Economic ConsultingIntroduction to Transfer Pricing Principles,Methods and Recent DevelopmentsSébastien GonnetGonnet, NERA Economic ConsultingHong-Kong, The Hong Kong Bankers Club, 28th September

Objectives of the Presentation Provide an overview of the principles governing transfer pricingworldwide, discuss recent developments in developed (OECD) countriesand in the BRICS, and describe transfer pricing / valuation methods 2011 NERA Economic Consulting www.nera.com1

Contents WhatWh t isi TransferTf Pricing?Pi i ? The Arm’sArm s Length Principle OOECDC Developmentse e op e ts anda d Recentece t Trendse ds Transfer Pricing and Valuation Methods Transfer Pricing Challenges in the BRICS 2011 NERA Economic Consulting www.nera.com2

What is Transfer Pricing? 2011 NERA Economic Consulting www.nera.com3

What is “Transfer Pricing”?!Shanghai DailyDaily, 15 September 2011 2011 NERA Economic Consulting www.nera.com4

Case Study 1 - Producing in China Overview of transfer pricing flowsTransfer PriceGroup Manufacturing PlantChinaMarket PriceGroup Commercial entitiesEuropeRelated TransactionUnrelated Transaction 2011 NERA Economic Consulting www.nera.com5

Case study 1 - Producing in China What is the “right” (arm’s length) Transfer Price?Plant P&LVolumesBudget / normal courseof businessFollowing year / sudden drop indemand1000060000.0110.0110.0131106677Cost of Goods352121OPEX – variable402424OPEX - fixed252525Operating profit10(4)7Transfer Price (per unit)RevenuesReturn on total costs 2011 NERA Economic Consulting www.nera.com10%-5.7%5 7%10%6

Case Study 2 - Selling in ChinaGroup Parent (EU)IP owner / Service ProviderWHAT REMUNERATION FOR PARENT’S IPAND SERVICES?Market PriceThird-partyThirdpartyManufacturing PlantsAsia 2011 NERA Economic Consulting www.nera.comMarket PriceGroup Commercial EntityChina7

The Arm’sArm s Length Principle 2011 NERA Economic Consulting www.nera.com8

The Arm’s Length Principle What is transfer pricing?– TransferTf pricingi i refersftot cross-borderb d iintra-grouptttransactionsti- Products- Services- Intangibles- Financial transactions What does it do for your company?– It drives the allocation of profit inside your company- Allocation between business units, divisions, countries – And ultimately it is seen as the major controversy issue with the tax authorities 2011 NERA Economic Consulting www.nera.com9

The Transfer Pricing Equation How do you manage it?– Key concept is “arm’s length”- Determine the price that would have been agreed between third parties, fora given transactiontransaction, under similar economic circumstances IIn orderd tot meett theth “arm’s“’ length”lth” requirement,it it iis essentialti l tto adequatelydt lmap the “circumstances”– To design a transfer pricing system which is consistent with the waybusiness operates, and follows its dynamics 2011 NERA Economic Consulting www.nera.com10

Meeting the Arm’s Length Requirement – Beyond « Compliance »BUSINESSOPERATIONSTRANSFER PRICINGTAXLEGAL 2011 NERA Economic Consulting www.nera.comECONOMICSFINANCE11

Meeting the Arm’s Length Requirement – Sustainable Transfer Pricing SystemBUSINESSOPERATIONSTRANSFERPRICINGTAXLEGAL 2011 NERA Economic Consulting www.nera.comECONOMICSFINANCE12

Process For Designing an Arm’s Length Transfer Pricing System« tation/ LitigationBenchmarkingIndustryAnalysisECO 2011 NERA Economic Consulting www.nera.comFunctionalAnalysis /Value ChainBUSINESSEconomicAnalysis /TP designECO /BUSINESSImplementation /ContractsTAX / LEGALBUSINESS / ITCommunication(internal &external)TAX13

OECD developments and recent trends 2011 NERA Economic Consulting www.nera.com14

The OECD’s Role in the Promotion of the Arm’s Length Principle RevisedR i d TransferTf PricingP i i GuidelinesG id li– Chapters I -III Methods and Comparability (final & approved)– Chapter IX Business Restructurings (final & approved) Attribution of Profits to Permanent Establishments (final & approved)– 2010 version of the Report on the Attribution of Profits to Permanent Establishments Intellectual Property (on-going) 2011 NERA Economic Consulting www.nera.com15

Revised Transfer Pricing GuidelinesRRevisedChapter IIIC1 New Guidance on the selection of the “most1.most appropriate TP method tothe circumstances of the case”2. New guidance on how to apply the Transactional Net Margin Methodand the Profit Split method in practiceNewChhapter III3. New Guidance on comparability analysisNewChhapter IXX4 Ne4.New GGuidanceidance on the transfer pricing aspects of bbusinesssinessrestructuringsExtract from OECD presentation, Caroline Silberztein, IBC London, March 2011 2011 NERA Economic Consulting www.nera.com16

New Guidance on the Transfer Pricing Aspects of BusinessRestructurings (Chapter IX)What is a “business restructuring” in the context of the TP Guidelines? Cross-border redeployment by a multinational enterprise of functions, assetsand risks; cross-border reallocation of profits (or loss) potential–Can involve the transfer of valuable intangiblesintangibles, although not always thecase–Can also,, or alternatively,y, involve the termination or substantialrenegotiation of existing arrangements.- example: conversion of “full fledged distributors” into “commissionaires”;of “fullfull fledged manufacturers”manufacturers into “tolltoll-manufacturersmanufacturers”;; etc4 Parts:1 Risks1.Ri k2. Compensation of the restructuring itself3. Remuneration of post-restructuring transactions4. Recognition of transaction / recharacterisation issuesExtract from OECD presentation, Caroline Silberztein, IBC London, March 2011 2011 NERA Economic Consulting www.nera.com17

Attribution of Profits to PEs The Authorized OECD Approach– The Functionally Separate Entity Approach- To determine the profits attributable to the PE, a mechanism has to bedeveloped for attributing risks, economic ownership of assets and capitalto the hypothetically distinct and separate PE, forf associating with thePE the rights and obligations derived from its “dealings” with other partsof the enterprise of which the PE is a part and from its transactions withrelatedl t d andd unrelatedl t d parties.ti– The Significant People Functions- The significant people functions relevant to the assumption of risks arethose which require active decision-making with regard to theacceptance and/or management (subsequent to the transfer) of thoserisksi k 2011 NERA Economic Consulting www.nera.com18

Intellectual Property (1/2) Current guidance: Chapters VI and VIII of the TP Guidelines Major area of disputes / uncertainty for business and for governments Main areas covered– Definition / scope beyond traditional / accounting / legally protectablei tintangiblesibl assets:t- e.g. some marketing intangibles, workforce in place, businessopportunities etc:opportunities,– Are these intangibles?– More importantly, should they be compensated at AL?Extract from OECD presentation, Caroline Silberztein, IBC London, March 2011 2011 NERA Economic Consulting www.nera.com19

Intellectual Property (2/2) Main areas identified for possible future work– R&D; contract R&D– Know-how, employee assignments ( Similarities and differencesb tbetweenththe characterisationht i ti off a servicei or royaltylt ffor ArticleA ti l 12 purposesand the TP notion?)– Marketing intangibles– Business attributes and others– Identifying and characterizing an intangible transfer– Right of an enterprise to share in the return of an intangible it does notown:- Notions of “economic”, “beneficial”, “functional” ownership?– Cost contribution arrangementsg– Valuation of intangiblesExtract from OECD presentation, Caroline Silberztein, IBC London, March 2011 2011 NERA Economic Consulting www.nera.com20

Transfer Pricing and ValuationMethods 2011 NERA Economic Consulting www.nera.com21

Transfer Pricing Methods for Pricing TransactionsComparable UncontrolledPrice Method (CUP) OVERVVIEW Resale Price Method(RPM)Transactional NetMargin Method (TNMM) Compares the intragroup resale margin(gross margin) toresale margin earnedin comparableuncontrolledtransactions undercomparablecircumstances Compares themarkup on costs ofthe tested party tothe markups earnedin comparableuncontrolledtransactions undercomparablecircumstances Splits the profitsbetween the relatedcompaniesengaged in thesame transaction(s)based on therelated value ofeach company'scontribution to thecombined profit Compares thecontrolled company'sprofitability to theone of similarcompanies"The most direct andreliable way" to apply thearm's length principle Less comparabilityrequired than in theCUP methodWell adapted todistribution activities Less comparabilityrequired than in theCUP methodWell adapted tomanufacturingactivities andprovision of servicesAdapted when bothparties in therelated-partytransaction havedevelopedsignificanti ifiintangible assets SimpleIn practice, the mostusedLess comparabilityreq ired than inrequiredCUP, RPM andCPLMFinancial data (gross profit) of comparablecompanies may not be availableConsistencyCos s e cy oofaccountingstandardsComplexCl economicianalysisNot adapted to alleconomic models PRROSCOONS Profit SplitComparable intra-groupprice to prices earned incomparable uncontrolledtransactions undercomparablecircumstancesInternal/External CUPs Cost Plus Method(CPLM)High comparabilityrequired (products,volumes, markets)Lack of publicly availabledata Financial data (gross profit) of comparablecompanies may not beavailable ConsistencyCos s e cy oofaccounting standards 2011 NERA Economic Consulting Ex-post / testingmethodNet margin may beimpacted by nontransfera se ppricingc gissues22

Valuation Methods for Pricing Assets, Rights, Businesses or CompaniesMarket approachCost approach Direct measure of the value of a Most accurate measure ofcompany based on referencesasset/company value, as equalto multiples derived fromto the net present value ofpublicly-traded comparableexpected future cash flows ofcompanies and/or transactionsthe asset/company Take into account thespecificity of an (intangible)asset/company RReasonablebl llevell offcomparability with the publiclytraded/acquired companies isnecessary The method is rarely used for The method is frequently usedfor company valuation givenasset/company valuation,the availability of publiclyexcept in cases where it istraded/acquired companiesassumed that no value abovethe costs incurred is For asset valuation, multiplesperceived to have beenmay not be readily availablecreated Seems easy to implementStrengthsgMore complexMl ththan it seems Replacement costs shouldbe computed not actual costsWeaknesses Provides a wrong measure,in general the lower end offthe rangeOur point ofviewIncome approach 2011 NERA Economic Consulting R b tRobustnessoff projectionsj ti The income approach providesthe most accurate asset /company value23

The Economic Framework for Accurately Valuing IP Most firms originate their value and growth through a combination of uniqueknow-how, intangibles, and value-creating activities Intellectual Property (IP) can generally be considered as key differentiators forthe group and ultimately at the origin of a performance above average Accurate valuations can only be developed under the economic framework thatreflects:– The competitive advantage to the user of the IP and– The opportunity cost to the owner of the IP The economic framework is superior to other valuation methods– Adapts to the specific context of the IP– Is best suited to deal with the uncertainty associated with IP 2011 NERA Economic Consulting www.nera.com24

Transfer Pricing Challenges in theBRICS 2011 NERA Economic Consulting www.nera.com25

BRICS and FDIsExpected location of FDI by MNEs in 2011-2012Number of xicoRussiaUSBrazilIndiaChina0Source: World investment prospects survey 2010-20122010 2012 – United Nations 2011 NERA Economic Consulting www.nera.com26

The BRICS’s Economic Environment2000 - 2010Produce in China, Selloutsidet id ChinaChiLocation savings at stake2010 - 2020Produce in China (oroutside),), Sell in ChinaLLocationti savingsiatt staket kand « market premium » 2011 NERA Economic Consulting www.nera.com27

Examples of Subjects at a Center Stage in China“substantial market premium in theautot iindustry”d t ” (SAT, July 2010)“locationlocation savings, intangibles,and market premiums”(SAT, April 2010)“unique potential in the Chinesemarketmarket”(Director Wang, head of APA program July 2009)“howhow cost advantage impacts profitabilityprofitability”(Director Wang, head of APA program July 2009)“RMB0RMB0.55 billion was collected as additional tax revenue inBAPA cases in 2009 applying the concepts of location savingand market intangible”intangible (SAT) 2011 NERA Economic Consulting www.nera.com28