5 transfer pricing methods 2

Transfer Pricing Methods for Your Multinational Business Mowery & Schoenfeld

Seeing that a sales support service is provided, you conclude that this method is inappropriate and inferior to other methods. The CPM is a one-sided method that often ignores information on the counterparty to the transaction. Tax authorities are increasingly likely to take the position that the CPM is not a good match for organizations with complex business models, such as high-tech companies with intellectual property. Using data from companies who do not meet the OECD’s standards of comparability creates audit risk for organizations.

Tested party and profit level indicator

The cost-plus method, in particular, may be favored by tax authorities and taxpayers due to ease of administration. The OECD Guidelines provide that the provisions relating to goods should be applied with minor modifications and additional considerations. In both cases, standards of comparability and other matters apply to both goods and services. The mark-up is applied to the direct and indirect costs of ‘production’, ie it is a gross profit method not a net profit method.

The comparable profits method

Because the external market is competitive, the firm is a price taker and must accept the transfer price determined by market forces (their marginal revenue from transfer and demand for transfer products becomes the transfer price). If the market price is relatively high (as in Ptr1 in the next diagram), then the firm will experience an internal surplus (excess internal supply) equal to the amount Qt1 minus Qf1. Contemporaneous means the documentation existed with 30 days of filing the taxpayer’s tax return. Documentation requirements are quite specific, and generally require a best method analysis and detailed support for the pricing and methodology used for testing such pricing.

Comparable profits method

The Circular instructs field examiners to review taxpayer’s comparability and method analyses. The method of analyzing comparability and what factors are to be considered varies slightly by type of transfer pricing analysis method. The guidelines for CUP include specific functions and risks to be analyzed for each type of transaction (goods, rentals, licensing, financing, and services). The guidelines for resale price, cost-plus, transactional net margin method, and profit split are short and very general. Since this method compares extremely similar products or services, it is considered the most effective and most reliable way in determining arm’s length price for controlled transactions. However, due to the high standards of comparability required in applying CUP method, it is usually a challenge to identify a transaction that’s appropriately comparable to the controlled transaction.

• Companies may dispute these adjustments through appeals or litigation, or they may seek to resolve disputes through mutual agreement procedures (MAP) under tax treaties.
• Enterprises must prepare extensive documentation to justify their transfer pricing policies.
• To arrive at an appropriate TP method for the transaction at hand, we must first of all understand the at arm’s length principle.
• 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”).
• That said, it can be very challenging to identify a transaction that’s appropriately comparable to the controlled transaction in question.

What Strategies Might Be Used to Determine a Transfer Price?

On the other hand, external CUP uses comparable data of transactions entered into between two unrelated third parties. Between the two, external CUP is more difficult to apply due to the usual lack of publicly available data on comparable third-party transactions. Instead of trying to price individual transactions, it looks at the combined profits from related activities and splits them based on each company’s contribution to creating that profit. The TNMM assesses net profit in relation to an appropriate base, known as the profit level indicator (‘PLI’), such as costs, sales, or assets, that a taxpayer realizes from an intercompany transaction. To ensure reliable application, the TNMM must be applied consistent with the manner in which the cost plus-method is applied. To prevent group companies from cooking up conditions that only serve tax purposes.

To qualify, the documentation must reasonably support the prices used in computing tax. 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.

Even the addition of a few small variables can differentiate the cases enough to render the CUP method insufficient for establishing an accurate price based on the available information. Regardless of which transfer pricing method you use, your business can use a transfer pricing tool to alleviate the manual burdens of this transfer pricing accounting process. Software-based transfer pricing also allows you to monitor the success of each pricing method you use, and gather insights to help you guide your transfer pricing method strategy going forward.

Our team at Crowe Peak is dedicated to simplifying these methods and guiding you through the process to ensure compliance and accuracy in your transfer pricing documentation. Rely on our expertise to navigate the complexities and select the best method tailored to your needs. In the rest of this article, we provide detailed explanations of the different transfer pricing methods.

• However, it will be hard if the related party purchase the service which just a part of production cost or the goods is only a small part of the finished product.
• Transfer pricing consultants have determined that independent third parties typically apply a cost mark-up of 30%.
• The 2010 version of the Guidelines, approved in July this year, has substantially revised the discussion on transfer pricing methods in the new Chapter II.
• This method is commonly used for distribution activities where the reseller adds limited value to the product.
• Transfer pricing works by establishing prices for intercompany transactions that mirror prices that would be charged between unrelated, independent entities.
• It’s considered the most effective and reliable way to apply the arm’s length principle to a controlled transaction.

The burden of proof that a transfer pricing adjustment by the IRS is incorrect is on the taxpayer unless the IRS adjustment is shown to be arbitrary and capricious. However, the courts have generally required both taxpayers and the IRS to demonstrate their facts where agreement is not reached. CPM inherently requires lower levels of comparability in the nature of the goods or services.

However, finding the comparable data necessary to use these methods is often very difficult. Even the smallest 5 transfer pricing methods variations in product features can lead to significant differences in price, so it can be very challenging to find comparable transactions that won’t raise red flags and be questioned by auditors. The RPM stipulates that the gross margin earned by the U.S. distributor on shoes purchased from the related company must be the same as the margin earned on sales of shoes purchased from the unrelated supplier.