Transfer Pricing Methods

(First of two parts)

By Deonah L. Marco-Go

First Published in Business World (11/12/2012)

In a previous article Transfer Pricing: A Local Perspective published last September 17, we talked about transfer pricing from a local perspective and the urgent need to actively and regularly revisit pricing policies on related party transactions to ensure compliance with the arm’s length standard, as more and more transfer pricing audits are being undertaken by tax authorities throughout the region.

In theory, arm’s length pricing means that the price in a related party transaction should be set as if the parties are independent of each other. However, the definition itself offers little guidance on how the arm’s length principle can be applied in practice. It would be ideal then to have a comprehensive set of guidelines for testing, measuring and determining compliance with the arm’s length standard.

In 2008, the Bureau of Internal Revenue (BIR) adopted the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, (OECD Guidelines), as an interim set of transfer pricing guidelines. The OECD Guidelines prescribe the use of five methods, which were classified into the traditional transaction methods and the transactional profit methods, to determine an arm’s length price. These methods were to be applied hierarchically, in that if two methods are applicable to a particular case, the first method in the hierarchy should be applied. However, the arm’s length principle does not require the application of more than one method for a given transaction. The use of a single method is enough unless its application is inconclusive. In 2010, the OECD Guidelines on the transfer pricing methods were revised. The revised guidelines departed from the old rules which required the hierarchical application of the methods, and instead recommend that the method to be selected depends on the most appropriate method for a particular case. Under the guidelines, selecting the appropriate method should take into account several factors, such as their respective strengths and weaknesses, availability of reliable information needed to apply the selected method and/or other methods, the degree of comparability between the controlled and the uncontrolled transactions, and the reliability of adjustments that may be needed to eliminate material differences between them. For this purpose, controlled transactions are transactions between two enterprises that are associated with each other. Under the guidelines, two enterprises are typically associated if one of the enterprises participates directly or indirectly in the management, control or capital of the other, or if “the same persons participate directly or indirectly in the management, control or capital” of both enterprises, although local country rules may have their own definition of when parties are related. Uncontrolled transactions are those between enterprises that are independent of each other.

The traditional transaction methods are the Comparable Uncontrolled Price Method (CUP Method), the Resale Price Method, the Cost-Plus Method, and the Profit Method. The transactional profit methods set out in the OECD Guidelines are the Profit Split Method and the Transactional Net Margin Method (TNMM). .
The CUP Method

The CUP Method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. If there is any difference between the two prices, this may imply that the price in the related party transaction is not arm’s length. In such a case, the price in the uncontrolled transaction is deemed the “arm’s length price” and will have to be substituted for the price in the related party transaction.

Of the methods recognized by the OECD Guidelines, the CUP Method is given preference because it is the most direct and reliable way to apply the arm’s length principle. However, there are strict standards in terms of product and functional comparability that have to be met. Among others, the products or services being compared should be similar, such that there exists no difference in them that would materially affect their price, or if there are differences, the differences can be eliminated by reasonably accurate adjustments.

Aside from the characteristics of the product or service, the functions of the enterprises undertaking the transaction should also be the same and must be undertaken at the same stage of the value-chain. For example, while a product may physically be the same, there may have been more marketing activity undertaken prior to the sale for one product compared to another; this would affect the price charged for that product. As such, the price of products sold by a manufacturer may not be comparable with the price of the same products sold by a distributor.

In the second part of this article, we will continue the discussion on the different Traditional Transaction and Transactional Profit methods covered by the OECD Guidelines, including the Resale Price Method, the Cost-Plus Method, the Transactional Net Margin Method and the Profit Split Method.

Deonah L. Marco-Go is a Tax Director of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.

Transfer Pricing Methods
(Second of two parts)
By Deonah L. Marco-Go
In last week’s article, we began the discussion on the five methods for measuring and determining compliance with the arm’s length method. These methods are listed in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines), which were adopted in 2008 by the Bureau of Internal Revenue as an interim set of guidelines in applying the arm’s length principle in related party transactions. We also looked at the Comparable Uncontrolled Price (CUP) Method, the first of the Traditional Transactional Methods. We will now continue with the other prescribed methods.

Resale Price Method
The Resale Price Method (RPM) involves a two-step process to determine an arm’s length price. There are three parties involved: the related party selling the goods or services to the reseller, the reseller, and the third party customer.
The first step takes into account the price at which a product that has been purchased from a related party is resold to an independent enterprise. The second step involves reducing the price arrived at in the first step by an appropriate gross margin (resale price margin) representing the amount out of which the reseller seeks to cover its selling and other operating expenses, and make an appropriate profit. What is left after deducting the gross margin can be regarded, after adjustment for other costs associated with the purchase of the product, as an arm’s length price for the purchase by the reseller of the goods or services from the related party.
The Resale Price Method is actually a misnomer since this method is applied to determine, not an arm’s length resale price, but rather an arm’s length price on the purchase of the goods or service by the reseller from another related party.
Thus, in a transaction where A sells goods to related-party B, and B resells to C, a third party, the Resale Price Method is applied in order to determine what may be an arm’s length price on the purchase of goods or services by B from A, after deducting from the resale price of B to C an arm’s length gross margin and other adjustment for other costs associated with the purchase of the product. The resale price of the goods from B to C will not give rise to a transfer pricing issue as it arises from a transaction between independent enterprises. This method is usually applied to distributors with limited value-added activities and ownership of valuable intangibles.

Cost-Plus Method
Under the Cost-Plus Method, an arm’s length price is determined by adding an appropriate mark-up to the direct costs incurred by the supplier of goods or provider of services. The Cost-Plus Method is usually applied to routine manufacturing activities (without significant intellectual property) and service transactions.
Since both the cost-plus and resale price methods are based on gross margin, an issue often encountered in the use of these methods is the lack of consistency on the part of enterprises in categorizing costs as direct costs because of differences in accounting treatment of such costs.

Transactional Profit Methods
The transactional profit method is determined with reference to the net profit earned from comparable uncontrolled transactions. There are two transactional profit methods.
The first is the Transactional Net Margin Method (“TNMM”), which examines the net profit relative to an appropriate base. Net profit may be examined relative to some key Performance Level Indicators (PLIs), which may include:
1. Costs where they are a relevant indicator of the value of the functions performed, assets and risks assumed by the tested party;
2. Assets in the case manufacturing or other asset- or capital-intensive activities; or
3. Sales (i.e. testing an operating margin) in the case of purchases from associated enterprises for resale to independent customers.
Of the five methods, the TNMM is the most commonly applied because the level of comparability required in applying it is lower than the other methods. This is important given the difficulties in finding appropriate comparable companies to test.
The second is the Profit Split Method, which is based on a division of profits that independent enterprises would expect to realize under circumstances similar to the transaction under review. This method calculates the profits, either total or residual, from the related party transaction and splits those profits based on the contribution of the entities involved in the transaction and with what would have occurred in a transaction between independent entities. This method is most commonly applied to intercompany transactions where each of the related parties possesses certain unique, valuable intangibles.
There are a variety of ways to measure the arm’s length price and there is no hard and fast rule to determine the best method. In a transfer pricing exercise, several factors – including the business and commercial structure of the taxpayer, the levels of comparability, the quality and quantity of information available – should be considered to establish the method that provides the most reliable arm’s length result. But beyond determining the most suitable method, companies should consider a transfer pricing exercise as an opportunity to gain comfort in their pricing policies on related party transactions.
Deonah L. Marco-Go is a Tax Director of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.