Methods of Transfer Pricing
In the OECD Guidelines, 5 main methods for setting transfer prices are
outlined:
The Comparable Uncontrolled Price, or CUP, Method
It is the most common form and, in most instances, the OECD prefers it. In an
intercompany trade, the CUP Approach compares the price of products or services to the price
adjusted between separate parties. It is essential that goods and services are measured under
comparable conditions in order to achieve an accurate price that will be approved by the tax
authorities.
This can also be referred to as market-set pricing, since the CUP approach is focused on fair market
rates, unlike other approaches that rely on margins. If a company makes a product, by selling it to
the “outside world,” they have to weigh what they will gain. The corporation needs to optimize
profit margins, so it can certainly exercise good habits, like charging fair market rates for
products or services provided inside the organization.
Cost-Plus-Percent Method
It is an approach favored by some manufacturers and is popular with the aerospace
industry. It’s a transaction method that compares gross profit to costs of sales. The division
supplying goods or services determines the cost of the transaction, then adds a markup for profit on
the goods or services delivered. The markup should be equal to what a third party would earn for
transactions in a comparable situation, including similar risks and market conditions.
The Resale Price Method
It explores the gross profit or the difference between the price at which the product or
service is bought and the price at which the product or service is sold to a third party. Although
similar to the Cost-Plus-Percent System, only the margin (minus related costs such as customs duty)
is considered as the transfer price in the resale price method. It is most suitable for distributors
and resellers, as opposed to manufacturers, for this reason.
Transaction Net Margin Method, or TNMM
It has recently emerged as a preferred model for many multinationals because, as opposed
to comparable external market pricing, transfer pricing is focused on net profit. The CUP,
Cost-Plus-Percentage, and Resale Price Strategies are all focused on the real cost for external
sales of equivalent products or services. Instead, TNMM contrasts the net profit margin earned from
a regulated intercompany transaction with the net profit margin earned from a similar third-party
transaction. It can also look at the net margin gained on a similar deal with another third party by
a third party.
This measures the profit margin versus real costs, which is particularly attractive in the absence
of external pricing data to assess the market price. Organizations may calculate net profit against
revenue, expenditures, or assets with TNMM. Usually, it is implemented to a defined range by
targeting an operating margin. Although the CUP approach has been favored by the tax authorities,
TNMM is emerging as a new standard.
The Profit-Split Method
Like TNMM, it is based on benefit, not a market price, which is comparable. For this
process, transfer pricing is calculated by the determination of the division between the separate
undertakings engaged in the transaction of the benefit resulting from a specific transaction. This
is focused on the relative contribution of each of the relevant business parties to the transaction,
as calculated by the functional profile, and the external market data as applicable.
Each approach has pros and cons, and each company can decide what works best with its specific
requirements. In certain cases, with particular kinds of transactions, an entity may also use
different approaches.
