STUDY ON TRANSFER PRICING WITHIN MULTINATIONAL COMPANIES

Author: Onu Georgiana Andreea

Coordinator:Prof. Univ. Dr. Georgeta Vintilă

Abstract:

The transactions carried out between related parties have become more significant during

the last years. Therefore, the transfer pricing rules become one of the very important areas in

international taxation that have to be observed by each company in relation with the

transactions performed with related parties. These transactions should observe the arm’s

length principle as the price used would have been agreed between unrelated parties in free

market conditions.

The aim of this article is to present the main legislative provisions in relation to transfer

pricing, including the main steps and methods used for transfer pricing analysis.

Furthermore, the article outlines the applicability of the regression analysis in traditional

transfer pricing analysis. More specifically, we have used to regression analysis in order to

determine the most appropriate profitability indicator for applying the transactional net

margin method in a transfer pricing analysis.

Key words: transfer pricing, inter-company transactions, arm’s length principle, regression,

transactional net margin method

Introduction

It is well known that multinational companies have been using the transfer prices as a

tool to decrease their tax burden at the level of the group and thus maximising the overall

profits.

As a result, the transfer pricing rules appeared in order to create a balance in the

international tax planning. However, there are still many multinational which do not observe

the transfer pricing rules when performing transactions with related parties.

Moreover, for many of the major multinational companies, the transfer pricing rules

are seen as a simple tax compliance obligation and thus ignored. Relying on lower costs of

taxation, most often inconsistent with the legislative provisions in relation to transfer pricing,

multinational companies may throw away real optimization opportunities at the level of the

group and even ending up paying ten times more for what appeared to be a "saving".

The aim of this article is to emphasize the importance of transfer pricing in

international tax planning besides the idea of a pure tax compliance obligation. Indeed, the

transfer pricing rules are binding and therefore must be fulfilled by every company who carry

out transactions with related parties. Furthermore, the transfer pricing documentation

provided by legislative provisions in force is quite voluminous and complex and thus may

induce the idea of tax compliance obligation.

In addition, the article aims to highlight the applicability of regression analyzes in the

traditional analyzes of transfer pricing.

As part of our case study, we have tested the applicability of regression analysis in the

selection of the most appropriate profitability indicator for applying the transactional net

margin method in order to determine the transfer prices in the transactions carried out

between related parties. Thus, we have compared the results obtained by following the

theoretical transfer pricing recommendations to those obtained from the application of the

regression equations. The results obtained in both situations were similar.

Literature review

During the last years there have been published many studies and articles proving the

connection between transfer pricing analyzes and regression analyzes. For example,

regression analysis were used to demonstrate the taxes impact on the level of prices charged

between related parties or to determine a range for the market value prices for certain types of

transactions (e.g., the interest rate for lending between companies ). Also, there were

performed certain studies proving the usage of the regression analysis for choosing the most

appropriate method for determining the transfer price (i.e., selection of the most appropriate

profitability indicator for applying the transactional net margin method). Case Study - Economic analysis of a distribution transaction

Background

A Romanian company, SC RO CO SRL (hereinafter referred to as "RO CO")

performs sales of commodities to an entity within the group located in Cyprus (hereinafter

referred to as "CY CO"). As a first step, the commodities are purchased by RO CO from

various entities and then distributed to CY CO.

RO CO does not have available an agreement covering the sales of commodities

towards CY CO. The sales are performed based on purchase orders.

The transaction price is established as the purchase price of the commodities plus a

profit margin of 10%.

The time period subject to our analysis is the period spanning between 2007 and

2011. Thus, in order to establish the market value we have used comparable information

available for the previous period 2006 - 2010. The five year period should capture the

evolution of commodity sales transactions during the last years.

The functional analysis

In order to perform our transfer pricing analysis on the distribution transactions

performed by RO CO to CY CO, we should firstly determine what type of distributor is RO

CO.

In this respect, we have performed a functional analysis of the sales transactions

performed by RO CO, by considering the items included in the table below:

Functions Risks Assets

Supply Market risk Commodities

Quality control - volume Warehousing spaces

Packaging and labeling - price

Stocks Inventory risk

Warehousing Guarantee risk

Sale FX risk

Transport The risk of non-recovering the receivables

Guarantee and assistance

Considering the results of the functional analysis performed based on the information

presented above, we have concluded that RO CO operates as a limited distributor. The

main reasons underlying our conclusion are presented below:

- The activity of RO CO is limited to acquiring certain quantities of goods based on

orders received from its customers. The goods acquired this way are further on sold to

the customers;

- The goods/commodities acquired by RO CO become its property;

- RO CO does not have booked valuable marketing intangibles.

Selecting the method for the transfer pricing analysis

According to the domestic transfer pricing regulations corroborated with the OECD

transfer pricing guidelines, in order to determine whether a price for a certain transactions

fulfills the arm’s length principle, one may apply on the following methods:

- The traditional methods: the comparable uncontrolled price method, the resale price

method or the cost-plus method;

- The transactional methods provided by OECS: the profit split method and the

transactional net margin method.

a) The comparable uncontrolled price method (“CUP”)

In order to apply the CUP method, it is necessary to identify comparable uncontrolled

transactions performed between independent parties.

As a general rule, two transactions are considered as being comparable if the products

transferred / the services rendered are similar in terms of physical characteristics and the

transaction takes place under similar economic conditions.

Clearly, there will be differences between the transaction under review and those

performed by the comparable entities selected. Some of these differences may be accepted,

but only if they do not affect the price in the open market. Otherwise, reasonable adjustments

should be performed so as any potential significant impact to be removed. The CUP method

can use both internal and external comparable transactions.

As identified only isolated cases of potentially comparable transactions both internal

and external (because, in general, the contractual terms for these types of transactions have a

confidential nature), we are of the view that the CUP method is not feasible in our specific

situation.

b) The resale price method

This method is based on the comparison of the gross margin from sales and purchase

operations performed with related parties with the gross margin from purchase and resale

operations concluded with/between independent parties.

Given the above, the method is most commonly applied to distributors. Therefore,

since the transaction subject of our analysis is performed by an entity having a limited

distributor functional profile, one may say that the method can be applied in this situation.

However, considering that in order to apply this method is necessary to know the

functions undertaken by entities that distribute goods, the method may be difficult to apply in

our situation because of the lack of information regarding the functions held by comparable

companies.

c) The cost-plus method

This method compares the gross margins achieved in the transactions performed with

related party with the gross margins applied to the transactions carried out between

independent entities.

Typically, the method is used to evaluate gross profit margin achieved by the

producing companies with limited risks or by the services providers.

Since this method is particularly recommended in the evaluation of transfer pricing in

for manufacturers or services suppliers, we are of the view that it cannot applied to the

distribution operations performed by RO CO.

d) The profit split method

This method is used in order to determine the part of profit corresponding to each

entity involved in a transaction.

The profit split method is generally used for transactions carried out by joint-ventures

or partnerships, for which cannot be applied a method testing only one of the contracting

parties of the transactions (as for the other methods).

Considering the above, we are of the view that the profit split method should not be

applied for the transactions subject to our analysis.

e) The transactional net margin method

This method compares the net profit margin realized in a controlled transaction by

reference to a suitable basis, with the net profit margins realized in uncontrolled transactions

by reference to the same basis.

This method is often used in comparability analysis, since it is based on net profit

margins, which are less affected by differences in transactions than prices.

Furthermore, the current method is more permissible in terms of the degree of

similarity between the compared products, the functions and risks undertaken by the entities

involved in the transactions.

Given the above, we are of the view that the transactional net margin method is the

most appropriate transfer pricing method for our particular case.

Selecting the profitability indicators

The transactional net margin method involves choosing a profitability indicator to

restore the amount of revenue to be received by the test subject when the transaction

(conducted between affiliates) occurs in the market.

Profitability indicators that can be used in the application of the transactional net

margin method are: the operational profit margin, the net mark-up margin, the return on

assets and the ratio of operational income and operational expenses, also known as the Berry

rate.

Basically, profitability indicators measure the return on invested capital, given the

resources involved in a transaction, as well as the risk. For the profitability indicators to be as

appropriate as possible, adjustments are allowed.

a) Operational profit margin

The profitability indicator is calculated as the ratio between operational profit and

operational income, according to the formula below:

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 × 100

This indicator may be seen as an indicator of the company’s pricing strategy and

operational efficiency and is generally applied to companies which can establish a direct link

between profits and income, such as companies engaged in distribution activites.

In our specific case, RO CO deploys distribution activities (i.e., sale of commodities),

therefore this indicator could be used in the transfer pricing analysis.

b) Net mark-up margin

This indicator is computed as the ratio of operational profit and operational expenses,

thus measuring the relationship between the profit and the cost of obtaining it:

𝑁𝑒𝑡 𝑚𝑎𝑟𝑘 − 𝑢𝑝 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 × 100

This indicator is mainly used for transactions involving services provision or

production activities for producers with limited risk profile. The reason that this happens in

practice is because the amount of operational expenses includes most of the features that

contribute to the value of the service / product.

In our specific situation, RO CO is a distributor and not a manufacturer or service

provider. Therefore net mark-up margin cannot be considered as a suitable profitability

indicator in our analysis.

c) ROA

ROA is an indicator that measures the profitability of a company in relation with the

assets involved in obtaining it. More specifically, ROA measures the efficiency with which

management uses the assets of a company in generating earnings. The formula by which this

indicator is calculated as follows:

𝑅𝑂𝐴 =𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 × 100

Operational assets concept refer to all assets used in carrying out the most important

business activities, including both fixed assets and current assets (such as cash, cash

equivalents, receivables, inventories). They do not include investments in subsidiaries,

surplus cash and investment portfolio.

Since the relationship between operational profit and assets is generally less affected

by functional differences than the relationship between profit and sales that requires a lower

functional comparability.

Using ROA in transfer pricing analysis is not usually recommended for services

transactions. ROA is usually for producers and activities that require significant assets. As

distribution activities do not involve the use of significant assets, we conclude that ROA is

not an appropriate profitability indicator for our analysis.

Selecting the comparable

According to the legislative provisions regarding the applicability of the transactional

net margin method, we have looked upon independent entities performing similar activities,

having similar functions and risks like RO CO for the distribution transactions. For this

selection, we have used the database „Bureau van Dijk’s Amadeus”.

In order to identify the comparable entities having an activity similar with the RO

CO’s one, we have used various selection criteria, such as: activity code (“CAEN” - 4652 –

Comerț cu ridicata de componente și echipamente electronice și de telecomunicații.), years

with available information, the place where the activity is performed, the activity’s status, the

independence level, the subsidiaries number, the registration year.

After applying the above filters, we obtained a sample of 183 companies.

Testing the profitability indicators through regression analysis

From the previous analysis, we have concluded that the most appropriate profitability

indicator that should be used in the transactional net margin method seems to be the operating

profit margin. The other indicators are not generally recommended in transfer pricing

analysis of distribution activities or are more difficult to put in practice.

In this section we have tested the most appropriate profitability indicator through

linear regression equations that are used to describe the relationship between two variables.

Thus, for each of the four profitability indicators described above, we have applied the

following regression equation:

y = α + β*x

In our analysis, the dependent variable is represented by the profitability indicator.

For the independent variable, we have used the ratio between operating expenses and

operating revenues on the assumption that such indicator is closely linked with an

enterprise’s margins as well as with its assets and stocks.

The regression equations were applied to a number of 180 observations (except of

ROA profitability ratio - where the number of observations was only of 176 due to the fact

that we have removed the negative values).

The observations used in our regression analysis are related to entities operating in the

telecommunications industry. Some of the indicators included in our database include:

operating income, operating expenses, operating profit, economic rate of return.

By applying these regression equations, we have tried to determine the independence

level between the four profitability indicators and the ratio between operating expenses and

operating income. The profitability indicator which will be depend less by the independent

variable will be considered as being the most appropriate for being used in the transactional

net margin method.

a) Operational profit margin

By applying the linear regression equation between the operational profit margin as

the dependent variable and the ratio of operating expenses and operating income the

independent variable, we have obtained the following results:

As a first step, the determination coefficient R2 should be analysed in order to

determine whether the model is a well specified regression. This indicator shows the extent to

which the total variance of the dependent variable (i.e., operating income margin in our case -

abbreviated in EViews DL_MPO) is due to the independent variable. R2 may have values

from 0 to 1. However, in order for a regression to be well specified, this indicator should

exceed 0.5. In our specific case, the value of R2 is of approximately 0.57, which means that

the variance of the operational profit margin is explained by the variance of the ratio between

operational expenses and operation income in a proportion of 56.88%

Another aspect to be considered is the "t-test", which supports the null hypothesis that

the coefficients used in the regression equation are 0. The probabilities associated with the t-

statistic item are very important in this test. Thus, if the probability associated with the t-

statistic is lower than the relevance level for the regression analysis (i.e., 5%), the null

hypothesis is rejected. In our case, this probability for the independent variable is 0, which

means that the coefficient is significantly different from 0.

The “F-test” works similarly to the “t-test” determines how well the dependent

variable is explained by the evolution of the independent variable. In our specific case, the

probability associated to F-statistic is 0, therefore we can concluded that at least one of our

regression coefficients are significantly different from 0 (i.e., the regression is significant

from a statistical point of view).

Other tests were also performed in order to verify the validity of the regression model.

b) Net mark-up margin

By applying the linear regression equation between the net mark-up margin as the

dependent variable and the ratio of operating expenses and operating income the independent

variable, we have obtained the following results:

By analysing the value obtained for the determination coefficient R2 (i.e., 0.8), we

may say that the variance of the net mark-up margin is explained in a proportion of 80.17%

by the ratio between the operational expenses and the operational revenues.

Furthermore, the probability associated with the t-statistic for the independent

variable is 0, which means that the coefficient is significantly different from 0.

As regards the F-test, the associated probability of F-statistic is 0. Therefore, we may

conclude that at least one of our regression coefficients is significantly different from 0. So

the regression equation is significant from a statistical perspective.

Also, other tests were performed to verify the validity of the model.

c) ROA

By applying the linear regression equation between ROA as the dependent variable

and the ratio of operating expenses and operating income the independent variable, we have

obtained the following results:

From the regression equation applied is the value of the determination coefficient R2

is approximately 0. This means that the ratio of operating expenses and operating income

does not explain ROA’s variance.

Regarding the “t-test” and “F-test”, we noticed that the probabilities associated with

the t-statistic and F-statistic are significantly higher than the relevance level of our analysis

which is of 5%. Therefore, we may conclude that for this regression the coefficients are not

relevant from a statistic perspective.

d) Berry rate

By applying the linear regression equation between the Berry rate as the dependent

variable and the ratio of operating expenses and operating income the independent variable,

we have obtained the following results:

By analyzing the value of the determination coefficient R2 (i.e., 0.91), we can say

that variance of the Berry rate variance is explained in a proportion of 91.10% by the ratio of

operating expenses and operating income.

As regards the "t-test" and “F-test”, the probabilities associated with the t-statistic,

respectively F-statistic are 0 and thus lower than our relevance level of 5%. Therefore, we

can conclude that the regression equation applied is significant from a statistic point of view.

In conclusion, by analyzing the results obtained for each of the above mentioned

regression equations, we noted that for ROA the regression coefficients are not significant

from a statistic point of view. Therefore, we believe that ROA is not an appropriate

indicator for applying the transactional net margin method.

For the other three remaining profitability indicators, the lowest degree of

independence from the ratio between the operating expenses and operating income is seen in

the operational income margin situation. Also, the coefficients of the regression equation

applied are significant from a statistical point of view.

Therefore, based on the regression analysis, we may conclude that most appropriate

profitability indicator for applying the transactional net margin method is considered to be the

operational profit margin.

Manual selection of the relevant comparable entities

Usually, in order to verify the relevance of the comparable entities, a manual selection

is performed by verifying the publicly available information for those companies.

In our specific situation, after the manual selection of the comparable entities, we have

reduced the number of observation from 183 to 12. The main reasons for which the other

comparable entities were removed from the analysis are represented by: different functions

performed, different risks assumed, lack of relevant information related to the work

performed, etc.

Quartile series

Under this section, we sought to determine the quartile series for the comparable

entities resulting from the manual sorting. The main purpose of this step is to increase the

reliability of the transfer pricing analysis.

For our set of comparable entities, we have obtained by applying QUARTILE

function in Excel worksheet the following values:

Minim 0.72%

Cuartila inferioară 4.27%

Mediana 6.25%

Cuartila superioară 8.51%

Maxim 15.05%

The operating income margin of comparable companies is spanning between 4.27%

and 8.51%, with a median of 6.25%.

Considering that the average operating profit margins used by RO CO during 2007 -

2011 is of 11.00%. As it can be seen, this value is higher than the upper quartile and thus we

may say that the prices used by RO CO for the sales transactions performed with CY CO are

not undervalued.

Conclusions and further research

For large multinational companies, performing a large volume of transactions with

other group entities gives transfer pricing a significant importance. Moreover, given the

volume of such transactions, the impact on local taxes due (e.g., income tax, value added tax

and other indirect taxes) is significant and therefore cannot be neglected by the authorities.

Even though often central management of multinationals is rather interested in the

results of the entire group, leaving second place compliance into transfer pricing, transfer

pricing effects will be questioned by the local tax authorities in each country.

The transfer pricing issues in transnational corporations began to gain more and more

importance among these companies in recent years. Moreover, adopting the right approach,

transfer prices used in transnational corporations may be consistent legislative provisions in

force concerning transfer pricing and also can generate tax savings at the level of the

companies. International tax planning component transfer pricing is basically one of the most

important areas of the field.

In addition, in certain types of transactions, transfer pricing and the associated

documentation can be an element to support the economic substance of a transaction.

Substance issues in certain types of transactions are more likely to appear given the fact that

the tax legislation was recently amended on the economic substance part. The changes are

due to a recommendation issued by the European Commission at the end of 2012, which

refers to aggressive tax planning.

Consequences of non-compliance in respect of transfer pricing are numerous

significant in terms of value and can impact a company both short and long term.

In addition, in order to eliminate the association of the transfer pricing concept with a

simple tax obligation, maybe we should encourage the use of regression analysis in transfer

pricing.

As it can be seen from the literature review and from our empirical analysis, the

applicability of regression analysis in transfer pricing analysis is quite varied. The regressions

can be used to support the results obtained in the analysis by following theoretical aspects on

transfer pricing matters to strengthen the credibility of the results. Also, with the regressions

may be used in order to determine the relevant criteria for choosing comparable entities.

Thus, the number of comparable entities may be reduced to those very relevant for the

analysis saving time for the manual sorting. Also regressions may be used in determining a

range for transfer prices.

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