The OECD Guidelines define a number of methods that can be used to determine arm’s-length prices for intra-group transactions. These methods are categorized either as traditional transaction methods or transactional profit methods.
Traditional transaction methods will compare third-party prices, or other less direct measures such as gross margins on third-party transactions, with the same measures on the transactions under review. A transactional profit method, on the other hand, examines the overall net operating profits that arise from the intercompany transactions under review. The transactional profit methods are generally less precise than the traditional transaction methods but more commonly applied as a result of practical difficulties in finding suitable information for the application of the traditional transaction methods.
The OECD Guidelines prescribe that the taxpayer should select the most appropriate method. If a traditional transaction method and a transactional profit method are equally reliable, the traditional transaction method is preferred. Moreover, if the Comparable Uncontrolled Price (“CUP”) method and any other transfer pricing method can be applied in an equally reliable manner, the CUP method is to be preferred.
The OECD Guidelines in total discuss five specified methods that may be used to examine the arm’s-length nature of the intercompany transactions. The five transfer pricing methods as specified by the OECD are described below.
Traditional transaction methods
The CUP method evaluates the arm’s-length character of a controlled transaction by comparing the price and conditions to the price and conditions of similar transactions between the taxpayer and an unrelated party (“internal CUP”), or between two unrelated parties (“external CUP”).
Where it is possible to locate comparable uncontrolled transactions, the CUP method is the most direct and reliable way to apply the arm’s-length principle and to determine the prices for the related party transactions. However, in considering whether controlled and uncontrolled transactions are comparable, the comparability requirement of applying the CUP method is very high. Thus, in practice, the CUP method is not usually applied unless the products or services can meet the strict requirements of high comparability.
Cost Plus Method
The cost plus method is typically used to test the activities of manufacturing entities by comparing gross profits to cost of sales.
This method requires detailed comparisons of products produced, functions performed, risks borne, manufacturing complexity, cost structures, and intangibles between controlled and uncontrolled transactions. Comparability is most likely found among controlled and uncontrolled sales of property by the same seller (i.e., internal cost-plus method). In the absence of such sales, an appropriate comparison may be derived from comparable uncontrolled sales of other producers (i.e., external cost-plus method).
The cost plus method is less likely to be reliable if material differences exist between the controlled and uncontrolled transactions with respect to intangibles, cost structure, business experience, management efficiency, functions performed and products.
A reasonable number of adjustments may be made to compensate for the lack of comparability between controlled and uncontrolled transactions in inventory turnover, contractual terms, transport costs and other measurable differences.
Resale Price Method
The resale price minus method (“RPM”) is normally used to test gross profits earned by sales and distribution entities. This method compares gross profit relative to turnover of the tested party to gross margins earned by comparable third parties.
Comparability under the RPM requires that there are no differences that would materially affect the resale price margin in the open market. Or that reasonably accurate adjustments can be made to account for such differences. The extent and reliability of adjustments will affect the reliability of the RPM analysis itself.
Transactional profit methods
Profit Split Method
Where transactions are very interrelated it might be that they cannot be evaluated on a separate basis. Under similar circumstances, independent enterprises might decide to set up a form of partnership and agree to a form of profit split. Accordingly, the profit split method seeks to eliminate the effect on profits of special conditions made or imposed in a controlled transaction by determining the division of profits that independent enterprises would have expected to realize from engaging in the transaction or transactions.
The profit split method first identifies the profit to be split between the associated enterprises from the controlled transactions in which the associated enterprises are engaged. It then splits those profits between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length. The combined profit may be the total profit from the transactions or a residual profit intended to represent the profit that cannot readily be assigned to one of the parties, such as the profit arising from high-value, sometimes unique, intangibles. The contribution of each enterprise is based upon a functional analysis, and valued to the extent possible by any available reliable external market data.
Transactional Net Margin Method
The transactional net margin method (“TNMM”) compares the tested party’s net profitability on a controlled transaction to the net profit obtained by broadly similar uncontrolled companies on similar transactions. The OECD Guidelines state that the TNMM may be a practical solution to otherwise insolvable transfer pricing problems when used sensibly with appropriate adjustments to account for any material differences between transactions. Also, the degree of comparability required to apply the TNMM is less stringent than what is necessary under other methods. A primary benefit of the less stringent comparability standards is a significant increase in the number of arm’s-length observations available to establish the arm’s-length remuneration of the entities tested.
The profitability margins used for the comparison are often referred to as profit level indicators (“PLIs”). PLIs are ratios that capture relationships between profits and costs incurred, revenues generated, or resources employed. Below, a few commonly applied PLIs are described:
Net cost plus margin
The net cost plus is the ratio of recent years of operating profit to total cost. The net cost plus margin is a measure of return on costs using the total operational expenses of the company. The ratio can allow for differences in functions by assuming that they are reflected in the level of total operating expenses, with many items able to be included in either cost of goods sold or other operating expenses.
Operating profit margin
The operating profit margin (“OPM”) is the ratio of EBIT to turnover. The OPM is generally the preferred PLI for sales and marketing activities of a distributor. Where the level of sales can be a reliable forecast, the OPM is often used to establish transfer prices to be earned by a sales and marketing entity.
The Berry Ratio is the ratio of gross profit to operating expenses. This ratio essentially measures the amount of gross profit a company earns in support of every Euro of operating expense incurred. It represents a return on a company’s value added functions and assumes that those functions are captured in its operating expenses. Therefore, the Berry Ratio is useful measure of the mark up earned on a distributor’s distribution activities.
For the calculation of Berry Ratio the numerator, i.e. gross profit equals sales minus cost of goods sold divided by number of years, depends on the accessibility of the data. In this case that cost of goods sold information is not available, the accepted practice is to substitute costs of goods sold with material costs in case the former are not accessible.
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