INTM463100 - Transfer Pricing: OECD and methodologies: OECD: which transactions to review: Intentional set offs

A single company may have many different types of transactions with a single affiliate or a number of affiliates. The company under review may make purchases from and sales to the same affiliate; it may pay a royalty to the same affiliate for the right to manufacture. In these circumstances, it may be inappropriate to look at only the royalty since all three types of transaction form part of the overall trade of the company.

The OECD Transfer Pricing Guidelines address 'intentional set offs' at Para 3.13 - 3.17 (1.60 to 1.64). Essentially this recognises the fact that under commercial arrangements, parties might accept under or over pricing for certain types of transactions if they were happy with the overall receipts. If a company needs 100 units each of two products from the same supplier and the market price is a £1,000 in total, then the company may be indifferent if the price of each product is £5 or the price of product 1 is £1 and the price of product 2 is £9 assuming the market price can be established. Alternatively, two companies might both buy from and sell to each other at the same time. In such circumstances they might agree a package deal covering the pricing of all the transactions

This example illustrates why the need to consider all relevant transactions between the parties. You should anticipate the possibility that the company may ultimately accept that the price of its purchases from its parent company is too high but argue that this is cancelled out by the fact that other purchases were made at less than market price. In such a case the profits might be at arm's length overall. It is important to establish, as part of your initial review, risk analysis and information trawl, whether there are any such offsetting transactions.

You should also be alert to the possibility of unintentional set offs. In some cases the use of two offsetting prices (one too high, one too low) may be a conscious decision. This is distinct from the situation where, perhaps by chance, an affiliate is able to purchase at a low price and make a high profit in one activity but can only achieve a lower than arm's length profit in another activity involving the same affiliated supplier. You must consider what would have happened at arm's length. If market prices were charged on each occasion then the company would be left with the arm's length reward for its activity and there should be no set off of the lower profit against the higher to reduce the profit.

You should also not accept claims that there should be set offs between more than two parties. For instance, it may be suggested that a company enjoys a lower than arm's length profit on trade with one affiliate but a higher than arm's length profit with another affiliate - so overall everything must be arm's length. This does not reflect what would really happen at arm's length - traders endeavour to maximise their profit with everyone they trade with.

The chapter on Case Selection (INTM461000 onwards) has further practical guidance on this issue at INTM461250.