What are the common methods of transfer pricing, also called transfer pricing policies?

Transfer pricing is the mechanism by which multinational corporations (MNCs) transfer goods, services, or intangible assets within their global group of companies. Transfer pricing refers to the prices at which these transactions occur and is a significant tool for allocating profits among different jurisdictions. The main goal of transfer pricing is to ensure that profits are allocated in a manner that reflects the actual economic activities of the different entities within a multinational group. It also enables MNCs to maximize their tax efficiency by allocating profits to low-tax jurisdictions.

Transfer pricing methods can be categorized into two types: traditional methods and transactional methods. Traditional methods are based on the profitability of the entire business or division, while transactional methods are based on the specific transaction between related parties. In this article, we will discuss the different methods of transfer pricing and provide examples for each method.

  1. Comparable Uncontrolled Price Method (CUP)

The CUP method is the most straightforward method of transfer pricing. It compares the price charged in a related-party transaction with the price charged in a similar transaction between unrelated parties. The CUP method is used when there are similar transactions between unrelated parties that can be used as a benchmark. The price charged in a related-party transaction should be comparable to the price charged in the unrelated-party transaction.

For example, a company that produces widgets in the United States sells them to its related company in Europe. If there is a similar transaction between an unrelated U.S. company and an unrelated European company, the price charged in that transaction can be used as a benchmark to determine if the price charged in the related-party transaction is at arm’s length.

  1. Cost Plus Method (CPM)

The cost-plus method is based on the costs incurred by the seller, plus a markup. The markup should be a reasonable profit margin for the seller. The method is used when there are no comparable transactions between unrelated parties or when the comparable transactions are unreliable.

For example, a company that produces specialized equipment in the United States sells it to its related company in Asia. If there are no comparable transactions between unrelated parties, the company can use the cost-plus method to determine the price charged to the related company. The cost of producing the equipment in the United States, plus a reasonable profit margin, would be used to determine the transfer price.

  1. Resale Price Method (RPM)

The resale price method is based on the price at which the related buyer resells the product to an unrelated party. The method takes the resale price and subtracts a reasonable profit margin for the buyer. The resulting amount is the arm’s length price for the related-party transaction.

For example, a company that produces electronics in China sells them to its related company in the United States. The related company in the United States resells the electronics to unrelated parties. The price at which the electronics are sold to the unrelated parties can be used as a benchmark to determine the arm’s length price for the related-party transaction. The resale price method would take the resale price and subtract a reasonable profit margin for the buyer to determine the transfer price.

  1. Profit Split Method (PSM)

The profit split method is used when the contribution of each related party to the transaction cannot be separated. The method involves splitting the profits from the transaction between the related parties based on their relative contributions to the transaction.

For example, a company that produces a popular product in the United States sells it to its related company in Europe. The related company in Europe is responsible for marketing and distributing the product in Europe. The contribution of each company to the transaction cannot be separated. The profit split method would be used to split the profits from the transaction between the related parties based on their relative contributions.

  1. Transactional Net Margin Method (TNMM)

The TNMM is based on the net profit margin of the related party involved in the transaction. The

TNMM compares the net profit margin of the related-party transaction to the net profit margin of a comparable transaction between unrelated parties. The net profit margin is the ratio of net profit to sales.

For example, a company that produces software in India sells it to its related company in the United States. The net profit margin of the Indian company is compared to the net profit margin of a comparable transaction between unrelated parties. If the net profit margin of the Indian company is within the range of the net profit margin of the comparable transaction between unrelated parties, the transfer price is considered to be at arm’s length.

  1. Transactional Profit Split Method (TPSM)

The transactional profit split method is used when the contribution of each related party to the transaction can be separated. The method involves splitting the profits from the transaction between the related parties based on the value of their contributions to the transaction.

For example, a company that produces a new drug in the United States sells it to its related company in Europe. The related company in Europe is responsible for conducting clinical trials and obtaining regulatory approval for the drug. The contribution of each company to the transaction can be separated. The transactional profit split method would be used to split the profits from the transaction between the related parties based on the value of their contributions.

In conclusion, transfer pricing is an essential tool for MNCs to allocate profits among different jurisdictions and maximize tax efficiency. Different methods of transfer pricing are used depending on the circumstances of the related-party transaction. Traditional methods are based on the profitability of the entire business or division, while transactional methods are based on the specific transaction between related parties. The methods include the CUP method, cost-plus method, resale price method, profit split method, TNMM, and transactional profit split method. These methods help to ensure that related-party transactions are conducted at arm’s length, meaning that the prices charged in the transactions are similar to those that would be charged between unrelated parties.

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