Question

Compare between different approaches for setting up transfer price

Answer 1

Solution :

The Five Different Approaches for Setting up Transfer Price

As mentioned, the OECD Guidelines given five different approaches for setting up transfer pricing that may be used to examine the arm’s-length nature of controlled transactions. Three of these methods are traditional transaction methods, while the remaining two are transactional profit methods.

Traditional transaction methods:

1. CUP method

2. Resale price method

3. Cost plus method

Transactional profit methods:

4. Transactional net margin method (TNMM)

5. Transactional profit split method.

1. Comparable uncontrolled Price (CUP) Method :-

The Comparable Uncontrolled Price (CUP) 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. The CUP Method may also sometimes be used to determine the arm’s length royalty for the use of an intangible asset. CUPs may be based on either “internal” comparable transactions or on “external” comparable transactions.

The CUP Method compares the terms and conditions (including the price) of a controlled transaction to those of a third party transaction. There are two kinds of third party transactions.

Firstly, a transaction between the taxpayer and an independent enterprise (Internal Cup).

Secondly, a transaction between two independent enterprises (External Cup).

2. The Rsale Price Method :-

Another traditional transaction method for determining transfer pricing is the resale price method. This method starts by looking at the resale price of a product that has been bought from an associated enterprise and then sold onto an independent party. The price of the transaction where the item is resold to the independent enterprise is called the resale price. The method then requires the resale price margin to be identified, which is the amount of money the party reselling the product would require to cover the costs of the associated selling and operating expenses. The resale price margin also includes the amount the reseller would need to make a fair profit, taking into account the functions it performed (including assets used and risks assumed). This gross resale price margin is deducted from the resale price. The amount that remains after the margin has been subtracted and fair adjustments have been made (e.g. expenses like customs duty have been taken into account) is the arm’s length price for the original transaction between related entities.

The Resale Price Method is also known as the “Resale Minus Method.”

As a starting position, it takes the price at which an associated enterprise sells a product to a third party. This price is called a “resale price.”

Then, the resale price is reduced with a gross margin (the “resale price margin”), determined by comparing gross margins in comparable uncontrolled transactions. After this, the costs associated with the purchase of the product, like custom duties, are deducted.

What is left, can be regarded as an arm’s length price for the controlled transaction between associated enterprises.

3. The Cost Plus Method :-

The Cost Plus Method compares gross profits to the cost of sales. The first step is to determine the costs incurred by the supplier in a controlled transaction for products transferred to an associated purchaser. Secondly, an appropriate mark-up has to be added to this cost, to make an appropriate profit in light of the functions performed. After adding this (market-based) mark-up to these costs, a price can be considered at arm’s length.

The application of the Cost Plus Method requires the identification of a mark-up on costs applied for comparable transactions between independent enterprises. An arm’s length mark-up can be determined based on the mark-up applied on comparable transactions among independent enterprises.

4. Transactional Net margin Method :-

With the Transactional Net Margin Method (TNMM), you need to determine the net profit of a controlled transaction of an associated enterprise (tested party). This net profit is then compared to the net profit realized by comparable uncontrolled transactions of independent enterprises.

As opposed to other transfer pricing methods, the TNMM requires transactions to be “broadly similar” to qualify as comparable. “Broadly similar” in this context means that the compared transactions don’t have to be exactly like the controlled transaction. This increases the amount of situations where the TNMM can be used.

A comparable uncontrolled transaction can be between an associated enterprise and an independent enterprise (internal comparable) and between two independent enterprises (external comparables).

5. Profit Spilt Method :-

Associated enterprises sometimes engage in transactions that are very interrelated. Therefore, they cannot be examined on a separate basis. For these types of transactions, associated enterprises normally agree to split the profits.

The Profit Split Method examines the terms and conditions of these types of controlled transactions by determining the division of profits that independent enterprises would have realized from engaging in those transactions.