Transfer Pricing (TP) guidelines generally require associated entities to invoice each other appropriately so as to correspond to the value of the goods transferred or services provided whenever an intra-group transaction takes place. The basis for determining proper compensation is, in most cases, the arm’s length principle. In a nutshell, the arm’s-length principle requires that compensation for any intercompany transaction conform to the level that would have agreed, had the transaction taken place between independent companies.
Sales of machinery and equipment
Machinery and equipment is usually provided to manufacturing affiliates in the form of the sale of complete manufacturing lines to a new startup of the group, under circumstances of a business restructuring. In addition, a group strategy may target on the support of an existing subsidiary with a potential of growth or with a comparative advantage in the manufacture sector.
The equipment provided to a related company may:
– Have been purchased from an independent firm;
– Have been manufactured by the parent company;
– Be older equipment that the manufacturing affiliate no longer needs.
National tax rules, which are in line with OECD directives, generally require that the vendor of this machinery should receive an arm’s-length consideration. This is generally accepted to be the fair market value of the equipment at the time of transfer.
Documentation of the equipment transfer
OECD Guidelines require the selection of the most appropriate method, taken into account the strengths and weaknesses of each recognized method. The method selection procedure shall be based on several elements, including a comparability analysis and the availability of reliable information, necessary for the application of the selected method. It shall be noted that if the Comparable Uncontrolled Price (CUP) method and another TP method can be applied in an equally reliable manner, the CUP method is preferred.
Therefore, in case of the intra-group provision of machinery and equipment, both the vendor and the purchaser shall investigate if they executed similar transactions with unrelated parties. It is of great importance that the machinery and equipment purchased (sold) by (to) an independent company have the same features (technical, age etc) with the objects transferred under the controlled transaction. Most times, the lack of internal data (similar transactions between affiliates and third parties) forces companies to search for external comparable prices. This procedure requires the existence of an active machinery and equipment market which discloses arm’s length prices to an accessible database. Moreover, terms and conditions (such as credit lines) of real transactions between independent companies remain unknown, so reliable adjustments are difficult to be made in order to approximate a CUP to compare with controlled transactions.
If the CUP cannot provide reliable results due to lack of comparable internal or external data, the Cost Plus Method (CPM) is usually applied. More specifically, if a parent company purchases a new machinery (or equipment) and resells it to a subsidiary, the markup put on the acquisition cost constitutes the gross margin to be compared with the margins realized by independent companies. The same methodology can be used if the parent company manufactures the machinery on its own. In this case, the total direct and indirect expenses associated with the manufacture of the equipment shall be taken under consideration in order to determine the base on which the markup is imposed.
The sale of older equipment is usually more complicated, because the equipment is stated at cost less accumulated depreciation or/and impairment. The TP analyst shall define if the cost base is the acquisition cost or the depreciated value as stated in the balance sheet. Therefore, the determination of the absolute profit and margin depends on the cost definition, taking under consideration the economic and market circumstances.
If the parent company’s main activity is to provide machinery to third parties, it may calculate gross margins per client and compares them with the margin received from the controlled transaction. The importance and the turnover by client are taken also under review for the specification of the comparables set. However, if the seller of the equipment is not involved in similar transaction with non affiliates, comparable data shall be retrieved by external databases (Amadeus, Thomson Reuters etc). The analyst implements a number of filters such as activity code and geographic region in order to exclude companies without the same characteristics as the company under review.
In most cases, the documentation of intragroup transactions on machinery and equipment requires the rejection of the CUP and the application of another traditional or non-traditional transaction method. Any intangible (such as patents) or/and R&D costs connected with the machinery and equipment shall be evaluated and taken also under consideration for the price determination.