30 July 2010

International
Tax Alert
News and views from
Transfer Pricing

OECD releases revised

Transfer Pricing
Guidelines
Chapters I-III
On 22 July, the OECD concluded two recent initiatives to rene its
guidance on transfer pricing with the publication of:
• Revisions to Chapters I-III of the Transfer Pricing Guidelines, those
chapters that deal with the arm’s length principle, transfer pricing
1
methods and comparability analysis
• A new Chapter IX addressing how transfer pricing principles and
2
corresponding treaty rules should apply to business restructuring
3 4
Both sets of guidance closely follow drafts issued in 2008 and 2009 on
which we have issued separate Alerts.
This Alert focuses on Chapters I-III. It highlights the key features of this
new guidance. It also provides a fuller description based on our earlier
Alert and notes the few changes that have been made to the earlier draft.
We will be providing an Alert on the new Chapter IX shortly.

1 “Review of Comparability and of Prot Methods: Revision of Chapters I-III of the

Transfer Pricing Guidelines” (hereinafter TPG). A copy is available at http://www.oecd.org/
dataoecd/23/12/45690353.pdf
2 “Report on the Transfer Pricing Aspects of Business Restructurings: Chapter
IX of the Transfer Pricing Guidelines.” A copy is available at http://www.oecd.org/
dataoecd/22/54/45690216.pdf
3 “Transfer Pricing Aspects of Business Restructurings: Discussion Draft for
Public Comment.” (2008 Draft). A copy is available at http://www.oecd.org/
dataoecd/59/40/41346644.pdf
4 “Proposed Revision of Chapters I-III of the Transfer Pricing Guidelines.”(2009 Draft or
Proposed Revision). A copy is available at http://www.oecd.org/dataoecd/1/57/43655703.
pdf
 Guidelines Chapters I-III: the key
changes
The main changes to the 1995
Transfer Pricing Guidelines (1995
TPG) are:
• Replacement of the hierarchy
of transfer pricing methods and
adoption of the “most appropriate
method to the circumstances
of the case” principle for the
selection of transfer pricing
method
• Detailed discussion of the
importance and requirements of a
“comparability analysis”
• Extension and renement of
the guidance provided on the
application of transactional prot
methods (i.e., the Transactional
Prot Split Method [PSM] and
Transactional Net Margin Method
[TNMM])
Even though the 1995 TPG
expressed an explicit preference
for traditional transaction
methods over the transactional
prots methods, in practice many
taxpayers, faced with the inherent
problems of lack of information,
tended to use transactional prots
methods. The new Guidelines
establish the “most appropriate
method” principle. This principle,
adopted in the 2009 Draft, is based
on the facts and circumstances
5
of the transaction and is aimed
“at nding the most reliable
6 Affairs to the Comments Received on the
comparables.” Thus it largely
replaces the previous hierarchy of
methods.
5 See TPG Paragraph 2.9.
6 See TPG Paragraph 3.2.
2 International Tax Alert Transfer Pricing
The newly released Guidelines
manifest the OECD’s intention
to increase the comparability
standards of the 1995 TPG. As
such, they retain chapter III as
incorporated in the 2009 Draft,
with only minor changes.
Also, as part of the OECD’s effort
to increase comparability, the
new Guidelines extend and rene
the guidance provided on the
application of transactional prot
methods with very little change
from the 2009 Draft.
Detailed description
Most appropriate method
The most signicant change in the
revised guidance is the substitution
of the hierarchy of transfer pricing
methods with the principle of the
“most appropriate method to the
7
circumstances of the case.” As
such, the TNMM and PSM are no
longer considered methods of last
resort. However, to some degree
the new Guidelines still maintain
the hierarchy principle between
the transactional prot methods
and the traditional transaction
methods: when both can be applied
8 analysis of the conditions of the
in an “equally reliable manner,”
the traditional transaction method
should be selected. The Guidelines
arrive at a similar conclusion
regarding the application of the
Comparable Uncontrolled Price
[“CUP”] Method, which will trump
any other method if both it and the
other method can be applied in an
equally reliable manner.
7 See TPG Paragraph 2.2.
8 See TPG Paragraph 2.3.
The OECD explained, in a clarifying
9
document, that in the selection
and substantiation of the most
appropriate method under the
circumstances of the case there
is “no requirement to perform a
detailed analysis and rejection of
all alternative methods; usually
some methods will be easily
eliminated as not being the most
appropriate based on simply a high-
level analysis of the comparability
10
factors.”
In a change from the 2009 Draft,
the new Guidelines remove the
phrase “reasonably reliable
comparables.” “Reasonably reliable
comparables” were dened as
“the most reliable comparables
in the circumstances of the case,
keeping in mind the [availability
11
of information] limitations.” It
is difcult to assess whether this
exclusion relaxes the comparability
standards in any meaningful way.
Comparability
General concept
The new Guidelines emphasize
the importance of a comparability
analysis (including a preliminary
controlled transaction, selection
of the transfer pricing method,
identication of potential
comparable transactions, and
12
a conclusion), which “is at
the heart of the application of
9 “Response of the Committee on Fiscal
September 2009 Draft Revised Chapters
I-III of the Transfer Pricing Guidelines”
(hereinafter Response), issued 22 July
2010, OECD.
10 See Response Paragraph 9.
11 See “Proposed Revision.” Paragraph
3.2.
12 See TPG Paragraph 3.1.
 13
the arm’s length principle.”
It also recognizes the need
to balance reliability with the
burden it creates for taxpayers
and tax administrations. This
balance is particularly relevant
to the search for and selection of
comparables. The new Guidelines
remove the previous standard of
“reasonably reliable comparables”
(incorporated in the 2009 Draft),
while retaining the requirement
that a comparability analysis
should aim at nding the most
reliable comparables. An exhaustive
search of all possible sources
of comparables, however, is not
14
mandatory.
The new Guidelines suggest nine
fundamental (but not mandatory)
steps to be undertaken when
performing a comparability
15
analysis. They are:
• Determination of years to be
covered
• Broad-based analysis of the
taxpayer’s circumstances
• Functional analysis
• Review of existing internal
comparables
• Determination of available
sources of information on external
comparables
• Selection of the most appropriate
transfer pricing method
• Identication of potential
comparables
13 See TPG Paragraph 1.6.
14 See TPG Paragraph 3.2.
15 See TPG Paragraph 3.4.
• Determination of and making
comparability adjustments where
appropriate
• Interpretation and use of data
collected
The 2009 Draft had suggested
10 fundamental steps, the
previous nine and another: the
existence of review processes to
ensure adjustments for material
changes. Though this last step was
removed, no signicant impact is
expected from this exclusion as this
requirement is partially covered by
Paragraph 3.3 and 3.82.
The new Guidelines analyze
the basis and requirements for
performing or not performing
adjustments to the comparables.
In particular, they state that if
there exist differences that could
materially affect the comparison,
adjustments must be made where
16
possible. The general principle
is that “[t]he only adjustments
that should be made are those
that are expected to improve
17
comparability.” Nevertheless,
the presence of too many
adjustments, the Guidelines note,
could be an indication of very poor
18
comparability.
Comparable Uncontrolled
Transactions
The new Guidelines maintain the
distinction between “internal” and
“external” comparable transactions,
while noting that internal
comparable transactions “are not
always more reliable [than external
16 See TPG Paragraph 1.35.
17 See TPG Paragraph 3.53.
18 See TPG Paragraph 3.51.
International Tax Alert Transfer Pricing
19
comparables].” Furthermore,
the new Guidelines maintain the
point raised by the 2009 Draft
that “it is not the case that any
transaction between a taxpayer
and an independent party can be
regarded as a reliable comparable
for controlled transactions carried
20
on by the same taxpayer.”
The new Guidelines also incorporate
an interesting discussion
regarding the presence of minority
shareholders in a related party
transaction, concluding that their
presence may approximate a third
party transaction while not being
21
determinative in itself.
Finally, the new Guidelines discuss
the appropriate use of databases
when searching for external
comparable companies. They
highlight that database use “should
not encourage quantity over
22
quality.” An in-depth comparable
company analysis is to be preferred
over a broad classication
screening.
Transparency
The new Guidelines call attention in
several sections to the importance
of transparency both on the
part of the taxpayer and the tax
administration (e.g., regarding the
23
use of proprietary databases).
In particular, they indicate that
whenever either side, the taxpayer
or the tax administration, uses
comparable companies to support
a transfer pricing position, it should
provide the other side appropriate
19 See TPG Paragraph 3.28.
20 See TPG Paragraph 3.28.
21 See TPG Paragraph 3.26.
22 See TPG Paragraph 3.33
23 See TPG Paragraph 3.34.
3
 documentation to assess the
reliability of the comparable
companies.
Transactional Profit Methods
Transactional Prot Split Method
The new Guidelines explain that
the PSM should only be applied
in cases where both sides of
the transaction make unique or
24
valuable contributions, or when
the transaction involves highly
integrated operations by both
25 26
sides. The allocation of prots
should be based, when possible,
on “how independent parties in
comparable circumstances would
have split the prot in comparable
27
transactions.” This same concept
is reiterated a few pages later when
the Guidelines state that total
prots should be divided “based
upon a reasonable approximation
of the division of prots that
independent enterprises would have
28
expected to realize.” Signicantly,
the aforementioned quote replaces
the following sentence from the
1995 TP Guidelines: “[based
upon] the relative value of the
functions performed by each of
the associated enterprises.” In the
new Guidelines, the allocation of
prots may be based on the division
of functions if there is no other
more direct evidence of third party
behavior.
24 See TPG Paragraph 2.59.
25 See TPG Paragraph 2.109.
26 Note that the new Guidelines indicate
references to prots should be taken
as applying equally to losses. See TPG
Paragraph 2.108.
27 See TPG Paragraph 2.111.
28 See TPG Paragraph 2.119.
4 International Tax Alert Transfer Pricing
The new Guidelines also provide
the following guidance for the
application of the PSM and the
determination of the combined
prot to be split and the splitting
29
factors. They should:
• Be consistent with the functional
analysis
• Be consistent with what would
have been agreed between
independent parties
• Be consistent with the type of
prot split approach
• Be capable of being measured in a
reliable manner
30
Additionally:
• The term of the arrangement and
allocation keys should be agreed
to in advance of the transaction
• The taxpayer using the method
should be prepared to explain the
appropriateness of the method
• The determination of the
combined prot to be split and
of the splitting factors should
generally be applied consistently
over time
Further, the new Guidelines discuss
various approaches for splitting
prots, as well as a wide set of
allocation keys that can be used and
when such keys are appropriate.
Paragraph 2.134 incorporates the
requirement that “[w]here more
than one allocation key is used, it
will also be necessary to weight the
allocation keys used to determine
the relative contribution that each
allocation key represents to the
earning of the combined prots.”
29 See TPG Paragraph 2.116.
30 See TPG Paragraph 2.117.
The Response, issued by the OECD,
claries that in those situations
where the arm’s length principle
is difcult to apply due to the lack
of comparable transactions “it
may be appropriate, in relevant
circumstances, to use a prot
split method with no comparable
31
data.”
Transactional Net Margin Method
The new Guidelines suggest that
the TNMM is unlikely to be reliable
if both parties to a transaction
contribute unique contributions,
but it may be applied where only
one of the parties is responsible for
32
all of the unique contributions.
However, the new Guidelines,
following the 2009 Draft,
distinguish this situation from the
case where both parties make
33
contributions but only one of
them makes unique contributions.
In such a case – or even where
there are no unique contributions
involved at all – although the
TNMM may be applied, the new
Guidelines clarify that the absence
of unique contributions involved in
a transaction does not necessarily
imply that the TNMM is the most
34
appropriate method. Other
methods may still be more reliable.
Finally, the new Guidelines,
following the 2009 Draft, discuss
at length the guidance for the
application of the TNMM, including
the selection of the appropriate
31 See Response Paragraph 21.
32 See TPG Paragraph 2.59.
33 Note that the new Guidelines replace
the term “intangibles” with “contributions”
throughout the document.
34 See TPG Paragraph 2.61.
net prot indicator (in the 2009
Draft called the “net prot margin
indicator”). For additional information, please contact any of the
Documentation and compliance professionals listed below or your Ernst & Young advisor.
burden on taxpayers
In its Response, the OECD reminded
Ernst & Young, EMEIA Tax Centre - Transfer Pricing and
readers that “the specic required
Tax Effective Supply Chain Management, London
content and timing of transfer
pricing documentation are matters • Robert Miall +44 20 7951 1411
properly left to local country rmiall@uk.ey.com
35
law.” As such, it was reiterated
that Article 9 of the Model Tax Ernst & Young LLP, Transfer Pricing, Washington, DC
Convention does not create
documentation requirements. • Karen Kirwan +1 202 327 8731
karen.kirwan@ey.com
• Carlos Mallo +1 202 327 5689
calos.mallo@ey.com

35 See Response Paragraph 7.

International Tax Alert Transfer Pricing 5

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6 International Tax Alert Transfer pricing