4.Mitigation for the 1st TP Risk Zone: Do Not Be There

Critics of the arm’s length principle tend to lament that MNEs systematically abuse transfer pricing by setting transfer prices that favor subsidiaries located in low-tax countries. From the above, it should be clear that such criticism is misguided, especially when we talk about the 1st TP Risk Zone. Setting transfer prices within a range of appropriate net profit ranges for routine entities hardly offers an enticing “lever” to shift profits. While there may be opportunities to profit shifting in the case of subsidiary 1 in our example if it would only be subject to a 20% tax rate, the incentive to purposefully engage in profit shifting is low9. Also, tax auditors will check and easily detect when there is a misalignment between the profit allocation to routine entities and the BASIC TP RATIONALE. To them, such adjustments are low-hanging fruits in the sense that they do not require a detailed assessment and are comparatively easy to enforce and uphold during audit negotiations. In other words, it is not worth your while to be creative around the 1st TP Risk Zone. Consequently, the best mitigation strategy for these cases can be summarized as: “Do Not Be There”, which coincidentally, is the advice on how to best avoid being hit in the face that is dispensed by the Karate Sensei (Mr. Miyagi) from the Karate Kid Movie. Applied to the transfer pricing context, you should strive to avoid fights that are easy to avoid and rather dedicate your resources to the more pressing (high-risk) issues discussed in the subsequent Chapters.

Remember, in the current Chapter we work on the assumption that the routine classification of the relevant entities can be determined with a high degree of certainty (in our case this is assumed to apply to subsidiary 1 and subsidiary 2, but clearly NOT to HQ which is classified as an entrepreneur). The in-between cases for which you are not sure about the routine classification, will be addressed later. On a related note, we did not address the “economic substance” issue thus far – all the fun stuff must wait.

How do you operationalize the “Do Not Be There” strategy? The answer really should be evident, as it was provided at the end of Section 3: Namely, regularly review the net profit margins of your routine entities and adjust the transfer prices in case the margin falls outside of the arm’s length range (in the above figure the arm’s length range was assumed to be 1% to 8%). In more sophisticated terms, you should apply a “target-margin system”. Again, this approach is viable irrespective of whether your pricing is based on a cost-plus method, a resale price method, the TNMM a master price lists, commission fees or lump-sum payments.

A target-margin system starts with the target. In this context, we continue to solely talk about net margins. In Section 2 and Section 3 reference was made to the EBIT margin as well as the EBT margin. The EBIT margin can be conceived as the main focal point for transfer pricing purposes. Specifically, the EBIT margin is often utilized as the basis (so-called “Profit Level Indicator”, “PLI”10) when determining the typical level of profitability realized by independent companies engaging in business activities that are comparable to that performed by the related entities classified as “routine”. In this context the related routine entities are called “tested parties” because their EBIT margins (or another PLI) are “tested” against the profitability real