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An introduction to the 5 Transfer Pricing Methods

Ruchi Gandhi

| Updated: Feb 02, 2022 | Category: Transfer Pricing in India

Transfer Pricing Methods

Multinational enterprises and tax authorities can apply a variety of methodologies to determine an appropriate arm’s length transfer price for transactions between related businesses. MNEs and tax authorities can employ five different transfer pricing methods, according to the Organization of Economic Co-operation and Development (OECD).

Traditional transaction techniques and transactional profit methods are the two types of transfer pricing methods available. Traditional transaction techniques focus on individual transactions, whereas transactional profit methods focus on the company’s overall earnings. There is no such point as a “great” or “poor” method; it is simply the one that best suits a company’s business strategy. Organizations must choose the method that is suitable for them, according to the transfer pricing regulations.

Transfer Pricing Methods

Traditional transaction methods:

  1. Comparable Uncontrolled Price Method
  2. Resale price method
  3. Cost-plus method

Transactional profit methods:

  1. Transactional Net Margin Method (TNMM)
  2. Profit Split Method

Comparable Uncontrolled Price Method

The comparable uncontrolled price (i.e., CUP) technique compares the price and terms of items or services in a controlled transaction to those of unrelated parties in an uncontrolled transaction. The CUP approach requires comparable data in order to do this comparison. The uncontrolled transaction must meet rigorous standards of comparison in order to be recognized as a comparable price. To put it another way, for this strategy to work, transactions must be substantially similar. This method falls into the category of traditional transaction transfer pricing methods.

Whenever possible, the OECD recommends this method. It is regarded as the most efficient and dependable method of applying the arm’s length principle to a controlled transaction. However, it can be difficult to identify a transaction that is appropriately comparable to the controlled transaction in question. As a result, the CUP method is one of the most commonly used transfer pricing methods when there is a large amount of information to compare.

The OECD classifies the CUP method as a traditional transaction method (as opposed to a transactional profit method). It compares the price of goods and/or services as well as the terms and conditions of a controlled transaction (between two related entities) to those of an uncontrolled transaction (between two unrelated entities).

If the prices from the two transactions vary, it suggests that the arm’s length principle may not be applied in the commercial and financial circumstances of the associated enterprises. According to the OECD, in such cases, the price in the unrelated party transaction might be needed to be substituted for the price in the controlled transaction.

Resale price method

The resale price method is yet another traditional method for determining transfer pricing. This method begins by examining the resale price of a product that has been purchased from a related enterprise and then sold to an unaffiliated party. The resale price refers to the price of the transaction in which the item is resold to an independent business. The method subsequently requires determining the resale price margin, which is the sum of money that is required by the party reselling the product to satisfy the associated selling and operational costs.

The resale price margin additionally contains the amount a reseller would need to make a reasonable profit based on the services it provided (including assets used and risks assumed). The resale price is reduced by this gross resale price margin. The arm’s length price for the original transaction between associated companies is the amount that remains after the margin has been deducted and fair adjustments have been made (for example, expenses such as customs duty have been taken into account).

With a view to determining an arm’s length price, the resale pricing approach requires that the resale price margins be identical. This means that things like whether or not a warranty is available (and how it is administered) must be considered. If a distributor provides a warranty and charges a higher price for the goods to cover the warranty, the distributor will have a higher gross profit margin than if the distributor does not provide a warranty and charges a lower price. The taxpayer must produce precise adjustments to the transaction cost to account for the margin differential for the two transactions to be comparable.

Cost-plus method

The cost-plus approach is a typical transaction analysis method that looks at a controlled transaction between a supplier and an associated buyer. When semi-finished items are traded between connected parties, or when related entities have long-term “purchase and supply” agreements, this method is frequently employed. The costs of the provider are added to a mark-up for the product or service such that the supplier makes a profit that is acceptable for the functions they performed and the current market conditions. The combined price is the transaction’s arm’s length price. This method also falls into the category of traditional transaction transfer pricing methods.

The cost-plus method is particularly effective for determining transfer prices for low-risk operations such as tangible products and their manufacture. This strategy is simple to use and understand for many businesses. But the availability of comparable data and consistency in accounting is a shortcoming of the cost-plus approach (and, in fact, all traditional transactional methods). In many circumstances, there are no comparable companies or transactions, or at least none that are comparable enough to produce an accurate and dependable outcome.

The use of the Cost-Plus Method necessitates the determination of a mark-up on expenses applied for comparable transactions between independent businesses. The mark-up applied on comparable transactions across independent firms can be used to estimate an arm’s length mark-up.

Transactional Net Margin Method (TNMM)

The TNMM[1] analyses a taxpayer’s net profit margin from a controlled transaction in relation to a suitable basis (e.g., costs, sales, assets) (or from transactions that are appropriate to be aggregated). The TNMM, like the Cost-Plus Method and Resale Price Method, looks at the profits of one of the connected parties involved in a transaction. 

The TNMM compares the net profit margins gained by the tested party in controlled transactions (relative to a suitable base) to similar net profit margins generated by the tested party in corresponding uncontrolled transactions or, otherwise, by independent comparable firms. This approach is a less direct method than the Cost-Plus Method and Resale Price Method, which compare gross margins and TNMM uses net margins to estimate arm’s length prices. It is also a more indirect way than the CUP Method, which compares prices directly.

According to the OECD, the taxpayer should use the same net profit measure that may be applied in comparable uncontrolled transactions in order to be accurate. Taxpayers can utilize the comparable firms’ data to calculate the net margin that independent businesses would have received in similar transactions. A functional examination of the transactions is also required by the taxpayer in order to determine their comparability.

If a gross profit markup needs to be adjusted to be comparable, but the information on the necessary costs is not readily available, taxpayers can assess or examine the transaction by using the net profit technique and indicators. In addition, when the functions performed by comparable entities differ slightly, this strategy can be used. For example, in exchange for the sale of a piece of IT equipment, an independent business may provide technical support. The cost of support is included in the product price, although it is difficult to separate. A related company sells the same product but does not provide the same level of service. As a result, the transaction gross margins aren’t comparable. The difference in transfer price in relation to the functions provided can be more clearly identified by looking at net margins.

Profit Split Method

When both parties to a controlled transaction make a contribution of considerable intangible property, the Profit Split Method is often used. Profits will be split as in a joint venture. By establishing the division of profits that independent entities would have expected to recognize from participating in the transaction and/or aggregate transactions, the Profit Split Method aims to eradicate the effect on profits of special conditions made or imposed in a controlled transaction.

The Profit Split Method begins by determining the earnings from controlled transactions that should be split among the related firms. The earnings are then split among the related firms based on the relative worth of each enterprise’s contribution, which should represent the functions performed, risks taken, and assets employed by each enterprise in the controlled transactions.

If possible, external market information (for example, profit split percentages among entities having performed comparable functions) must be used to evaluate each entity’s contribution, so that the division of combined earnings between the associated enterprises is comparable to that between the independent entities that are performing functions comparable to the associated enterprises’ functions.

In cases involving highly interconnected transactions that cannot be analyzed separately, the Profit Split Method may be used. It means that the Profit Split Method can be used when the associated enterprises engage in a series of transactions that are so much interdependent that they cannot be evaluated separately using a traditional transaction method. In other words, the transactions are so interlinked that identifying comparable transactions is impossible. In this regard, the Profit Split Method is appropriate for complex industries such as global financial services. This method falls into the category of transactional profit transfer pricing methods.

When it comes to profit splitting, there are two primary options. These are the following:

  • Contribution analysis: The profits are split according to the proportionate value of the functions performed by each of the associated businesses inside the controlled transaction (after considering the assets used and risks assumed).
  • Residual analysis: The total profits are split into two halves. To begin, each entity gets compensated at arm’s length for the functions and contributions it makes to the controlled transaction. Second, any profit or loss that remains after the first step is distributed based on an appraisal of the transaction’s facts and circumstances.

Conclusion

These are the five transfer pricing methods or mechanisms that the OECD recommends. The decision that an organization chooses is determined by the situation at hand. It should consider the amount of relevant comparable companies’ data available, the level of comparability of the uncontrolled and controlled transactions in consideration, and whether a method is appropriate enough for the nature of the transaction in question (may be determined through a functional analysis). When determining the arm’s length price for a transaction, the OECD maintains that it is not required to utilize more than one transfer pricing method.

Read our Article: Transfer Pricing and Its Implication

Ruchi Gandhi

A CA together with MBA (Fin) and M Com, she relishes taking interest in insightful writing in the domain of taxation and finance. She has gained experience as a full-time author and has also served an accounting role in industry.

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