A transfer pricing method is applied for the purpose of determining the price of a controlled transaction.
Methods acknowledge by the OECD
The five methods approved by the OECD are the comparable uncontrolled price (CUP) method, resale price method (RPM), cost plus method (CPM), transactional net margin method (TNMM) and the transactional profit split method (TPSM).
OECD also acknowledge use of methods applying techniques used by independent parties for price setting (e.g. valuation techniques for pricing transfers of business assets and credit ratings for determining interest payment).
Under narrowly defined circumstances special transfer pricing methods can be applied for simplification purposes according to the OECD Transfer Pricing Guidelines (e.g. the simplified method for LVAS and bilaterally agreed Safe Harbors).
At the outer boundary of the arm’s length principle, transfer pricing methods are applied to minimise tax avoidance. This includes the HTVI guidance, the so called sixth method used for commodity transactions, and the group rating approach for setting interest rates on inter-company loans.
Pricing methods outside the arm’s length principle include formulary apportionment, industry averages and use of rules of thumb.
The Process of Pricing Controlled Transactions
Consider the materiality of the transaction vs. the administrative burden and the purpose for pricing the transaction – pricing at the time of the transaction, retrospective price testing, tax assessment, MAP/APA or risk assessment purposes. This is relevant for the overall approach and thoroughness of the pricing exercise.
Read the terms and conditions of the agreement and then make an effort to get a full understanding of the true nature/substance of the transaction (or the combined/aggregated transactions), the parties to the transaction and the circumstances under which the transaction has been agreed . Then read the terms of the written agreement again and compare – delineation (what is the real deal). Is remuneration of the transaction included in other transactions. Are there tax incentives for mis-characterizing and/or -pricing the transaction (e.g. low tax jurisdictions)
Search for pricing data on comparable transactions – internal, external, historical and other useful information related to pricing of similar transactions. Consider if segregation or aggregation of transactions is needed.
Select the most appropriate transfer pricing method – choice of tested party, profit level indicator, use of more than one method for complex transactions
Find the information needed to apply the chosen transfer pricing method – benchmark study, comparability adjustments, financial data, cost base, relevant profit, splitting factor, cash flow, credit rating etc.
If the method is based on comparable transactions diagnostic ratios (e.g. turnover compared to costs, profit per employee) may need to be checked?
Determine the price of the transaction.
Verifying Compliance with the Arm’s Length Principle
The last step in the process of pricing a transaction is testing that the price arrived at is in accordance with the arm’s length principle.
- How is the combined profit from the transaction ultimately shared between the parties and does it reasonably reflect the functions, assets and risk of the parties in relation to the transaction?
- Will the parties each have a separate benefit from the transaction – are both parties better of by engaging in the transaction taking into account their options realistically available?
- Is the transaction commercially rational for both parties?
If the answer to any of those three questions is – NO – the pricing exercise will have to be revisited.
Illustration of Transfer Pricing Methods