Multinational Enterprises (MNEs) and tax authorities use several Transfer pricing methods to determine the accurate arm’s length transfer pricing for transactions between associated enterprises. The selection of the most appropriate methods depends entirely on the functional analysis and information provided in any transaction. The chosen method will lead to identifying an arm’s length prince given the important facts and availability of resources. The Organization for Economic Co-operation and Development (OECD) outlines 5 transfer pricing methods tax authorities, and MNEs can use. We explore the five methods to help organizations decide which one is appropriate for their needs.
What are Traditional Transaction-Based Methods?
These methods determine the terms and conditions of actual transactions between independent enterprises and compare these with controlled transactions. Taxpayers can make comparisons based on direct measures such as the price of the transaction or based on indirect measures such as gross margins realized on a particular transaction. Here are 3 traditional transaction methods MNEs can use;
Comparable Uncontrolled Price (CUP) Method
OECD group CUP method as a traditional method. It compares the price of goods or services and conditions in a controlled transaction (between related parties) and those in an uncontrolled transaction (between unrelated parties). Therefore, CUP methods require data from commercial databases to compare these transactions.
When prices in two transactions are different, commercial and, related parties cannot implement the price. In such cases, the OECD states that the related parties use transaction prices for the unrelated party. But when comparable data is available, OECD prefers MNEs to use the CUP method because it is the most direct and easy method to apply the arm’s length principle.
Suppose the two transactions result in different prices. In that case, this suggests that the taxpayer may not implement the arm’s length principle that may affect the commercial and financial conditions of the associated enterprises. In such circumstances, the OECD says the price in the transaction between unrelated parties may need to be substituted for the price in the controlled transaction. The CUP method is the OECD’s preferred method in situations where comparable data is available.
Resale Price Method
Resale Price Method is another traditional transaction method, also called Resale Minus Method. The methods start by looking at the price at which an associate enterprise sells a product to an independent party (third party), called resale price.
Then you reduce resale price with gross margin, called resale price margin. Resale price margin is the amount of money a reseller has to sell the goods to cover associate selling and operational charges. You then deduct other charges, such as customs duties, to get an arm’s length price.
Cost Plus Method
The Cost Plus Method compares profits to the cost of sales between the associated supplier and the purchaser in a controlled transaction. It starts by identifying the relevant costs that a supplier incurs. Secondly, you add an appropriate mark-up to the cost to determine the arm’s length price. The mark-up should ensure that the supplier makes a reasonable profit in the functions they perform.
The method requires the identification of mark-up on the cost applied for a comparable transaction between independent enterprises. An arm’s length mark-up can be determined based on the mark-up applied on comparable transactions among independent enterprises.
Transactional Profit Based Methods
The lack of benchmarking data may lead MNEs and tax authorities to apply profit-based methods. These methods look at profits that may arise from controlled transactions. These methods differ from the traditional method since they look at a net profit rather than the gross profit of transactions.
Transactional Net Margin Method (TNMM)
The TNMM involves assessing an appropriate base such as assets or sales that results from a controlled transaction. According to OECD, to be accurate, a taxpayer needs to use the same net profit indicator when determining prices in comparable uncontrolled transactions. The taxpayer can use comparables data to find the net margin that independent enterprises in comparable transactions would have earned. The taxpayer also needs to carry out a functional analysis of the transactions to assess their comparability.
Profit Split Method
The method aims at dividing profits and losses between independent enterprises in comparable transactions. Therefore, it helps eliminate any special conditions that taxpayers would have imposed a controlled transaction. The method starts by determining the profits incurred in a controlled transaction and how the taxpayer will split these profits. Then the profits or losses are split according to how they would have been divided in comparable uncontrolled transactions resulting in arm’s length price.
Two main approaches can taxpayer can use for profit splitting are;
Residual analysis approach
It states that combined profit of controlled transaction can be allocated based on two approaches;
- Parties involved in the transaction are given remunerations for their less complex, easily benchmarked functions. Then can use the traditional methods or transactional net margin method.
- Residual profit allocations are determined by the relative of the valuable unique contributions of the parties.
Contribution analysis
This approach allocates profits based on the relative value of the valuable and unique contribution of the parties. It will depend on;
- Functions performed by each of the involved parties tasking in consideration of assets used and risks are taken.
- Approximation of division of profits that the independent enterprise would have expected to realize from engaging in comparable transaction
MNEs and tax authorities around the world mostly use the same transfer pricing methods. The OECD guidelines provide five methods which include 2 transactional profit methods and 3 traditional transactional methods.
The taxpayer is to select the most appropriate method that fits their business model. Still, most firms prefer traditional methods over transactional methods. And they prefer the CUP method over others.
In practice, most tax authorities and taxpayers prefer using the TNMM over the other methods, followed by the CUP method and Profit Split Method. However, they barely use the Resale Margin method and Cost Plus Method.
