Analysis

B. Analysis

1.

1. General General considerationsconsiderations

180. The analysis below is concerned with the determination of whether the controlled

transactions entered into between XYZ Corp and XYZ Sub are on terms that accord with the arm’s length principle. This determination is based on a thorough comparability analysis, including a functional analysis. In this example, XYZ Corp provides XYZ Sub with the basic customer-interface software, access to the existing XYZ Host System outside of Country B, and other data or information needed to enable XYZ Sub to perform its specified activities in County B. As noted above, a royalty-free license agreement and an agreement to split the fees paid by participating airlines for ticket purchases srcinating in Country B are in effect. In addition, XYZ Corp compensates XYZ Sub on a cost plus basis for activities related to adapting the customer-interface software for use in Country B, and for activities to develop and expand the customer base of authorized travel agents in Country B.

2.

2. Functional analysisFunctional analysis

181. In this example, the respective functions, assets, and risks of XYZ Corp and XYZ

Sub are as follows: a) Functions

182. XYZ Corp undertakes the following functions:

 Provides worldwide reservations of airline tickets for travel agents through the

XYZ Host System located in Country A

 Provides the information needed for travel agents to issue airline tickets

 Recruits and enters into contracts with airlines, which provide the information

that is displayed on the XYZ Host System

 Research and development: XYZ Corp developed the XYZ Host System

 XYZ Corp employees manage, process, and store all input and output of the XYZ

Host System

 _{Provides capital to develop and maintain the XYZ Host System}

 Provides basic software, technology and know-how needed to access the system

 Collects fees from airlines and remits 50% of the applicable fees to XYZ Sub.

 Performs administrative, legal, treasury, employee benefits functions

183. XYZ Sub undertakes the following functions:

 Enters into contracts with travel agents in Country B to provide access to the

XYZ Host System and to provide hardware, software, and communications lines

 Develops and maintains specialized network software used to operate the

telecommunications system in Country B

 Maintains the node in Country B used to transmit communications from travel

I.3 TYPICAL FACT PATTERNS OF B2B MOD ELS: AIRLINE COMPUTER RESERVATIONS SYSTEMS

 Adapts the XYZ Host customer-interface software so that it will operate

efficiently in Country B (these activities are subject to cost-plus remuneration from XYZ Corp)

 Arranges for access to communications lines so that the system can function

efficiently during peak demand periods

 Develops the Country B customer base of travel agents and enters into sub-license

agreements with authorized travel agents in Country B (these activities are subject to cost-plus remuneration from XYZ Corp)

 Provides capital to pay for its assets and the Country B network

 Performs administrative, legal, treasury, and employee benefit functions

 Collects and retains fees paid by authorized travel agents for access to the XYZ

Host System and various support functions

 Manages local regulatory matters in Country B, including maintaining a license to

sell airline tickets in Country B. b) Assets used

184. XYZ Corp uses and owns the following assets:

 _{Copyrights and patents to the XYZ Host System}

 Hardware and software used in the XYZ Host System outside Country B

 Trademark and trade name to the XYZ Host System

 Basic customer-interface software used by travel agents

185. XYZ Sub uses and owns the following assets:

 The telecommunications node and related equipment in Country B

 Hardware provided to travel agents

 Royalty-fee license from XYZ Corp that permits XYZ Sub and authorized sub-

licensees in Country B to access the XYZ Host System

 Licenses from Country B to operate an international reservation and ticketing

system and telecommunications network

 Specialized network software that is needed to operate the XYZ Host System

efficiently within Country B c) Risks assumed

186. XYZ Corp bears substantially all the economic and technological risks of

developing and maintaining the XYZ Host System outside of Country B. By means of an arm’s length cost-plus agreement with respect to certain activities conducted by XYZ Sub, XYZ Corp also bears the risk of customizing the customer-interface software used by travel agents in Country B, and the marketing risk of developing and expanding the customer base of travel agents in Country B.

187. XYZ Sub bears certain economic and technological risks of operating the Country

I.3 TYPICAL FACT PATTERNS OF B2B MODE LS: AIRLINE COMPUTER RESERVATIONS SYSTEMS

Sub also bears similar risks for the hardware that it provides to the travel agents. XYZ Sub bears the risks associated with the development and operation of the specialized network software that is needed to operate the system within Country B. Finally, XYZ Sub bears the risk associated with maintaining its regulatory license to provide the reservation and ticketing activities in Country B.

3.

3. Application of the OECD Guidelines and Transfer Pricing MethodologiesApplication of the OECD Guidelines and Transfer Pricing Methodologies

188. The starting point for the analysis is to examine if there are comparable

transactions of independent parties in comparable circumstances. When it is possible to locate comparables meeting the specified conditions, paragraph 2.7 of the Guidelines provides that the CUP method is the most direct and reliable method, and preferable to all other methods. For instance independent telecommunication enterprises in Country B might use similar software, since they would also have to deal with certain challenges including the different standard of country B’s telephone system. However, a thorough comparability analysis has revealed that independent enterprises do not use similar technology and that the technology created by XYZ Corp and further developed by XYZ Sub is quite unique and highly valuable. As a result, it is not possible to find a transaction between independent enterprises similar enough to the controlled transaction, nor is it possible to make reasonable accurate adjustments to eliminate the material effect of the differences.

189. The comprehensive comparability analysis also revealed that other traditional

transaction methods could not be reliably applied alone, since both parties contributed to this unique technology. This difficulty is compounded by the fact that the transactions are very interrelated, making it difficult to evaluate the contributions on a separate basis. Consequently, it may be appropriate to apply the residual profit split method to allocate the residual profit, as recommended in Chapter III of the Guidelines.

190. When applying a residual profit split method the gross profits subject to analysis

would include the fees paid by participating airlines to XYZ Corp for bookings that srcinate in Country B (which are split between XYZ Corp and XYZ Sub), as well as the monthly fees paid to XYZ Sub by authorized travel agents in Country B for access to the XYZ Host System. The first step in the residual approach requires allocation of a return to the routine functions performed by XYZ Corp and XYZ Sub. It might be determined, for example, that the functions performed by XYZ Corp in operating the XYZ Host System and the functions performed by XYZ Sub in making available its Country B communications network can be compensated by reference to market returns. Similarly, market returns might be available for other functions performed by XYZ Sub under the cost-plus compensation arrangement, i.e., adapting the customer-interface software and developing and expanding the customer base of authorized travel agents in Country B.

191. In the second step of the analysis, any residual profit or loss from operation of the

XYZ Host System would be allocated based on the way in which independent enterprises would have divided such residual profit based on the facts and circumstances. The Guidelines note that the basic return provided under the first step would generally not account for the return that would be generated by any unique and valuable assets possessed by the parties. The Guidelines provide that indicators of the parties’ contributions of intangible property and relative bargaining positions could be useful, but do not set forth an exclusive list of ways in which the profit split method may be applied. In this example, application of the profit split method to XYZ Corp and XYZ Sub would depend on the circumstances of the case and the available information. It may be

I.3 TYPICAL FACT PATTERNS OF B2B MOD ELS: AIRLINE COMPUTER RESERVATIONS SYSTEMS

appropriate to consider the amount, nature, and incidence of the costs of the participants in developing and/or maintaining intangible property in order to determine the value of each participant’s contributions under the profit split method. The residual profits would be allocated among the participants based on each participant’s contributions, to the extent that those contributions are not already recognised in the basic return. In this example, XYZ Corp contributed the XYZ Host System, the basic customer-interface software, and the XYZ Host System trademark and trade name. XYZ Corp also compensated XYZ Sub for its activities of adapting the customer-interface software for use in Country B and developing and expanding the customer base of authorized travel agents in Country B. XYZ Sub contributed the specialized network software needed to operate the communications network in place in Country B, and the regulatory licenses needed to operate in Country B.

4.

4. ConclusionConclusion

192. This example is not intended to resolve all outstanding issues, but rather to

illustrate briefly how the Transfer Pricing Guidelines can provide the relevant guidance to allow the application of the arm’s length principle to business models such as those under which associated enterprises make highly valuable contributions to a computerized airline reservation and ticketing system. The transfer pricing issues arising under such this particular business model are neither fundamentally different from nor more challenging than those encountered in more traditional business models.

ISBN 92-64-00720-2

E-commerce: Transfer Pricing and Business Profits Taxation © OECD 2005