Centre for Tax Policy and Administration Organisation for Economic Co-operation and Development Auditing Multinational Enterprises 6. Transfer pricing methods

Methods for applying the arm’s length principle. Traditional transaction methods  Comparable uncontrolled price  Resale price method  Cost-plus Transactional Profit Methods  Transactional net margin method (TNMM)  Transactional profit split method 2

Hierarchy of methods OECD Transfer Pricing Guidelines: Where it is possible to locate reliable enough comparable uncontrolled transactions, CUP is the most direct and reliable way to apply the arm’s length principle. Where they can be applied in a reliable enough manner, traditional transaction methods are preferred over transactional profit methods. Transactional profit methods “exceptionally” applicable in cases of last resort. 3

Comparable Uncontrolled Price  Identifies the price in place in respect of identical transactions between independent parties…. and applies that price to the controlled transaction.  Can be used where transactions are not identical if differences can be adjusted for. 4

Comparable Uncontrolled Price Key question: What would be the sales price of units if they had been sold by, or to, an independent third party under identical conditions? Cutting Edge Corporation Cutting Edge (B) Products sold to CE (B) at $ each

Cost-Plus Method  Uses as a basis of comparability the costs incurred by the supplier of goods or services.  Comparison between the tested party and the comparable party (or comparable parties) is in relation to the mark-up on “direct costs” made by each. 6

Cost-plus method Key question: What mark-up would Cutting Edge Corporation earn if it sold the goods to an independent third party? Cutting Edge Corporation Cutting Edge (B) Mark-up on direct costs of 25% Products sold to CE (B) at $ each

Resale Price Method  Applies to transactions where the tested party sells to third parties, but buys from a connected party.  Most frequently used for a sales/distribution entity.  Comparison is made between the gross profit margin made by the tested party and that made by the comparable party (or parties). 8

Resale price method Key question: What gross profit rate would Cutting Edge (B) earn if it purchased and sold similar goods from an independent supplier? Cutting Edge Corporation Cutting Edge (B) Customers Products sold to CE (B) at $ each Products sold to customers at $ each

Transactional Net Margin Method Comparison is made at the level of operating margin (ie before interest deductions) achieved by the tested party and the comparable parties. Normally expressed as operating profit as a percentage of turnover, costs or assets. 10

Transactional Net Margin Method Uncontrolled Transaction 11 Key questions  What net margin would the manufacturer earn on sales to an independent distributor Or  What net margin would the distributor earn from the sale on goods purchased from an independent supplier? NB Net margin may be in relation to sales, costs or other measures such as assets Manufacturer Net margin, say 5% Customer Distributor Net margin = 10%

Profit Split Method Comparison is made at the level of split of overall profit between the parties. The profit split between parties to the controlled transaction should be equivalent to that between independent parties. 12

Profit Split Uncontrolled transaction 13 Key question: What would be the split of profit between the manufacturer and distributor - arising from the transaction between them - if they had been independent? (A residual profit split method may also be available) Manufacturer Profit =15 Distributor Profit = 10 Customer

Methods - Summary Method CUP RPM Cost-plus TNMM Profit split 14 Basis for comparability Price Gross margin made by resellers Mark-up on direct costs incurred by supplier Operating margin Split of profit

Practical application of methods 1. CUP. Most reliable method, but may be unavailable. 2. Resale price. Often appropriate to benchmarkable sales/distribution functions. Less appropriate where distributor owns valuable intangible 3. Cost-plus. May be appropriate to benchmarkable manufacturing, R&D or service operations. Less appropriate where manufacturer owns valuable intangible 4. TNMM. May be appropriate to benchmarkable manufacturing, service or sales/distribution functions. 5. Profit split. May be appropriate to transactions between entities that both make significant non- benchmarkable contributions. 15

Benchmarkable functions  CP, RPM and TNMM typically rely on benchmarking against comparable transactions between independent parties.  They are one-sided methods that determine an arm’s length reward for one of the parties to the transaction, leaving the residual return to the other party,  We would normally benchmark the function for which sufficiently reliable comparable information can be found (ie the benchmarkable function)  Low-risk functions involving no valuable assets are most likely to be benchmarkable. 16

Choice of method Depends on:  Suitability, in the light of functional analysis  The reliability of the method  Availability of sufficiently reliable comparable information 17