Multinational companies (MNCs) and large enterprises use five methods in determining the transfer price (TP) as mandated by the Organisation for Economic Co-operation and Development (OECD).
The OECD and TP
The OECD is a government arm that deals with various economic and trade affairs, which gives them jurisdiction over TP. Initially, they want to provide a consistent international framework but due to inevitable changes, there are now a variety of TP approaches.
The OECD guidelines outline the transfer pricing methods MNCs and tax authorities use to establish the arm’s length price for controlled transactions among associated entities.
What is arm’s length pricing?
This is the foundation of the TP principle. Arm’s length pricing is the internationally accepted standard for tax agencies and large enterprises, which states that the price charged in controlled transactions between related entities should yield the same results when external clients enter into similar transactions in an uncontrolled condition.
Transfer Pricing methods
Here are the transfer pricing methods as outlined in the OECD guidelines.
Comparable Uncontrolled Price (CUP) Method
Under the traditional transaction category is the CUP method which also happens to be the preferred approach of the OECD since it’s based on a fair market price.
The CUP method compares the price set between controlled transactions of related entities with those of uncontrolled transactions among unrelated companies. If both transactions come up with different prices, this indicates that the arm’s length was not implemented in the surrounding circumstances of the associated enterprises (controlled transaction), meaning that the price in the uncontrolled transaction should be substituted for the controlled one.
MNCs that want to maximize their profit margin use this method as it includes the fair market price for exchanged goods and services between the organization.
Resale Price Method
The Resale Price method is most known among distributors and resellers. This looks at the price the associated enterprise sells its product or services to a third party. This is what we refer to as the resale price.
To determine the gross margin, you need to compare gross margins in comparable uncontrolled transactions. How do you do this? Take into account the amount that covers your expenses, including the selling and operating expenses. Subtract this resale price margin to the resale price, and the amount you come up with stands as the arm’s length price or the transfer price between the associated entities.
Cost Plus Method
The Cost Plus method is another example of how transfer pricing works.
It focuses on the transaction between an enterprise and a related supplier. The costs the supplier incurred [for their products transferred to an associated purchaser] are marked up to cover the functions they performed and the current market conditions, coming up with a reasonable profit. Then the resulting price is what we consider the arm’s length price.
Transactional Net Margin Method (TNMM)
While the CUP method is highly recommended by the OECD, MNCs are more inclined to using TNMM as this approach is based on their net profit.
TNMM compares the net profit from the [controlled] intercompany transactions to the net profit margin generated when they do a similar transaction with a third party. They can also bump this up with the net margin earned by the external entity with another external entity.
Transactional Profit Split Method
Subsidiaries or affiliate companies under one organization can sometimes overlap in certain activities; thus leading involvement in the controlled transactions. This is where the Profit Split method comes in.
Under this approach, the transfer price is established by how profit (and losses) would be divided among the engaged associated enterprises. The splitting of profit would be relative to the contribution of each affiliate to the transaction in question. This method results in an appropriate arm’s length price of controlled transactions.
TP in its nature, can be intimidating. But as MNCs and corporations, doing this practice develops your business and builds solutions that scale over time. Finding out the best transfer pricing method that suits your growing company can help deliver financial efficiency and business advantages, among others.
If you find TP too much to handle for your team, let D&V Philippines do the work for you. Our Transfer Pricing services and suite of financial and accounting services guarantee to help your corporation beat the complexities of the changing industry regulations. You can get our guide Outsourcing: How to Make it Work to know how we can be the right accounting partner you’re looking for.