This article first appeared in the November 2008 edition of Irish Tax Review and is reproduced here with their kind permission.

Introduction
Transfer prices are prices charged in transactions between related parties – generally, multinational enterprises. They include prices for tangible goods, services, or management fees as well as royalties for intellectual property and interest on related party loans. Currently, there are at least 45 countries with specific transfer pricing legislation and regulations, and this number grows on a yearly basis. A greater focus on transfer pricing enforcement has become increasingly apparent in audits worldwide. In many countries a requirement for contemporaneous transfer pricing documentation exists, and there is potential for a greater assessment of penalties if this documentation does not exist.

Transfer Pricing Incentives
Finance directors, controllers, and in-house tax equivalents are interested in getting transfer prices right so that they recognise true economic profits, establish appropriate incentives, and facilitate resource allocation. Common transfer pricing risks facing multinational corporations include:

• Double taxation,
• Unexpected cash calls,
• Interest on tax, and
• Penalties for non-compliance.

The group impact of the associated risks can range from negative publicity to a decrease in shareholder value and the weakening stability of the financial reporting of the corporation. These incentives and related risks put transfer pricing at the top of international tax issues facing multinational corporations today.

Arm’s-Length Standard and the Best/Most Appropriate Transfer Pricing Method
The question about how to set intra-group transfer prices invariably arises. The Organisation for Economic Co-operation and Development (OECD) set forth Transfer Pricing Guidelines for Multinational Enterprises in 1995 instructing that the pricing of intra-group transactions should be based on the arm’s-length standard. The arm’s-length standard states that:

“A controlled transaction meets the arm’s-length standard if the results of the transaction are consistent with the results that would have been realised if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s-length result).”1

The arm’s-length standard is also the basis of the United States’ transfer pricing legislation under s482 of the Internal Revenue Code, as well as other jurisdictions throughout the world. The assessment of the arm’s-length standard is open to interpretation. However, the OECD Guidelines and other transfer pricing legislation urge taxpayers to employ the best (or most appropriate) transfer pricing method rule, which states:

“The arm’s-length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s-length result.”2

There are five methods highlighted in the OECD Guidelines that are appropriate for setting and evaluating transfer prices. There are three applicable “transactional methods” specified in the OECD Guidelines. They are:

• Comparable Uncontrolled Price (CUP), which evaluates the arm’s-length nature of intra-group prices based on the prices applied in comparable uncontrolled (unrelated) transactions;
• Resale Price Method (RPM), which compares the gross profit margin earned in the controlled (related) transaction to the gross profit margin realised in comparable uncontrolled transactions; and
• Cost Plus Method (CPLM), which compares the gross profit mark-up realised in a controlled transaction with that earned in comparable uncontrolled transactions.
  
  

There are two specified “profit-based” methods:

• Transactional Net Margin Method (TNMM), which evaluates the arm’s-length character of a controlled transaction based upon objective measures of profitability (known as profit level indicators) of one of the participants to the transaction (tested party) derived from uncontrolled taxpayers who engage in similar business activities under similar circumstances; and
  
  
• Profit Split Method (PSM), which determines an arm’s-length division of the combined operating profits/losses from one or more controlled transactions based on the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss.

Transfer Pricing in Ireland
For all practical purposes, Ireland has no transfer pricing legislation, and there are currently no specific transfer pricing documentation requirements. However, there are a number of sections in the TCA 1997 that have relevance to transfer pricing and which require application of the arm’s-length principle – that is, requires that transfer prices charged between related parties are equivalent to those which would have been charged between independent parties in the same circumstances.

Section 81
Section 81 provides that no sum shall be deducted in respect of:

(a) any disbursement or expenses, not being money wholly and exclusively laid out or expended for the purposes of the trade or profession;

While not explicitly mentioning arm’s-length pricing, the provision nonetheless provides the Irish Revenue with the power to adjust the price paid by an Irish taxpayer for goods or services. More specifically, section 81 could apply in an inter-company pricing context in at least two ways. For one, the Irish Revenue could deny the portion of any business expense deemed to be in an excess of arm’s-length pricing by determining that the excess amount was not incurred for the purpose of the trade or business. Secondly, the Irish Revenue could fully deny any business expense incurred on behalf of or for the benefit of a non-resident related party.

Section 1036
This is the oldest “transfer pricing” provision in the TCA 1997. It applies where, for example, an Irish company carries on business with a non-resident company and the inspector is of the view that because of the close connection between the two, the Irish company produces either no profits or less than the ordinary profits which might have been expected to arise had the companies not been connected. In these circumstances, the overseas associate will be chargeable to Irish income tax in the name of the Irish company as if it were an agent of the Irish company.

Section 1036 is not commonly used by Revenue in practice and there is no Irish case law on the section.

While there is currently no Irish transfer pricing regime, any Irish multi-national doing business in a foreign country through a subsidiary or branch will likely have to conform to a transfer pricing regime on the other side of the transaction.

Again, while there is no specific Irish transfer pricing legislation, there are legislative rules governing the pricing of transactions of goods between a company entitled to the 10 percent corporation tax rate (manufacturing relief) and other Irish-connected companies. These transfer pricing rules are designed to determine that the profits of the connected company, subject to Irish corporation tax – are not understated, but they do not affect transactions with connected companies not subject to Irish corporation tax. These rules are rarely an issue in practice.

In addition, arm’s-length requirements apply to certain Irish-developed patents which produce royalty flows between connected parties in Ireland in order for such parties to benefit from tax exemptions available on patent-related income.

Practical Transfer Pricing Example
This section provides an example behind the mechanics of a buy/sell related party arrangement. As an example, we provide the following company profile:

• Product development and manufacturing company is based in the UK (owns all IP (Intellectual Property)).
• UK sells tangible products for resale to a related party distributor in Ireland.
• Related party distributor sells to customers in Ireland.
  
  

In addition, the following functional profile is given:

• UK takes risk for product development and manufacturing investments and does not sell products to unrelated parties.
• Ireland is a limited risk buy-sell distributor and does not purchase similar tangible products from any third-parties and neither does the UK manufacturer sell the same products to third-party distributors.

Method selection
In this situation, the transaction-based methods (CUP, RPM, CPLM) are probably not appropriate, as neither party is involved with third parties in a comparable manner. In addition, the PSM would not be appropriate as the UK owns all IP associated with this transaction. Therefore the TNMM would most likely be the best (most appropriate) method to test or benchmark this transaction.

The TNMM requires the selection of a tested party. The tested party is the participant in the controlled transaction whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest and most reliable adjustments, and for which reliable data regarding uncontrolled comparables can be located. In this instance, the Irish distributor would be more appropriate to use as the tested party.

After determining that the TNMM is most appropriate, and the tested party is selected, a profit level indicator (PLI) selection is chosen. PLIs are ratios that measure the relationship between profits and costs incurred or resources employed. Practitioners may examine the rate of return on operating assets, return on sales, the ratio of gross profit to operating expenses, and other PLIs that provide reasonable indications of the tested party’s income under arm’s-length circumstances. Typically, for simple buy-sell transactions, the operating margin is selected as the PLI. Operating margin is defined as operating profit divided by total revenue.

Economic analysis
A comparable company search would then be conducted to determine an arm’s-length range of results for the tested party, in this case, the distributor – using databases with access to company financial information, conducts a search to find companies performing the same functions in the same location and incurring the same risks as the tested party. In this way one is able to make inferences about the arm’s-length nature of the transfer pricing as between the UK manufacturer and Irish distributor by analysing the operating margin results of the “comparable” distributors. The OECD Guidelines use the minimum and maximum of the comparable company results to establish the arm’s-length range. Certain countries, such as the US, may restrict this to the inter-quartile range of results. Typically, the three year weighted average of comparable company financial data is used to minimise business cycle fluctuations. In this example, suppose that the distributor search yielded the operating margin results below.

In advising on the appropriate transfer pricing policy, one might target the median operating margin of the three year weighted average of comparable companies. In this instance that value would be 3%.

In terms of policy, suppose, for example, that Ireland generated €100 in turnover for the latest fiscal year. Therefore, given the results of the comparables, the operating profit returned to Ireland should be €3. If operating expenses were held constant, the transfer price (or cost of goods sold) for Ireland would be calculated so as to maintain the 3% operating margin result for the Irish entity. This transfer price would be paid to the UK entity for their supply of the finished product, and would be listed as intra-group revenue on the UK financials.

• Using hypothetical figures, assume the following:
• Total revenues from sales for the Irish entity are €100;
• Operating Expenses for Irish entity are held constant at €80; and
• There are no other cost of sales for the Irish entity.

Given the above, the P&L for Ireland would look like:

Therefore the UK would receive a payment of €17 for their supply of the finished product. This transfer pricing policy would ensure that the intra-group transaction is at arm’s-length.

Conclusion
Transfer pricing is the most important international tax issue currently facing multinational enterprises. It is a relatively new field, with far-reaching consequences for non-compliance. Most European countries today have specific transfer pricing legislation and regulations. While Ireland does not have specific transfer pricing legislations, Irish companies with foreign subsidiaries need to remain vigilant that any inter-company transactions are transacted at arm’s-length and can be verified as being arm’s-length.