If you have transactions with group companies or if you will soon have transactions with group companies, then you know you must set a price for the transaction. This price has to be comparable to the price that a third party would have set. In transfer pricing we call that an at arm’s length price. Did you know that there are certain methods for determining this at arm’s length price? You need to choose a method for each transaction that you need to price. The method you choose should be the most suitable method for your specific transaction.
What are the OECD transfer pricing methods?
The transfer pricing methods are different ways to establish a business price. The OECD’s transfer pricing guidelines describe the five different methods:
- The comparable uncontrolled price method (CUP);
- The cost plus method (CPLM);
- The resale price method (RPM);
- The transactional net margin method (TNMM);
- The profit split method (PSM).
The specialists at Crowe Peak have extensive experience with different transfer pricing methods and are happy to help you choose the most suitable method for your specific case. The explanation on this page is informative and does not serve as advice. We strongly encourage you to not select a transfer pricing method yourself based on this article.
The main points of each method will be explained below. You may experience this article as being more complicated than what you are used to from us. We have done our best to explain the five transfer pricing methods in an easy to understand way, but nevertheless the transfer pricing methods remain fairly technical in nature.
Comparable Uncontrolled Price Method
With the CUP method, the price charged for the related transaction is compared with the price charged for a comparable transaction between:
- Two independent parties, or;
- One of the parties involved in the related transaction and a third party.
In practice, the CUP method is generally applied on commodities for which the market price is known or on loans.
Cost Plus Method
The CPLM is applied in transactions between a supplier and a group company.
When applying the CPLM, the total production costs of the goods are increased by a cost surcharge. The production costs and the cost surcharge form the resale price to the group company. The cost surcharge is determined by analyzing which cost surcharge is used for comparable transactions between third parties.
For example: You B.V. makes machine parts. You B.V. purchases the raw materials for 100 from Y GmbH, a third party. The direct and indirect production costs of You B.V. is 50. Research by transfer pricing advisors has shown that independent third parties apply a cost surcharge of 30%. Thus, the transfer price to RelatedParty GmbH is 195 (i.e. the production costs (100 + 50) + 30% = 195).
Resale Price Method
The RPM is applied in cases where a product is purchased from a group company and is resold to a third party. The transfer price, the price that the reseller must pay for the product in business terms, is determined by reducing the sales price to the third party by a gross business margin. The gross operating margin is determined on the basis of the gross margins achieved on transactions between third parties.
An example: You B.V. sells the machine parts made by RelatedParty GmbH for 100 to Y GmbH, a third party. You B.V. must generate an at arm’s length profit. Research by transfer pricing consultants has shown that independent third parties achieve a gross margin of 25% on the sale of comparable machine parts. An at arm’s length price between RelatedParty GmbH and You B.V. is therefore 75 (25% of 100 = 25; 100-25=75).
Transactional net margin method
The TNMM compares the operating profit margin (i.e. EBIT margin) that is achieved on the transactions with a related company with the operating profit margins achieved by independent companies involved in comparable transactions / activities.
To be calculate a margin, you must set off the operating profit against something else. The thing against with you set off the operating profit is called the profit level indicator. There are various profit level indicators. The most commonly used are the Operating Margin (Operating Profit / Turnover) or the Net Cost Plus Mark-up (Operating Profit / (Sales – Operating Profit). As with selecting the most suitable transfer pricing method, you must choose the most suitable profit level indicator for the specific situation. The transfer pricing experts at Crowe Peak can advise you in this.
For example: RelatedParty GmbH sells machine parts to its Dutch group company You B.V. You B.V. sells these products to independent third parties on the Dutch market. The consultants of You B.V. have determined that the TNMM is the most suitable transfer pricing method to generate business profits for You B.V. and that the operating profit must be compared to turnover. The transfer pricing advisers have determined that independent third parties achieve an operating profit equal to 6% of turnover. If You B.V. has € 1 million turnover, then the price for the machine parts purchased from RelatedParty GmbH should be set in such a way that the operating profit for You B.V. will amount to € 60,000 (i.e. 6% of € 1 million).
Profit split method
When group companies apply the PSM, the (operating) profit achieved with the transaction is divided between the group companies concerned. In order to correctly apply the PSM, the (operational) profit will have to be distributed in a manner that third parties would also have agreed in a comparable situation.
We often times see clients applying this method. It may feel fair to share risks and thus profit and loss, but this is often times not correct from a transfer pricing point of view. The PSM is the most suitable method only in a limited number of cases. In addition, the use of the PSM is often not desirable. Admittedly, the method seems to be easy to apply operationally. However, substantiating the profit allocation key used is very difficult because it can only be objectified and can never be determined objectively. As a result, the allocation key used will almost always lead to discussions with tax authorities. It is therefore always important in these, and in other cases, to have an adviser look at the chosen transfer pricing method.
What if I don’t choose the most suitable transfer pricing method?
What happens if you don’t choose the most suitable transfer pricing method? As part of your transfer pricing documentation, you need to be able to substantiate why the transfer pricing method you have chosen is the most suitable in the given situation. When conducting an audit, the Dutch tax authorities will always start from the transfer pricing method chosen by the taxpayer.
You are free to choose your transfer pricing method, provided it leads to an at arm’s lengthoutcome for the specific transaction. If the Tax Authorities feel that the chosen transfer pricing method does not lead to an at arm’s lengthoutcome, then they will impose a transfer pricing adjustment.
A transfer pricing adjustment affects more than your taxable profit. By taking into account a (fictitious) transaction, it must also become clear how the profit correction has been incorporated in the accounts. For example, the adjustment may be implemented by means of a current account position or the distribution of a (constructive) dividend. These (fictitious) transactions can then again influence your profit or taxation. For example, a current account can affect your profit by taking an at arm’s length interest rate into account and a (constructive) dividend can lead to the payment of dividend withholding tax.
Do you need help choosing the most suitable transfer pricing method for your situation? Please do not hesitate to contact our transfer pricing specialists.