PKN Alert
'Sixth method' raises transfer pricing
concerns in developing countries
January 29, 2013
In brief
Application of a so-called 'sixth method' for determining transfer prices of commodities presents
practical concerns because the method does not consider critical drivers in the determination of an arm's
length price or reference. The method first was implemented in Argentina and now has been adopted by
a number of developing countries — primarily in Latin America but extending beyond to India — with
expansion of the method expected to continue. Companies should consider whether they might be
required to adopt the sixth method in countries in which they operate and how such a requirement could
affect their worldwide tax liability.
In detail
OECD transfer pricing
methods
The OECD Transfer Pricing
Guidelines describe five transfer
pricing methods that may be
applied to establish whether the
conditions of controlled
transactions are consistent with
the arm's length principle: three
'traditional transaction
methods' (the comparable
uncontrolled price (CUP)
method, the resale price
method, and the cost plus
method) and two 'transactional
profit methods' (the
transactional net margin
method and the transactional
profit split method).
The OECD states that the 'most
appropriate method' should be
selected for a particular case,
taking into account (1) the
respective strengths and
weakness of the recognized
methods; (2) the
appropriateness of the method
considered in view of the nature
of the controlled transaction,
determined in particular
through a functional analysis;
(3) the availability of reliable
information (in particular on
uncontrolled comparables)
needed to apply the selected
method and/or other methods;
and (4) the degree of
comparability between
controlled and uncontrolled
transactions, including the
reliability of comparability
adjustments that may be needed
to eliminate material differences
between them. In applying these
criteria, the OECD regards the
traditional transaction methods
(particularly the CUP method)
as more direct and therefore
preferable to transactional
profit methods where the
methods can be applied in an
equally reliable manner.
Other methods
In addition to the five transfer
pricing methods specified by the
OECD, 'other methods' may be
used in certain circumstances. A
transfer pricing method other
than the specified methods may
be applied where it can be
demonstrated that (1) none of
the approved methods can be
reasonably applied to determine
arm's length conditions for the
controlled transaction and (2)
such other method yields a
result consistent with that which
would be achieved by
independent enterprises
engaging in comparable
uncontrolled transactions under
comparable circumstances.
Therefore, while other methods
may be applied to establish
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prices if the result satisfies the arm's
length principle, such methods should
not be used in place of the five
specified methods if the recognized
methods are more appropriate to the
facts and circumstances. A 'sixth
method' required in some countries
may be viewed as an 'other method'
under the OECD Guidelines or as a
specific application of the CUP
method.
In addition to the OECD Guidelines,
the United Nations has published its
Practical Manual on Transfer Pricing
for Developing Countries to offer
practical guidance to policy makers
and administrators in developing
countries on the application of the
arm's length principle. The UN
Manual generally shows a preference
for the CUP method and does not
explicitly address a sixth method.
Why a 'sixth method'?
The sixth method originated in
Argentina, where the government
sought to address raw materials
transactions that utilized an agent
located in a country where
significantly less tax was paid than in
the exporting country. For many
developing countries, exports of
commodities are such a significant
part of the economy that it is
important to the governments to avoid
price manipulations that lower
transfer prices and taxes collected. For
developing countries with economies
heavily dependent upon commodities
exports, changes to transfer pricing
rules may be viewed as a source for
raising taxable income. This strategy
appears to be supported by
international development
organizations. Mandating use of the
sixth method has been an effective
way for governments to increase the
tax assessed on companies exporting
commodities.
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Applying the sixth method
The sixth method applies to certain
commodities that usually are specified
in the local regulations and vary
among jurisdictions. For example,
transfer pricing legislation in
Argentina, Uruguay, and Ecuador and
amendments to the legislation in
Brazil and Peru stipulate certain
restrictions and guidelines to test the
transfer pricing of commodities.
Although in countries such as
Argentina the sixth method is
explicitly described in legislation, in
countries like Uruguay and Peru the
sixth method is referred to only as a
variation of the CUP method. In
addition, amendments to the Brazilian
legislation introduced new transfer
pricing methods for commodities. The
concept of how to test the nature of
the arm's length price for
commodities is similar in these cases.
The sixth method generally may apply
in the following circumstances:
Export/import transactions of
tangible goods (classified as
commodities) between related
parties.
The price of the tangible goods are
publicly quoted in the transparent
market (known public price).
In certain cases, when there is a
foreign intermediary in the intercompany transaction such that
goods do not reach the final
consumer directly (triangular
transactions).
The sixth method attempts to avoid
transfer of passive income to
jurisdictions with low or no taxation.
The application of this method
considers quoted prices of
export/import goods at the time of
shipment, regardless of volume,
geography, and other key factor that
influence the price. Importantly, the
sixth method does not take into
account transportation costs,
agreement covenant, or the agreed
price between the taxpayer and the
intermediary.
Under the sixth method the only
reference point to evaluate an intercompany transaction is the quoted
price at the time of shipment, which
may not be comparable to the
economic conditions of the
transaction under review. An
exception may be applicable when the
agreed price is greater than the most
recent quoted price available, in which
case the greater of the two is taken as
the most appropriate transfer price for
local transfer pricing purposes.
Use of the sixth method typically is
mandatory unless an exception
applies. For example, Argentina
effectively requires use of the sixth
method in certain situations by stating
in its legislation that the best method
to assess Argentine-source income is
the trading value of the good in the
market on the date in which the goods
are shipped — regardless of the means
of transport — without considering
the price that would have been agreed
upon with an international broker
unless the agreed price is higher than
the publicly traded price. The transfer
pricing methodology included in
Argentine income tax law establishes
no order of precedence for the use of
the methods, except where the sixth
method is applicable. In addition, the
taxpayer must indicate the reasons
why a given method has been chosen
and prove that the mechanism chosen
is the most appropriate for the
transaction made.
Mandatory use of a trading price for
transfer pricing may raise serious
concerns for taxpayers because this
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method does not take into
consideration the circumstances of the
transaction. Requiring companies to
use the sixth method may contradict
the OECD standard for selecting the
most appropriate method based on
the specified criteria.
The sixth method may not be
applicable when the intermediary in
the transaction operates under the
following conditions:
Has real presence in the place of
residence and its functions, risks,
and assets are consistent with the
transaction volume it conducts.
The principal activity may not
constitute passive business
(income) or exclusive intermediary
agent of goods between the related
parties of a group.
The inter-company transactions
with foreign related parties may
not exceed 30 percent of the total
activity performed by the
intermediary.
Some jurisdictions may require a
formal certification regarding the
items listed above from a public
accountant from the country of
residence where the intermediary
operates.
Practical concerns
The circumstances in which products
are sold are particularly important
and mandatory use of the sixth
method does not allow the evaluation
of those circumstances. For example,
consider a farmer who makes an
investment by planting and harvesting
grain. At market, the farmer can
expect to obtain the publicly traded
price for grain. A very different
scenario occurs if a farmer receives up
front a guaranteed price for the output
of his crop, regardless of factors such
as grain quality or the market price at
the time the crop reaches the market.
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It is clear that in this case the farmer
may accept a different price. Under
the best method or most appropriate
method analysis, it is possible that in
this situation a different method
would be preferable over the publicly
traded price. Mandated use of the
sixth method, however, could result in
imposition of the market price. As a
result, taxpayers operating in
jurisdictions that have introduced the
sixth method may want to consider
avoiding target return arrangements,
which may not conform to application
of the sixth method.
Which countries have adopted the
sixth method?
Argentina in 2003 was the first
country to implement the sixth
method, with countries such as
Ecuador and Uruguay soon following.
Latin American countries have been
active in adopting the sixth method in
the last two years. Of the new
jurisdictions in Latin America
introducing transfer pricing
legislation (e.g., Dominican Republic,
El Salvador, Guatemala, and Chile) all
but Chile introduced the sixth method
and of those amending their current
regulations (e.g., Brazil, Panama,
Peru, and Colombia), Brazil and Peru
adopted the sixth method. India also
has introduced a sixth method that
appears to expand the CUP method.
As a result of these changes,
multinational companies increasingly
are becoming subject to the sixth
method. As tax authorities in Latin
America and other developing
countries increase their focus on
transfer pricing, companies will need
to consider their global transfer
pricing positions as well as
compliance with local transfer pricing
requirements.
platform contribution transactions.
The Income Method is not a method
under the OECD Guidelines, UN
Manual, or Section 482 regulations for
evaluating transactions for the use of
intangibles. Nevertheless, since its
introduction in an IRS Coordinated
Issue Paper (CIP) published in 2007,
the Income Method has become the de
facto method of choice for the IRS in
evaluating transfers or contributions
of intangible property (while the CIP
was later withdrawn, the Income
Method was still the preferred method
in the proposed and then final cost
sharing regulations).
The takeaway
Adoption of the sixth method is
expanding in Latin America and in
other developing countries. Applying
the sixth method raises a number of
transfer pricing issues because the
method does not consider critical
drivers in the determination of an
arm's length price or reference.
Practical concerns include:
The quoted price does not consider
geography, which has a direct
impact in the transportation,
logistics, and insurance costs.
The volume and agreement terms
are not considered and directly
impact in the price.
The sixth method imposes
limitation to future transactions
and planning.
In many cases, the tax authorities
fail to provide a clear
determination of what would be
considered publicly or known
prices as well as what is considered
a commodity.
Preference for other methods
There currently is a similar issue in
the United States regarding the use of
the Income Method in evaluating
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Let’s talk
For a deeper discussion of how this issue might affect your business, please contact:
Transfer Pricing
Amparo Mercader, Washington Metro
+1 703 918 3043
[email protected]
Horacio Peña, New York
+1 646 471 1957
[email protected]
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© 2013 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers (a Delaware limited liability partnership),
which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.
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