The comparable profits method (CPM) is one of the five primary transfer pricing methods outlined in the US transfer pricing regulations. It evaluates whether the amount charged in a controlled transaction is arm’s length based on objective measures of profitability (i.e., profit level indicators or PLI) derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances. (To get an overview of all five transfer pricing methods, start with this article: 5 Transfer Pricing Methods: Approaches, Benefits & Risks.)
The CPM is known as the transactional net margin method (TNMM) in countries outside the United States. Like the CPM, the TNMM examines the net profit relative to an appropriate base (e.g., costs, sales/revenues or assets) that a taxpayer realizes from a controlled transaction. Under the CPM/TNMM method a taxpayer’s pre-tax profit margin is compared to a range of results from a selected group of uncontrolled taxpayers. If the taxpayer’s results fall within the arm’s length range calculated from the comparable companies, then it is considered to be an arm’s length result as defined in the arm’s length principle.
How The Comparable Profits Method Works
To properly apply the CPM or TNMM transfer pricing method, a taxpayer must first identify publicly traded companies that operate in a similar fashion to the taxpayer’s entity being tested. The comparable companies financial data is used as the basis to “test” the related party transaction. The most commonly used profit level indicator—figures used to indicate a company’s financial performance—is operating profit. This is because it’s easily measured, universally recognized, and the data necessary to calculate it is relatively simple to access.
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Once an average operating profit is determined based on the financial reports of the comparable companies, the number can be compared to the taxpayer’s operating profit. If the profit margin falls within the middle 50% (i.e., interquartile range) after arriving at an average, then the company is considered to be operating at arm’s length under the US transfer pricing regulations.
An Example Of The Comparable Profits Method
Let’s say a clothing company (“Parent Co.”) is headquartered in the United States. Parent Co. is responsible for setting business strategies and financing the global operations. Parent Co. also develops and owns the intellectual property (e.g., trademarks, trade names, designs and “know-how”) that helps it to successfully compete across the globe. Parent Co. wishes to expand its global footprint and is establishing a Canadian distribution affiliate (“Dist Co.”). Dist Co. will be responsible for developing the Canadian market by using Parent Co.’s brand and selling clothing items to Canadian consumers.
To comply with both US and Canadian transfer pricing rules, Parent Co. must determine how much profit the Dist Co. should earn for its functions performed. In other words, what’s an arm’s length profit for the Canadian division of the company?
In this scenario, the Dist Co. acts as a routine distributor; it buys finished products from Parent Co. and resells these products to Canadian consumers. To determine an arm’s length profit for the Dist Co., Parent Co.’s transfer pricing team identifies similar distributors in Canada, calculates their pre-tax profit margin and determines a range of arm’s length results. Using this information, Parent Co. will sell the finished goods to Dist Co. using an intercompany pricing arrangement that allows the Canadian entity to earn a pre-tax profit that falls within this arm’s length range.
The CPM helps determine what the average retail distributor would earn by calculating the price of the retail product sold from the United States to Canada. It ultimately ensures that, after all costs are accounted for, the remaining profit falls within arm’s length range and will be deemed acceptable by tax authorities.
Benefits & Risks Of The Comparable Profits Method
As far as benefits go, the CPM is easier to implement because it relies on external financial data that is accessed using various public data sources. This is unlike some of the other methods, which often require access to information that can be less reliable, more difficult to access or have higher standards of comparability in order to use the data. The CPM is particularly effective for transactions that involve the intercompany sale of products or the provision of intercompany services. This is because it’s not difficult to access financial data on similar transactions, making the CPM easy to implement.
However, the CPM method, because of its simplistic nature (i.e., typically examines one side of the transaction) is not always the most reliable method for companies with more complex business models. This is because it can sometimes oversimplify transactions and fail to account for ancillary transactions or the presence of intangible assets that can alter the results of a transaction. Simple methods don’t work well in complex environments. For example, technology companies and pharmaceutical companies who develop, own and license intellectual property to related parties will rely on other transfer pricing methods to help determine arm’s length pricing or compensation for transactions with related parties.
For more involved transactions, it’s almost impossible to find a completely clean set of comparable data. Data discrepancies create a gray area that is typically a problem for tax authorities. When a company is unlikely to find an exact comparable, they should select one of the other methods to fairly allocate profit or measure arm’s length behavior among the related parties that comprise the global enterprise.
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