In the world of corporate taxation, transfer pricing is the practice of setting the price for transactions between associated enterprises applying the arm’s length principle. This is achieved through the use of various transfer pricing methods (or “methodologies”).
Five Transfer Pricing Methods
The OECD Guidelines provide for five methods, which can be used to determine the price for intra-group transactions (also referred to as “controlled transactions”). In the selection of the most appropriate transfer pricing method, consideration shall be given to the respective strengths and weaknesses of each method taking into account the specific controlled transaction, the nature of the controlled transaction, the availability of reliable information to apply the selected method, and the degree of comparability between controlled and uncontrolled transactions.
The first step in selecting the appropriate transfer pricing method is to understand the controlled transaction based on a functional analysis, assessing the functions performed, assets used and risks assumed by the parties to the controlled transaction.
#1 Comparable Uncontrolled Price (CUP) method
The OECD preferred and most reliable transfer pricing method is the Comparable Uncontrolled Price (CUP) method. The CUP method establishes a price based on the pricing of similar transactions which have taken place between third parties or between a MNE entity and a third party. When applying the CUP Method, an uncontrolled transaction is considered comparable to a controlled transaction if:
- there are no differences in the transactions being compared that would materially affect the price; or
- reasonably accurate adjustments can be performed to account for material differences between the controlled and the uncontrolled transaction.
#2 Cost-Plus Method
When the CUP cannot be utilized due to lack of sufficiently comparable transactions, the cost-plus method may be applied. This method calculates the price on the basis of the cost of supplying the goods or providing the services, and adding a profit margin. However, this pricing method looks solely at the costs of the enterprise and ignores the prices set by competitors, therefore, it may not always be the most appropriate method.
#3 Resale Price Method
The third OECD approved method is the Resale Price method, which bases the price for an intercompany controlled transaction on the resale price of a product, asset or service sold to a third party. The resale price is then adjusted by subtracting the gross margin, along with additional costs associated with the purchase and for this reason is mostly applicable to the supply of goods.
#4 Transactional Net Margin Method
When transaction data is not available, MNEs can use margin levels to establish the arm’s length price. The transactional net margin method measures the net operating profits realized from controlled transactions and then compares the profit level to the profit level realised by independent enterprises engaging in comparable transactions.
#5 Profit-split Method
The last method is the profit split method, which is appropriate to be used when two parties are contributing to a venture and it’s difficult to examine each party on its own. Instead, the profit split method uses the profitability, or potential profitability, of a product or venture and utilises allocation keys to split profits in a fair manner between the transaction parties.
It is to be noted that the transfer pricing methods discussed are not determinative in and of themselves. If an associated enterprise reports an arm’s length amount of income, without the explicit use of one of the OECD recommended transfer pricing methods, this does not necessarily mean that the pricing of the transaction shall automatically be regarded as not being at an arm’s length.
Which is the most appropriate method to apply when pricing your intra-group transactions?
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