If the parties are affiliated, pricing could be distorted by other factors. One of which is tax-motivated profit shifting. If the tax rates governing the parent and the subsidiary differ, taxpayer may be tempted to apportion income beyond what is arm’s length to the entity in low-tax jurisdiction. As enterprises become globalized, and capitals increasingly morphed into intangibles (Haskel and Westlake, 2017) this problem has grown in size and complexity (Borkowski and Gaffney, 2012).

The arm’s length principle purports that if conditions are made or imposed between affiliated enterprises that differ from those that would be made between independent enterprises negotiating at arm’s length, that difference must be included in the profits of that enterprise and taxed accordingly. Further, Para 1.40 of OECD Transfer Pricing Guideline 2017 states that “All methods that apply the arm’s length principle can be tied to the concept that independent enterprises consider the options realistically available to them.”

**“Options Realistically Available”**

“Options realistically available” implies that independent, economically-rational enterprises would strive for Pareto optimality, i.e. only enter into a transaction if it is not expected to make them worse off than their next best option. They will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objectives.

One example of the adoption of options realistically available in domestic regulation is the US Treasury Regulation Section 482, which cites “alternatives available” to the taxpayer in determining whether the terms of the controlled transaction would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under comparable circumstances. The changes to Section 482 by the Tax Cuts and Jobs Act (TCJA) 2017 also stipulates “realistic alternatives” as a basis of valuation of intangible property transfer.

In the Indonesian tax regulation, the Minister of Finance Regulation no. 22/PMK.03/2020 concerning Advance Pricing Agreement also contains similar clause in its transfer pricing provision. Article 14 of PMK-22/2020 considers transactions involving service, use/the rights to use intangibles, cost of debt, transfer of property, business restructuring, and cost contribution arrangement (CCA) to be special transactions that warrant a preliminary step. For the transaction involving transfer of property and business restructuring, the regulation mandates that taxpayer must demonstrate that such transaction is “the best option out of other available options”. This clause also reiterates the ex-ante application of arm’s length principle in the Indonesian transfer pricing regime.

Parekh (2015) and Amici (2020) proposed various approach to identify, value, and determining options realistically available,

*inter alia*:

- Capital budgeting, using internal calculation to value a project based on its internal rate of return or its net present value or its payback periods, or a combination of these methods ;
- Opportunity cost, using explanation of why the other options are not realistically available, e.g. due to being incompatible with the business of taxpayer as such, commercially unattractive, not available at the time of transaction, not acceptable by the other party, or not in accordance with the regulation
- Best alternative to a negotiated agreement (BATNA), using reservation point and alternatives if negotiation fails
- Risk simulation, using the expected value of the investment (weighted average sum of all the probabilities of the possible outcomes of an investment) and the variance (deviation of possible outcomes). Other techniques such as Monte Carlo simulation could also be used.
- Bargaining power theory and game theory, using hypothetical negotiation that can be simulated based on the bargaining power, the contributions made to the marginal benefit of the transaction, and the strategy of the other party to the negotiation

Probably owing to its mechanistic and mathematical foundation, Nash’s theory rarely enters the legal world. Even its admissibility in patent infringement case is somewhat inconsistent and vary from judge to judge, depending on its ties to the facts of the case (e.g. Compare Robocast Inc. v. Microsoft Corp. (2014), Gen-Probe Inc. v. Becton Dickinson & Co. (2012)).

Economists, on the other hand, have noted the applicability of Nash’s bargaining in transfer pricing, for instance in interdivision negotiated price (Clempner and Poznyak, 2017) or vertically integrated supply-chain (Rosenthal, 2008). There have also been studies of game theory’s application for specific taxation purpose such as in applying profit-split method (Pogorelova, 2015; Voegele, Gonnet, and Gottschling, 2008) or a BEPS-related reporting game (Dorey, 2015). Indeed, Sattertwaithe noted at least 6 elements of similarity between Nash bargaining problem with transfer pricing in general: 1) players and subject of bargaining, 2) alternatives and rationality, 3) surplus utility maximization, 4) zero-sum competing interest, 5) utility value, and 6) allocation.

Sattertwaithe further notes that the profit-split method is readily applied to intangible property primarily because it offers a solution when each party provides unique and valuable contributions but comparable data are lacking, and that an allocation of value (e.g. residual profit) should be calculated anyway under profit-split. For a tax authority’s perspective, profit-split also overcomes the deficiency of one-sided methods where they automatically assume that the residual profit earned by the “untested party” as arm’s length, even though it is literally untested (Wells and Lowell, 2014). This opens up an avenue for abuse. In the case of intangibles, an MNE group can easily designate its intellectual property holder in low-tax jurisdiction, reducing its overall tax liability on royalty income and shielding it from adjustment.

We thus borrow some parts of profit-split into our calculation.

**Nash Bargaining**

Nash solution for bargaining problem is:

where U denotes utility; subscript P denotes Player P; subscript S denotes Player S; and V denotes fall-back utility, which would be gained if the player chose the second-best option to bargaining that is realistically available to her. X is possible bargaining outcome, for which if U(X) > V implies a surplus utility.

This section is again motivated by Sattertwaithe’s paper. However, we differ in the sense that we use a tax administration’s perspective in doing arm’s length outcome testing (

*ex post*) approach when doing the audit. We thus do not assume the existence of third party firm to value the (

*ex ante*) price of intangible. At the very least, this could serve as a sanity check in intangible transfer pricing analysis. Para. 6.113 of OECD TPG 2017 is relevant here, as transferor would not be expected to accept a price for the transfer of either all or part of its rights in an intangible that is less advantageous to the transferor than its other realistically available options which includes making no transfer at all. In a similar vein, Para. 6.79 of OECD TPG 2017 noted that “Compensation based on a reimbursement of costs plus a modest mark-up will not reflect the anticipated value of, and the arm’s length price for the contribution of the research team in all cases.”

**The Setup**

Assume a parent company P and subsidiary S, where – besides doing its routine functions – also conducts R&D activity to enhance P’s intangibles. (Despite its “contract research” features, Para. 7.41 OECD TPG 2017 note that the consideration of options realistically available may also prove useful in this situation.) Assume that the R&D results in a material, identifiable structural advantage in the market (thus valuable). This synergistic benefit increases the combined profit of P and S, either via increased sales and/or reduction of costs.

Following the residual approach for profit split, we first calculate the residual income of P and S after deducting the remunerations for their respective routine functions, hereinafter denoted as Π, such that:

where r

_{P}and r

_{S}denote the routine function of P and S, respectively. Suppose S is remunerated for its R&D function using a cost-plus method, where some mark-up µ is added to R&D costs borne by S (denoted C

_{r}). The Pareto-optimum fall-back positions of P and S are thus

and

where there are additional profits of (1 + µ) C

_{r}for P for not having to remunerate S; and C

_{r}for S for not having to bear the R&D costs. The Nash bargaining problem is thus used to solve:

which is done by first taking the derivative with respect to X,

then setting it to zero. Resulting in:

which then could be solved for X, the proportion of Π for P; and (1 – X), which is the proportion of Π for S.

The usage of Nash bargaining as “splitting factor” indeed differs from the usual asset/capital/cost-based allocation keys. We note that while R&D expense may be suitable for manufacturers, it may be insufficient given that: 1) it is only independently born by S, and 2) it may not be a reliable measure of the relative value of the transaction, taking into account options realistically available.

Illustration:

P is the parent of S, a contract manufacturing companies which sources raw material from third party suppliers. S manufactures, and subsequently sells the finished goods to P. P then sells the product to third party customers. S’s cost of goods sold and P’s sales are of independent transactions.

Assume that 100% of P’s inventory comes from S, and 100% of S’s sales are sold to P. S also conducts research for improving the products. P will remunerate S by S’s costs of doing research with a mark-up of 10%. P will also remunerate S for its contract manufacturing function with a full-cost mark-up of 10%.

Suppose the cost of research is 2, thus remuneration from P to S related to research is 2.2. The combined profit of P and S, after remunerating their respective routine functions is 16. Suppose it is sufficiently established that there is simply no justification from the taxpayer as for why the residual profit should all be automatically attributed to P, in the absence of their internal arrangement. (For example, P neither performs nor controls the research.) Hence the relative bargaining position is:

Therefore, out of profit of 16, 8.1 could be attributable to P, while 7.9 could be attributable to S. (This is almost similar to if the taxpayer use profit-split with 50:50 splitting factor). Nevertheless, this shows that S is inadequately remunerated since – viewed in totality – it is doing functions beyond mere contract manufacturer-contract research service provider.

**A Partial Contribution Approach**

The above-mentioned residual approach necessitates tax administration to calculate the routine function of P and S. We note that this does not take into account a marketing function done by P that may be similarly valuable. One obvious approach is to take into account marketing expense in calculating the relative bargaining position, which results indeed in higher proportion for P. Alternatively, we may calculate both parties’ contributions simultaneously.

Consider that the P’s sales is affected by S’s contributions in the form of R&D, or further development or enhancement of manufacturing know-how (which is accounted in S’s cost of goods sold or costs of employee). These contribution enables P to either increases price or maintains a desired profit margin given a determined price (via reduced costs). We thus propose – combining P’s effort to market the products – that a log-log function of:

where Cm is P’s marketing expense and ε is error term, may be appropriate. The model could of course be expanded to include other costs, or to use profit in lieu of sales. The error term, which may reflect the residual, “non-routine” profit, may also be employed. (These alternatives warrant further explorations, which is the limitation of this post.)

Exploiting approximation that (1 + x)

^{a}≈ 1 + ax for small a, then % Δ Y

_{P}≈ β1% Δ C

_{r}, i.e. a 1% change in S’s R&D cost result in β1% change in P’s sales. Π is then obtained by approximation of β1% * Y

_{P}, and the Nash bargaining as mentioned above will follow.

Second alternative, considering that not every R&D could be expected to always increase sales – especially if the research is “blue-sky” – we may instead be interested in R&D expense variability in relation to the variability of sales. Using variability instead of correlational direction may also alleviate the drawback that using historical data would arguably constitute a hindsight.

Following Shorrocks (1982), the proportional contribution of factor C

_{r}to the decomposition of the variance of Y

_{P}could be computed as:

where cov(C

_{r}, Y

_{P}) is the joint variability of C

_{r}and Y

_{P}, and σ

^{2}(Y

_{P}) is the variance of Y

_{P}. While this is not intuitively easy to associate, via Scherrer (1984), coefficient of determination R

^{2}could be computed as:

where a

_{j}is standardized regression coefficient of j-th explanatory variable, and r

_{y,xj}is the Pearson correlation coefficient of y and x

_{j}. Assuming we regress C

_{r}and other variables mentioned above to Y

_{P}, then the contribution of C

_{r}to the variance of Y

_{P}equals to:

It should be noted that this function is

**not**monotonic. A more exact approach would be to use Shapley-Owen decomposition. But for

*k*parameters this requires

*k*! combinations, hence 2

^{k}possible models to be calculated, and this is computationally expensive.

Illustration:

Assume P as the parent of a contract manufacturing subsidiary S similar to the illustration above. The table below gives the sales of P, R&D expense of S, and marketing expense of P, all in natural log, for the last 10 fiscal years:

The log-log regression gives result:

So even though the coefficient of R&D expense is higher than marketing, given that marketing expense is more statistically significant than R&D in explaining P’s sales, the contribution of R&D is lower than marketing expense. In this case, 33% and 62% of P’s variability of sales may be approximately contributed by S’s R&D activity and P's own marketing activity, respectively (5% of sales variability is due to other factors). Subsequently, the current pricing policy could be tested against 35:65 split (0.33:0.95 = 0.35 and 0.62:0.95 = 0.65) similar to the Nash bargaining problem as outlined above, and see if their ex-ante testing is appropriate.

**Conclusion**

Nash bargaining could be used in

*ex-post*outcome testing whether a transaction involving research resulting in valuable intangibles would have been entered into by independent parties, taking into account options realistically available. It should be noted that this analysis is presumptive, and should not be taken as

*prima facie*proof of transfer mispricing. OECD cautions that better-than-expected result may not be reasonably foreseeable

*ex-ante*by taxpayers. Indeed, assuming taxpayers do not provide adequate justification of

*ex-ante*pricing, insofar as the remuneration for transferor and the actual outcome do not deviate by 20% from the projection, Para. 6.194 OECD TPG 2017 discourages the usage of

*ex-post facto*rationalization, as it is considered as hindsight.

**Reference**

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OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2017 Edition

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