Transfer Pricing Methods

A. Traditional methods: (Compare price with each-other)

i. Comparable Uncontrolled Price (CUP)
ii. Cost-plus (CP)
iii. Resale Price (RP)
B. Transactional Profit methods:
iv. Transactional Net Margin Method (TNMM)
v. Transactional Profit-split Method
Application and Selection of the most Appropriate Method
 The relative strengths and weaknesses of the possible methods;
 The circumstances, including the functions, assets and risks of the
entities;
 The availability, coverage and reliability of the data; and
 The degree of comparability that exists between the controlled and
uncontrolled dealings or between enterprises undertaking the
dealings, including all the circumstances in which the dealings took
place
Traditional transaction methods are preferred to transactional profit
methods where both can be applied in an equally reliable manner.
Moreover, where comparable uncontrolled transactions (CUP) and another
method are applicable in an equally reliable manner, the CUP method (Less
subjective) is to be preferred.
There may be situations where transactional profit methods are found to be
more appropriate than traditional transaction methods.
1. Comparable Uncontrolled Price Method (CUP)
This method is applicable when company trades in the same goods, in the same
market with independents; or Similar enterprise trading in the same goods in the
same market, at the same level in the market, and apply its prices to the
company. The comparable prices are compared to the intra-group transactions.
The CUP method compares the price charged for goods or services transferred
in a controlled transaction to the price charged for comparable goods or services
transferred by independent parties in comparable circumstances. This is the
most direct and reliable method (OECD preferred) but comparability is critical.
In theory, CUP is the best method but in practice, it may be difficult to satisfy
the 5 comparability factors, even where internal comparable exists.

Charactristics of the CUP Method

• The goods or services are unique and sold only to associates
• The goods are the product of sophisticated research
• no comparable exists and there is a wide margin between production cost
and end price
• Sales in similar goods take place at different levels in the market (e.g.
retail as opposed to wholesale); or at the same level but in vastly differing
quantities (e.g. bulk sales as opposed to specific small orders)
• Different FAR profile of related and unrelated parties
• Major problems can arise with the valuation for the use of intangibles

2. Resale Price Method

This method is used in comparison of the resale price margin achieved in a
controlled transaction to that obtained in a comparable transaction on the open
market (Internal/external comparisons).
The resale price method begins with the price at which a product that has been
purchased from an associated enterprise is resold to an independent enterprise.
This price (the resale price) is then reduced by an appropriate gross margin
(representing the amount out of which the reseller would seek to cover its
selling and other operating expenses, as well as profit).
What is left after subtracting the gross margin from the resale price can be
regarded (after adjustment for other costs associated with the purchase of the
product e.g. customs duties), as an arm’s length price (the cost price) of the
original transfer of goods between the associated enterprises.
The gross margin that will be used to calculate the Transfer Price must be
comparable to the gross margin of a comparable independent transaction under
comparable circumstances.
This method is particularly appropriate when the distributor/reseller does not
add substantial value to the product (e.g.: distributors performing a routine
function and assuming only the risks specific to this function).

• Look at end selling price and deduct a reasonable gross margin to arrive
at cost
• Need an end sale to a third party, with the intra-group transaction earlier
in the chain
• Most useful where a distributor purchases goods intra group and sells to
third parties. The resale minus method will set the price of the intra
group purchases by reference to the third-party sales
• Less useful where goods are further processed or incorporated into a
more complicated product so that their identity is lost or transferred
 • Need to consider any “value-add” performed by the distributor.
3. Cost Plus Method
The cost-plus method is another method that can be used to determine the arm’s
length revenue from a controlled transaction. The method involves the addition
of an appropriate mark-up on cost, charged by independent parties dealing in
comparable transactions, to the costs incurred in a controlled transaction to
arrive at an arm’s length sales price or revenue of the controlled transaction.
The cost-plus method begins with the costs incurred by the supplier of goods (or
services) in a controlled transaction for goods transferred or services provided
to a related purchaser.
An appropriate cost plus mark-up is then added to this cost (to make an
appropriate profit in light of the functions performed and the market
conditions). What is arrived at after adding the cost plus mark up to the costs
may be regarded as an arm’s length price of the original controlled transaction.
The mark-up that will be used to calculate the Transfer Price must be
comparable to the mark-up of a comparable independent transaction.
• This method tests the arm’s length mark-up of the service fee (not the
cost base)
• The cost plus method begins with the costs incurred by the supplier of
property or services to a related purchaser. An appropriate percentage
mark-up is applied to the costs to give the arm’s length profit.

When to use it:

• pure manufacturing companies within a group (e.g. contract
manufacturing)
• group services companies providing basic services such as
administration support
 • limited sales function companies
• smaller branches of overseas entities
• Method is useful where:
• simple or peripheral service is being provided
• costs are relatively stable and predictable
• provider does not participate in the risks associated with making
the profits and therefore has no right to share in the profits or losses

4. Transactionary Profit Method are classified into two:

A. TNMM method
B. Profit split Method
• These methods test the profitability of an entity based on functions, assets
and risks performed
• These analyses may be performed at a:
− Whole of entity level
− Segment/business unit level
− Transaction level
4.1. Profit Split Method
• This is applicable when use of traditional methods is not practicable for
the following reasons:
• There is insufficient reliable data to analyse comparability so as to
determine an arm's length outcome rather than through a profit split
method
• Product or service in question is unique and contain out-of-the-
ordinary intangibles;
• There are overlapping transactions involving tested party and its
related parties;
• Tested party’s operations are diverse and complex, that is, it
performs a number of non-routine and routine functions
When to use the Method
• Begin with the overall profit from start to finish e.g., from obtaining raw
materials to end sale or the profit on a trading book
• Allocate a share of the profit to each company in the chain
• In order to do this, we have to evaluate the economic contribution made
by each group member taking into account assets used and risks assumed
by each company
• Contribution analysis
• Residual analysis (2 stage process)
Allocation keys (asset or cost based)
• This method is useful where transactions are very inter-related and cannot
be evaluated on a separate basis
4.2. Transitionary Net Margin Method (TNMM)
This is used to test the comparison of the net margin achieved in a controlled
transaction to that obtained in comparable transactions in an open market.
Determination of net profit: Exclusion of expenses and income not related to the
controlled transaction in question – Exclusion of financial and exceptional
elements
 Selects the least complex entity in the transaction under review to be the
“tested party”
 Commonly applied at a whole of entity level
 Looks at the net profit margin compared to appropriate bases for:
 a particular transaction
 business unit
 whole of entity level
 Consider appropriate profit level indicator (PLI), including Operating
Margin, EBIT Margin, Return on Assets, Net Cost Plus, etc.