1. Comparable Uncontrolled Price Method

The comparable uncontrolled price (CUP) method compares the price and conditions of products or services in a controlled transaction with those of an uncontrolled transaction between unrelated parties. To make this comparison, the CUP method requires what’s known as comparable data. In order to be considered a comparable price, the uncontrolled transaction has to meet high standards of comparability. In other words, transactions must be extremely similar to be considered comparable under this method.

The OECD recommends this method whenever possible. It’s considered the most effective and reliable way to apply the arm’s length principle to a controlled transaction. That said, it can be very challenging to identify a transaction that’s appropriately comparable to the controlled transaction in question. That’s why the CUP method is most frequently used when there’s a significant amount of data available to make the comparison.

2.The Resale Price Method

The resale price method (RPM) uses the selling price of a product or service, otherwise known as the resale price. This number is then reduced with a gross margin, determined by comparing the gross margins in comparable transactions made by similar but unrelated organizations. Then, the costs associated with purchasing the product—such as customs duties—are deducted from the total. The final number is considered an arm’s length price for a controlled transaction made between affiliated companies.

When appropriately comparable transactions are available, the resale price method can be a very useful way to determine transfer prices, because third-party sale prices may be relatively easy to access. However, the resale price method requires comparable with consistent economic circumstances and accounting methods. The uniqueness of each transaction makes it very difficult to meet resale price method requirements.

3. The Cost Plus Method

The cost plus method (CPLM) works by comparing a company’s gross profits to the overall cost of sales. It starts by figuring out the costs incurred by the supplier in a controlled transaction between affiliated companies. Then, a market-based markup—the “plus” in cost plus—is added to the total to account for an appropriate profit. In order To use the cost plus method, a company must identify the markup costs for comparable transactions between unrelated organizations.

The cost plus method is very useful for assessing transfer prices for routine, low-risk activities, such as the manufacturing of tangible goods. For many organizations, this method is both easy to implement and to understand. The downside of the cost plus method (and really, all the transactional methods) is the availability of comparable data and accounting consistency. In many cases, there are simply no comparable companies and transactions—or at least not comparable enough to get an accurate, reliable result. If it’s not an apples to apples comparison, the results will be distorted and another method must be used.

4.Transactional Profit Methods

Unlike traditional transaction methods, profit-based methods don’t examine the terms and conditions of specific transactions. Instead, they measure the net operating profits from controlled transactions and compare them to the profits of third-party companies making comparable transactions. This is done to ensure all company mark-ups are arm’s length.

However, finding the comparable data necessary to use these methods is often very difficult. Even the smallest variations in product features can lead to significant differences in price, so it can be very challenging to find comparable transactions that won’t raise red flags and be questioned by auditors.

5. The Comparable Profits Method

The comparable profits method (CPM), also known as the transactional net margin method (TNMM), helps determine transfer prices by looking at the net profit of a controlled transaction between associated enterprises. This net profit is then compared to the net profits in comparable uncontrolled transactions of independent enterprises.

The CPM is the most commonly used and broadly applicable type of transfer pricing methodology. As far as benefits go, the CPM is fairly easy to implement because it only requires financial data. This method is really effective for product manufacturers with relatively straightforward transactions, as it’s not difficult to find comparable data.

The CPM is a one-sided method that often ignores information on the counterparty to the transaction. Tax authorities are increasingly likely to take the position that the CPM is not a good match for organizations with complex business models, such as high-tech companies with intellectual property. Using data from companies that do not meet the OECD’s standards of comparability creates audit risk for organizations.

6. The Profit Split Method

In some cases, associated enterprises engage in transactions that are interconnected—meaning they can’t be observed on a separate basis. For example, two companies operating under the same brand might use the profit split method (PSM). Typically, the related companies agree to split the profits, and that’s where the profit split method comes in.

This approach examines the terms and conditions of interrelated, controlled transactions by figuring out how profits would be divided between third parties making similar transactions. One of the main benefits of the PSM is that it looks at profit allocation in a holistic way, rather than on a transactional basis. This can help provide a broader, more accurate assessment of the company’s financial performance. This is especially useful when dealing with intangible assets, such as intellectual property, or in situations where there are multiple controlled transactions happening at a time.

However, the PSM is often seen as a last resort because it only applies to highly integrated organizations equally contributing value and assuming risk. Because the profit allocation criteria for this method is so subjective, it poses more risk of being considered a non-arm’s length outcome and being disputed by the appropriate tax authorities.

If you’re struggling to determine which of the five transfer pricing methods is an ideal fit for you, we can help. Our team of transfer pricing experts has the know-how and firsthand experience to help guide you in the right direction. Get in touch to learn more about how we partner with tax teams to help them achieve the best financial outcomes possible. Among the biggest changes in transfer pricing documentation and reporting over the past few years are the maintenance of both master and local files as specified in the Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Sharing (BEPS) action items. Prior to the introduction of BEPS in 2017, the OECD standards were nebulous, specifying only that documentation should “reasonably” demonstrate that the arm’s length standard was used to establish transfer pricing. Under this subjective standard, some companies provided minimal information to tax authorities, complicating efforts to ensure compliance. In addition, many jurisdictions required primarily documentation related to the local company and thus lacked the context of the parent enterprise’s transfer pricing practices. The OECD’s goals in adopting new BEPS guidelines were to increase transparency and standardize the documentation taxpayers are required to provide to ensure tax authorities have the necessary information to assess transfer pricing policies. To address these goals, the BEPS guidelines established a three-tiered approach for documenting intercompany transactions, requiring companies to prepare a master file, a local file, and a country-by-country report. This tiered documentation is intended to provide tax authorities in all jurisdictions with the context required to verify compliance. This standardized approach also seeks to achieve three objectives. The first is for companies to self-assess compliance with the arm’s length principle. The second is to provide tax authorities with a means of identifying potentially risky transfer pricing, while the third is to provide them with a specified level of information about the taxpayer in the event of an audit. In this article, we’ll review the local file and transfer pricing master file requirements and look at how transfer pricing local file templates may vary from one jurisdiction to another.

The master file provides a global overview of the enterprise’s transfer pricing. It includes high-level information about the company’s global operations and transfers pricing policy. The OECD has developed an outline of the information that should be included in the master file. For the most part, every country has adopted the OECD master file guidelines:

• • • Organizational structure
    • Geographic locations of operations
    • Main value/profit drivers
    • Descriptions of business activities of business units (products and services)
    • Intangible assets
    • Intercompany financing
    • Enterprise financials and tax positions

The master file is compiled at the enterprise level, typically the parent company. BEPS guidelines suggest that the master file be made available to tax authorities in the jurisdictions where the enterprise has business operations and many tax authorities have adopted the master file as a requirement in their own legislation.

While the BEPS guidelines stipulate the required information, there is some flexibility in how companies can present or format the information. The enterprise’s OECD master file may, for example, be presented by a line of business, as long as centralized functions and transactions are thoroughly documented. Although the master file needs to be available to local tax authorities, it does not have to be compiled by each business entity—only by the parent company.

The master file represents an opportunity to explain the transfer pricing policy to tax authorities. Although following the guidelines requires some taxpayers to provide much more extensive information than they previously had, the transfer pricing master file requirements introduced a level of security for companies that carefully apply the arm’s length principle in their intercompany transactions.

What’s most important in preparing the master file, aside from including the required documentation, is avoiding risk. Discrepancies or contradictions between information in the master and local files increase audit risk, so it’s critical to make sure the descriptions that are provided in the files are consistent.

The local file preparation is specific to each country to document the activities of the business units operating in that specific jurisdiction. The local file provides detailed information about the local company’s intracompany transactions. Local files are filed with the tax authority for the jurisdiction.

As with the master file, BEPS has guidelines for the information that should be included in local files. BEPS local file requirements include these details:

• Management structure of the local entity
• Intracompany transactions executed during the tax year
• Related intercompany agreements
• Transfer pricing methodology and application
• Local entity financials

While many countries have adopted the OECD’s transfer pricing local file template, some have tweaked it with requirements for additional information or with a specific format for ordering the information. In these jurisdictions, the information stipulated for OECD requirements will be the same; the difference is that the specific jurisdiction may require additional information or have unique stipulations as to how the information is presented.

As already noted, ensuring that the information in the local file is consistent with information in the master file is crucial. Disparities can create audit risks.

The first step in avoiding audits and penalties is to make sure all required documentation is prepared on time,  and submitted to the tax authority if necessary.

Due to the increased complexity of the three-tiered approach introduced by BEPS, a detailed work plan to meet important deadlines and successfully manage the compliance process is critical. Developing this plan is a challenge in itself, so GSPU has designed a scalable work plan with timelines and task lists to serve as a work plan template.

Although the OECD BEPS requirements introduced a more complex documentation regimen, companies can more easily assess their compliance with the arm’s length principle in their transfer pricing plan—and reduce their risk of an audit by complying with all requirements. However, companies with complex international business structures that conduct large volumes of intracompany transfers may want to seek out the guidance of third-party transfer pricing specialists—like the team at GSPU—to ensure all BEPS requirements are being addressed.