There are five main OECD methods for transfer pricing: CUP, Cost Plus, Resale Price, TNMM and the Profit Split Method. Taxpayers must apply the 'most appropriate' method for their particular case. There is no longer an overt hierarchy of methods, but where a 'CUP' exists it should be used. Cost Plus and Resale Price are gross profit methods and can be hard to apply in practice. TNMM, under which the net profit margin is targeted, has almost become the default method in recent years but given the complexity of modern business the use of Profit Split may increase. Taxpayers should not simply jump to the easiest method but must be prepared to explain why they have chosen their selected method.
Every year Grant Thornton takes on new graduates into its international tax and transfer pricing practice, and one of the first things they are asked to do is to read about the five transfer pricing methods in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Transfer Pricing Guidelines or Guidelines).
Very soon each new intake is clear on what the methods are and how they are applied. Later on they start to see why those methods, which appeared so simple in theory, can be very difficult to apply to real-life intra-group transactions.
This article reminds readers of the theory behind the five methods and considers their pros and cons in practice. The 2010 version of the Guidelines, approved in July this year, has substantially revised the discussion on transfer pricing methods in the new Chapter II. There is no longer an overt hierarchy of methods, but there is now a requirement to use the ‘most appropriate’ method, having regard to the functions and risks of all parties.
Comparable Uncontrolled Price
The Comparable Uncontrolled Price (CUP) method compares the price charged for property or services transferred in a controlled transaction with the price charged for property or services in a comparable transaction undertaken between independent parties. To be considered a CUP, an uncontrolled transaction has to meet high standards of comparability.
The advantages and disadvantages of the CUP method
A CUP is one of the most direct ways of ascertaining an arm’s-length price of a controlled transaction because it is the 'open market' price of the tested transaction between related parties. Consequently, where a CUP meets the stringent comparability criteria then it should be used.
The Guidelines state: ‘Where it is possible to locate comparable uncontrolled transactions, the CUP method is the most direct and reliable way to apply the arm’s-length principle. Consequently, in such cases the CUP method is preferable over all other methods’ (OECD Transfer Pricing Guidelines 2010 para 2.14).
In practice, many potential CUPs are rejected because they cannot match one or more of the comparability criteria, such as similar markets, volumes and position in the supply chain. In many industries, even a small difference between the circumstances of two transactions could impact the price.
For example, two transactions in Product A, being exactly the same in all regards with the exception that in one transaction the vendor has monopoly power in the market and in the other the purchaser has monopoly power is likely to result in two very different prices for what at first blush is the same transaction. The importance of relative bargaining power in transfer pricing is addressed, for example in DSG Retail Ltd and others v HMRC [2009] STC (SCD) 397.
As a consequence, true CUPs are most commonly available for transactions in products that are traded on commodity-type markets. The homogenous nature of the product and the availability of pricing information to both buyers and sellers means that prices are driven by equilibrium between supply and demand and it is possible to be sure that the tested transaction and the uncontrolled transaction occur in comparable circumstances.
Furthermore, whilst adjustments to CUPs are permitted, many practitioners prefer to use an alternative method rather than apply somewhat arbitrary adjustments to a CUP, arguing that every ‘adjustment’ distances the CUP from what was actually agreed in the open market.
Common errors are for taxpayers to seek to apply a ‘CUP’ that is derived from one or two ‘distress purchases’ or transactions outside their normal markets, or conversely to ignore apparent CUPs without explaining why they should be distinguished.
Cost Plus method
The Cost Plus method seeks to determine an arm’s-length range of prices for a transaction by identifying the costs incurred by the vendor of the goods or services in a controlled transaction and then adding an arm’s-length mark-up to that cost base. The mark-up should be comparable to what a third party would earn if it performed comparable functions, bore comparable risks, owned the same assets and operated in comparable market conditions.
The mark-up is applied to the direct and indirect costs of ‘production’, ie it is a gross profit method not a net profit method. A method applying a mark-up on full cost including operating costs is strictly a transactional profit method (see below). In practice the Cost Plus method is often applied in sales of goods from manufacturing entities to related-party distributors.
Advantages and disadvantages of the Cost Plus method
For many businesses, the Cost Plus method has the clear advantages of being simple to understand and easy to implement through most accounting systems. Once the ‘plus’ has been determined, invoices can be raised and payments made without the need for complex spreadsheets to determine profit allocations or margins, as required by some other methods.
The simplicity of implementation can also mean that the Cost pPlus method (together with ‘full cost mark-up’, see below) is one of the methods that in our view is most often inappropriately applied. For example, taxpayers may use a Cost Plus method for pricing the sale of goods by a manufacturer to a related party even when the manufacturer may be the owner and developer of valuable intangibles.
This can result in the distributor, in transfer pricing terms the ‘simpler’, less risk bearing party, being the one that takes the residual profit or loss and the one whose profitability fluctuates the most.
The usual reason for adopting this approach is the ease of implementing a Cost Plus policy on management accounting systems that are set to capture standard costs and overheads.
The theory is simple but in practice determining the mark-up on costs through benchmarking analysis can be difficult. One key issue is the potential inconsistency between costs that some companies record in their cost of goods sold and other companies may record in operating expenses.
The potential for mark-ups to be distorted in this way is hard to overcome, given the typically limited information about comparable companies available in the public domain. To overcome this, many practitioners identify comparable companies’ mark-ups based on their total costs (ie cost of goods sold plus operating expenses), which is in effect a profit-based method.
Resale Price Method
The Resale Price Method (RPM) is based on the gross margin or difference between the price at which a product is purchased and the price at which it is on-sold to a third party. The resale price less the arm’s-length gross margin (and after adjusting for other costs eg, customs duty) is considered to be the arm’s-length transfer price for the goods.
The RPM is typically most appropriate to distributors and resellers.
Advantages and disadvantages of the RPM
One of the disadvantages of the RPM is that it is very difficult to identify whether the comparable businesses do (or do not) employ valuable marketing intangibles in their business.
Arguably the presence of such intangibles may allow the comparable entity to enjoy a higher level of profitability compared with those marketing/selling companies without such an intangible. Without the ability to undertake a functional analysis of the comparables the practitioner is always uncertain on this point.
Furthermore, small product differences can make a large difference to the gross margin that a company earns. For example, some products ‘sell themselves’, whilst for others the marketing company has to make significant efforts to make even a low level of sales. In the latter case one might expect that the distributor should receive a higher gross margin to cover its additional selling costs.
Profit based methods
Going forward, the abolition of the traditional hierarchy of methods may mean that more taxpayers are encouraged to adopt profit based methods ie, the Transactional Net Margin Method (TNMM) or Profit Split Method. The lack of widely available benchmarking data also leads taxpayers to apply profit-based methods in preference to other methods which require information on open-market prices of comparable transactions.
Transactional Net Margin Method
The TNMM tests the net profit margin earned in a controlled transaction with the net profit margin earned by the related party on the same transaction with a third party or the net margin earned by a third party on a comparable transaction with another third party.
The net profit margin can be measured against a number of bases including sales, costs or assets, and in practice is typically applied by targeting an operating margin within a set range.
As noted above, ‘full cost mark-up’ methods are an adaptation of TNMM.
They are popular in practice for the provision of services between related parties for example, back office management services and routine low-risk contract Research and Development (R&D), but paradoxically can have the effect of rewarding inefficiency.
Advantages and disadvantages of TNMM
TNMM has almost become the ‘default’ method for taxpayers in recent years.
The key advantage of the TNMM is that there is often available data in the public domain about the net profits that comparable independent businesses earn from their trading activities in comparable markets with other third parties. As such, the TNMM often proves easier to apply than, say, the Cost Plus or RPM methods, and TNMM is less sensitive to minor differences in the products being sold.
Therein, of course, also lies the main disadvantage of the TNMM, because there is typically insufficient information in the public domain to be certain that the comparable companies are truly comparable to the tested party.
Given that the practitioner cannot perform a functional analysis of the comparable companies, one has to rely on the accounts and other publicly available information about the comparables, and there always remains a risk that they are not sufficiently comparable to meet the criteria.
The potential overuse of full-cost mark-up methods is a common refrain from several tax authorities, including the UK’s HMRC. Its argument is that many taxpayers automatically apply a mark-up approach to the provision of valuable services provided by UK companies to the worldwide group, not recognising for example, that cost plus may not be appropriate for strategic leaders without whom the business could not function.
Similarly where valuable intangibles are created by R&D activities, especially where the UK company may be deciding upon and directing the choice of projects, it is important to be able to explain why a mark-up on costs is appropriate.
Profit Split Method
The Profit Split Method (PSM) seeks to determine the way that a profit arising from a particular transactions would have been split between the independent businesses that were party to the transaction. The PSM divides the profit based upon the relative contribution of each related party business to the transactions enterprise as determined by their functional profile and, where possible, external market data.
Advantages and disadvantages of the PSM
Over recent years we have increasingly seen multinational groups apply a profit split as the basis of their transfer pricing policies. For many it is because globalisation requires that they manage their business along divisional lines with the consequent scant regard to the profit profile of the underlying legal entities.
In many cases, the increasing importance and value of a group’s Intellectual Property (IP) and the often shared nature of the development of that IP, and the attached business risks, may lead taxpayers to the PSM.
In our experience, the take-up of the PSM is particularly marked in the financial services industry where often complex transactions are undertaken jointly between related party businesses rather than being outsourced to third parties.
A good example here is the fund management industry, where value-driving functions and key executives may be located in multiple jurisdictions. In these cases a form of 'contribution analysis’ can be adopted, whereby activities are analysed and weighted according to importance, and revenues are allocated accordingly.
Despite the attractiveness of the PSM, there are significant difficulties in applying it in practice.
The simplicity of the requirement in the OECD Transfer Pricing Guidelines to split the profit between the parties, ‘on an economically valid basis that approximates the division of profits that would have been anticipated and reflected … at arm’s length’ (para 2.108 OECD Transfer Pricing Guidelines 2010) belittles the difficulty in working out what profit should be shared and the relative contribution of each participant to the profit share.
Profits arising today may have been the result of work undertaken by one of the businesses many years in the past. Conversely, including all costs in the profit to be shared could allow some participants to ‘export’ the cost of their own inefficiency to others.
The use of more than one method
The OECD specifically states that the use of more than one method for a given transaction is not ‘required’ and is usually not necessary, recognising that this could create an additional burden on taxpayers (para 2.11 OECD Transfer Pricing Guidelines 2010). However, in complex cases the use of more than one method, or the use of a corroborative method, can be helpful.
Conclusions
On first reading, the OECD Transfer Pricing Guidelines are beguilingly simple, but it does not take long to recognise that each method can be hard to apply in practice. In many cases a method is discarded, despite being theoretically the most appropriate, because of the difficulty in finding uncontrolled transactions between independent businesses against which the arm’s-length nature of the controlled transaction can be tested.
This is particularly an issue in certain industries (especially financial services), certain sizes of companies, and for certain countries (particularly in the developing world).
To date, the profit-based methods (TNMM or PSM) have often been the default methods adopted by taxpayers, except in the simplest cases. This trend looks likely to continue in the future, mainly because of the limitations on the benchmarking information which is available in the public domain.
Obviously no one method is perfect in all circumstances and many transfer pricing disputes are driven by the fact that the taxpayer and tax authority have sought to apply different transfer pricing methods to the tested transaction.
Given the inherent possibility of disagreement over the method to apply, the authors believe that the arm’s-length principle is best delivered when taxpayers acknowledge the pros and cons of their selected method, and are prepared to explain why their chosen method is indeed the ‘most appropriate’.
Wendy Nicholls is a Partner and Leader of Grant Thornton's transfer pricing practice in the UK. Email Wendy.Nicholls@gtuk.com Tel 0207 728 2302.
Elizabeth Hughes is a Senior Manager with Grant Thornton UK LLP. She specialises in transfer pricing and thin capitalisation. Email Elizabeth.Hughes@gtuk.com Telephone 0207 728 3214
