There exist numerous methods that multinational enterprises (MNEs), including tax admins, can utilize to ascertain precise arm’s length transfer pricing for transactions that take place between one or more organizations. OECD, the Organization for Economic Co-operation and Development, states five primary transfer pricing methods that multinational enterprises and tax admins can adopt. In this blog post, we are going to explore each method. After digesting this post, you will have the best understanding of the diverse transfer pricing methods and how you can apply them to the transaction of your company.
1. The Comparable Uncontrolled Price, or CUP Method
The CUP method is the most popular transfer pricing method that is widely preferred by the OECD. This method works by comparing the price of goods or services of two different companies to the altered price between autonomous parties. Goods and services must be scrutinized based on comparison to get a precise price that is acceptable to tax authorities.
This method can also be seen as market set pricing because it is based on equitable market price and not like other methods that focus on margins.
Just as everything that has an advantage also has a disadvantage, this method of transfer pricing has a disadvantage. The disadvantage of this method is that when the external market doesn’t match the criteria for internal transfer pricing, the prices of goods and services can skyrocket. For instance, the prices for oil aren’t stable, so for enterprises that rely on oil for their manufacturing, this method might not be the best for them.
2. Cost-Plus-Percent Method
The cost-plus-percent-method is a measure that is highly regarded by some manufacturers and is prominent with the aerospace sector. This method is a transaction method that assesses the similarities and differences between gross profits and the costs of sales. The cost of a transaction is usually determined by the division supplying goods and services; then, a markup is included for profits on the delivered goods and services.
The included markup should not be different from what a third party would gain for transactions in a comparable situation and tasks that are alike, including market conditions. A disadvantage of this method is that it makes the supply team lazy and less efficient when it boils down to limiting things such as material labour and overhead variances.
3. The Resale Price Method
This method is similar to the gross margin, or the disparity between the cost of a product or service and the price at which it is sold (to a third party). While this method bears huge similarities to the Cost-Plus-Percent Method, the Resale Price Method only considers the margin (leaving out the related costs like customs duties) as the transfer price. Because of this, the resale price method is best for distributors and resellers. This method isn’t ideal for manufacturers.
4. Transaction Net Margin Method, or TNMM
Recently, this method was favoured by several multinationals because transfer pricing is founded on net profit, unlike comparable market pricing. Other transfer pricing methods, such as the cost-plus-percentage, CUP, and resale price methods, have their basis on the real cost of similar goods or services for external transactions.
Rather, the transaction margin net method compares the net profit margin gained in a controlled transaction between two different companies to the net profit margin earned by an identical transition with another party (a third party).
This is similar to drawing a comparison with the profit margin against actual costs and is very attractive when there are no external pricing data available to ascertain the current market price. This transfer pricing method can assist organizations in measuring net profit against sales, cost, or assets. It is usually utilized by aiming at a functional margin within a given range.
5. The Profit-split Method
Similar to the transaction margin method, this transfer pricing method is based on profit and non-comparable market price. In this method, transfer pricing is known by taking note of how the profit emanating from a certain transaction would have been shared between the independent parties that took part in the transaction. This is based on the relative offering of each related organization to the transaction, as stated by the functional profile, and as available, external market information.
In a Nutshell
The five transfer pricing methods come with some pros and cons, so it is best for all organizations to examine the method that would work fine for them. In some situations, an organization may choose to use diverse methods for diverse types of transactions. Accountants can prepare transfer pricing documents. Aside from preparing transfer pricing documents and financial statements etc., accountants also offer payroll services. To ensure that your transfer pricing document is void of errors, make certain they are well scrutinized. For more information, get in touch with us.