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Section 3. Finance, money circulation and credit
3. Law On National Bank of Ukraine № 679-XIV, 20/05/1999. - [online]: http://zakon5.rada.gov. ua/laws/show/679-14
4. Recommendation of the European Systemic Risk Board of 22 December 2011 on the macroprudential mandate of national authorities (ESRB/2011/3) - [online]: http://www.esrb.europa. eu/pub/pdf/ESRB_Recommendation_on_National_Macroprudential_Mandates.pdf?87d54 5ebc9fe76b76b6c545b6bad218c
5. The views expressed herein are those of the author and can therefore in no way be taken to reflect the official opinion of the National Bank of Ukraine.
Dessatniuk Oksana, Cherevko Olga, Ternopil National Economic University, E-mail: o.cherevko@ukr.net
Practical application of the methodology for calculating the arm’s length range of prices/profitability for transfer pricing purposes
Abstract: In order to ensure that the price in a transaction between related parties coincide with the market price, the arm’s length range must be calculated. This involves identification of comparable transactions, listing prices or calculating profitability ratios, defining the arm’s length range, its quartiles and usually a median. Despite the process being mostly subjective and judgmental, there are certain strict rules and techniques to be followed. The goal of this paper is to examine the arm’s length range determination and its regulation by Ukrainian government.
Keywords: arms length range, transfer pricing
The use of transfer pricing (further — TP) for multinational enterprises (further — MNE) is now a common practice. The governments are usually responsible for defining legislative rules on this process. International organizations such as the Organization for Economic Co-operation and Development (further — OECD) or the United Nations are also very much involved in developing guidelines based on current world practice and experience.
The fundamental concept in TP is the well-known “arm’s length” principle, an international TP standard that OECD member countries have agreed should be used for tax purposes by MNEs and tax administrations. The concept first introduced in the USA, was subsequently used by the OECD and has been adopted by virtually all tax authorities in major market countries [1]. Transfer price should be the same as if the two companies involved were indeed two independents [2]. Applying the arm’s length principle leads to calculation of the taxable income
median, quantile, OECD.
that reasonably is expected to be derived if the parties were dealing at arm’s length with one another.
To establish the arm’s length conditions (or a range of profitability/prices thereof), it is necessary to compare the attributes of the transactions or enterprises in order to find the most comparable ones with regard to a certain transactions with its related parties. Usually it is hard to meet an exact price (a single figure — price or a margin) based on the arm’s length principle. These difficulties may be explained by:
• the application of the arm’s length principle only produces an approximation ofthe conditions that would have been established between independent enterprises — it’s nearly impossible to find the exact same ones;
• independent enterprises engaged in comparable transactions under comparable circumstances may not establish exactly the same price — different factors may influence their pricing decision;
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Practical application of the methodology for calculating the arm’s length range of prices/profitability for transfer pricing purposes
• difficulty in obtaining adequate information, etc.
That is why the arm’s length range of prices or profitability is used for cases where there are no exact or similar transactions. This provides a broad parity of tax treatment for both the members of the MNE groups and independent enterprises.
Using a range of prices or profitability allows neutralizing the negative influences from change in economic conditions, short-term foreign exchange fluctuations, seasonal work, frequent law alterations, etc.
In addition, in order to neutralize or reduce (if possible) these negative circumstances and make economic conditions for different companies as equal as possible, multiple year data is used. This means that, for comparison, the data of the year of the transaction is examined as well as the data for prior periods [4].
In general, the use of multiple-year data is considered to be appropriate when there are variations in the year-to-year performance of the tested party and the comparable companies due to factors other than TP.
For example, an economic downturn in a particular industry may not affect the performance of all of the companies in that industry at the same time. Rather, certain companies may be able to withstand the effects of a downturn in the industry longer than others. This type of timing difference can create inconsistencies in the short-term results of companies within the same industry and can therefore make a single-year data comparison between the tested party and the comparable companies unreliable. In practice, virtually all TP practitioners rely on multiple year data when performing profit based analyses — for example, the three-year average results for the tested party are compared to the three-year average results of the comparables.
Being aware of this issue at the outset of a project allows a company to set its TP policies in a way that will increase the likelihood that the company will be able to meet the varying requirements of the jurisdictions in which it operates. For instance, a company with an intercompany transaction between its US parent and Canadian subsidiary may
want to target a more conservative point in its range of results to increase the probability so that, at year end, its results will fall within both the three-year and single-year average ranges of results [5; 6].
The OECD Guidelines and Ukrainian TP rules [5] recommend the use of data from both the year under review and prior years [2, art. 1.49]. This enables an understanding of the effect on profits of the product life cycles, industry cycles, economic conditions, and other factors. The OECD Guidelines also recommend that multi-year data be considered to take into account the effects on profits of the product life cycle and short-term economic conditions [2, art. 3.44].
Taking into account all the above, is why a solid approach has been established: usually the three most recent years of data of similar independent companies in the benchmark analyses are used.
After establishing the use of multiple year data and the arm’s length range, the calculation should be performed. In order to do that, the approach for determining the arm’s length range should be chosen. In common practice, two methods are being used: (1) the pool method, and (2) the average method.
In the pool method, the data for all the years is used for the calculation. Meanwhile, in the average method, first, the data is calculated as the average amount, and only after that, the received data is used for determining the arm’s length range. The average method smoothens the effects of inequality in information, different economic conditions, etc. Each of the two methods gives different results.
If no material differences between the comparable companies can be adjusted for, the taxpayer must increase the reliability of the results using the interquartile range. The interquartile range is the range from the 25th to the 75 th percentile of the results derived from the uncontrolled comparable results. The use of the interquartile range of results is meant to exclude potential outliers and, consequently, increase the reliability of the comparison.
Recently a new procedure for calculation of the arm’s length range and a median of the range has been adopted in Ukraine [6]. According to it, the controlled transaction should not be included into the sample. In order to calculate the arm’s length
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range, the first (lower) and a third (upper) quartile have to be identified, and their values would be the minimum and maximum of the range.
For calculating the arm’s length range the number of values in the sample (N) should be counted and ordered from the smallest to the biggest, and
In order to calculate the range using the average method, the average PLI was calculated for each of the five companies. Then the calculated data (five items) was arranged from low to high. And finally, the interquartile range [6.67% — 17.33%] and the median (14.67%) were calculated.
Taxpayers should generally set their TP policies to target a return that is comfortably within the interquartile range of results. As a rule, the taxpayer will not be subject to adjustment if its results fall within such an arm’s length range. However, according to Ukrainian TP rules in the case of adjustments, additional tax liabilities will be accrued to the median, not to the range limits.
We believe that instead of the median the average should be used. The median and the average might be close and they might not. The median of a set of numbers is that number where half the numbers are lower and half the numbers are higher. Adjusting the price to the median means that it would only show the middle value of the set, and it would not necessarily be the fairest.
The average of a set of numbers is the total of those numbers divided by the number of items in that set. Adjusting the price to the average value means that the arithmetic mean value is calculated, which is closer to the actual middle. Considering
then lower and upper interquartile range has to be calculated.
This can be explained in the following example. The profit level indicator (further — PLI) was calculated for five companies for three years.
In order to calculate the range using the pool method, the PLIs were calculated for each of the five companies. Then the calculated data (15 items) was arranged from low to high. And finally, the interquartile range [5% — 18%] and the median (11%) were calculated.
that the extremes are rejected by the lower and upper interquartile, the use of the arithmetic average should provide the fairest result considering the diversity of the market and the unstable economic conditions.
In practice, taxpayers often target the middle of the range. This has a number of potential benefits. First, since TP is often set at the beginning of the year based on budget numbers, companies often miss their targeted result because of differences between their budgeted and actual financials. By targeting a point that is comfortably within the range, a company provides itself with a certain amount of leeway if it misses its target and still fall within an acceptable range of results. Second, since comparable company results are likely to vary from year-to-year, a TP policy that targets a midpoint in the range will be more likely to fall within the range.
TP rules are relatively new for both Ukrainian businesses and the tax authorities. Many companies (mostly with a foreign parent or foreign influence
Company Year 1 Year 2 Year 3 Average for years 1-3
A 4% 6% 10% 6.67%
B 18% 18% 16% 17.33%
C 24% 5% 15% 14.67%
D 11% 26% 17% 18.00%
E 2% 5% 6% 4.33%
Average method Pool method
Number of data 5 items Number of data 15 items
Minimum 4.33 Minimum 2
Lower quartile 6.67 Lower quartile 5
Median 14.67 Median 11
Upper quartile 17.33 Upper quartile 18
Maximum 18.00 Maximum 26
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Practical application of the methodology for calculating the arm’s length range of prices/profitability for transfer pricing purposes
through business) already adapted to the rules, and also conducted benchmarking studies for transactions held in 2013 and 2014 as well as prepared TP documentation.
At the same time, the vast majority of companies are still waiting for a reaction from the Ukrainian tax authority on their submitted reports on controlled transactions for September-December 2013 and 2014 as well as for the rulings on the first tax audits on TP issues. Many of them are waiting for a request for TP documentation from the tax authority, and only upon a request would start performing the study and preparing the documentation.
In general, the tax authorities have made huge progress in creating TP rules throughout 2012-2015. The Ukrainian parliament and its working groups have made tremendous changes in the legislation by adopting the first law on TP. On September 1,
2013, these rules went into force. Since that law was adopted, additional legislative documents were developed and implemented.
In these constantly changing legislative conditions it is hard for a business to react as quickly as possible, so the most realistic way to cope with this is to conclude an advance pricing agreement (further — APA) between the taxpayer and the tax authorities, which can provide a level of certainty against adjustments, penalties, etc.
Due to a general lack of data on the prices used within a MNE and the prices for comparable arm’s length transactions on the market, it is hard to use comparable uncontrolled price method. Thus, benchmarking study has to be conducted in order to ensure the prices used in the transactions comply with “arm’s length” principle.
References:
1. http://www.duffandphelps.com/SiteCollectionDocuments/Other/GuidetoInternationalTransferPric-ing_Chapter1.pdf
2. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2010. - 444 p.
3. Mark Bronson, Michelle Johnson & Kate Sullivan. Guide to International Transfer Pricing. - Wolters Kluwer. Law & Business. - P. 1-67.
4. Tax Code of Ukraine. The law of Ukraine #2755-VI as of02.12.2010.
5. http://www.visnuk.com.ua/ua/pubs/id/8390
6. http://www.voxeu.org/article/multinational-firms-and-transfer-pricing-new-evidence
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