Precise delimitation of the transaction and transfer pricing analysis

Issuing reports as a result of the work of the BEPS Action Plan resulted in a major update of the OECD Guidelines applicable to transfer pricing for multinational enterprises and tax administrations (“OECD Guidelines”) in 2017. The different jurisdictions in Latin America have focused efforts in adapting their regulations to this new reality, however, most have focused their efforts on the adoption of the Action 13 “Revisiting the transfer pricing documentation”, issue we discussed in previous publications (See publication Adoption of Master File, Local File and Country by Country Report on the regulatory framework of Transfer Pricing in Latin American countries) .

With respect to actions related to economic substance, the trend has been to build on the OECD guidelines rather than developing specific local regulations. On this last point, one of the most important changes is related to the incorporation of a precise delimitation of the transaction, explained in Section D, Chapter I of the OECD Guidelines, as part of the implementation of the Arm’s Length principle. This concept demands a thorough review of the transaction in order to obtain a sufficiently clear understanding of it to allow an analysis of appropriate comparability, since a superficial review of the transaction could result in an incorrect transaction definition that would result in the wrong selection of comparable transactions or companies and therefore incorrect transfer pricing analysis by the taxpayers. This incorrect analysis could, in their process of self-determination, lead them to apply incorrect transfer pricing adjustments in their tax returns and the tax authorities to errors in their actions to oversight and control.

The exact definition of the transaction involves clarity in the context in which the transaction was made, implying that the taxpayer must identify the parties involved in the transaction, and their interaction with the global value chain of the business: (i) trade and financial relations; and (ii) relevant economic circumstances. This implies a broad understanding of the industrial sector of the taxpayer and the factors that affect it, including business strategies, markets, products, their supply chain, and the key functions performed, the tangible assets used and the risks assumed as important.

In order to be able to define precisely the transaction, although the identification and clear understanding of the context is vital, it is necessary to analyze the economically relevant characteristics of the transaction or the comparability factors, which can be categorized as follows:

Contractual terms:

  • Starting point for the delimitation of the transaction when it has been formalized through a written contract and reflects the responsibilities, obligations, rights, risks and how the anticipated benefits of the interaction between the parties shall be distributed;
  • If the economically relevant characteristics of the transaction are inconsistent with the written contracts, the actual transaction must be defined for the purposes of transfer pricing analysis according to the characteristics reflected by the conduct of the parties;
  • When there are no written contracts, the actual transaction must be deducted from the evidence of the actual behavior observed by identifying the economically relevant characteristics of the transaction.

Functional analysis (functions performed by each of the parties, taking into account the assets used and risks assumed):

  • It seeks to identify the economically significant activities and responsibilities of each of the parties, and the capabilities they bring;
  • Understanding of how the economic group creates value, and the interaction of functions and contribution of each of the entities that make up the group;
  • Importance of functions in terms of frequency, nature and value;
  • Consideration of used assets (tangible and intangible).

Characteristics of the transferred property or services provided:

  • Tangible property: (i) Physical characteristics, (ii) Properties, (iii) reliability, (iv) Availability and (v) Volume.
  • Services: (i) nature and (ii) scope;
  • Intangible Property: (i) Method of operation (e.g. licensing or sale), (ii) Type of property (e.g. patent, trademark, skills or know-how), (iii) duration, (iv) Degree of protection, (v) expected benefits of the use of intangible property.

Economic circumstances:

  • When looking for the arm’s length prices, ensure that the markets in which the related companies and independent companies operate do not have significant differences that affect prices, or that appropriate adjustments can be made;
  • Relevant economic circumstances for the comparability of markets: (i) geographical location, (ii) dimension, (iii) degree of competition and the relative competitive position of buyers and sellers, (iv) availability (risk) of goods and alternative services (v) levels of supply and demand in the market, (vi) purchasing power of consumers, (vii) the nature and extent of market regulation, (viii) production costs, (ix) market level (e.g. : retail or wholesale); (x) date and /or time of operation; (xi) economic cycles and /or product life/ business; (xii) geographic market and (xiii) other.

Business strategies:

  • Aspects of the company contained in the strategy such as: (i) innovation, (ii) development of new products, (iii) degree of diversification, (iv) risk aversion, (v) political changes, (vi) penetration of markets and (vii) other;
  • Temporal aspects of the strategy involving evaluation in the long run.

Other elements to be considered are: losses, government policies, and savings from the location of activities, established workforce, and synergies, among others.

The precise delimitation of the transaction will allow performing the adequate search for the appropriate comparable transactions, to apply correctly any of the transfer pricing methods. The challenge of taxpayers in Latin American countries will be able to locate, with the limited information available and considering the above, the most appropriate comparable transactions that allow them to evaluate their compliance with the Arm’s Length principle.

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