Page 153 - SAIT Compendium 2016 Volume2

PN 7/1999 Income Tax acT: PracTIce noTes PN 7/1999
• Under the contribution analysis approach, it is generally the combined operating pro t (pro t before interest and tax) that is divided between the parties on the basis of the relative contribution of each party to that combined gross pro t.
However, paragraph 3.15 of the OECD Guidelines notes that these approaches are not necessarily exhaustive or mutually exclusive. There may be alternative ways to split a pro t to achieve a reliable arm’s length result.
As is explained in paragraph 3.17 of the OECD Guidelines it may, in some circumstances, be appropriate to split gross pro ts (as opposed to operating pro ts) between the connected parties and then deduct the operating expenses incurred by or attributable to each relevant enterprise. The example used in paragraph 3.17 of the OECD Guidelines is the case of a multinational that engages in highly integrated world-wide trading operations involving various types of property. It may be possible to determine the enterprises in which expenses are incurred or attributed, but not to accurately determine the particular trading activities to which those expenses relate. In such case it may be appropriate to split the gross pro t from each trading activity and then deduct from the resulting overall gross pro t the operating expenses incurred by or attributable to each enterprise.
The allocation of gross pro t should be consistent with the location of activities and risks. Care must be taken to ensure that the expenses incurred by or attributable to each enterprise are consistent with the activities performed and risks assumed by the relevant entities.
(a) Residual Pro t Split Analysis
The residual pro t split approach rst provides both the parties to the transaction with a basic return, based on what independent rms would obtain for performing similar functions and undertaking similar risks. Applying other transfer pricing methods, such as a cost plus method or a resale price method, could also achieve this.
The residual pro t remaining after the rst stage division would be allocated among the parties, in accordance with the way in which this residual would have been divided between independent enterprises. Facts and circumstances that could in uence the pro t allocation in the second stage include the parties’ contributions of intangible property and relative bargaining positions.
This requires a judgment about what factors contribute to the residual pro t, and their relative contribution. For example, it may be determined that the process development and the marketing are the only relevant contributors to the residual pro t and that each contributes 50 per cent to that pro t. A 50:50 split of the residual pro t between the manufacturer and the retailer would then be justi ed.
There is no de nitive guide on how the relative contribution of the parties should be measured. It is quite likely that the transaction between the parties will be unique, so there will be no external benchmark against which to test the reliability of the assessment of relative contributions. In practice, the assessment of relative contribution may, of necessity, need to be a somewhat subjective measure, based on the facts and circumstances of each case.
(b) Contribution analysis
Multinationals are organisationally different from comparable domestic enterprises. Large integrated multinationals may have the bene t of cost savings attributable to the scale of their operations, otherwise known as economies of scale. Such savings are not necessarily available to independent enterprises. For example, the administration costs incurred by a multinational which both manufactures and retails toasters are likely to be less than the aggregated costs faced by two separate rms, one of which manufactures toasters, and the other of which retails them. In the absence of intangibles, the price determined under the cost plus method would then be higher than the price determined under the resale price method. This means that there would be a negative residual if the residual pro t split approach were to be used.
Economies of scale is not an aspect which can readily be evaluated in a traditional arm’s length analysis. However, it is an important factor that needs to be addressed when determining whether a multinational’s transfer prices are consistent with the arm’s length principle.
One approach to this problem may be to use the contribution analysis approach. Under this approach, the combined gross pro t of the two parties to a transaction is allocated between them, on the basis of their relative contribution to that pro t. This differs from the residual pro t split approach, in that basic returns are not allocated to each of the parties to the transaction before the pro t split is made.
9.8.3 Practical problems
(a) The application of the pro t split method relies on access to world-wide group data, which may be dif cult to obtain.
(b) The allocation of pro ts is subjective.
(c) This method may result in a less reliable measure of the arm’s length price than an analysis under one of the
other methods.
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