Part 1 - AL-Tax

International Taxation Handbooklength test is subject to the economic fact pattern of the transfer pricing case. Whatis new is that, in addition to deploying external data such as comparable units(so-called “comparables”) of price or margin, in most cases the arm’s length test isexpected to be established on the basis of internal data such as budget-actual analysisand assessment (cf. Paragraph 3.4.12.2 of Administrative Principles 2005).Because transfer prices have the feature that their arm’s length nature cannot beaudited by means of one single figure but a corridor of plausible results, generallythe tax authorities request the taxpayer to demonstrate that transfer prices wereconsidered on the basis of the arm’s length principle. In many countries documentationrequirements are based on the notion of a legal concept that, while the burdenof proof is with the tax authority, the taxpayer is obliged to provide evidencethat it believes the appropriateness and the arm’s length nature of transfer prices.Obviously, several ways of documentation approaches can be found. A flowcharton frequently used documentation steps in many countries is provided inFigure 7.1. Transfer prices are primarily documented by means of two dependentpackages of information: Documentation of facts and arm’s length documentation.The documentation of facts consists of the documentation of the company and thegroup, as well as the documentation of the business environment. In order to preparethe arm’s length analysis, the identification of relevant related-party transactionsis necessary. As the circled part of the chart shows, the arm’s length analysisitself is based on the function and risk analysis and a choice on the arm’s length testapproach. Subject to the underlying fact pattern (‘routine’ yes or no, ‘entrepreneur’yes or no), the three alternatives proposed are comparable analysis, planning andadjustment calculation, and value chain analysis. Special related-party businessissues (e.g. expatriates, long-term losses, restructuring, and shift of functions andintangibles) may require specific steps (which are not discussed in this paper).For instance, the Administrative Principles 2005 provide in Paragraph 3.4.10.2that the appropriateness of margin analysis to test for arm’s length transfer prices islimited to simple and repeating business activities (cf. IRS Sections 1.482-3 and1.482-6). In mainstream transfer pricing language, such business activities are calledroutine functions. Now, the Administrative Principles 2005 provide that more complexfunctions with nonroutine and/or entrepreneurial features are not accessible tothe traditional margin analyses. Rather, arm’s length analysis is more complex usinginternal data and value chain analysis (on the use of database analyses, see Tucha,2002; Oestreicher and Vormoor, 2004).Hence, in order to select the appropriate procedure for arm’s length analysis,classification of company types involved in the related-party business is essential.This chapter offers such a classification, together with features to be considered.152