Objectives of tranfer pricing

Companies with dispersed production facilities, usually in different countries, use transfer pricing. It
involves over- or undercharging for goods sold between branches at a price determined by the
company. The main objective is to take advantage of different tax rates between countries. Transfer
pricing also is used to evaluate performance of divisions within a company.

Tax Savings
 Imagine a company with two branches, where one makes semi-finished goods in a low-tax
country and exports them to a branch in a high-tax country, where they are finished and sold.
By increasing the transfer price and declaring more of its profits in the low-tax country, the
company can reduce its global tax bill.

Boost Profits
 By undercharging for goods crossing national borders, a company can save money on
customs duties paid by the branch in the importing country. Conversely, by overcharging, a
company can extract more money from a country with tighter currency outflow restrictions.

Measure Performance
 Companies need to know how their individual divisions are performing. A way of measuring
that is through transfer pricing. By setting a price for goods in each stage of the production
process, a company can measure the profitability of each division and decide where to make
organizational adjustments.

Arm's Length Standard

 The basic principle of this standard used by most developed countries is that for transactions
between branches a company should use market prices. However, enforcement of this rule
is complicated, especially when a company has branches in numerous countries.

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.

The use of the CUP method precludes an additional allocation of related product development
costs or overhead unless such charges are also made to arm's length parties. This prevents
the double deduction of those costs-once as an element of the transfer price and once as an
allocation.

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.