Transfer Pricing Methods: Which One is Right for Your Business?

• Transfer Pricing
• ||
• October 15, 2024

Transfer pricing is critical for ensuring that transactions between related entities in multinational companies are conducted fairly. Several methods are available, like the Comparable Uncontrolled Price (CUP), Resale Price Method (RPM), and Cost-Plus Method (CPM); choosing the correct approach is essential for compliance and reducing tax risks. This article explains each method in detail to help businesses determine the best way to set the arm’s length price for intercompany transactions.

The methods for determining the arm’s length price are as follows:

(A) Comparable Uncontrolled Price (CUP) Method

The CUP (Comparable Uncontrolled Price) method helps evaluate whether prices between related parties are done at arm’s length by comparing them to prices in similar transactions between unrelated entities.

Steps for applying the CUP method:

1. Identify the controlled transaction that needs analysis.
2. Find comparable uncontrolled transactions within the same market, industry, and period.
3. Adjust for differences in product features, quantity, or terms.
4. Compare prices between controlled and uncontrolled transactions.
5. Determine the arm’s length price based on the comparison.

Challenges:

• It may be challenging to find truly comparable uncontrolled transactions, especially for unique products or services.
• Making accurate adjustments for differences is complex and requires detailed analysis.
• In some cases, other methods like the Cost-Plus Method or Resale Price Method might be more suitable.

(B) Resale Price Method (RPM)

The Resale Price Method (RPM) method bases the price on the sale of goods to an independent customer, factoring in the gross profit margin for similar independent companies.

Steps for applying the RPM method:

1. Identify the resale price to the independent customer.
2. Find a comparable gross margin from similar companies.
3. Adjust for any differences between the related party and comparables.
4. Subtract the adjusted gross margin from the resale price to calculate the transfer price.
5. Add any direct costs incurred by the reseller.
6. Compare the calculated transfer price with the actual price charged between the related parties.

Challenges:

• It may be difficult to find independent companies that are truly comparable in terms of functions, risks, and market conditions.
• Making accurate adjustments for differences can be complex and requires careful analysis.
• RPM is suitable when the reseller does minimal functions and assumes minimal risks.

(C) Cost Plus Method (CPM)

The Cost-Plus Method (CPM) determines the price based on the supplier’s total costs plus a reasonable profit margin, factoring in direct and indirect costs. In a more straightforward form, it is :

Arm’s length price as per CPM = Direct costs + Indirect costs + Adjusted GP margin.

Steps for applying the CPM method:

1. Determine the supplier’s direct(e.g., materials, labor)  and indirect costs(e.g., overhead, administrative expenses).
2. Set a profit margin that an independent third party would earn for similar goods or services. It is mainly based on market data.
3. Adjust the profit margin for differences between related and independent comparables.
4. Add the profit margin to the supplier’s costs to calculate the price.
5. Compare the calculated price to the actual price charged between the related parties.

Challenges:

• Allocating costs between related parties can be tricky, especially when the supplier provides multiple products or services.
• Finding reliable market data for profit margins can be tough, especially for unique products.
• Adjusting profit margins for functional differences requires a deep understanding of the supplier’s operations.

(D) Profit Split Method (PSM)

The Profit Split Method (PSM) is used when both parties significantly contribute to the total profit and divide the profit based on each party’s contribution.

Steps for applying the PSM method:

1. Determine the total combined profit from the transaction.
2. Assess the contributions of each party. This includes analyzing their functions, assets, and risks.
3. Select a method for splitting the profit (equal or residual split).
   1. Equal Split: Profits are divided equally.
   2. Residual Split: Profits are first allocated based on routine returns, with the remaining profits split based on additional contributions.
4. Allocate profits based on contributions.
5. Adjust the profit split for differences in functions, risks, or assets.
6. Use the profit split to determine the appropriate transfer prices or profit shares for each related part.

Challenges:

• Assessing contributions can be challenging, especially for similar functions or assets.
• Finding comparable market data to support the profit split method is challenging.
• The PSM method can be complex, particularly for transactions involving multiple parties or complex business structures.

(E) Transactional Net Margin Method (TNMM)

The Transactional Net Margin Method (TNMM) compares the profit margin of the related party to those of independent companies operating in similar markets and performing similar functions.

Steps for applying the TNMM method:

1. Identify the related party whose profit margin will be analyzed.
2. Choose a suitable profit indicator (operating profit margin, etc.).
3. Identify independent companies for comparison.
4. Calculate the tested party’s margin.
5. Establish an arm’s length range based on comparable companies and establish a benchmark range.
6. Compare the tested party’s margin to the range.
7. Adjust transfer prices if necessary.

Challenges:

• Finding comparable companies that are truly comparable in terms of functions, risks, and market conditions is difficult.
• Obtaining accurate financial data for both the tested party and the comparable can be challenging.
• Making accurate adjustments for differences between companies is complex.

(F) Other Methods (Rule 10AB)

If the traditional methods (CUP, RPM, CPM, PSM, TNMM) are unsuitable, other methods can be used as long as they follow the arm’s length principle.

Key Requirements:

• The method must consider prices charged in similar transactions between unrelated parties.
• All relevant factors must be considered when assessing comparability.

Steps for applying an alternative method:

1. Determine if traditional methods aren’t suitable for the transaction.
2. Choose a method that fits the transaction’s economic context.
3. Conduct an economic analysis to support the chosen method.
4. Apply the method to calculate the arm’s length price.
5. Keep detailed documentation for the selected method.
6. Review the approach periodically and adjust as needed.

Challenges:

• Finding comparable uncontrolled transactions is difficult for unique products.
• Justifying the alternative method requires a clear rationale.
• Economic analysis can be time-consuming and require expert knowledge.

In conclusion, selecting a suitable transfer pricing method is essential to ensure compliance with tax regulations while aligning with a company’s financial structure. Whether using the CUP, RPM, CPM, or profit-based methods like PSM and TNMM, each method has specific strengths and is suited for different transactions. Choosing the best method requires understanding the transaction’s context, available comparable, and functional contributions.

Companies should also stay aware of regulatory changes and keep thorough documentation to defend their approach during audits or disputes. In the ever-evolving global business environment, effectively applying transfer pricing methods is vital for both compliance and tax strategy integrity.

At Mercurius, our professionals are skilled in providing comprehensive and personalized support for all transfer pricing requirements. If you have any questions or wish to know more about what needs to be covered for transfer pricing compliance, kindly contact us.