Transfer Pricing
Transfer pricing involves a range of activities from setting, analysis, documentation to adjustment of charges made between related parties for goods, services, or use of property (including intangible property). Inter company transactions across borders are growing rapidly and are becoming much more complex. This has led to the rise of transfer pricing regulations as governments seek to stem the flow of taxation revenue overseas, making the issue of great importance for multinational corporations.
Companies often use transfer prices as substitutes for market prices - maybe market prices do not exist for the scenario or they do not facilitate internal trading or factor in the synergies created. Thus, a transfer price imposition helps benefit from these synergies. However, the complication might be that synergistic benefits’ sharing between responsibility centers is often arbitrary, so the "correct" transfer price cannot exist. Transfer prices affect the profit reported in each responsibility center, and, more importantly, they are used to influence decision making, especially in a decentralized environment.
The extensive use of transfer pricing has management, financial as well as tax implications. For instance, low transfer pricing can make a division's financial performance look better than it might be if it would have paid open market prices for its inputs. On the other hand, unusually high transfer pricing can cause the division's taxable income to be lower than it might ordinarily be, while the selling division will have inflated profits.
The "arm's length" principle is used as a standard to calculate transfer prices. Under this approach, the price that an independent buyer would pay an independent seller for an identical item under identical terms and conditions, where neither is under any compulsion to act is taken into account.
There are practical difficulties in implementing this approach. For items other than goods, there are rarely identical items. Terms of sale may vary from transaction to transaction. Market and other conditions may vary geographically or over time. Also, most systems recognize that an arm's length price may not be a particular price point but rather a range of prices.
Some of the common Transfer Pricing methods are:
Some methods are more appropriate and indicative for an arm’s length result for certain transactions than others. For example, a cost‐based method is usually considered more useful for determining price for services and manufacturing, while a resale price‐based method is usually considered more useful for determining price for distribution/selling functions.
Comparable Uncontrolled Price method (CUP)
The method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances or after reasonable adjustments are made to account for the differences. This method is widely used in practice with respect to royalties. If reasonable adjustments cannot be made, the reliability of the CUP method is decreased. In such cases, another transfer pricing method should be used in combination with the CUP method or considered instead of the CUP method.
CUP method is not a one sided analysis, as price is arrived at between two parties to the transaction and also a detailed transactional comparison is involved. In addition, unlike the other methods, it avoids the issue as to which of the related parties should be the tested parties for transfer pricing purposes. However, often it is hard to find closely comparable uncontrolled transactions as strict comparability standard is required particularly with respect to product comparability. What adds to the complexity is the fact that internal comparable transactions frequently don’t exist while external comparable transactions are difficult to find in practice.
Resale Price method
Cost Plus method
This method focuses on the manufacturing company as the tested party in the transfer pricing analysis. It begins with the costs incurred by the supplier in a controlled transaction for property transferred or services provided to a related purchaser. An appropriate cost plus markup is then added to this cost, to make an appropriate profit in light of the functions performed, risks assumed, assets used and market conditions. It compares the gross profit markup earned by the manufacturing company or service provider to the gross profit markups earned by comparable companies. The financial ratio used here is the gross profit mark‐up, which is defined as the gross profit to cost of goods sold ratio of a manufacturing company.
Third parties can be easily found that are using cost plus method to set prices. Also, since the basis is internal costs, the data is readily available. However, there may be no link between the level of market prices and the costs. It is also a one sided analysis and accounting consistency with the comparable uncontrolled transactions may be a problem. In addition, since the calculation is based on actual costs, there may be no incentive for cost control to the manufacturer or service provider.
Profit Split method
Transactional Net Margin method (TNNM)
Transfer pricing involves a range of activities from setting, analysis, documentation to adjustment of charges made between related parties for goods, services, or use of property (including intangible property). Inter company transactions across borders are growing rapidly and are becoming much more complex. This has led to the rise of transfer pricing regulations as governments seek to stem the flow of taxation revenue overseas, making the issue of great importance for multinational corporations.
Companies often use transfer prices as substitutes for market prices - maybe market prices do not exist for the scenario or they do not facilitate internal trading or factor in the synergies created. Thus, a transfer price imposition helps benefit from these synergies. However, the complication might be that synergistic benefits’ sharing between responsibility centers is often arbitrary, so the "correct" transfer price cannot exist. Transfer prices affect the profit reported in each responsibility center, and, more importantly, they are used to influence decision making, especially in a decentralized environment.
There are practical difficulties in implementing this approach. For items other than goods, there are rarely identical items. Terms of sale may vary from transaction to transaction. Market and other conditions may vary geographically or over time. Also, most systems recognize that an arm's length price may not be a particular price point but rather a range of prices.
- Comparable Uncontrolled Price method (CUP)
- Resale Price method
- Cost Plus method
- Profit Split method
- Transactional Net Margin method (TNNM)
The method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances or after reasonable adjustments are made to account for the differences. This method is widely used in practice with respect to royalties. If reasonable adjustments cannot be made, the reliability of the CUP method is decreased. In such cases, another transfer pricing method should be used in combination with the CUP method or considered instead of the CUP method.
This method is one of the traditional transaction methods and focuses on the selling company as the tested party in the transfer pricing analysis. The mechanism of the resale price method reduces the price of a product that the selling company charges to an unrelated customer by an arm’s length gross margin, which it uses to cover its selling, general and administrative (SG&A) expenses, and still make an appropriate profit, taking into account its functions performed and risks incurred. The financial ratio used here is the gross profit margin, which is defined as the gross profit to net sales ratio of the selling company.
The resale price method is a demand driven method as the base price is the market price and it can be used to without forcing distributors to make unrealistic profits. However, unlike the CUP method, it is a one sided analysis focusing on the selling company and the data on gross margin may not be comparable in uncontrolled transactions due to accounting inconsistencies.
This method focuses on the manufacturing company as the tested party in the transfer pricing analysis. It begins with the costs incurred by the supplier in a controlled transaction for property transferred or services provided to a related purchaser. An appropriate cost plus markup is then added to this cost, to make an appropriate profit in light of the functions performed, risks assumed, assets used and market conditions. It compares the gross profit markup earned by the manufacturing company or service provider to the gross profit markups earned by comparable companies. The financial ratio used here is the gross profit mark‐up, which is defined as the gross profit to cost of goods sold ratio of a manufacturing company.
Third parties can be easily found that are using cost plus method to set prices. Also, since the basis is internal costs, the data is readily available. However, there may be no link between the level of market prices and the costs. It is also a one sided analysis and accounting consistency with the comparable uncontrolled transactions may be a problem. In addition, since the calculation is based on actual costs, there may be no incentive for cost control to the manufacturer or service provider.
Profit Split method
This method seeks to eliminate the effect of special conditions made or imposed in a controlled transaction on profits by determining the division of profits that the involved parties would have expected to realize from engaging in it. The first step is to identify the profits to be divided between the parties from the controlled transactions. Then, these profits are divided between them based on the relative value of their contribution, which should reflect the functions performed, risks incurred and assets used in the transactions.
The split can be decided through contribution analysis or residual analysis. In contribution analysis, the combined profits are allocated on the basis of the relative value of functions performed. In the residual analysis, first, a basic profit for the routine contribution is allocated and then, the residual profit is allocated based on the circumstances.
This method is used where comparable transactions could not be found. It results in avoiding extreme result for one of the involved parties due to its two sided approach and also is best to deal with the returns which occur as a result of synergies. However, there may be certain measurement problems in applying this method. For instance, due to different accounting practices, the costs and revenues of each party may be difficult to compare.
The method examines the net profit margin relative to an appropriate base (say, costs, sales, assets) that a taxpayer realizes from a controlled transaction and compares it with net profit margins earned by the tested party in comparable uncontrolled transactions. This method is a more indirect method compared to others as net profit margin is compared and there may be many factors which affect it but have nothing to do with transfer pricing.
It may be better to choose the TNMM if, for example, there is different reporting of the cost of goods sold and operating expenses for the tested party and the comparable parties, so that the gross profit margins reported are not comparable and reliable adjustments cannot be made, the resale price method may be relatively unreliable. However, this type of accounting inconsistency will not affect the reliability of the TNMM, as this method examines net profit margins instead of gross profit margins.
This method can be applied to the less complex party in the transaction and hence less complex analysis is needed. Also, it can be applied to both sides of the transaction and gives the same results as a modified resale price or cost plus method. However, several countries do not recognize the use of this method. In addition, it may be difficult to calculate back the transfer price from a determination of arm’s length net margin.
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