Chang Hee Lee, What is wrong with the OECD Approach to Finding an Arm’s Length Price, Journal of IFA, Korea, Vol. 35 (3) (2019), pp. 36-89.
<Abstract>
For finding an arm’s length price applicable to a related party transaction, Korean law mandates finding actual transactions (comparable transactions) between or among independent parties that are comparable to the related party transaction and derive an arm’s length price from the actual price used in the comparable transactions by adjusting the differences between the comparable and related party transactions. This idea originates from the OECD transfer pricing guideline (“TPG”), which permeated into the law of many countries including Korea. This article tries to prove that the arm’s length or, in verbatim translation of Korean law, normal price so derived may hardly be considered an arm’s length price per se that unrelated parties would have reached in a good faith bargain. In a market in imperfect competition, an arm’s length price is not to be found at a single point. Even in an effectively competitive market, chasm exists between the arm’s length price per se and the hypothetical or constructive arm’s length price endorsed by the TPG for a number of reasons. First, the mathematics or accounting suggested by the TPG is simply wrong in a few aspects. More importantly, in adjusting the differences, the TPG fundamentally assumes that the non-related party in a comparable transaction is making a normal profit or no profit in microeconomics sense of the word in a competitive market. The concept of normal profit compares the level of profit to capital investment. It is a profit to stock comparison or an ROI concept. The several methods of the TPG, however, assume that the ratio of the profit indicator to the flow of sales, gross income, or operating income would be similar between a related party and a comparable transaction. The same or similar ROI between the two transactions does not imply that the ratio of profit to sales or another flow concept will also be similar between the two. Third, from a statistical perspective, the comparable transactions are not random samples that would unbiasedly represent the general population of unrelated market transactions. The TPG does not guarantee random sampling. After the Introduction, Chapter II briefly summarizes the significance of the arm’s length price in transfer pricing. Chapter III analyses the burden of proof issue, and establishes that the TPG methods of adjusting differences in transactional conditions are often based on impossible assumptions. Chapter IV and the following discussions specifically analyze the CUP, resale price, cost plus, transactional net margin, and the profit split methods, and show that the TPG fails to establish the arm’s length price as discussed in the previous paragraph.
<Keywords>
transfer pricing, arm’s length price, normal profit, comparable transaction, CUP, resale price, cost plus, transactional net margin, profit split
Chang Hee Lee, What is wrong with the OECD Approach to Finding an Arm’s Length Price, Journal of IFA, Korea, Vol. 35 (3) (2019), pp. 36-89.
<Abstract>
For finding an arm’s length price applicable to a related party transaction, Korean law mandates finding actual transactions (comparable transactions) between or among independent parties that are comparable to the related party transaction and derive an arm’s length price from the actual price used in the comparable transactions by adjusting the differences between the comparable and related party transactions. This idea originates from the OECD transfer pricing guideline (“TPG”), which permeated into the law of many countries including Korea. This article tries to prove that the arm’s length or, in verbatim translation of Korean law, normal price so derived may hardly be considered an arm’s length price per se that unrelated parties would have reached in a good faith bargain. In a market in imperfect competition, an arm’s length price is not to be found at a single point. Even in an effectively competitive market, chasm exists between the arm’s length price per se and the hypothetical or constructive arm’s length price endorsed by the TPG for a number of reasons. First, the mathematics or accounting suggested by the TPG is simply wrong in a few aspects. More importantly, in adjusting the differences, the TPG fundamentally assumes that the non-related party in a comparable transaction is making a normal profit or no profit in microeconomics sense of the word in a competitive market. The concept of normal profit compares the level of profit to capital investment. It is a profit to stock comparison or an ROI concept. The several methods of the TPG, however, assume that the ratio of the profit indicator to the flow of sales, gross income, or operating income would be similar between a related party and a comparable transaction. The same or similar ROI between the two transactions does not imply that the ratio of profit to sales or another flow concept will also be similar between the two. Third, from a statistical perspective, the comparable transactions are not random samples that would unbiasedly represent the general population of unrelated market transactions. The TPG does not guarantee random sampling. After the Introduction, Chapter II briefly summarizes the significance of the arm’s length price in transfer pricing. Chapter III analyses the burden of proof issue, and establishes that the TPG methods of adjusting differences in transactional conditions are often based on impossible assumptions. Chapter IV and the following discussions specifically analyze the CUP, resale price, cost plus, transactional net margin, and the profit split methods, and show that the TPG fails to establish the arm’s length price as discussed in the previous paragraph.
<Keywords>
transfer pricing, arm’s length price, normal profit, comparable transaction, CUP, resale price, cost plus, transactional net margin, profit split