5 Transfer Pricing Methods: Approaches, Benefits & Risks
Posted by Valentiam Group on February 8, 2021
To say that transfer pricing is complex is an understatement. From international regulations to calculation methods, there are many technicalities to manage when it comes to transfer pricing. After a brief industry overview, we’ll help break down the five transfer pricing methods, along with the pros and cons to each approach.
A Quick Transfer Pricing Overview
In the world of corporate tax and accounting, transfer pricing is the practice of setting the price of goods and services for transactions between affiliated organizations—for example, a manufacturer and a distributor owned by the same parent company. The effective management of transfer pricing allows global companies to avoid paying unnecessary taxes and to achieve the best financial outcome possible.
The Organisation for Economic Co-operation and Development (OECD) is responsible for regulating transfer pricing guidelines for multinational organizations. These guidelines, which are accepted by nearly all tax authorities, outline the rules and regulations on transfer pricing to ensure accuracy and fairness. They specify that the price of a controlled transaction—one made internally between related companies—must follow what’s known as the arm’s length principle. This principle specifies that a company must charge a similar price for a controlled transaction as an uncontrolled transaction made by a third party. In other words, the transaction amount must be a fair market price.
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In addition to outlining the rules of transfer pricing, OECD guidelines also outline the five primary transfer pricing methods. The different methods of transfer pricing all look at comparable transactions and profits of similar third-party organizations in order to arrive at arm’s length transfer prices. The methodology used to arrive at these prices is included in financial reporting documents, which are closely reviewed and checked for accuracy by tax authorities. Companies are required to provide transfer pricing tax documentation to tax authorities in order to show the rationale for the prices of transactions made internally.
The Five Transfer Pricing Methods
The five different methods of transfer pricing fall into two categories: traditional transaction methods and transactional profit methods. While the traditional transaction methods look at individual transactions, the transactional profit methods look at the company’s profits as a whole. Each method takes a slightly different approach and has associated benefits and risks, which we’ll explore in more detail in future articles. There’s no right or wrong method—only the one that best fits a company’s business model. Transfer pricing regulations specify that organizations select the method best-suited to their organization.
Below, we break down the different approaches to transfer pricing to explain how they work, the risks and benefits of each, and examples of how they are used.
Traditional Transaction Methods
Traditional transaction methods examine the terms and conditions of uncontrolled transactions made by third-party organizations. These transactions are then compared with controlled transactions between related companies to ensure they’re operating at arm’s length. There are three traditional transaction methods:
1. Comparable Uncontrolled Price Method
The comparable uncontrolled price (CUP) method compares the price and conditions of products or services in a controlled transaction with those of an uncontrolled transaction between unrelated parties. To make this comparison, the CUP method requires what’s known as comparable data. In order to be considered a comparable price, the uncontrolled transaction has to meet high standards of comparability. In other words, transactions must be extremely similar to be considered comparable under this method.
The OECD recommends this method whenever possible. It’s considered the most effective and reliable way to apply the arm’s length principle to a controlled transaction. That said, it can be very challenging to identify a transaction that’s appropriately comparable to the controlled transaction in question. That’s why the CUP method is most frequently used when there’s a significant amount of data available to make the comparison.
An example of the CUP transfer pricing method:
There are actually two ways to apply the CUP method: the internal CUP and the external CUP. The internal CUP relies on examples of comparable transactions the company has made with unrelated third parties. The external CUP looks at pricing of comparable transactions made between two unrelated third parties—which can be difficult to find. For this reason, the internal CUP method is preferred. The following is an example of the internal CUP method:
A U.S. car rental company needs to determine how to price the use of its brand name and logo by its Canadian subsidiary. The company’s transfer pricing team must find an example of a licensing agreement the company has made with an independent third party to use their branding. If that arrangement is sufficiently comparable, the car rental company can apply the same price it charges the independent third party to its Canadian subsidiary for the use of the brand and logo.
2. The Resale Price Method
The resale price method (RPM) uses the selling price of a product or service, otherwise known as the resale price. This number is then reduced with a gross margin, determined by comparing the gross margins in comparable transactions made by similar but unrelated organizations. Then, the costs associated with purchasing the product—such as customs duties—are deducted from the total. The final number is considered an arm’s length price for a controlled transaction made between affiliated companies.
When appropriately comparable transactions are available, the resale price method can be a very useful way to determine transfer prices, because third-party sale prices may be relatively easy to access. However, the resale price method requires comparables with consistent economic circumstances and accounting methods. The uniqueness of each transaction makes it very difficult to meet resale price method requirements.
An example of the resale price transfer pricing method:
A U.S. company that distributes running shoes buys shoes from a related company in Ireland. It also purchases similar shoes from another, unrelated supplier. Assuming that the terms and conditions of the related and unrelated party transactions are comparable, the RPM can be applied to ensure the Irish company charges its related U.S. distributor a price comparable to the price charged by the unrelated third-party supplier.
The RPM stipulates that the gross margin earned by the U.S. distributor on shoes purchased from the related company must be the same as the margin earned on sales of shoes purchased from the unrelated supplier. If the distributor makes a gross profit of $65 on each pair of shoes from the unrelated supplier sold for $100, the gross profit margin is 65%. This is the gross margin which must be used to determine the price of the shoes the distributor purchases from its related Irish supplier.
3. The Cost Plus Method
The cost plus method (CPLM) works by comparing a company’s gross profits to the overall cost of sales. It starts by figuring out the costs incurred by the supplier in a controlled transaction between affiliated companies. Then, a market-based markup—the “plus” in cost plus—is added to the total to account for an appropriate profit. In order to use the cost plus method, a company must identify the markup costs for comparable transactions between unrelated organizations.
The cost plus method is very useful for assessing transfer prices for routine, low-risk activities, such as the manufacturing of tangible goods. For many organizations, this method is both easy to implement and to understand. The downside of the cost plus method (and really, all the transactional methods) is the availability of comparable data and accounting consistency. In many cases, there are simply no comparable companies and transactions—or at least not comparable enough to get an accurate, reliable result. If it’s not an apples to apples comparison, the results will be distorted and another method must be used.
An example of the cost plus transfer pricing method:
A French corporation produces products under contract for its German-based parent company and needs to determine the appropriate markup (gross cost plus) for the goods it sells to its German partner. If the French company has made similar comparable transactions with third parties, the markup used for those transactions can be applied to the sales the company makes to the related German company. If the French company has made no comparable third party transactions, then the transfer pricing team can identify several companies similar to the French manufacturer and apply those companies’ average gross cost plus to the transactions with the related German company.
Transactional Profit Methods
Unlike traditional transaction methods, profit-based methods don’t examine the terms and conditions of specific transactions. Instead, they measure the net operating profits from controlled transactions and compare them to the profits of third-party companies making comparable transactions. This is done to ensure all company markups are arm’s length.
However, finding the comparable data necessary to use these methods is often very difficult. Even the smallest variations in product features can lead to significant differences in price, so it can be very challenging to find comparable transactions that won’t raise red flags and be questioned by auditors.
4. The Comparable Profits Method
The comparable profits method (CPM), also known as the transactional net margin method (TNMM), helps determine transfer prices by looking at the net profit of a controlled transaction between associated enterprises. This net profit is then compared to the net profits in comparable uncontrolled transactions of independent enterprises.
The CPM is the most commonly used and broadly applicable type of transfer pricing methodology. As far as benefits go, the CPM is fairly easy to implement because it only requires financial data. This method is really effective for product manufacturers with relatively straightforward transactions, as it’s not difficult to find comparable data.
The CPM is a one-sided method that often ignores information on the counterparty to the transaction. Tax authorities are increasingly likely to take the position that the CPM is not a good match for organizations with complex business models, such as high-tech companies with intellectual property. Using data from companies who do not meet the OECD’s standards of comparability creates audit risk for organizations.
An example of the comparable profits transfer pricing method:
A U.S.-based clothing company with global reach establishes a Canadian distribution affiliate. The U.S. parent company supplies products, sets business strategies, finances the global operations, and owns the intellectual property (trademarks, designs, and operational know-how) for its global affiliates. The parent company needs to determine how much profit the Canadian distributor should earn for its operations.
The transfer pricing team identifies similar distributors in Canada, calculates their pre-tax profit margins, and establishes a typical profit margin range. Prices are set to allow the related Canadian distributor to earn a pre-tax profit that falls within that typical margin range.
5. The Profit Split Method
In some cases, associated enterprises engage in transactions that are interconnected—meaning they can’t be observed on a separate basis. For example, two companies operating under the same brand might use the profit split method (PSM). Typically, the related companies agree to split the profits, and that’s where the profit split method comes in.
This approach examines the terms and conditions of interrelated, controlled transactions by figuring out how profits would be divided between third parties making similar transactions. One of the main benefits of the PSM is that it looks at profit allocation in a holistic way, rather than on a transactional basis. This can help provide a broader, more accurate assessment of the company’s financial performance. This is especially useful when dealing with intangible assets, such as intellectual property, or in situations where there are multiple controlled transactions happening at a time.
However, the PSM is often seen as a last resort because it only applies to highly integrated organizations equally contributing value and assuming risk. Because the profit allocation criteria for this method is so subjective, it poses more risk of being considered a non-arm’s length outcome and being disputed by the appropriate tax authorities.
An example of the profit split transfer pricing method:
A pharmaceutical company affiliate performs research and development (R&D) to bring a new drug to market. The affiliate bears the costs and risks of launching the new drug. The two related parties need to determine the right profit split and decide that they’ll use the contribution PSM to divide profits from sales of the new drug.
The two parties have invested a total of $500 million in bringing the medication to market. The R&D company invested $375 million—or 75% of the total investment. Therefore, 75% of the profits will go to the R&D company, with the remaining 25% going to the pharmaceutical manufacturer.
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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.