To CUP or Not To CUP Commodities
Tax authorities worldwide are increasing their focus on companies involved in commodity transactions as a result of the introduction of new guidance on commodity transactions by the OECD in 2015 and the number of court cases involving companies in the mining industry worldwide.
Certain countries have implemented ‘the six method’ rule (mainly mineral-rich countries) as an anti-abuse rule to discourage the use of trading hubs with no economic substances. The six method rule looks through the intermediary trading entity (with no economic substance) as if the transaction had taken place between the seller and the third party customer. Under the six method rule, the intercompany price between the seller and the trading entity is deemed to be higher of either the intercompany price on sale date or the sales price on the shipment date of the commodities to the unrelated buyer.
Multinational enterprises trading in commodities should seek to review and if necessary review their price setting policies to ensure
compliance with the new OECD guidelines and transfer pricing laws in their respective countries.
So…what exactly are commodities?
Commodities are physical products for which a quoted price is used as a reference by independent parties in the industry to set prices in
independent transactions. Examples of commodities include gold, silver, crude oil, coffee beans, rubber among others.
How to determine the arm’s length price of commodities?
According to the OECD, the Comparable Uncontrolled Price (CUP) method would generally be the most appropriate transfer pricing method for establishing the arm’s length price for the transfer of commodities between related parties.
The CUP method is one of the five transfer pricing methods provided in the OECD Transfer Pricing Guidelines and is the most direct and reliable way of ascertaining an arm’s length price. For those unfamiliar with CUP method, it compares the price in a related party (controlled) transaction to the price in an independent (uncontrolled) transaction in comparable circumstances. Under the CUP method, the arm’s length price for commodity transactions may be determined by reference to either:
- Comparable uncontrolled transactions; or
- Quoted price.
For the CUP method to be reliably applied, the economically relevant characteristics (listed in the diagram below) of the controlled
transaction and the uncontrolled transaction need to be assessed to determine a strong degree of comparability. Comparability is at the
heart of any transfer pricing analysis that involves the application of the CUP method and is a strict requirement for a reliable transfer
The diagram below illustrates the application of the CUP method for transactions involving commodities.
Where there are differences between the conditions of the controlled transaction and the conditions of the uncontrolled transactions or conditions determining the quoted price, reasonably accurate adjustments should be made to ensure that the economically relevant characteristics of the transactions are comparable.
Comparable Uncontrolled Transaction
Comparable uncontrolled transactions refer to independent third-party transactions operating under similar conditions. There are two (2) types of independent third-party transactions:
- Transaction between the taxpayer and an independent enterprise (Internal CUP)
- Transaction between two independent enterprises (External CUP)
Company A and Company B are related parties controlled by the same shareholder. Company C is an independent party. The controlled and uncontrolled transactions are as follows:
Transaction 1: Company A sells gold to Company B.
Transaction 2: Company A sells gold to Company C.
Assuming both transactions operate under similar contractual terms and conditions and gold sold in both transactions are of similar type, quality and quantity, the Internal CUP may be applied using the price in Transaction 2 as a comparable arm’s length price in Transaction 1.
However, if Company A were to sell gold of a different quality and in very large quantities (with discount) and reasonably accurate adjustments cannot be made, the Internal CUP may not be reliable and should not be used.
Quoted price refers to the price of the commodity in the relevant period obtained in an international or domestic commodity exchange market and includes prices obtained from recognised and transparent price reporting or statistical agencies, or governmental price-setting agencies. Examples include the London Metal Exchange, Singapore Commodity Exchange, Tokyo Commodity Exchange, etc.
A relevant factor in determining the appropriateness of using the quoted price is the extent to which such price is widely and routinely used in the ordinary course of business in the industry to negotiate prices between independent parties. Certain economically relevant characteristics (e.g. prompt delivery) may lead to a premium or a discount. Besides, if the quoted prices are used as a reference, the standardised contracts which specify the terms on which the commodities are traded on the exchange may be relevant.
What information should I include in my TP Documentation?
Taxpayers should provide as part of their transfer pricing documentation key information about the commodity transaction including:
- The price-setting policy for commodity transactions;
- The information needed to justify price adjustments based on the comparable uncontrolled transactions or quoted price; and
- Any other relevant information such as formulas used, independent party end-customer agreements, broker price, premium or discounts applied, pricing date, supply chain information and other information prepared for non-tax purposes.
What should taxpayers consider?
When pricing commodity transaction by reference to the quoted price, the pricing date is a particularly relevant factor. Pricing date refers to the specific time and date selected by the parties to determine the price for commodity transactions.
The selection of pricing date between related parties should be justified and evidenced by proposals and acceptances, contracts or registered contracts, or other documents setting out the terms of the arrangements and compared with what independent buyers and sellers would have agreed in comparable circumstances.
However, if the pricing date specified in any written agreement between the related parties is inconsistent with the actual conduct or with other facts of the case, the tax authorities may determine a different pricing date consistent with those other facts of the case and what independent enterprises would have agreed in comparable circumstances.
In the event where there is no reliable evidence of the pricing date agreed by the related parties, and the tax authorities cannot otherwise determine a different pricing date, the tax authorities may deem the pricing date for the commodity transaction to be the date of shipment as evidenced by the bill of lading or equivalent document. Tax authorities may make transfer pricing adjustments which could lead to an increase in tax payable and possible penalty implications depending on local transfer pricing laws.
Contact Transfer Pricing Solutions. We can assist with the preparation of cost effective transfer pricing documentation locally and regionally, transfer pricing planning, and Country-by-Country reporting statements.
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Contributed by our Consultant Samuel Tay
Samuel was attached to two international accounting firms prior to joining Transfer Pricing Solutions Asia. He has prepared transfer pricing documentation for clients from the Asia Pacific region (e.g. Malaysia, Singapore and Australia).
His expertise includes handling transfer pricing engagements and conducting benchmarking studies for companies from various industries such as oil and gas, shipping, chemical, wood, jewellery and the electronics industry.
In his spare time, Samuel enjoys reading and playing sports.