The different methods of TP: pros and cons

Tue, 28/09/2010 - 14:00 -- Development

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 arms-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 arms-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 arms-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 armslength 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 arms-length gross

margin (and after adjusting for other costs eg, customs duty) is considered
to be the arms-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 UKs 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 groups
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 arms 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 arms-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 arms-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 [1] 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 [2] Telephone 0207 728 3214
Author(s):
Elizabeth Hughes [3]
Wendy Nicholls [4]
Tax type:
Analysis [5]
Tax topic:
Transfer pricing [6]
Speed read:
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.
Source URL: http://www.taxjournal.com/tj/articles/different-methods-tp-pros-andcons
Links:
[1] mailto:Wendy.Nicholls@gtuk.com
[2] mailto:Elizabeth.Hughes@gtuk.com
[3] http://www.taxjournal.com/tj/content/elizabeth-hughes
[4] http://www.taxjournal.com/tj/content/wendy-nicholls

[5] http://www.taxjournal.com/tj/category/tax-type/analysis
[6] http://www.taxjournal.com/tj/international-taxes/transfer-pricing