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Transfer pricing: how to value transactions between group companies or related parties

The obligation established by corporate income tax regulations to value transactions between related parties at "market" is becoming more and more widely known in the business world. However, two basic concepts need to be clarified: what are related party transactions and what is an arm's length valuation?

Definition of linked transactions

The rule expressly regulates what are considered to be related parties or entities, and it is important to bear this in mind in order to know when this mark-to-market obligation applies.

In general, we could summarise them as follows:

  • Partners of an entity with the entity itself as well as family members up to the third degree (by blood or affinity).

  • Transactions between the entity and the administrators or directors (de jure or de facto), as well as their relatives up to the third degree. Remuneration for the function of director is outside the scope). This is an issue that has given rise to great doctrinal debate.

  • Two entities of the same group.

  • An entity and the directors of another entity if they all belong to the same group.

  • One entity and another indirectly owned for at least 25% of its share capital.

  • Two entities having the same partners (or their relatives) when these partners have a stake of more than 25% in both entities.

What does it mean to mark to market a transaction?

The corporate income tax law requires related party transactions to be valued at market value, and defines market value as "...".that which would have been agreed upon by independent persons or entities on terms which respect the principle of free competition."

Essentially, the rule requires that when a transaction is carried out with a related party, the same prices, contractual terms and conditions and assumption of risk apply as would have applied with an unrelated third party.

How is the market valuation justified?

Corporate Income Tax legislation regulates a series of formal obligations which we will discuss in detail in future posts, where each transaction between related parties must be analysed and it must be justified that the price applied is market price.

Thus, on the one hand, it requires keeping at the disposal of the administration a transfer pricing dossier and, on the other hand, there is an obligation to present annually an information return on related-party transactions (form 232) which is presented every November with respect to the transactions of the previous year. In order to justify that the transaction has been made at market value, Spanish law, based on the OECD Guidelines applicable to transfer pricing for multinational companies and tax administrations, regulates a series of valuation methods, and the transaction can be subsumed under the one that best suits the specific circumstances.

Transfer pricing valuation methods

There are 5 main methods, which can be grouped into two categories:

a) Traditional methods based on operations.

1.- Comparable free price method or Comparable Uncontrolled Price (CUP) in its English terminology

The comparable free price method is defined by the OECD as that which consists of compare the price invoiced for goods or services transferred or lent in a related party transaction with the invoiced price for goods or services in a comparable uncontrolled transaction in comparable circumstances.

And, if there are differences between the two prices, this may indicate that the terms of the commercial and financial relationships of the associated enterprises are not at arm's length and that the price of the tied transaction may have to be replaced by the price of the non-tied transaction.

Therefore, in order to be able to apply this method, it is essential to have a transaction between two independent parties that is comparable to the one we want to value, and these transactions must have been carried out between two independent parties. Comparable data can be internal or external.

If it is a comparable transaction between a party involved in the controlled transaction under scrutiny and an independent party, it is known as an "internal comparable" (e.g. the company sells the same product to a related subsidiary and to third party customers). And, if the comparable transaction is between two independent parties, neither of which is involved in the controlled transaction, it is an "external comparable".

It should be borne in mind that for the free comparable price method to be reliably applied, the relevant economic characteristics of the related and unrelated transactions must be comparable.

Ultimately, this method is particularly reliable in cases where the company performing the related party transaction provides the same service or sells the same goods to other unrelated parties (e.g. the company markets the product to a subsidiary and other unrelated customers) or there are simply a multitude of external comparables in the market (i.e. financing transactions).

Incremental cost method or Cost-plus in its English terminology

The cost plus method is based on determining the costs incurred by the supplier of the goods or services to carry out a particular linked transaction. This cost is increased by a margin that allows it to earn an appropriate profit taking into account the functions performed and market conditions.

The OECD considers that the result, which is obtained after increasing the above-mentioned cost with such a mark-up, can be considered as an arm's length price of the original tied transaction. In this case, the key is to prove that the margin (mark-up) applied to the incurred cost base is market conform.

This method is the most commonly used when the linked transaction consists of the provision of services. Moreover, when dealing with what the OECD defines as low value-added services [1], it has been accepted that a margin of 5% is arm's length and market conform.

It is also a method used for the sale of semi-finished products between associated parties when the associated parties have entered into joint operating or long-term sale and purchase agreements.

3.- Resale price method or Resale Price in its English terminology

In contrast to the cost plus method, which bases its methodology on the cost incurred, this resale price method starts from the price at which it has been acquired from an associated undertaking a product which is then sold to an independent company.

It is the most useful method when applies to distribution or marketing activitiesn. The structure of a corporate group whose parent company is located in a given country and which manufactures and stores the products is common, and the group has several subsidiaries in various countries which only perform the function of marketing the product (limited risk distributor) manufactured by the parent company. In this case, the parent company sells the products to the subsidiaries, which resell them on the local market.

The resale price method seeks to determine the appropriate margin to be left in the trading company.The price agreed between the marketing company and the final customer (the resale price) is reduced by an appropriate gross margin (the "resale price margin") to allow the reseller/distributor to cover its selling costs and operating expenses and to earn an appropriate profit, taking into account the functions actually performed.

And, what remains after subtracting the gross margin, can be understood to constitute an arm's length price of the initial transfer of goods between the associated companies, which in the example given would be the price of the sale of products from the manufacturing parent company to the marketing subsidiary.

b) Methods based on the results of operations.

4.- Net Operating Margin Method or Transactional Net Margin Method (TNMM) in its English terminology.

The net operating margin method analyses the net profit calculated on a given magnitude (e.g. costs, sales or assets). that a taxpayer obtains by reason of a controlled transaction.

Thus, this net profit indicator should be comparable to the net profit indicator that the same taxpayer obtains in comparable transactions on the open market, i.e. using internal comparables as a benchmark. If an internal comparable is not available, the net margin that would have been achieved by an independent company in a comparable transaction (external comparable) can be used.

A simple example would be to determine that the percentage of profit to be made on sales to a related party is comparable and similar to the percentage of profit that company makes on sales to other unrelated parties (i.e. a third party customer).

5.- Result distribution method or Profit Split in its English terminology

The method of distribution of the result is usually applied in transactions that are carried out jointly by several related companies and is intended to determine the distribution of profits obtained jointly. agreed by independent undertakings on the basis of their participation in the transaction.

This methodology first identifies the profit to be distributed to the associated enterprises for the related transactions in which they are involved, which would be called "joint profits".

This common result is then distributed among the associated companies on the basis of economically valid criteria, i.e. according to the functions performed by each company, the risks assumed and the assets contributed to the operation, in such a way as to approximate the distribution of profits that would have been envisaged and reflected in an arm's length agreement.

How to know which method is applicable - The importance of functional analysis

As indicated by the OECD, the selection of the most appropriate method must be analysed for each specific circumstance because there is no single method that is appropriate for all situations.

For this to be the case, the selection process must take into account (i) advantages and disadvantages of the methods (ii) the nature of the controlled transaction (functional analysis), (iii) availability of reliable information (whether comparables exist), and (iv) the degree of comparability between controlled and uncontrolled transactions.

The functional analysis of the operation deserves special mention.which will involve analysing the (1) risks assumed by each party (insolvency, credit, shrinkage, etc.), (2. the functions it performs related party involved (marketing, R&D, customer management, etc.) and (3) the assets involved in the transaction (skilled workers, machinery, installations, know-how, etc).

As can be seen, the transfer pricing regulation is delimiting the pricing and conditions that can be agreed between related parties, so that groups of companies must pay increasing attention to how these transactions are being carried out and whether they are obliged to have documentation of related party transactions.

At MERAC Legal & Tax Lawyers we have extensive experience in advising on transfer pricing and in the preparation of the formal documentation required.


[1] The OECD defines low value-added services as those that (i) have a support function, (ii) do not form part of the core business of the multinational group, (iii) do not require the use of or lead to the creation of unique and valuable intangible assets, and (iv) do not involve the assumption of significant risk by the service provider.

This includes financial accounting services, tax advice and invoicing management, human resources management and ORP, legal advice and IT maintenance services, among others.

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May 10, 2022