The Comparable Uncontrolled Price (CUP) Method: How It Works
Posted by Valentiam Group on February 15, 2021
The comparable uncontrolled price (CUP) method is one of the five main transfer pricing methods. It’s used to ensure transactions between related companies are comparable in price to those conducted with unrelated organizations.(For an overview of all five transfer pricing methods, start with this article: 5 Transfer Pricing Methods: Approaches, Benefits & Risks.)
The CUP method is a traditional transaction method. It looks at the terms and conditions of transactions made between both related and unrelated organizations to ensure arm’s-length pricing across the board. In most parts of the world it’s called the CUP method, but in the U.S. it may be referred to as any of the following: the CUP method for pricing tangible goods, the comparable uncontrolled transaction (CUT) method for pricing intangible goods, or the comparable uncontrolled services price (CUSP) method for pricing services. We’ll refer to it as the CUP method in this article.
How The Comparable Uncontrolled Price Method Works
There are generally two different ways to apply the CUP method: the internal CUP and the external CUP. We’ll break them down for you.
To determine arm’s-length transfer prices using the internal CUP method, a company must find examples of comparable transactions it has made with third parties. In order to be compliant with transfer pricing regulations, the CUP method requires the terms of transactions with related parties must be the same as those of the third-party transactions.
To determine arm’s-length transfer prices using the external CUP method, a company may look to the pricing of comparable transactions that take place between third-parties—to the extent that they exist.
While tax authorities accept both the internal and external CUP method, it’s extremely challenging for companies to find external transactions that are sufficiently comparable to their own. That’s why the internal route is almost always preferred to apply the CUP method.
CUP Method Transfer Pricing Examples
Let’s start with the internal CUP method. Say a well-known car rental company is trying to determine how much to charge its Canadian subsidiary for the use of its brand name and logo. To apply the internal CUP method, their transfer pricing team must find examples of licensing agreements between the car rental company and an independent third-party that uses their branding. Assuming that the third party arrangement is sufficiently comparable, to be accepted by tax authorities, the car rental company should charge its Canadian subsidiary the same licensing fee that it charges the third party they do business with.
Another example using the internal CUP method is a company that manufactures industrial equipment and parts and sells them to third parties at set prices. The company also sells parts and equipment to related entities. In this case, it’s fairly straightforward; the company can use the prices it charges to third parties to determine prices for goods sold to related parties—if the sales volume and terms are similar. For example, if the company charges a lower price per unit to third parties who place large orders, and the company sells a similar number of units to a related party, the defensible transfer price is the discounted price for large orders offered to third parties.
Now we’ll look at an example of the external CUP method. Say a diamond company is trying to determine an appropriate amount to charge its subsidiary for diamonds. The diamond company has no relationships with third parties and thus has no similar internal transactions to use. Its transfer pricing team can apply the external CUP method by identifying comparable transactions between two unrelated companies. Assuming that identifies sufficiently comparable transactions, to be accepted by tax authorities, the diamond company should charge its subsidiary a price comparable to the market price of diamonds.
Benefits & Risks Of The CUP Transfer Pricing Method
When you have the right facts and data to apply the CUP method, it’s almost foolproof—your transfer pricing risk should be very low. That’s because it’s the most exact way to determine and defend transfer prices. Most tax authorities recommend using this method when possible.
That said, a perfect CUP is somewhat of a unicorn—it’s very rare and may not exist. The downfall of the CUP method is that the standard of comparability is extremely high. Transfer pricing regulations specify that a number of different factors—such as volume, contractual terms, and profit potential to name a few—must be comparable in order to apply this method. In other words, the circumstances of the transactions must be nearly identical. Satisfying these requirements is difficult, as there are many variables that can change the end result.
For example, say the diamond company is selling 10 diamonds in an order. The only comparable transactions it can find are for 1,000 diamonds. The cost per diamond will be lower in the larger order, right? So many variables impact the pricing of goods, intangibles, and services, which is why it’s hard to find sufficiently comparable transactions for applying the CUP method. Volume is just one example of how even similar transactions can have many inherent differences. As far as the CUP method goes, tax authorities will likely scrutinize even the slightest differences.
Make Sense Of Transfer Pricing
If you’re still struggling to make sense of the CUP method—or other transfer pricing complexities—Valentiam can help. Let’s talk about your company’s unique situation and how we can help you optimize your pricing, mitigate tax risk, and boost your bottom line.
Topics: Transfer pricing
There are no guarantees for avoiding transfer pricing audits, but taking these steps will reduce your risk—and ensure you’re prepared if you are audited.