Transfer pricing methods

There are several methods that multinational enterprises (MNEs) and tax administrations can use to determine accurate arm’s length transfer pricing for transactions between associated enterprises. The Organisation for Economic Co-operation and Development (OECD) outlines five main transfer pricing methods that MNEs and tax administrations can use. We explore the five methods, giving examples for each, to help organizations decide which is most appropriate for their needs. RoyaltyRange’s premier-quality databases enable organizations to access the latest comparable agreements and other comparables data so that they can apply transfer methods accurately and efficiently.

1. Comparable uncontrolled price (CUP) method

The CUP method is grouped by the OECD as a traditional transaction method (as opposed to a transactional profit method). It compares the price of goods or services and conditions of a controlled transaction (between related entities) with those of an uncontrolled transaction (between unrelated entities). To do so, the CUP method requires comparables data from commercial databases.

If the two transactions result in different prices, then this suggests that the arm’s length principle may not be implemented in the commercial and financial conditions of the associated enterprises. In such circumstances, the OECD says the price in the transaction between unrelated parties may need to be substituted for the price in the controlled transaction. The CUP method is the OECD’s preferred method in situations where comparables data is available.

An example of when the CUP method works well is when a product is sold between two associated enterprises and the same product is also sold by an independent enterprise. The OECD gives the example of coffee beans. The two transactions can be seen as comparable if the conditions are the same, they happen at a similar time and take place in the same stage of the production or distribution chain. If there are differences in the product sold in each of the transactions (e.g. the uncontrolled transaction used coffee beans from another source) then the associated enterprises would need to determine whether this affected the price. If so, it would need to make adjustments to the cost to ensure it was priced at arm’s length.

2. Resale price method

Another traditional transaction method for determining transfer pricing is the resale price method. This method starts by looking at the resale price of a product that has been bought from an associated enterprise and then sold onto an independent party. The price of the transaction where the item is resold to the independent enterprise is called the resale price. The method then requires the resale price margin to be identified, which is the amount of money the party reselling the product would require to cover the costs of the associated selling and operating expenses. The resale price margin also includes the amount the reseller would need to make a fair profit, taking into account the functions it performed (including assets used and risks assumed). This gross resale price margin is deducted from the resale price. The amount that remains after the margin has been subtracted and fair adjustments have been made (e.g. expenses like customs duty have been taken into account) is the arm’s length price for the original transaction between related entities.

The resale price method requires resale price margins to be comparable in order for an arm’s length price to be identified. This means that factors such as whether a warranty is offered (and how it is applied) must be taken into account. If a distributor offers a warranty and sells the product at a higher price to account for that warranty, then they will make a higher gross profit margin than a distributor that does not offer a warranty and sells the product at a lower price. For the two transactions to be comparable, the taxpayer must make accurate adjustments to the transaction cost to account for the margin discrepancy.

3. Cost plus method

The cost plus method is a traditional transaction method that analyzes a controlled transaction between an associated supplier and purchaser. It is often used when semi-finished goods are transacted between associated parties or when related entities have long-term arrangements for ‘buy and supply’. The supplier’s costs are added to a markup for the product or service so that the supplier makes an appropriate profit that takes into account the functions they performed and the current conditions of the market. The combined price is the arm’s length price for the transaction.

For example, Party A manufactures zips for business bags and briefcases to be sold by companies around the world. Party A sells the product to Party B, which is an associated company in another country. From this transaction with Party B, Party A earns a gross profit markup. Party A does not include operating expenses in the cost of the product. Party C and Party D are independent enterprises that manufacture zip mechanisms for coats. They sell their products to independent clothing brands and also earn a gross profit markup for the transaction. Party C and Party D include operating expenses in the cost of their products. So, the gross profit markups of Party C and Party D need to be adjusted to be comparable with Party A’s.

4. Transactional net margin method (TNMM)

The TNMM is one of two transactional profit methods outlined by the OECD for determining transfer pricing. These types of methods assess the profits from particular controlled transactions. The TNMM involves assessing net profit against an “appropriate base”, such as sales or assets, that results from a controlled transaction. The OECD states that, in order to be accurate, the taxpayer should use the same net profit indicator that they would apply in comparable uncontrolled transactions. Taxpayer can use comparables data to find the net margin that would have been earned by independent enterprises in comparable transactions. The taxpayer also needs to carry out a functional analysis of the transactions to assess their comparability.

If an adjustment is needed for a gross profit markup to be comparable, but the information on the relevant costs are not available, then taxpayers can use the net profit method and indicators to assess the transaction. This approach can be taken when the functions performed by comparable entities are slightly different. For example, an independent enterprise offers technical support for the sale of a piece of IT equipment. The cost of the support is included in the price of the product but cannot be easily separated from it. An associated enterprise sells the same product but doesn’t offer this support. So, the gross margins of the transactions are not comparable. By examining net margins, associated enterprises can more easily identify the difference in transfer pricing in relation to the functions performed.

5. Transactional profit split method

The second transactional profit method outlined by the OECD is the transactional profit split method. It focuses on highlighting how profits (and indeed losses) would have been divided within independent enterprises in comparable transactions. By doing so, it removes any influence from “special conditions made or imposed in a controlled transaction”. It starts by determining the profits from the controlled transactions that are to be split. The profits are then split between the associated enterprises according to how they would have been divided between independent enterprises in a comparable uncontrolled transaction. This method results in an appropriate arm’s length price of controlled transactions.

There are two main approaches that can be taken for splitting profits. These are:

1. Contribution analysis: The combined profits are divided based on the relative value of the functions performed by each of the related entities within the controlled transaction (considering assets used and risks assumed).
2. Residual analysis: The combined profits are divided in two stages. First, each entity is allocated arm’s length compensation for its functions and contribution to the controlled transaction. Second, any remaining profit or loss after the first stage is divided based on analysis of the facts and circumstances of the transaction.

Accessing data for transfer pricing analyses

These are the five transfer pricing methods, and the ones favored by the OECD. The option that an organization chooses to use depends on the particular situation. It should take into account the amount of relevant comparables data that is available, the level of comparability of the uncontrolled and controlled transactions in question, and whether a method is appropriate for the nature of a particular transaction (determined through a functional analysis). The OECD states that it is not necessary to use more than one transfer pricing method when determining the arm’s length price for a particular transaction.

Our databases allow organizations to find high-quality comparables data to apply transfer pricing methods outlined above. Our data is fully compliant with the OECD’s guidelines and is assessed against more than 50 comparability factors. Our databases contain the most recent agreements for determining arm’s length pricing for controlled transactions. Contact us at RoyaltyRange to find out more.