Methods of Transfer Pricing

Pricing of goods transferred from operations or sales units in one country to the units of company elsewhere is called Transfer pricing. It is also known as intra firm trading of goods and services .

The various methods for establishing transfer pricing are classified as follows :-

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  • The Comparable Uncontrolled Price (CUP) method:

The CUP Method compares the terms and conditions (including the price) of a controlled transaction to those of a third party transaction. This is the most commonly used method among all the other methods for determining the transfer price.

By comparing the price of good and services in an intercompany transaction with the price used by independent parties, a benchmark price that the tax authorities will accept can be determined.

  • The Cost Plus Percent Method :

The Cost Plus Method compares gross profits to the cost of sales. It doesn’t just look at the price per product, but instead measures the cost plus mark-up (the actual profit earned from the products). Once the mark-up is determined, it should be equal to what a third party would make for a comparable transaction, in a comparable context with similar external market conditions.

An arm’s length mark-up can be determined based on the mark-up applied on comparable transactions among independent enterprises.

  • The Resale Price Method : 

Also known as Resale Minus Method, this method takes the prices at which the associated enterprise sells its product to the third party. This price is referred to as the resale price. The gross margin which is determined by comparing the gross margins in a comparable uncontrolled transaction is then reduced from this resale price. After this, the costs associated with the purchase of the product, like custom duties, are deducted.

The balance amount is regarded as an Arm’s length price for the controlled transaction between associated enterprises.

  • The Transactional Net Margin Method

TNMM is based on the net profit of a controlled transaction, rather than comparable external market pricing. This net profit is then compared to the net profit realized by comparable uncontrolled transactions of independent enterprises. In this case, comparisons do not have to be like for like and can qualify as long as they are “broadly similar”.

  • The Profit Split Method

The Profit Split Method (PSM) seeks to determine the way that a profit arising from a particular transactions would have been split between the independent businesses that were party to the transaction.

 It divides the profit based upon the relative contribution of each related party business to the transactions enterprise as determined by their functional profile and, where possible, external market data.

 

Thus, all the methods have their own pros and cons . In practice, the TNMM is the most used of all five transfer pricing methods, followed by the CUP method and Profit Split method. Cost Plus Method and Resale Margin Method are barely used.

No one method is perfect in all circumstances and many transfer pricing disputes are driven by the fact that the taxpayer and tax authority have sought to apply different transfer pricing methods to the tested transaction.

Accounting & Finance for Banking

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