Five Transfer Pricing Methods with Examples

Are you looking into the five transfer pricing methods and examples of how to use them?

Below, we explain the common methods which you can use to determine transfer prices. We also
explain for every method when and how you should use it.

After reading this article you have a better understanding of the different methods and how they
can be applied to your firm’s transactions.

Before we continue, it is important to understand that the main purpose of transfer pricing
methods is to examine the “arm’s-length” nature of “controlled transactions.” If these terms do
not ring a bell, we advise you to first read our article What is transfer pricing?.

Or go here if you need transfer pricing services in Asia.

What Transfer Pricing Methods Are There?

The good thing about transfer pricing is that the principles and practices are quite similar all
around the world. The OECD Transfer Pricing Guidelines (OECD Guidelines) provide 5
common transfer pricing methods that are accepted by nearly all tax authorities.

The five transfer pricing methods are divided in “traditional transaction methods” and
“transactional profit methods.”

Traditional Transaction Methods

Traditional transaction methods measure terms and conditions of actual transactions between
independent enterprises and compares these with those of a controlled transaction.

This comparison can be made on the basis of direct measures such as the price of a transaction
but also on the basis of indirect measures such as gross margins realized on a particular
transactions.

Transactional Profit Methods

The transactional profit methods don’t measure the terms and conditions of actual transactions.
In fact, these methods measure the net operating profits realized from controlled transactions and
compare that profit level to the profit level realized by independent enterprises that are engaged
in comparable transactions.

The transactional profit methods are less precise than the traditional transaction methods, but
much more often applied. The reason is that application of the traditional transaction methods,
which is preferred, requires detailed information and in practice this information is not easy to
find.
In short:

 Traditional transaction methods rely on actual transactions.

 Traditional profits method rely on profit levels.

The Five Transfer Pricing Methods

As mentioned, the OECD Guidelines discuss five transfer pricing methods that may be used to
examine the arm’s-length nature of controlled transactions. Three of these methods are traditional
transaction methods while the remaining two are transactional profit methods.

We list the methods below:

Traditional transaction methods:

1. CUP method
2. Resale price method
3. Cost plus method

Transactional profit methods:

4. Transactional net margin method (TNMM)

5. Transactional profit split method.

The OECD Guidelines provide that you as a taxpayer should select the most appropriate transfer
pricing method. However, if a traditional transaction method and a transactional profit method
are equally reliable, the traditional transaction method is preferred.

In addition, if the CUP method and any other transfer pricing method can be applied in an
equally reliable manner, the CUP method is to be preferred.

We’ll explain each of these methods in more detail now.

The CUP Method

The CUP Method compares the terms and conditions (including the price) of a controlled
transaction to those of a third party transaction. There are two kinds of third party transactions.

 Firstly, a transaction between the taxpayer and an independent enterprise (Internal Cup).
 Secondly, a transaction between two independent enterprises (External Cup).

The below example shows the difference between the two types of CUP Methods:
CUP Method Example

With this in mind, let”s look at an example of the application of the CUP method:

A manufacturing company (X) manufactures the “Buster 3.0.” This is a high-quality vacuum
cleaner. It is up to 10 times stronger than the models of most competitors. The only competing
manufacturer that can provide a vacuum cleaner performing similarly is the Dust Company, with
its renowned “Dragon Buster.” X and Z sell their vacuum cleaners via both associated and third
party distributors. X and Y operate completely similar.

Now say that X has received an order from distribution company Y for the supply of 1 Buster 3.0.
X and Y have the same shareholder (Z). X wonders what transfer price it should apply. This
means that X should find the terms and conditions (here: the price) of a comparable transaction.
Under the CUP method, there are now 2 options:

1. X looks at the price for which it sells 1 “Buster 3.0” to a third party distributor (Internal
CUP).
2. X looks at the price for which Z sells 1 “Dragon Buster” to a third party distributor
(External CUP).

Obviously, option 1 is the easy option here and would be acceptable. But option 2 would also be
acceptable and provides a better defense towards tax authorities (because “X is doing what an
independent enterprise does”).

The below example summarizes the use of the CUP Method in this case:
Use of CUP Method In Practice

The CUP method is the most direct and reliable way to apply the arm’s length principle to a
controlled transaction. However, it is often difficult to find a transaction that is sufficiently
comparable to a controlled transaction. Therefore, this method is used when there is a lot of
available data.

In practice, the CUP method is often used for financial transactions such as group loans. For
these types of transactions there is a lot of data available and market standards help determine
terms and conditions. For example, most banks work with the same formulas to determine credit
ratings of borrowers. This serves as a basis for the interest rate of a loan.

This method is also often used to determine prices of intellectual property (IP) charged for the
use of brands and licenses.

The CUP Method with Example – Conclusion

The CUP Method is one of the 5 common transfer pricing methods provided by the OECD
Guidelines. It compares the terms and conditions (including the price) of a controlled transaction
to those of a third party transaction.

The CUP Method is the most direct and reliable way to apply the arm’s length principle to a
controlled transaction.

But, in practice it is often difficult to find sufficiently comparable transactions. The method is
often applied to financial and IP transactions.
The Resale Price Method

The Resale Price Method is also known as the “Resale Minus Method.” As a starting position, it
takes the price at which an associated enterprise sells a product to a third party. This price is
called a “resale price.”

Then, the resale price is reduced with a gross margin (the “resale price margin”), determined by
comparing gross margins in comparable uncontrolled transactions. After this, the costs associated
with the purchase of the product, like custom duties, are deducted. What is left, can be regarded
as an arm’s length price for the controlled transaction between associated enterprises.

The below image is an example of the Resale Price Method:

Resale Price Method Example

With the above image in mind, let’s look at a Resale Price Method example:

Apple & Pear, based in Hong Kong, brews a very exclusive non-alcoholic beverage called “the
Mountain.” It sells this beverage to high-end nightclubs around Asia via associated distributors.
The market price for one can of “the Mountain” is USD 100. Apple & Pear does not sell the
beverage to independent distributors. Also, there is no company in Asia that brews a comparable
beverage.

However, there are comparable distributors that sell “the Vulcano.” This is a competing
alcoholic beverage brewed by Gin & Juice, a company also based in Hong Kong. The market
price for one bottle of “the Vulcano” is USD 100. In addition, distributors report USD 5 gross
margin per bottle sold with 2 USD on custom duties.
Apple & Pear wants to set the transfer price for the supply of “the Mountain” to the associated
distributors. There is no Internal Cup (no third party transactions by Apple & Pear) or External
Cup (no comparable transactions). Therefore, the CUP method can’t be applied here (The CUP
Method with example).

In our example, the distributors of “the Vulcano” are comparable to the distributors of “the
Mountain.” The result is that the gross margin and custom duties reported can be used as input
for the Resale Price Method.

This would look as follows:

In this example, when using the Resale Price Method, Apple & Pear needs to charge a transfer
price of 93 USD to its associated distributors.

Use of Resale Price Method in practice

The Resale Price Method requires that third party transactions are comparable with the
controlled transaction. As a result, there can be no differences that have a material effect on the
resale price margin. Because each transaction is unique, it is quite difficult to meet this
requirement.

Therefore, the Resale Price Method is not often used.

However, in case sufficient comparable transactions are available the Resale Price Method can
be useful to determine transfer prices. The reason is that in such a case, third party sales prices
are easily found.

Resale Price Method With Example – Conclusion

The Resale Price Method is one of the 5 common transfer pricing methods provided by the
OECD Guidelines. First of all, it takes as a starting position the price at which an associated
enterprise sells a product to a third party (the “resale price”). It then reduces this price with a
gross margin (the “resale price margin”). This margin is determined by comparing gross margins
in comparable uncontrolled transactions.

The Resale Price Method is not often used. The reason is that it is difficult to find comparable
transactions. However, in case those can be found, the Resale Price Method is suitable to
examine gross margins of associated enterprises engaged in sales and distribution to third parties.
The Cost Plus Method

With the Cost Plus Method, you focus on the costs of a supplier of property or services in a
controlled transaction. Once you know the costs, you add a mark-up. That mark-up should
reflects the profit for the associated enterprise on the basis of functions and risks performed. The
result is an arms’ length price.

In general, the mark-up in a cost plus method will be computed after direct and indirect costs of
production or supply. However, operating expenses of the enterprise such as overhead expenses
are not part of the mark up.

The mark-up can be determined in two ways. The first, it can be compared to the mark-up
applied by the associated supplier of property or services for comparable transactions with third
parties (internal cost-plus method). If such transactions do not take place, the alternative is to
look at the cost plus mark-up applied in transactions between third parties (external cost-plus
method).

It is explained in this figure:

Cost Plus Method Example

With this in mind, let’s look at an example of the application of the Cost Plus Method:

Company X provides administrative support services such as invoicing and bookkeeping. There
are many companies around that provide comparable services, including independent enterprise
B. B and X provide exactly the same services.

Now say that X is asked by associated enterprise Y to provide invoicing services. X wonders
what transfer price it should charge. This means that X should find the terms and conditions
(here: the price) of a comparable transaction. Under the Cost Plus Method, there are now 2
options:

1. Company X looks at the price for which they themselves sell their invoicing services to a
third party client (Internal Cost Plus Method).
2. Company X looks at the price for which Company B sells invoicing services to a third
party client (External Cost Plus Method).

Obviously, option 1 is the easy option here and would be acceptable. But option 2 would also be
acceptable and provides a better defense towards tax authorities (because “X is doing what
independent enterprise B does”)

The below image illustrates this example:

Use Of Cost Plus Method In Practice

In theory, the Cost Plus Method can be helpful to assess the arm’s length remuneration of low-
risk routine-like activities. Examples are manufacturing and some types of services. By
comparing gross profits to cost of sales, an acceptable transfer price can be calculated.

However, the downside of the Cost Plus Method is that it requires controlled and uncontrolled
transactions to be very comparable. This means that detailed information should be available.
Examples are the types of products manufactured, actual activities, cost structures and the use of
intangible assets.

If this information is unavailable, the Cost Plus Method cannot be applied. For this reason the
Cost Plus Method is not often used in practice.
Conclusion

The Cost Plus Method is one of the 5 common transfer pricing methods provided by the OECD
Guidelines. It begins with the costs incurred by the supplier of property or services in a
controlled transaction and adds to that a mark-up.

An arm’s length mark-up can be determined based on the mark-up applied on comparable
transactions with third parties (internal cost-plus method) or on the mark-up applied in
transactions between third parties (external cost-plus method).

The Cost Plus Method is often applied to low-risk routine-like activities such as manufacturing.
In practice, it is often difficult to find information on sufficiently comparable transactions.

The Transactional Net Margin Method

With the TNMM, you need to determine the net profit of a controlled transaction of an associated
enterprise (tested party). This net profit is then compared to the net profit realized by comparable
uncontrolled transactions of independent enterprises.

As opposed to other transfer pricing methods, the TNMM requires transactions to be “broadly
similar” to qualify as comparable. “Broadly similar” in this context means that the compared
transactions don’t have to be exactly like the controlled transaction. This increases the amount of
situations where the TNMM can be used.

A comparable uncontrolled transaction can be between an associated enterprise and an

independent enterprise (internal comparable) and between two independent enterprises (external
comparables).

Let’s see how this looks in this example:

TNMM’s Key Element: The Net Profit Indicator

The most important aspect of the TNMM is the “net profit indicator.”

This is a ratio of net profit relative to a base, such as “costs,” “sales” or “assets.” The net profit
indicator that a taxpayer realizes from a controlled transaction, is compared with the net profit
earned in comparable uncontrolled transactions.

We will now explain two examples of commonly used net profit indicators: the “Net Cost Plus
Margin” and the “Net Resale Minus Margin.”

TNMM I: Net Cost Plus Margin

The Net Cost Plus Margin is the ratio of operating profit to total cost.

As “Operating profit” usually Earnings before Interest and Taxes is used, or simply “EBIT.”
Total cost means the direct and indirect operational costs without extraordinary items.

The Net Cost Plus Margin basically measures the return on total costs of a company. By using
this ratio, the comparison eliminates differences resulting from categorizing costs. An example is
costs that can be either qualified as “costs of goods sold” or “operating costs.” This net
comparison is not allowed under the traditional transactions method Cost Plus Method. That
method uses information on gross level (and thus requires costs to be categorized properly).

If the TNMM uses the Net Cost Plus Margin as net profit indicator, one often refers to it simply
as the Net Cost Plus Method.

This method is often used for low-risk routine-like activities such as manufacturing and
provision of administrative support services.
With this in mind, let’s look at an example.

Example Net Cost Plus Margin

Company X provides administrative support services such as invoicing and bookkeeping.

Associated enterprise Y asks X to provide invoicing services. Y thinks that they need about 1.000
hours of such services.

X knows that the total cost of 1.000 hour of services is 125.000 USD. X wonders what transfer
price it has to charge. This means that X should find the terms and conditions (here: the price) of
a comparable transaction.

There are many companies around that provide comparable services, including independent
Enterprise B. X and B have exactly the same business model. Company X can look at Enterprise
B to determine a good arm’s length price.

How to determine this price? As mentioned, first we need to find the ratio of operating profit to
total cost.

The second step is to use the Net Cost Plus Margin to calculate the arm’s length transfer price.
To calculate the transfer price one simply has to add the Net Cost Plus Margin to the existing
total cost.

We saw that the total cost of the services is 125,000 USD. If we add to that amount the Net Cost
Plus Margin of 0.25 (31,250 USD) we end up with a transfer price of 156,250 USD (or 156.25
USD per hour).

TNMM II: Net Resale Minus Margin

The Net Resale Minus Margin is the ratio of EBIT to turnover. It basically measures the return
on sales of a company.

By using this net ratio, the comparison eliminates differences resulting from categorizing sales
under sales revenues or other revenues. This is not allowed under the traditional transactions
method Resale Minus as that method uses information on gross sales level (and thus requires a
detailed specification).
If the TNMM uses the Net Resale Minus Margin as net profit indicator, one often refers to it as
the Net Resale Minus Method. This method is often used for sales and distribution activities.

With this in mind, let’s look at an example.

Example Net Resale Minus Method

Company X provides distribution services. Associated enterprise Y asks X to provide distribution

services. This means that X should find the terms and conditions (here: the price) of a
comparable transaction.

There are many companies around that provide comparable services, including independent
Enterprise B. X and B have exactly the same business model. Company X can look at Enterprise
B to determine a good arm’s length price.

How to determine this price? As mentioned, first we need to find the ratio of EBIT to turnover.

The second step is to calculate the arm’s length transfer price. For this, you simply charge a
price at which the Net Cost Plus Margin is not less or more than 0.15.

The Transactional Net Margin Method In practice

The TNMM is a good alternative for the traditional transactions methods. The fact that multiple
forms of net profit indicators can be used, makes this method widely applicable. It is therefore
not a surprise, that this is the most used transfer pricing method.

The TNMM can be helpful to assess the arm’s length remuneration of both low-risk routine-like
manufacturing and services and more complicated functions like sales or distribution.

The downside of the use of the TNMM is that the level of comparability of independent
transactions in some cases can be questioned. This point is often brought forward by tax
authorities. However, the fact is that the TNMM is often used exactly because other transfer
pricing methods cannot be applied because of a lack of comparability and / or information in the
first place.

Conclusion
The Transactional Net Margin Method is one of the 5 common transfer pricing methods provided
by the OECD Guidelines. It is a transactional profit method.

The TNMM compares the net profit realized in a controlled transaction to the net profit realized
by broadly similar independent enterprises in similar transactions. The TNMM makes use of a
“net profit indicator” as a means for this comparison. This is a ratio of net profit relative to a
base, such as “costs,” “sales” or “assets.”

The TNMM is the most used transfer pricing method. It is used for both low-risk routine-like
manufacturing and services and more complicated functions like sales or distribution.

The Profit Split Method

Associated enterprises sometimes engage in transactions that are very interrelated. Therefore,
they cannot be examined on a separate basis. For these types of transactions, associated
enterprises normally agree to split the profits.

The Profit Split Method examines the terms and conditions of these types of controlled
transactions by determining the division of profits that independent enterprises would have
realized from engaging in those transactions.

An example of this method is shown in this image:

In the above example, we see two comparable joint ventures. Joint Venture I is owned by
associated enterprises Y and X. Opposite to that, Joint Venture II is owned by independent
enterprises A and B.

Let’s say that we need to determine the transfer prices to be charged for the transactions related
to Joint Venture I.

For that, we can compare the terms and conditions of the controlled transactions by determining
the division of profits of comparable uncontrolled transactions. In this example, this means that
we can compare Profit Split I with Profit Split II.

Two Kinds Of Profit Split Methods

There are two kinds of Profit Split Methods:

1. Contribution profit split method;

2. Residual profit split method.

The contribution profit split method splits profit among associated enterprises according to the
functions performed and risks assumed. In addition, the assets are analyzed which are
contributed by each entity. In particular, intangible assets.

The application of the contribution profit split method requires careful analysis. First of all of the
functions performed, risks borne and assets used by each associated enterprise. In addition, the
allocation of cost, expense, earnings, and capital of the associated enterprises involved in the
transaction needs to be measured.

The residual profit split method requires the identification of the routine profit for an entity as
a first step. Any remaining profit is then split based on each party’s contribution to the earning of
the non-routine profit, for example the ownership of intangibles.

Use Of Profit Split Method In Practice

The Profit Split Method is usually applied in cases where the controlled transaction is highly
integrated. This makes it difficult to evaluate the operating result separately.

Examples are the set-up of a partnership or the joint exploitation of intangible assets such as
brands.

This method is not often used in practice, but is rising in popularity. It’s main benefit is that it
looks at profit allocation in a mere holistic way rather than on a transactional basis. This can be
appropriate for cases where there are multiple controlled transactions instead of one clearly
identifiable controlled transaction.

There is an important downside to the Profit Split Method. Due to the subjective profit allocation
criteria based on score cards, it can offer tax authorities the possibility to allocate a
disproportionate amount of profits to an associated enterprise engaging in a particular
transaction. This could lead to a non-arm’s length outcome and disputes with the tax authorities.

Conclusion

The Profit Split Method is one of the 5 common transfer pricing methods provided by the OECD
Guidelines. It is a transactional profit method.

The Profit Split Method measures the net operating profits realized from controlled transactions
and compares the profit level to the profit level realized by comparable independent enterprises
that are engaged in comparable transactions.

There are two kinds of Profit Split Methods: (1) contribution profit split method; and (2) residual
profit split method.

The Profit Split Method is not often used in practice but is rising in popularity. Especially in
cases where the controlled transaction is highly integrated, it can be a very useful transfer pricing
method. However, there are also important downsides, one being the risk of disputes with tax
authorities.

The Five Transfer Pricing Methods with Examples – Conclusion

Transfer pricing methods are quite similar all around the world. The OECD Guidelines provide
five transfer pricing methods that are accepted by nearly all tax authorities. These include 3
traditional transaction methods and 2 transactional profit methods.

A taxpayer should select the most appropriate method. In general, the traditional transaction
methods is preferred over the transactional profit methods and the CUP method over any other
method.

In practice, the TNMM is the most used of all five transfer pricing methods, followed by the
CUP method and Profit Split method. Cost Plus Method and Resale Margin Method are barely
used.