Method (CPSM) emphasises the quality of the third-

party evidence, for example a similar division of assets and combined return on assets

must exist between the uncontrolled independent parties and the controlled affiliates.

The similarity of the contractual terms of the controlled and uncontrolled parties is

particularly relevant to the CPSM, as such contractual terms tend to determine the

allocation of functions and risks. The regulations provide that if the combined

operating profit of the uncontrolled parties varies significantly from that of the

controlled parties (as a percentage of the combined assets), this method may not be

The reliability of the data and assumptions concerning each party to the transactions

in question is also an important consideration under the CPSM. If the data and

assumptions concerning one of the parties are significantly more reliable than the data

and assumptions concerning the other party, the regulations suggest that it may be

preferable to employ another method which focuses exclusively on the results of the

Opinions appear to be divided as to whether the CPSM is readily applicable to

intangible asset transactions. A number of commentators have stated their belief that

in practice, the difficulties involved in obtaining the extensive data on uncontrolled

taxpayers prevent most taxpayers from using this method. Others, however, are of the

opinion that the CPSM is ideally suited to intangible asset transactions, and that 'the

CPSM is the best method for assessing the value of the intangible property embodied

in a product with extraordinary profit potential'.

From the above, it is evident that the use of profit split methods for inter-affiliate

transfers of intangible assets will increase in the years ahead. The proliferation of

intragroup intangibles in the global economy, and especially high value and/or unique

intangibles, means that only in rare circumstances will it be possible to obtain data on

similar technology used by independent parties at a transactional level.

Foreign tax authorities, including Japan's National Tax Administration (NTA) and

other OECD countries are now indicating a marked preference for profit splits as the

preferred second-best alternative to traditional transactional methods where there is a

lack of suitable comparables. The OECD itself appears to be moving towards a

greater acceptance of profit methods, and there are significant indications that the

current chapter of the Guidelines which deals with the use of profit methods will soon

In Australia, the ATO have discovered that profit methods are becoming more

acceptable in competent authority processes, and that 'Generally, the profit methods

used in Australia are able to provide some certainty, produce fair results, require less

effort in terms of documentation and are reasonably easy to administer for taxpayers

In conclusion, despite historical resistance to the use of profit-split methodologies by

revenue authorities in the US and Australia, and by the OECD, there is now an

increasing openness to viewing such transfer pricing methodologies as at least one of

the ways forward, especially where intangible asset transactions are concerned.

THE TRADITIONAL RATIONALE OF THE ARM’S LENGTH APPROACH

TO TRANSFER PRICING – SHOULD THE SEPARATE ACCOUNTING

MODEL BE MAINTAINED FOR MODERN MULTINATIONAL ENTITIES?

Kerrie Sadiq

2004

Profit shifting by multinational entities may occur by means of transfer pricing, with

the result that traditional rules fail to yield a fair interjurisdictional allocation of

taxing rights. The current solution to the problem of transfer price manipulation is the

substitution of an arm’s length price for related party transactions. Despite the

artificial nature of the process that determines an arm’s length price, using the arm’s

length approach to determine a plausible price for related party transactions has

worked in the case of most multinational entities. This article argues, however, that

the application of the arm’s length methodologies to modern multinational entities,

taking into account their unique features, results in a transfer price that fails to accord

with economic reality. The premise of this article is that the arm’s length pricing

paradigm is not a theoretically sound model for allocating the profits of modern

multinational entities. To demonstrate, this article uses multinational banks as an

example of the modern multinational entity.

The first part of this article considers the OECD’s answer to transfer pricing

manipulation – the adoption of the arm’s length price methodology. It then examines

the rationale for the use of the arm’s length price, along with the arguments in favour

of such a regime. This article refutes these justifications on the general basis that the

traditional regime fails to recognise true economic activity.

This article examines the current transfer pricing regime to consider whether it is a

sound model to be applied to modern multinational entities. The arm’s length price

methodology is examined to enable a discussion of the arguments in favour of such a

regime. The article then refutes these arguments concluding that, contrary to the very

reason multinational entities exist, applying arm’s length rules involves a legal fiction

of imagining transactions between unrelated parties. Multinational entities exist to

operate in a way that independent entities would not, which the arm’s length rules fail

to take into account. As such, there is clearly an air of artificiality in applying the

arm’s length standard. To demonstrate this artificiality with respect to modern

multinational entities, multinational banks are used as an example. The article

concludes that the separate entity paradigm adopted by the traditional transfer pricing

regime is incongruous with the economic theory of modern multinational enterprises.

The analysis tools are traditional OECD approach of substituting an arm’s length

price which is determining the Arm’s Length Price and rationale for the use of the

Multinational bank, document transfer pricing and multinational enterprises.

Profits attributed to a jurisdiction may be distorted by a multinational entity, simply

by the separate but related parts of that entity manipulating the prices at which goods

transferred internally. This occurs because of the different motivation of the

multinational entity that considers itself a whole, and the taxing authorities that

recognise the separate parts of the multinational entity, rather than the whole. It is the

multijurisdictional activities of the firm that provide opportunities for profit shifting

It is recognised globally that multinational enterprises are one economic entity,

whether they operate through a branch structure or a subsidiary structure. As such, the

aim of the entity as a whole is to maximise profits. This results in the multinational

entity having no concern about the price paid or received for internal transactions,

except in so far as the overall profits of the multinational entity is maximised.

Consequently, the multinational entity takes advantage of different tax rates across

jurisdictions by shifting profits from one jurisdiction to another through transfer price

manipulation. In essence, profits attributed to a jurisdiction may be distorted by a

multinational entity simply by the separate but related parts of that entity

manipulating the prices at which goods and services are transferred. The process of

charging for internal transactions is known as transfer pricing. When the price is for a

non-arm’s length consideration, it is deemed to be a breach of the transfer pricing

Jurisdictions generally adopt, in their domestic legislation, a requirement that

transactions between related parties, or separate parts of the one entity, occur at an

arm’s length consideration. The arm’s length standard is based on what is referred to

as the separate accounting or separate entity approach. The separate parts of an entity

are defined by reference to national boundaries, or what is commonly referred to as

the “water’s edge”. Income and expenses are then allocated to the relevant

jurisdictions on a transactional basis, that is, specific transactions are considered as if

they were between distinct entities, with each entity reporting separate taxable

Empirical evidence suggests that multinational entities are undertaking transfer price

manipulation, as well as the fact that jurisdictions are losing revenue from such

activities. This evidence adds weight the theoretical argument that the traditional

regime allows for manipulation which results in an outcome that fails to allocate

income according to economic reality. While studies have

generally found that multinational entities are shifting profits through transfer pricing,

evidence suggests that this is particularly the case with modern multinational entities

such as multinational banks. It is believed that multinational banks have, even more

than other multinational entities, opportunities for reducing their tax burdens in high-

tax countries by way of intra-firm transfer pricing. In their study of multinational

banks Also Demirguc-Kunt and Harry Huizinga found that taxes paid by foreign

banks were relatively low in many of the major industrialised nations. By examining

the relationship between the taxes paid and the statutory tax rate, they obtained

further support for their profit shifting hypothesis. Their study showed a negative

relationship between taxes paid and the statutory tax rate suggesting the presence of

profit shifting. As additional support for the profit shifting premise Demirguc-Kunt

and Huizinga, controlling for bank characteristics, found that foreign banks payed

lower taxes in several developed countries. Further, on a cross-country basis, they

found that taxes paid by foreign banks fall with the statutory tax as additional

evidence of profit shifting by foreign banks.

While it is the multinational entities that undertake such behavior, it is the

Governments of the relevant jurisdictions that are concerned about revenue loss. As

evidence of revenue losses by taxing authorities, Eugene Lester suggests that in the

United States millions of dollars are being lost each year through profit shifting.

Lester relies on two sources: Senator Dorgan who asserted that Internal Revenue

Service studies show that the United States loses at

least two billion dollars a year through tax evasion under the arm’s length principle;

and James Wheeler, Professor of Accounting at the University of Michigan, who

estimated that foreign multinational entity groups operating in the United States cheat

the United States Treasury out of about thirty million tax dollars each year.

Consequently, if these studies and assertions are correct, there is a failure of the arm’s

length standard to allocate profits in an optimal manner.

Because of the potentially large revenue losses to taxing jurisdictions through transfer

price manipulation, the OECD has devised a means of adjusting transactions internal

to the multinational entity. The aim of these adjustments is to achieve a result that

means the allocation of income purportedly reflects the location of the activities

The fundamental theoretical failing of the traditional transfer pricing approach, when

applied to multinational banks, is that it does not take into account the unique features

of these banks when allocating profits. Yet, it is these unique features, particularly

entering the market through foreign direct investment to avoid market externalities,

which make the multinational bank is so successful. The separate entity paradigm

adopted by the traditional transfer pricing regime is incongruous with the economic

theory of multinational enterprises.

Consequently, it has been demonstrated in this article that the traditional OECD

approach to the problem of transfer price manipulation of substituting an arm’s length

price may not be optimal for multinational banks. Further, it was demonstrated that

the rationale for the use of the arm’s length price for traditional multinational entities

do not carry over to the enterprise of multinational banking. Despite this, the OECD

continues to insist upon the traditional application of the transfer pricing regime.

http://www.austlii.edu.au/au/journals/UWSLawRw/2004/3.html

http://www.austlii.edu.au/au/journals/JlATax/2004/10.html

By riyantobbs

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