Transfer Pricing

Transfer pricing is concerned with prices charged between associated enterprises for the transfer of goods, services and intangible property. It is  the  general  term  for the  pricing  of  cross-border,  intra-firm  transactions  between  related parties, forming part of a multinational enterprise group.  “Transfer  pricing”  therefore  refers  to  the  setting  of  prices  at  which  transactions  occur involving  the  transfer  of  property  or  services  between  associated  enterprises.  These  transactions  are  also  referred  to  as  “controlled”  transactions,  as distinct from “uncontrolled” transactions between companies that, for example, are not associated and can  be  assumed  to  operate  independently  (“on  an  arm’s  length  basis”)  in  reaching  terms  for such transactions.

The selection of a transfer pricing method always aims at finding the most appropriate method for a particular case. Traditional transaction methods are the most direct means of establishing whether conditions in the commercial and financial relations between associated enterprises are arm’s length. As a result, where, taking account of the comparability analysis of the controlled transaction under review and of the availability of information, a traditional transaction method and a transactional profit method can be applied in an equally reliable manner, the traditional transaction method is preferred to the transactional profit method. Where transactional profit methods are found to be more appropriate than traditional transaction methods in consideration of the comparability (including functional) analysis of the controlled transaction under review and of the evaluation of comparable uncontrolled transactions, a transactional profit method may be applied either in conjunction with traditional transaction methods or on its own.

The starting point to select a method is the functional analysis which is necessary regardless of what transfer pricing method is selected. Each method may require a deeper analysis focusing on aspects in relation with the method. Once the functional analysis is performed and the functionality of the entity as regards the transactions subject to review (or the entity as a whole) has been completed, it can be determined what transfer pricing method is most suitable to determine the arm’s length price for the transactions under the review (or the operating margin for the entity under review). For all transfer pricing methods access to information on comparable is necessary and it may be that due to difficulty in getting access to reliable data on comparable, in certain instances, other methods may need to be resorted to than those that would seem initially preferred and most reliable. Although there are a lot of methods for transfer pricing, we will only discuss the use of 3 methods:

	Strength	Weakness	Best applied to
Comparable Uncontrolled Price (CUP) Method	Most direct and reliable way to apply the arm’s length principle	High degree of product comparability required In practice, often difficult to find uncontrolled transactions similar enough that no differences have material effect on the price	Transactions where the same product is sold to the associated enterprise and independent enterprise (internal comparable) Transactions where an independent enterprise sells the same product as the associated enterprises (external comparable) In particular commodities and interest rates
Cost Plus Method	Product differences are less significant, i.e. are less likely to have material effect on profit margins than on price. Less product comparability required compared with CUP method. Fewer comparability adjustments needed compared with the CUP method to account for product differences, because focus is on functions performed	In practice, often difficult to determine appropriate cost basis Costs incurred may not always be determinant of profit level Not always discernible link between level of costs incurred and a market price Accounting consistency important for comparability purposes	(Contract) Manufacturer, in particular of semi-finished goods (Contract) R&D Service Provider
Resale Price Method	Product differences are less significant, i.e. are less likely to have material effect on profit margins than on price. Fewer comparability adjustments needed compared with the CUP method to account for product differences, because focus is on functions performed	Gross profit margins may be affected by management efficiency etc. which may have an impact on profitability but not on the price of the goods or services. Accounting consistency important for comparability purposes. Resale price method difficult to use when (i) goods are further processed before resale, or (ii) reseller contributes substantially to creation or maintenance of intangible associated with the product (e.g. trademarks)	Marketing operations (distributor not adding significant value to the product)

Sources:

Buttner, Wolfgang. (2011). Workshop on Transfer Pricing and Exchange of Information. Presented on Guatemala May 2-5^th2011.

Lau Mak Yee-ming, Alice. (2009). Transfer Pricing Guidelines – Methodologies and Related Issues. Inland Revenue Department Hong Kong.