As per recent developments in the transfer pricing documentation, several challenges have been identified as the controlled transactions are becoming increasingly complicated and Cyprus Tax Authorities increase the documentation required for the preparation and analysis of such transactions.
Transfer Pricing (TP) experts are using different models to approach and analyse the controlled transactions, since the TP is more subjective than other areas of taxations and is thus sensitive to disputes, with tax administrators not always sharing a common interpretation. See below OECD guidelines:
10.106. The reliability of economic models’ outcomes depends upon the parameters factored into the specific model and the underlying assumptions adopted. In evaluating the reliability of economic models as an approach to pricing intra-group loans it is important to note that economic models’ outcomes do not represent actual transactions between independent parties and that, therefore, comparability adjustments would be likely required. However, in situations where reliable comparable uncontrolled transactions cannot be identified, economic models may represent tools that can be usefully applied in identifying an arm’s length price for intra-group loans.
The capital asset pricing model (CAPM) is one of the most widely used models that helps to calculate investment risk and what return on investment an investor should expect. CAPM is based on the relationship between an asset’s beta, the risk-free rate and the equity risk premium, or the expected return on the market minus the risk-free rate as follows:
Expected Return on Equity = Risk-free rate + Beta x Risk Premium
Re=Rf + β x (Rm – Rf) or Re=Rf + β x Pc
Dur to the challenging of each of CAPM components, there are many opinions of failure of the model.
The Comparable Uncontrolled Price (CUP) method is the most direct way of ascertaining the arms’ length price as it compares the price charged for a product service transferred in a controlled transaction to the price charged for a property or services transferred in a comparable uncontrolled transaction, in comparable circumstances. Any difference between the two prices may be an indication that the conditions of the commercial and financial relations of the associated persons are not under arm’s length, and that the price in the uncontrolled transaction may need to substitute for the price in the controlled transaction. The downside of CUP method is that it is ideal where comparable products/services are available or reasonably accurate adjustments can be made to eliminate material differences.
Alternative to the CAPM, is the Arbitrage Pricing Theory (APT) model, in which an asset’s returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk as follows:
ER (x) = Rf + β1RP1 + β2RP2 + … + βnRPn
Where:
ER (x) = Expected return on the asset;
Rf = Risk-free rate of return;
βn (beta) = the asset’s price sensitivity to factor;
RPn = the risk premium associated with factor.
In conclusion, each transaction each different and each case shall examine the market environment, collaterals, economic infrastructure, terms and conditions etc. Various approaches and tools exist to assist presenting the fair value of the market. At ACLA AUDITORS we could assist you with the preparation of the Transfer Pricing, using the appropriate mechanisms and tools. Contact us for further information.