Transfer Pricing Methods

Best Method Rule of Transfer Pricing

The best method rule is intended to avoid the rigidity of the priority of methods that formerly had been required. The rule guides taxpayers and the IRS as to which method is most appropriate in a particular case. The temporary regulations no longer provided for an ordering rule to select the method that provides for an arm’s-length result. Rather, in choosing a method, the arm’s-length result must be determined under the method which provides “the most accurate measure of an arm’s-length result.”

The best method rule appears to be somewhat subjective and, because of its technical nature, may require special expertise. Certainly, the rule does not appear to eliminate the potential for controversy between the IRS and taxpayers. The rule will likely require taxpayers to expend more energy developing intercompany transfer prices and reviewing data.

The best method rule had three limitations:

1. Tangible property rules normally do not adequately consider the effect of nonroutine intangibles in determining which method is the best method. In these cases, adjustments may be required under the intangible property rules.⁷
2. Tangible property comparable methods may be superseded, especially as they effect significant nonroutine intangibles that are not defined.
3. A taxpayer can request an “advance pricing agreement” to determine its best method.

Multiple Methods of Transfer Pricing

The temporary regulations encouraged the taxpayer to use more than one transfer pricing method. When two or more methods produce inconsistent results, the best method rule should be applied to determine which method produces the most accurate measure. Presumably, if the results are consistent, it may not be necessary to invoke the best method rule.

If the best method rule does not clearly indicate the most accurate method, consistency between results should be considered as an additional factor. Using this approach, the taxpayer should ascertain whether any of the methods, or separate applications of a method, yields a result consistent with any other method.

Comparable Uncontrolled Price Method

The CUP method provides the best evidence of an arm's length price. A CUP may arise where:

• the taxpayer or another member of the group sells the particular product, in similar quantities and under similar terms to arm's length parties in similar markets (an internal comparable);
• an arm's length party sells the particular product, in similar quantities and under similar terms to another arm's length party in similar markets (an external comparable);
• the taxpayer or another member of the group buys the particular product, in similar quantities and under similar terms from arm's length parties in similar markets (an internal comparable); or
• an arm's length party buys the particular product, in similar quantities and under similar terms from another arm's length party in similar markets (an external comparable).

Incidental sales of a product by a taxpayer to arm's length parties may not be indicative of an arm's length price for the same product transferred between non-arm's length parties, unless the non-arm's length sales are also incidental.

Transactions may serve as comparables despite the existence of differences between those transactions and non-arm's length transactions, if:

• the differences can be measured on a reasonable basis; and
• appropriate adjustments can be made to eliminate the effects of those differences.

Where differences exist between controlled and uncontrolled transactions, it may be difficult to determine the adjustments necessary to eliminate the effect on transfer prices. However, the difficulties that arise in making adjustments should not routinely preclude the potential application of the CUP method. Therefore, taxpayers should make reasonable efforts to adjust for differences.

Resale price method of Transfer Pricing

The resale price method begins with the resale price to arm's length parties (of a product purchased from an non-arm's length enterprise), reduced by a comparable gross margin. This comparable gross margin is determined by reference to either:

• the resale price margin earned by a member of the group in comparable uncontrolled transactions (internal comparable); or
• the resale price margin earned by an arm's length enterprise in comparable uncontrolled transactions (external comparable).

Under this method, the arm's length price of goods acquired by a taxpayer in a non-arm's length transaction is determined by reducing the price realized on the resale of the goods by the taxpayer to an arm's length party, by an appropriate gross margin. This gross margin, the resale margin, should allow the seller to:

• recover its operating costs; and
• earn an arm's length profit based on the functions performed, assets used, and the risks assumed.

Where the transactions are not comparable in all ways and the differences have a material effect on price, the taxpayer must make adjustments to eliminate the effect of those differences. The more comparable the functions, risks and assets, the more likely that the resale price method will produce an appropriate estimate of an arm's length result.

An exclusive right to resell goods will usually be reflected in the resale margin.

The resale price method is most appropriate in a situation where the seller adds relatively little value to the goods. The greater the value-added to the goods by the functions performed by the seller, the more difficult it will be to determine an appropriate resale margin. This is especially true in a situation where the seller contributes to the creation or maintenance of an intangible property, such as a marketing intangible, in its activities.

Cost plus method of Transfer Pricing

The cost plus method begins with the costs incurred by a supplier of a product or service provided to an non-arm's length enterprise, and a comparable gross mark-up is then added to those costs. This comparable gross mark-up is determined in two ways, by reference to:

• the cost plus mark-up earned by a member of the group in comparable uncontrolled transactions (internal comparable); or
• the cost plus mark-up earned by an arm's length enterprise in comparable uncontrolled transactions (external comparable).

In either case, the returns used to determine an arm's length mark-up must be those earned by persons performing similar functions and preferably selling similar goods to arm's length parties.

Where the transactions are not comparable in all ways and the differences have a material effect on price, taxpayers must make adjustments to eliminate the effect of those differences, such as differences in:

• the relative efficiency of the supplier; and
• any advantage that the activity creates for the group.

The more comparable the functions, risks and assets, the more likely it is that the cost plus method will produce an appropriate estimate of an arm's length result.

In general, for purposes of applying a cost-based method, costs are divided into three categories:

(1) direct costs such as raw materials;

(2) indirect costs such as repair and maintenance which may be allocated among several products; and

(3) operating expenses such as selling, general, and administrative expenses.

The cost plus method uses margins calculated after direct and indirect costs of production. In comparison, net margin methods-such as the transactional net margin method (TNMM) discussed in Section B of this Part-use margins calculated after direct, indirect, and operating expenses. For purposes of calculating the cost base for the net margin methods, operating expenses usually exclude interest expense and taxes.

Properly determining cost under the cost plus method is important. Cost is usually calculated in accordance with accounting principles that are generally accepted for that particular industry in the country where the goods are produced.

However, it is most important that the cost base of the transaction of the tested party to which a mark-up is to be applied be calculated in the same manner as-and reflects similar functions, risks, and assets as-the cost base of the comparable transactions. Where cost is not accurately determined in the same manner, both the mark-up (which is a percentage of cost) and the transfer price (which is the total of the cost and the mark-up) will be misstated.

For example, if the comparable party includes a particular item as an operating expense, while the tested party includes the item in its cost of goods sold, the cost base of the comparable must be adjusted to include the item.

Transactional Profit Methods of Transfer Pricing

Traditional transaction methods are the most reliable means of establishing arm's length prices or allocations. However, the complexity of modern business situations may make it difficult to apply these methods. Where the information available on comparable transactions is not detailed enough to allow for adjustments necessary to achieve comparability in the application of a traditional transaction method, taxpayers may have to consider transactional profit methods.

However, the transactional profit methods should not be applied simply because of the difficulties in obtaining or adjusting information on comparable transactions, for purposes of applying the traditional transaction methods. The same factors that led to the conclusion that it is not possible to apply a traditional transaction method must be considered when evaluating the reliability of a transactional profit method.

The OECD Guidelines endorse the use of two transactional profit methods:

• the profit split method; and
• transactional net margin method (TNMM).

The key difference between the profit split method and the TNMM is that the profit split method is applied to all members involved in the controlled transaction, whereas the TNMM is applied to only one member.

The more uncertainty associated with the comparability analysis, the more likely it is that a one-sided analysis, such as the TNMM, will produce an inappropriate result. As with the cost plus and resale price methods, the TNMM is less likely to produce reliable results where the tested party contributes to valuable or unique intangible assets. Where uncertainty exists with comparability, it may be appropriate to use a profit split method to confirm the results obtained.

Profit split method of Transfer Pricing

Under the profit split method:

• The first step is to determine the total profit earned by the parties from a controlled transaction. The profit split method allocates the total integrated profits related to a controlled transaction, not the total profits of the group as a whole. The profit to be split is generally the operating profit, before the deduction of interest and taxes. In some cases, it may be appropriate to split the gross profit.
• The second step is to split the profit between the parties based on the relative value of their contributions to the non-arm's length transactions, considering the functions performed, the assets used, and the risks assumed by each non-arm's length party, in relation to what arm's length parties would have received.

The profit split method may be applied where:

• the operations of two or more non-arm's length parties are highly integrated, making it difficult to evaluate their transactions on an individual basis; and
• the existence of valuable and unique intangibles makes it impossible to establish the proper level of comparability with uncontrolled transactions to apply a one-sided method.

Due to the complexity of multinational operations, one member of the multinational group is seldom entitled to the total return attributable to the valuable or unique assets, such as intangibles.

Also, arm's length parties would not usually incur additional costs and risks to obtain the rights to use intangible properties unless they expected to share in the potential profits. When intangibles are present and no quality comparable data are available to apply the one-sided methods (i.e., cost plus method, resale price method, the TNMM), taxpayers should consider the use of a profit split method.

The second step of the profit split method can be applied in numerous ways, including:

• splitting profits based on a residual analysis; and
• relying entirely on a contribution analysis.

Following the determination of the total profit to be split in the first step of the profit split, a residual profit split is performed in two stages. The stages can be applied in numerous ways, for example:

• Stage 1: The allocation of a return to each party for the readily identifiable functions (e.g., manufacturing or distribution) is based on routine returns established from comparable data. The returns to these functions will, generally, not account for the return attributable to valuable or unique intangible property used or developed by the parties. The calculation of these routine returns is usually calculated by applying the traditional transaction methods, although it may also involve the application of the TNMM.
• Stage 2: The return attributable to the intangible property is established by allocating the residual profit (or loss) between the parties based on the relative contributions of the parties, giving consideration to any information available that indicates how arm's length parties would divide the profit or loss in similar circumstances.

Transactional net margin method (TNMM) of Transfer Pricing

The TNMM:

• compares the net profit margin of a taxpayer arising from a non-arm's length transaction with the net profit margins realized by arm's length parties from similar transactions; and
• examines the net profit margin relative to an appropriate base such as costs, sales or assets.

This differs from the cost plus and resale price methods that compare gross profit margins. However, the TNMM requires a level of comparability similar to that required for the application of the cost plus and resale price methods. Where the relevant information exists at the gross margin level, taxpayers should apply the cost plus or resale price method.

Because the TNMM is a one-sided method, it is usually applied to the least complex party that does not contribute to valuable or unique intangible assets. Since TNMM measures the relationship between net profit and an appropriate base such as sales, costs, or assets employed, it is important to choose the appropriate base taking into account the nature of the business activity. The appropriate base that profits should be measured against will depend on the facts and circumstances of each case.