Module 2: Overview of the Functions and Characteristics of Typical Transfer Pricing Rules

Welcome to Module 2 of the World Bank’s Transfer Pricing Electronic Learning Tool.

Slide 3
A tax administration can examine a taxpayer’s transfer pricing only if there are domestic rules in place
that allow an auditor to do so. This Module provides an overview of such rules and a description of the
essential features of typical domestic transfer pricing rules which are aligned with international best
practice. It should be noted that the terms rule, legislation and law are used interchangeably throughout
this module.

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Slide 4
Countries take different approaches to transfer pricing rules, reflecting, for example:
Different transfer pricing policies or strategies. Some countries have introduced exemptions or
simplifications for smaller taxpayers, or for low-risk transactions or low-risk sectors.
And countries also have differing legislative conventions, such as the balance between primary and
secondary legislation.
Effective transfer pricing rules, however, require several essential features that most countries adopt.
These features are described in the slides that follow.

Slide 5
It should not be forgotten that bilateral tax treaties impact on the rules governing transfer pricing
enforcement, and, where a treaty is in place between the jurisdictions of the parties to the transaction
under examination, the auditors need to be aware of the terms of that treaty.
In line with Article 9 of the OECD and UN Model Tax Conventions, treaties typically require a tax
administration to adhere to the arm’s length principle when it seeks to adjust taxable profit using its
domestic transfer pricing rules. It is important to note that a treaty cannot take the place of domestic
transfer pricing legislation and, by itself, does not confer on a tax administration the authority to examine
and adjust transfer pricing.

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Slide 6
This module describes the essential core components of transfer pricing legislation.
Later modules describe in more detail the components of practical, administrative and procedural
elements of legislation. But we should take a moment to have a quick look at what is meant by Core,
Practical, Administrative and Procedural.

‘Core’ provisions are those that set the framework for a country’s transfer pricing legislation. Typically,
they define the scope of the legislation, prescribe the applicable standard such as the arm’s length
principle, and authorize various types of adjustments.

‘Practical’ refers to how the arm’s length principle is applied. A statement of the arm’s length principle,
on its own, is typically not sufficient to establish how it should be applied. There are other provisions that
elaborate on and support the practical application of the arm’s length principle such as comparability, the
selection and application of the methods and the construction of a range. All these provisions are
typically necessary and are, to differing degrees, included in the legislation or guidance of almost all
countries with well-developed transfer pricing legislation.

In addition to provisions guiding the practical application of the arm’s length principle, certain provisions
concerning administrative and procedural matters are necessary.
Some provisions are specific to transfer pricing, for example, reporting requirements, documentation,
and advance pricing agreements, whilst others may be general in their scope such as the statute of
limitations, penalties, authority to issue secondary legislation and so on.

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Slide 7
Now let’s turn our attention back to the core elements of transfer pricing [Link] are a number of
essential core elements to any effective transfer pricing regime. These core elements that have been
adopted, in varying forms, by jurisdictions with comprehensive transfer pricing rules and include:
Provisions to:
- Define the scope of the rules. That is, to define the taxpayers and transactions affected by the rules.
- Stipulate the compliance criteria for transactions. Such provisions normally specify that the arm’s length
principle applies to transactions within the scope of the rules.
- Define the compliance requirements of taxpayers. These will normally require affected taxpayers to
apply the arm’s length principle to their relevant transactions, and to make adjustments if necessary; and
- Provide tax authorities with the powers necessary to enforce the rules. Such provisions normally allow
the tax authority to make adjustments to taxable income, if the taxpayer does not apply the arm’s length
principle. These core provisions are discussed in more detail, in later slides.

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Slide 8
Let us examine the first core element of transfer pricing rules, ‘defining the scope of the rules’.
Transfer pricing rules apply to cross-border transactions between related parties and, for an increasing
number of jurisdictions, they also apply to domestic transactions between related persons. In addition,
the rules may be deemed to apply to the attribution of profits to a permanent establishment.

Now, let’s pause for a moment and study each of the key terms highlighted in this slide:
 Cross-border transactions
 Domestic transactions
 Related persons and
 Profits to a permanent establishment
Please note that the term ‘control’ in the context of related persons is clearly important and it is
discussed in an upcoming slide. Click on each term and make sure you are comfortable with each term
before moving onto the next slide.

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Slide 9

Article 9 of the UN and OECD Model Tax conventions determine enterprises to be associsated
where:

 An enterprise of a contracting state participates directly or indirectly in the management,

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Slide 10
For example, if company A owns 55% of the ordinary shares of Company B, which owns 55% of the
ordinary shares of Company C, then:
Company A controls Company B, Company B controls Company C, and therefore, Company A, indirectly,
controls Company C.

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Slide 11
We saw in the previous slide that transfer pricing rules typically apply to transactions where one party to
the transaction controls the other, or both are under the control of the same persons or group of persons.
The definition of ‘control’ is normally found in domestic law and can vary from country to country.
Typically, control is defined according to two criteria, supplemented with anti-abuse ‘control’ provisions.
These are:
- legal control (also referred to as ‘de jure’ control) and
- actual control (also referred to as ‘de facto control’)
It is important to note that control in this context refers to high-level control over the person itself,
including the ability to dictate high-level policy and strategy to that person. There will be some situations
where one person has significant influence over the other’s business but cannot be said to control that
other for the purposes of the transfer pricing rules.

Slide 12
Let’s go through two examples.
Example 1
Company A, which operates a car dealership in your country, enters into an exclusive dealership
agreement with Company X, a foreign car manufacturer. Company A and Company X are unrelated legal
persons . The dealership agreement includes detailed provisions that govern the pricing and other terms
that Company A will use in its sales to independent customers in your country.
In this case, most countries would not consider Company A and Company X as related persons for
transfer pricing purposes. The dealership agreement is a contract between independent parties
operating at arm’s length.

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Slide 13
Example 2: Company B, which conducts a manufacturing business in your country, enters into a
manufacturing agreement with Company Y, a foreign company that designs and sells clothing. Company B
and Company Y are unrelated legal persons.
A manufacturing agreement between the two companies stipulates that Company B will manufacture
clothing for Company Y according to the designs, specifications and standards specified by Company Y. In
practice, over 80% of Company B’s production is for sale to Company Y.
In this case, most countries would not consider Company B and Company Y as related persons for
transfer pricing purposes. The manufacturing agreement is a contract between independent parties
operating at arm’s length.

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Slide 14:
In practice, transfer pricing is most often concerned with transactions between legal persons (such as a
company or a corporation) that are part of a multinational or domestic group.
The transfer pricing rules can, however, apply to transactions involving other categories of person,
including:
- an individual (‘natural person’). For example, if an individual provides financing, or leases property or
equipment, to a company which he or she owns controls. In such cases, transfer pricing rules may apply
to those transactions, depending on the wording of the domestic transfer pricing rules.
- a partnership. For example, if a taxable partnership has ownership of a company, then transactions
between that partnership and the company may fall within the scope of the transfer pricing rules.

Slide 15
Countries define ‘arm’s length’ in their domestic rules in different ways. A typical definition is:
The arm’s length principle compares the conditions that are made or imposed between two or more
related persons in their commercial or financial relations with those conditions which would be made
between unrelated persons engaged in comparable commercial or financial relations.
Arm’s length conditions are those conditions which would be made between unrelated persons engaged
in comparable commercial or financial relations.

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Slide 16
Transfer pricing rules typically specify that the taxable profit of an enterprise that conducts one or more
transactions with a related enterprise should be computed on the basis that those transactions are
conducted at arm’s length.
This means that:
- taxpayers should compute the profit reported in a tax return on the basis that their controlled
transactions are conducted at arm’s length.
- and tax administrations can adjust the measure of profit to the arm’s length amount.

Slide 17

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Country rules typically specify that adjustments made to taxable profit by either the taxpayer or the tax
authority should result in an increase in taxable profit, and not a decrease. Absence of such a provision
may give rise to tax avoidance. Let’s go through an example to illustrate this point.

Slide 18
In the example, ABC Manufacturing, located in Country A, sells products to a related distributor in
Country B, ABC Distribution.
The distributor then sells the products to third party customers.
The inter-company transfer price for the sale of the products is $100.
The revenue received by ABC Manufacturing $100 will be taxed in Country A, and ABC Distribution will be
able to claim a deduction of $100 for tax purposes.

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Slide 19
Now let’s examine what will happen if the tax jurisdiction of Country B determines that the arm’s length
price should have been $150 and proceeds to adjust the transfer pricing accordingly.
After the adjustment, ABC Distribution will receive a tax deduction of $150 in respect of its purchases,
reducing its taxable profit by $50.
Without a corresponding adjustment in Country A, ABC Manufacturing will still only be taxed on income
of $100. There is thus a mismatch between the taxable income and tax deduction and a portion of profit,
in our case $50, may not be taxed in Country A.
This is often termed as ‘double non taxation’.

Slide 20
Most countries that have adopted transfer pricing rules require taxpayers to file an arm’s length measure
of profit in their tax returns.
This would need to be the case for countries that operate a ‘self-assessment’ system.
In such cases, the transfer pricing rules need to specify this. Now please click on the self assessment
button. For example: For the purposes of [relevant provisions of Country’s tax law], where an enterprise
engages in one or more commercial or financial transactions with an associated enterprise that is not
residence of that Country, each such enterprise shall determine the amount of its taxable profits in a
manner that is consistent with the arm’s length principle.

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Slide 21
Some country transfer pricing rules stipulate that, for example, the Commissioner, or Minister, may make
adjustments to taxable profit, if the taxable profit filed in a tax return does not accord with the arm’s
length principle. In such cases, this could be read, as not requiring the taxpayer to file an arm’s length
measure of profit in the tax return, and therefore rules out the imposition of any penalties for making an
incorrect return.
It is vital that auditors are familiar with their country transfer pricing rules.

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Slide 22
Domestic transfer pricing rules must, of course, allow the tax administration to enforce the rules.
It is not always necessary to make this explicit in the law, but, where it is necessary, possible wording
could be as follows:
Where the conditions in commercial or financial transactions between associated enterprises are not
consistent with the arm’s length principle, then any amount of profits that would have accrued to an
enterprise and been taxable to that enterprise if the conditions to the transaction had been consistent
with the arm’s length principle, shall be included in the taxable profits of that enterprise and taxed
accordingly.

Slide 23
And finally, a short practice exercise'. The text is an extract from fictitious transfer pricing legislation of
the country of Genovia. It contains a number of potentially problematic issues. Can you spot these? Click
on the words or passages that you consider problematic.

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You have now successfully completed Module 2 of the World Bank’s Transfer Pricing Electronic Learning
Tool.

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