Transfer pricing is an accounting practice used to describe intercompany pricing arrangements relating to transactions between related entities. These can include transfers of wide range of transactions which can occur across local, state, or international borders, with transactions involving:
Due to growing government deficits, many jurisdictions are putting additional pressure on transfer pricing in order to secure a larger portion of entities' profits for their tax bases. This can result in the risk of tax assessments, double taxation of the same income by two jurisdictions, and penalties for failure to properly allocate income among two or more jurisdictions. Therefore, virtually all large MNCs should regularly review their international transfer pricing strategies to reduce the overall tax burden of the parent company and potential risks.
The international standard for determining the appropriate transfer price is the arm's-length principle. Under this principle, transactions between two related parties should produce results that do not differ from those that would have resulted from similar transactions between independent companies under similar circumstances. This principle is cited in the US transfer pricing rules (Code Section 482 and the Treasury regulations thereunder), the Transfer Pricing Guidelines, and the UN Transfer Pricing Manual for Developing Countries. There are some countries (e.g., Brazil) that do not follow the international application of the arm’s-length principle.
The Section 482 regulations are extensive and attempt to address a full range of transactions considering the arm's-length standard. In practice, however, it is not easy to determine the appropriate arm's-length result based on a given set of facts and circumstances. Transactions in goods and services may embody unique, company or industry-specific elements that are difficult to compare with transactions involving other companies. The Section 482 regulations concede the rarity of identical transactions, and instead attempt to determine the arm's-length results based on the ‘best method’ rule.
The Best Method Rule
The Section 482 regulations provide several methods to test whether a price meets the arm's-length standard but provide no strict priority of methods. No method invariably will be more reliable than another. Instead, every transaction reviewed under Section 482 must be judged under the method that, under the facts and circumstances, provides the most reliable measure of an arm's-length result (i.e., the ‘best method’). The selection of a method also varies depending on the type of transaction. Below we touch upon on the five common transfer pricing methods.
The five different methods of transfer pricing fall into two categories: traditional transaction methods and transactional profit methods. Traditional transaction methods look at individual transactions, while transactional profit methods look at company’s profits. Each method takes a slightly different approach and has associated benefits and risks. There’s no right or wrong method. Transfer pricing regulations specify that organizations select the ‘best method’ suited to their organization.
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:
The comparable uncontrolled price (CUP) method evaluates whether the amount charged in a controlled transaction is arm’s length by reference to the amount charged in a comparable uncontrolled transaction. 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 must meet high standards of comparability [transactions must be very similar]. If material differences exist between the two transactions, adjustments must be made for the uncontrolled transaction to have a similar level of comparability and reliability. In many cases, the reliability of the analysis will be improved by adjusting the range through the application of a valid statistical method, often the interquartile range of results.
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.
The resale price method (RPM) evaluates whether the amount charged in a controlled transaction is arm's length by reference to the gross profit margin realized incomparable uncontrolled transactions. The resale price method measures an arm’s length price by subtracting the appropriate gross profit from the applicable resale price for the property involved in the controlled transaction under review. The final number is considered an arm’s length price for a controlled transaction made between affiliated companies.
When appropriately comparable transactions are available, there sale price method can be a very useful way to determine transfer prices, because third-party sale prices may be relatively easy to access. However, there sale price method requires comparable with consistent economic circumstances and accounting methods. The uniqueness of each transaction makes it very difficult to meet resale price method requirements.
The cost plus method (CPLM) evaluates whether the amount charged in a controlled transaction is arm's length by reference to the gross profit markup realized incomparable uncontrolled transactions.
The cost plus method is ordinarily used in cases involving the manufacture, assembly, or other production of goods that are sold to related parties. 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 exact comparison, the results will be distorted, and another method must be used.
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.
The comparable profits method (CPM), also known as the Transactional Net Margin Method (TNMM), evaluates whether the amount charged in a controlled transaction is arm's length based on objective measures of profitability (profit level indicators) derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances.
The CPM is commonly used and broadly applicable type of transfer pricing methodology. It’s easy to implement because it only requires financial data and is effective for product manufacturers with relatively straightforward transactions, as it’s not difficult to find comparable data.
The profit split method (PSM) evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm's length by reference to the relative value of each controlled taxpayer's contribution to that combined operating profit or loss. The combined operating profit or loss must be derived from the most narrowly identifiable business activity of the controlled taxpayers for which data is available that includes the controlled transactions (relevant business activity).
One of the benefits of this method 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.
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.