Transfer Pricing Methods

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See my previous notes in this category for discussions of the arm’s length principle, the tested party, comparables and comparability analyses.

The OECD Guidelines describe three traditional transaction methods and two transactional profit methods for calculating a transfer price. Although no absolute hierarchy now exists within the Guidelines, the OECD states that where the comparable uncontrolled price (‘CUP’) and another pricing method can be applied in an equally reliable way, the CUP method is preferable.

1. Comparable uncontrolled price

The CUP method is the simplest and most reliable measure for arm’s length results, where the controlled and uncontrolled transactions are identical or if only minor, readily quantifiable differences exist.

It compares prices charged in controlled transactions with prices charged in comparable transactions with third parties. Comparable sales may be between two third parties or between one of the related parties and a third party, i.e. where the controlled party transacts in the same goods or services under the same circumstances and conditions with both a connected party and a comparable third party.

2. Cost plus method

The cost plus method compares gross margins of controlled and uncontrolled transactions.

The OECD Guidelines say that the cost plus method is most useful where finished or semi-finished goods are transferred between related parties, e.g. a manufacturing company selling to a distribution affiliate, or where the controlled transaction is the provision of services.

The starting point should be with the costs incurred by the supplier of the goods or services. A ‘plus’ percentage should be added to this to give the supplier a profit appropriate to the functions carried out, assets employed, risks assumed and the market conditions.

The profit element should be calculated by reference to the profit the supplier earns in comparable uncontrolled transactions, i.e. with an unconnected third party (an “internal comparable”).

In the absence of an internal comparable the mark up that would have been earned in comparable transactions by an independent enterprise (an “external comparable”) can serve as a guide.

If cost plus is the appropriate transfer pricing method to arrive at the arm’s length price, it is most important to ensure that all the relevant costs are included in the cost base in determining the price charged.

Although this would appear to be an accurate method of establishing a transfer price, in reality there can be wide differences between companies on the definition of “cost”, which may not be evident from publicly available data. Therefore, identifying appropriate and defendable comparables could prove to be a challenge.

3. Resale price method

The OECD Transfer Pricing Guidelines recommend the resale price (also called ‘resale minus’) method of establishing a transfer price as being most useful where a company purchases goods from a connected party for onward distribution to an unconnected third party.

The resale price method is similar to the cost plus method, but is instead found by subtracting a gross margin from the ultimate selling price to an unconnected enterprise.

The resale price method is most often used for distributors that resell products to third parties without physically altering them or adding substantial value to them. The more value added by the seller, the more difficult it will be to establish a gross margin. It is also useful when it is difficult to determine actual cost figures.

Once again, if there are no internal comparables, the relevant gross margin should ideally be determined by a comparison with the profit earned on a similar product by an unconnected enterprise in an uncontrolled transaction.

As with all the OECD methods, the resale price method can only be applied successfully if any differences in function between the tested party and any potential comparable companies are considered and an assessment made of how those differences might affect the price that would be paid between independents.

 

All three traditional methods above have one overriding problem in that publicly available data may not be available in sufficient detail for a comparability study. Therefore the OECD guidelines give two additional methods of establishing a transfer price.

 

4. Profit split method

The profit split method and the transactional net margin method are described in the OECD Transfer Pricing Guidelines as the transactional profit methods for establishing the arm’s length price. They concentrate on finding the arm’s length net profit margin as opposed to the gross profit margin sought by the ‘traditional’ methods of CUP, resale price and cost plus.

The profit split method can be applied to complex trading relationships involving integrated operations, where it is often very difficult to evaluate the transactions on a separate basis, or from the viewpoint of just one of the affected parties. It is also useful where the transactions make use of unique intangible assets where it would be virtually impossible to find an uncontrolled comparable.

The method attempts to eliminate the effect of a control relationship on profits accruing to each connected party by determining the division of profits that independent enterprises would have expected to realise from engaging in the tested transactions.

The profit split method is therefore a ‘multi-sided’ transfer pricing method.

The OECD Guidelines make clear that application of a profit split methodology should split the profits on an economically valid basis which approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length. Use of hindsight should be avoided, i.e. you have to consider what the parties would have done at the time the deal was struck.

So, what is an economic basis? Generally, at arm’s length profits will follow economic function, assets and risk. This is a fundamental principle of transfer pricing.

Due to the complexity of transactions, the profit split may often be employed in two stages. The first stage will allocate to each of the affected parties the profit related to the routine functions they perform, such as manufacturing and distribution, and this may be calculated using one of the three traditional methods.

The second stage will then allocate the residual profit attributable to intangible assets, based on the contribution of each company.

5. Transactional net margin method

The transactional net margin method (TNMM) is the OECD method most commonly used for justifying the transfer pricing of a company because it is reasonably accurate and easy to apply.

Although requiring an unconnected net profit / operating profit margin, such a figure will often be publicly available when a reliable gross profit margin is not. The unconnected net profit margin is then applied to an appropriate base such as costs, sales or assets employed.

The OECD Guidelines make it clear that any attempt to use TNMM should begin by comparing the net margin which the tested party makes from a controlled transaction with the net margin it makes from an uncontrolled one (an “internal comparable”).

Where this proves impossible, usually because the tested party has no uncontrolled transactions, then the net margin which would have been made by an independent enterprise in a comparable transaction (an “external comparable”) may serve as a guide.

Note the strict criteria of an independent enterprise, carrying out a comparable transaction, and the caveat that this will be only a guide. The emphasis is very clearly on finding a comparable transaction. A functional analysis of both the tested party and the independent enterprise is required to determine if the transactions are comparable.

A major weakness of TNMM is the fact that the net profit indicator of a company can be influenced by a range of factors that either have no effect or a different effect on gross margins or the actual price of a transaction. This makes comparing the tested party with another company very difficult if that company is not affected by the same factors.

It may of course be possible to adjust for minor functional differences, provided that there is sufficient comparability to begin with. However, the standard of comparability for application of TNMM is no less than that for the application of any other transfer pricing method.

Although the use of ranges of results applies whatever pricing methodology is adopted, in the light of its difficulties it may be particularly useful to consider a range of results when using TNMM.

A range of results may mitigate unquantifiable differences between the tested party and independent companies carrying out comparable transactions. A range would allow results which would occur under a variety of business conditions.

Note however that the range of results has to be constructed from the results of companies carrying out comparable transactions in the first place.

 

Bye for now.

 

References

– ACCA Global article on Transfer Pricing

– HMRC publicly available International Manual guidance

– The OECD Transfer Pricing Guidelines

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I try to make the contents of this website as useful, reliable and factual as possible but any opinions that slip through are solely my own. They do not represent the views of my employer or any other person I’m connected with.

The purpose of the site is to inform and educate readers with general guidance and useful tips. It provides only an overview of the regulations and guidance in force at the date of publication and is not a substitute for professional advice. It is not designed to provide professional advice or financial advice and should not be relied on as such.

You should not base any action on the contents of this website without first obtaining specific professional advice from appropriately qualified Transfer Pricing experts. They can establish the full facts and circumstances of your business – I can’t.

Therefore, no responsibility for loss occasioned by any person acting or refraining from action as a result of this Website can be accepted by the author.

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