Understanding transfer pricing methodologies
In our previous articles on transfer pricing (TP), we have discussed the functions, assets, and risks (FAR) analysis, entity characterization, and industry analysis. This time, we will talk about the different transfer pricing methodologies.
The Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines provide five methodologies that are widely used and accepted by almost all tax authorities in determining transfer prices. These include three traditional transaction methods — comparable uncontrolled price (CUP) method, resale price method (RPM), and cost-plus method (CPM); and two transactional profit methods — transactional net margin method (TNMM) and profit split method (PSM).
These have been adopted by the Bureau of Internal Revenue (BIR). To better understand them, we will discuss broadly each of the five TP methods with some sample illustrations.
1. CUP METHOD
The CUP method compares the price and conditions of products or services in a controlled transaction (i.e., between related parties) with those of an uncontrolled transaction (i.e., between unrelated parties). In applying the CUP method, comparable data between controlled and uncontrolled transactions are required which must be highly similar in order for prices to be considered comparable.
Since this method compares extremely similar products or services, it is considered the most effective and most reliable way of determining the arm’s-length price for controlled transactions. However, due to the high standards of comparability required in applying the CUP method, it is usually a challenge to identify a transaction that is appropriately comparable to the controlled transaction.
The CUP method can be applied in two ways — the internal CUP and external CUP. Internal CUP is applicable in case the company transacts comparable transactions with related and unrelated parties. On the other hand, external CUP uses comparable data of transactions entered into between two unrelated third parties. Between the two, external CUP is more difficult to apply due to the usual lack of publicly available data on comparable third-party transactions.
Below is an example of how the internal CUP method is applied.
Company A, which is engaged in the lease of commercial space, needs to determine how much rent it should charge Company B, an affiliate, for the lease of a commercial unit in one of the buildings owned by the former. Let’s say Company A leases some commercial space in the same building to third-party lessees. In applying internal CUP, Company A must ascertain that all lease arrangements made with the third-party lessees are sufficiently comparable with the terms and conditions of the lease to Company B (e.g., leased area, payment terms, liability provisions, etc.) in order for Company A to apply the same rent charged to independent third-party lessees to Company B.”
RPM evaluates whether the amount charged in a controlled transaction is at arm’s length by reference to the gross margin realized in a comparable uncontrolled transaction. It uses the selling price of a product or service, or the resale price, from which an appropriate gross profit is subtracted.
The usefulness of this method largely depends on how much added value or alteration the reseller has performed on the product before it is resold, or the time that has lapsed between purchase and onward sale. The greater the value added by the reseller, to the extent that market conditions might have changed before it is resold, the more difficult to use RPM to arrive at the arm’s length price.
Company C is a distributor of an energy drink manufactured by its parent company in Thailand. The product is being resold by Company C to consumers at P34 per 350ml bottle. Assuming comparable independent distributors earn margins of 5%, the arm’s length transfer price that the parent company may charge Company C is computed below.
Third-party sale price P 34.00
Less: Resale price margin — 5% 1.70
Transfer price P 32.30
Under CPM, the arm’s length price is arrived at by adding an appropriate gross profit to the overall cost (direct and indirect) of producing the goods or services involved in the controlled transaction. This method calls for a very high level of similarity in the functions being performed by the comparable companies. Therefore, if the comparison is not apples-to-apples, the results will not be reliable. As is the case for all transactional methods, the challenge in using CPM is the availability of comparable data and consistency in the accounting methods.
Here is an example of the application of CPM.
Company D provides engineering design services to its Japan-based parent company which is in the construction industry. In determining the appropriate markup (gross cost plus) for the services provided to the Japan affiliate, Company D may use the markup applied for its similar comparable transactions with third parties, provided the costs incurred are substantially the same for both services provided. If no comparable third-party transactions of Company D are available, then independent companies engaged in similar activity with Company D can be identified and can apply those comparable companies’ markup to the transactions with the Japan-based related party.
Instead of testing and comparing the transfer price, TNMM compares the net margins, relative to an appropriate base such as costs, sales, or assets, attained by an entity from a controlled transaction as against those attained by comparable independent companies involved in similar transactions such that if the level of net margin of the related party is comparable with those independent companies, then the transfer price is carried at arm’s length.
This method is based on the concept that similar firms operating in the same industry would tend to yield similar returns over time. TNMM is the most broadly applicable transfer pricing methodology and commonly used due to its fairly easy implementation which only requires financial data.
Below is an illustration of TNMM.
Company E is a Philippine subsidiary of a US business process outsourcing (BPO) company. The parent company engages Company E to provide BPO services to its clients.
To determine how much profit Company E should earn for its BPO operations, comparable companies engaged in the same business activity in the Philippines are identified. Using the independent comparable companies’ profit margins before tax, a range of profit margins is computed which can be referred to as the arm’s length range of net profit. As such, Company E may then charge service fees to the parent company allowing Company E to earn a level of net profit within the arm’s length range.
Affiliated entities normally enter into closely interrelated transactions, so that they cannot be observed independently from each other. This typically is the case when unique intangibles are involved or where multiple controlled transactions happen at the same time.
Normally, the affiliated entities would agree to split the profits. Thus, in the profit split method, the operating profits or losses from controlled transactions are allocated in proportion to the relative contributions made by each party in creating the combined profits or losses. The terms and conditions of interconnected related party transactions are evaluated to determine how profits would be divided in case similar transactions are entered into between unrelated parties.
Below is an example of the application of profit split method.
Company F is an Australia-based intangible holding company that provides patents to a related manufacturing Company G in Malaysia. Company G sells its entire production to a related marketing company H. Assuming there are no significant marketing intangibles (trademarks, etc.), the determination of arm’s length price for royalties to be charged by Company F to Company G would be as follows:
1. Determine the optimum profits that should be earned by Company G on the basis of the profits of comparable companies (i.e., engaged in manufacturing).
2. Determine the optimum profits that should be earned by Company H on the basis of the profits of comparable companies (i.e., engaged in marketing).
3. Aggregate the entire actual profits of the group (F, G, and H).
4. From such aggregate profits, the optimum profits attributable to activities of Company G and H as determined in the previous steps are deducted.
5. The balance profits would be the value of intangibles held by F and would indicate the optimum level of royalty to be paid by G.
The Philippine transfer pricing rules do not prefer any particular methodology. The tax authority only requires that the method used provides the most reliable measure of an arm’s length result. It is, therefore, crucial in preparing transfer pricing documentation that taxpayers are well informed of the different methodologies and on how and when they are applicable in order to arrive at justifiable transfer prices that comply with the arm’s length principle.
Stay tuned for our next month’s article as we continue to take you through the other components of transfer pricing documentation.
Let’s Talk Tax is a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
Arianne Cyril L. Mandac-Villarama is a senior manager from the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.