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The Resale Price Method In Transfer Pricing Explained

The Resale Price Method In Transfer Pricing Explained - Valentiam

The resale price method (RPM) is one of the five primary transfer pricing methods, all of which are used to ensure that transactions between related companies are carried out at an “arm’s length” price. (To get an overview of all five transfer pricing methods, start with this article: 5 Transfer Pricing Methods: Approaches, Benefits & Risks.)

The resale price method is a traditional transaction method. This means its application looks to transactions between unrelated parties as a means to determine an arm’s length price for the intercompany controlled transaction under review. (The arm’s length principle specifies that a company must charge a comparable, fair market price for both controlled and uncontrolled transactions.)

Unlike some of the other methods, which can be used to analyze more than one type of intercompany transaction, the resale price method is always applied to tangible property transactions. We’ll tell you a little bit about how it works.

How The Resale Price Method Works

The first step to applying the resale price method is to determine the gross margin (gross profit divided by net sales) earned by a distributor on the resale of products purchased from one or more third-party suppliers. The resulting gross margins—expressed as a percentage—are then used to determine the appropriate gross margin that should be earned by the controlled entity that you are analyzing (i.e., a distributor that purchases finished goods from related-party suppliers).

Here’s A Resale Price Method Transfer Pricing Example:

Let’s say a U.S. company distributes running shoes purchased from a related company in Ireland, and also purchases very similar—but not identical—running shoes from an unrelated supplier. For purposes of this example, let’s assume that all of the terms and conditions of the related party and unrelated party purchases are comparable.

In an arm’s-length context, an unrelated distributor would want to maximize its profits by keeping the purchasing cost low, while the unrelated supplier would want the price to be as high as possible. However, in a related party context, these incentives can be distorted. For example, because the corporate income tax rate in Ireland is 12.5% and the corporate income tax rate in the U.S. is 21%, a company may find it advantageous to sell the running shoes from the Irish company to the U.S. company at an artificially high price. This would serve to maximize the taxable profits reported in Ireland (i.e., lower-tax jurisdiction) and minimize the taxable profits reported in the U.S. (i.e., higher-tax jurisdiction).

The resale price method can be applied to ensure the prices charged by the Irish supplier to its related U.S. distributor are appropriate. Under the RPM, the gross margin earned by the U.S. distributor must be the same as it is for transactions with its third-party supplier. (In many cases, the RPM yields a “range” of acceptable gross margins rather than a “single” data point.)

Say, for instance, that the U.S. distributor makes a gross profit of $70 for each $100 pair of running shoes purchased from its unrelated supplier.

Here’s how to determine the gross margin on this transaction: 70 / 100 = 70 percent.

The gross margin is 70 percent, so the percentage must be the same in controlled transactions between the U.S. distributor and the related company in Ireland.

Because this method works in percentages, the RPM can be applied even when the underlying products are not identical. In some cases the price of shoes will vary slightly; however, the gross margin earned by the distributor should still be roughly the same. If the cost of the pair of shoes sold from Ireland to the U.S. is $200, the appropriate profit can be determined like this: $200 * 70% = 140. Sometimes the distributor earns $70 on a $100 pair of shoes, while other times it earns $140 on a $200 pair. Either way, the gross margin is 70% and should therefore be deemed acceptable by tax authorities.

The gross margin of the uncontrolled transaction between a distributor and third-party manufacturer is deemed appropriate because the market dictates the price. By applying the resale price method, the distributor can ensure that the transactions are being carried out at arm’s length.

Still trying to make sense of what a transfer pricing method is? Check out our overview on the different calculation methods and how they’re used to determine fair pricing for intercompany transactions.

Benefits & Risks Of The Resale Price Method

Each of the transfer pricing methods has its own benefits and risks, and the resale price method is no exception.

The Benefits

When the right data are available, the resale price method is a very effective way to ensure that intercompany transactions are carried out at arm’s length. Because it utilizes gross margin, the comparability requirements are slightly less stringent than with some of the other methods. (For example, the CUP method would only work in the event that the running shoes are identical in all facets.)

When applying the resale price method, there can be minor differences in the underlying product features. While of course the gross margins will vary dramatically between broadly different products—think running shoes vs. kitchen appliances—it’s safe to assume the gross margin will be relatively comparable on very similar products, like running shoes with different colors, designs and other features.

The Risks

Of course, every method also has its downfalls. While the resale price method can be very useful under the right circumstances, it’s not very commonly applied. This is because, despite allowing for slightly more variables than some of the other methods, it still requires the existence of comparable controlled and uncontrolled transactions and available gross margin data on a transaction-by-transaction basis.

The resale price method can also be difficult to apply because of inherent differences in the way accounting methods are applied across companies. Companies may categorize certain expenses differently on their financial statements, with some judgment required to determine what should be considered cost of goods sold (COGS) versus operating expenses.

While other methods (like the CPM) can be applied without regard to where costs are classified, these accounting differences can have a significant impact on the resale price method. This is because gross profit, which is used to determine the gross margin on a transaction, sits right between COGS and operating expenses. Companies can have identical profits, but if they categorize their expenses differently, they could have completely different margins.

We’ll Help You Make Sense Of Transfer Pricing

Still having a hard time making sense of transfer pricing and the different calculation methods? That’s where we come in. Valentiam works with multinational enterprises across the globe to establish transfer pricing policies that are tax-efficient and defensible; we can do the same for you. Contact us to get started.

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Topics: Resale price method