Transfer Pricing: Introduction For Traders
Transfer pricing refers to the process of setting prices for sales activities between related parties or permanent establishments. Related parties are typically defined as entities that are under the control of another single third entity or where one party is under the control of the other.
The concept of transfer pricing in cross border or international transactions is especially relevant to multinational companies that often have to sell inventory to local offices in other countries. Using a transfer pricing approach to set prices for such sales is not unusual. In fact, it is a very common practice. However, without regulations and rules, companies will be at liberty to set prices in a manner to shield profits from high corporate taxes attracted in some countries.
Hence, most countries generally companies to maintain an arm’s length approach to setting transfer prices.
However, without regulations and rules, companies will be at liberty to set prices in a manner to shield profits from high corporate taxes attracted in some countries.
Arm’s Length Principle
The concept of the arm’s length principle in pricing can be loosely defined as requiring prices to be set between related parties as if 2 independent parties were transacting with each other. However, trade practices in the modern world are complicated and often go beyond a simple buy/sell relationship between 2 parties.
Legitimate practices such as outsourcing services, third-party or third country invoicing sometimes can make it difficult to identify a suitable mechanism to derive an acceptable transfer price. As a result of these complexities, in many cases there will not exist suitable transactions between unrelated parties in order to make a price comparison.
As a result of these complexities, in many cases there will not exist suitable transactions between unrelated parties in order to make a price comparison.
OECD and Transfer Pricing Guidelines
The OECD (Organisation for Economic Co-operation and Development) is an association of 34 countries (at time of this writing). Most countries are developed countries such as European Union, United States and Japan. Many countries refer to the OECD’s published Transfer Pricing Guidelines to formulate local regulations. A significant aim of the guidelines is to recommend suitable means to test the arm’s length principle on prices.
The OECD describes 5 primary methods to evaluate transfer prices:
- Comparable Uncontrolled Price (CUP)
- Resale Price Method (RPM)
- Cost-Plus Method
- Profit split
- Transactional Net Margin (TNMM)
Traders have to choose the most suitable method depending on the amount of information available, appropriateness and reliability. They do not have to be considered in any hierarchical order. In fact, companies can use a combination of these methods if they so choose, or any other method that they deem suitable to determine the arm’s length price better than the 5 methods described by OECD.
Let’s look at these 5 methods in greater detail below:
Comparable Price Method (CUP)
This method requires the price in a transaction between related parties to be compared to a similar transaction between unrelated parties. A very high degree of similarity must exist in the circumstances surrounding both the transactions. This is in practice difficult to achieve. If there are differences between the two transactions, adjustments can be made to the price. However, the more adjustments made to the price, the less reliable the transaction becomes as a basis of comparison. Some major differences to look out and adjust for would be quality of the product and/or brand name equity. The CUP method is well suited for commodities trading in competitive markets.
However, the more adjustments made to the price, the less reliable the transaction becomes as a basis of comparison.
Resale Price Method (RPM)
Simply put, this method compares the gross profit margin of the buyer in a related party transaction to the gross profit margin of a buyer in an uncontrolled transaction. This method is most effective when the buyer (or reseller) does not add significant value to the product. If the uncontrolled reseller adds value to the product, this method is usually difficult to apply. This method is less direct than the CUP method. The RPM method is rarely used because it is difficult to get validated and reliable sources of information required to perform the necessary analysis.
The RPM method is rarely used because it is difficult to get validated and reliable sources of information required to perform the necessary analysis.
This method of evaluating transfer price has a more upstream focus: the gross profit margin made by the seller in a related party transaction is compared to the profit made by a seller in a uncontrolled transaction. This method is ideal when the product is mainly sub-assemblies, unfinished goods or semi-finished goods. The common challenges faced with using this method is the apportionment of indirect costs into the price of the product.
The profit split method can be applied in three ways which are the contribution profit split, residual profit split or comparable profit split. Typically, the exact method is chosen depending on the availability of data. The profit split method suits a business model where buyer and seller are highly integrated and by working together closely, offer a unique product or service. Each party must make a significant and measurable contribution. When only simple functions are performed by either party this method may not be appropriate.
Transactional Net Margin Method (TNMM)
This method’s focus is on comparing the net mark-up or net profit margin in transactions between related parties and transactions between unrelated parties. This method is different from Cost-Plus method and the Resale Price method which compares gross margins instead. Many industry experts think that this is the most common transfer pricing method used.
Many industry experts think TNMM this is the most common transfer pricing method used.
Note: Internal comparable transactions are usually preferred to external. For example, it would be a stronger case to compare a seller’s sale to an unrelated third party against the same seller’s sale to a related party, instead of looking for other external unrelated entity transactions to take reference against. Traders must also know that regardless of the method used, traders should generally conclude on a range of values and not an exact figure.
Transfer Pricing Documentation
When taxable entities use transfer pricing to set prices, they should maintain strong documented support for the pricing decisions. The documents should show strong evidence that the transfer prices where set after rigorous and careful analysis of all available facts. These documents will be the trader’s first defence when put under audit. Some countries legally require all companies using any form of transfer pricing mechanism to maintain such documentation. Companies should keep the actual Transfer Pricing study or report (TP Report), all sales contracts, accounting logs and records of any year end adjustments made via credit or debit notes issued/received.