Transfer Pricing Methods

Chapter 6

Transfer Pricing Methods

The OECD TP Guidelines provide five major TP methods to ensure compliance with the arm’s length principle. Usually, the appropriate method has to be applied to arrive at the appropriate arm’s length.

These methods fall into two categories, namely, Traditional Transaction Methods (CUP, RPM & CPM) and Transactional Profit Methods (TPSM/PSM & TNMM).

1. Comparable Uncontrolled Price (CUP) Method

 The CUP method compares the price charged for a property or services transferred in a controlled transaction to the price charged for a property or services transferred in a comparable uncontrolled transaction in comparable circumstances.

This method is reliable where an independent enterprise sells the same product as that sold between two associated enterprises.

2. Cost-Plus Method (CPM)

The cost-plus method is used to determine the price to be charged by a supplier of property or services to a related purchaser.

The price is determined by adding to the costs the supplier incurred, an appropriate gross margin so that the supplier will make an appropriate profit in the light of the market conditions and functions he performed. The value obtained after adding markup to costs may be regarded as the arm’s-length price of the originally controlled transactions.

This method is used when semi-finished goods are sold between related parties on the basis of joint agreements or for the provision of services in controlled transaction value.

This method is also used in resources/cost-sharing arrangements among group entities

3. Resale Price Method (RPM):

The resale-price method is used to determine the price to be paid by the reseller for a product purchased from an associated enterprise and resold to an independent enterprise.

The purchase price is set so that the margin earned by resellers sufficient to allow it to cover its selling and operating expenses and make an appropriate profit. Value arrived after subtracting the gross margins can be regarded, after adjustments for other costs associated with the purchase of the product, like customs duties, as an arms-length price for the original transfer of property between the associated enterprises. This method is usually applied to marketing operations.

4. Profit Split Method (PSM)

The profit-split method takes the combined profits earned by two related parties from one or a series of transactions and then divides the profits using a defined basis that is aimed at replicating the division of profits that would have been anticipated in an agreement made at arm’s length.

Arm’s-length pricing is derived from both parties by working back from profit to price.

Both the OECD and the US allow for profit-split methods and the main ways of applying profit split are as follows:

(i) Contribution profit-split

Under the contribution profit split method, the relative contribution of each member of a controlled group to the profits derived from

integrated transactions is valued on the basis of the activities and risks undertaken by each member. The combined profits are then allocated among the members of the controlled group on a pro-rata basis according to their contributions. To determine their relative contributions transactional methods may be used.

(ii) Residual profit-split

The residual profit split method looks at total profits, and removes the profits made by the routine functions of both parties, computed using the comparable profits method, and residual profits are split, generally based on each party’s investments and relative spending.

This method involves 2 stages: first, each member of the controlled group is allocated sufficient profit to provide it with a basic return appropriate to the type of transactions it undertook (primarily measured by traditional methods). The next stage is calculating residual profits based on an analysis of how it might have been allocated among

5. Transactional Net Margin Method (TNMM):

This method seeks to determine the level of profits that would have resulted from controlled transactions if the return realized on the transaction had been equal to the return realized by the comparable independent enterprise.

The TNMM under OECD guidelines compares the net profit margin of controlled transactions with the net profit margins of uncontrolled transactions.

The OECD does not recommend this method because it allows only comparison of net margins on a transactional basis and only in last-resort situations i.e places where “transaction methods cannot be reliably applied alone or exceptionally cannot be applied at all”.

This method is used when semi-finished goods are sold between related parties on the basis of joint agreements or for the provision of services in controlled transactions.

In addition, the recent OECD Guidance Notes provide guidance on specific transactions like:

1. Hard to Value Intangibles – BEPS Action Plan 8
2. Financial Transactions - Risks and Capital Transactions – BEPS Action Plan 9
3. High-Risk Transactions - controlled transactions that are not commercially rational (e.g. management fee, HO expenses, etc.) – BEPS Action Plan 10 intergroup
4. Business Restructuring