The following points highlight the top two methods for the determination of arm’s length price. The methods are: 1. Traditional Transaction Methods 2. Transactional Profit Methods.
1. Traditional Transaction Methods:
(a) Comparable Uncontrolled Price Method (“CUP”):
The price is based on the sale or purchase from an uncontrolled party, or from an uncontrolled transaction of third parties, of identical goods or services under comparable circumstances. Therefore, the method requires a comparison with a transaction undertaken either with an unrelated party, or by unrelated parties on similar terms.
The Guidelines refer to five comparability factors, namely:
(i) The characteristics of the property supplied or the services provided,
(ii) The functions performed (having regard to assets used and the risks assumed) by the parties,
(iii) The contractual terms and conditions,
(iv) Market circumstances and
(v) Business strategies.
A high degree of products or service comparability is required to apply this method, but reasonably accurate adjustments are permitted for differences between the controlled and uncontrolled transactions.
This method is less reliable if all the characteristics that significantly affect the price are not comparable. The Guidelines regard the CUP method as the best indicator of the arm’s-length price, but accept that other methods may be more appropriate in certain circumstances.
The CUP method may also be supplemented by other appropriate methods. The Guidelines also accept that comparability may not be possible in many situations because the price evidence is not available or is impractical to collect.
(b) Resale Price Method (“RPM”):
This method is suitable when goods or services are purchased from a related or controlled party. It is based on the price at which a trader (as purchaser from an associated enterprise) resells the goods to an independent enterprise, and the resale price margin adequate to compensate him for his services in reselling the goods.
The arm’s-length purchase price is the resale price as reduced by the adjusted uncontrolled resale price margin.
The margin should cover his selling and other operating expenses and allow him to make an appropriate profit for the functions performed, the assets used and the risks assumed. The resale price margin in the controlled transaction is determined by reference to similar margin which he makes in comparable uncontrolled transactions.
This margin rate should be adjusted for material differences that exist between the controlled transaction and the comparable uncontrolled transactions due to factors, such as:
i. The contribution by the reseller in terms of manufacturing or processing functions;
ii. The contribution the reseller makes to the ultimate sale;
iii. The application to the product of owned proprietary rights by the reseller;
iv. Other transfers of the product either within the group or to unrelated parties;
v. The characteristics of similar industry situations; etc.
Thus, the resale price method relies on the resale margin comparison between the controlled transaction and uncontrolled transactions at which a product is resold to an independent enterprise.
The appropriate margin is the resale margin, as a percentage of sales, earned by a reseller on the goods that are both purchased and resold in an uncontrolled transaction in the relevant market.
This method is appropriate when there are no direct comparables (or “CUP”), and the reseller does not add a significant value to the product itself. A typical situation would be a buy or sell transaction involving a distribution company. In some countries, the resale price method must be used by entities whose main function is sales and marketing.
Where the product is further processed or incorporated into another product or where it contributes substantially to the creation or maintenance of intangible property associated with the product, e.g. a trademark, the resale price method is difficult to use.
(c) Cost Plus Method (“CPP”):
This method is appropriate when goods or services are sold to a related or controlled party. Like RPM, this method also relies on comparison of gross margins (e.g. mark-up) to establish the arm’s-length price.
The arm’s-length sale price is the cost of the product or service plus a mark-up. The appropriate mark-up is the margin percentage earned by a manufacturer on comparable transactions in uncontrolled sales.
The method assumes that there is a fixed relationship between costs and profits, and relies on the direct and indirect production costs (but not operating expenses) incurred by the supplier. The mark-up should reflect any differences in the functions performed and cover both operating (e.g. marketing) and non-operating expenses (e.g. risks).
The products compared should be of the same basic category, although they need not be identical. There should be a general similarity between the products compared in terms of product characteristics, product market, functions performed, sales volume and proprietary rights.
Consistent costing methods should be used for both the arm’s-length and non-arm’s length product comparisons. The comparability under this method depends less on product similarity and more on similarity of functions performed, risks borne and contractual terms.
Some of the factors to compare the mark-up include:
i. Complexity of manufacturing, assembly and engineering processes;
ii. Functions, such as procurement, purchasing, inventory control and testing;
iii. Level of selling, general and administrative expenses;
iv. Degree of risks, such as foreign currency risk, and
v. Contractual terms like warranties, credit and transport terms, etc.
This method is suitable especially when the provider of goods or services does not use significant intangibles to manufacture the goods or provide the services, e.g. semi-finished goods sold between related parties under a joint facility agreement or long-term buy- and-supply agreement, contract manufacture, provision of services, etc.
The mark-up can be derived from the profit mark-up that the same supplier earns in comparable transactions with non-related parties. This method is frequently used to determine the transfer price when new or non-standard products are supplied for which comparables are not available, and for low-risk supporting, preparatory, and/or ancillary group activities with low profit mark-up.
2. Transactional Profit Methods:
The Guidelines recognize two transactional profit methods (“other methods”) under the arm’s-length standard. These other methods are profit-based and rely usually on the profit earned by one or both parties from the transaction, and not on the price.
They compare certain financial measures of the related parties’ controlled transactions (“tested party”) to the same measure for similar uncontrolled transactions in the same or comparable industry in respect of individual transactions or groups of transactions.
According to the Guidelines, the transactional profit methods should be applied as a last resort, only where it is not possible to apply one of the traditional transaction methods, or to provide a general reasonableness check on the traditional transaction methods.
(a) Transactional Net Margin Method (“TNMM”):
The TNMM method compares the net profit margin of an individual controlled transaction (or a group of aggregated transactions) with an uncontrolled transaction with unrelated parties or between unrelated parties.
The net operating margin of the transaction with unrelated parties is expressed relative to sales, costs or assets (generally the return on sales or assets) for the taxpayer under review. These Profit Level Indicators (PLI) are based on their average data from the balance sheet and income statements, usually for three years.
The PLI must be applied to the tested party’s most narrowly identifiable business activity covering the controlled transaction. A functional analysis of both the related enterprise and the non-related enterprise is required to determine the degree of comparability.
The Guidelines state that “the net margin of the taxpayer from the controlled transaction… should ideally be established by reference to the net margin that the same taxpayer earns in comparable uncontrolled transactions. Where this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise may serve as a guide”.
It differs from the “comparable profits method” (CPM) in the United States, which compares the total operating income or gross profit of the enterprise (and not just the pricing factors for a particular transaction) with uncontrolled taxpayers engaged in similar business activities under similar circumstances.
While TNMM is related to specific transactions, CPM is “company-wide”. According to the OECD, it is based on the total net profits of an entire enterprise, which comprises of profits from both third party and intra-group transactions.
TNMM is often the preferred method for justifying many international transactions. Under TNMM, the degree of functional comparability required to obtain a reliable result is generally less than that required under the RPM or CPM since the differences in functions performed are usually reflected in operating expenses.
The method is less affected by the transactional differences on price than under the CUP method, or the functional differences that affect gross margins under the resale price and cost plus methods. They are also less sensitive to differences in accounting standards as well as to some differences in products or functions.
However, this method has its drawbacks. For example, the operating efficiency and expenses in the same industry or over time can influence the net margin. The method also examines only one party to the controlled transaction. The Guidelines point out that this method “may leave other parties to the transactions with unreasonably high or low profits”.
Moreover, since it guarantees that a transaction will always be profitable for at least one party in a given transaction, it may not reflect an arm’s-length relationship between unrelated parties.
The Guidelines suggest that where this method is used it should preferably be used with net margins calculated from comparable uncontrolled transactions of the same taxpayer, where possible, rather than third-party transactions. As with other methods, any material differences between the controlled and uncontrolled transactions being compared should be adequately adjusted.
(b) Profit Split Method (“PSM”):
The Guidelines also accept the transactional profit split method. The profit split method under the Guidelines allocates the combined (generally: operating) profit or loss of associated enterprises, based on the relative value of each party’s contribution to the total profit or loss of the controlled transaction or transactions.
This method is useful where transactions are strongly interrelated. The combined profit under examination may also be split under a residual profit split method (RPSM).
A basic market return for similar transactions, as achieved by comparable independent enterprises, is computed first and allocated to each participant. In the second stage, the residual profit is allocated to them based on their respective contributions determined by an analysis of the facts and circumstances.
The Guidelines state that this method is useful where both parties to a transaction add significant value or use significant intangibles, or where traditional transaction methods are difficult to apply due to absence of comparables.
The contribution analysis is not related to closely comparable transactions. It is based on an analysis of the functions performed, the risks and responsibilities undertaken, the assets used and the facts and circumstances of the transaction.
The contribution analysis is supplemented by external market data on the relative value of the comparable functions (not profits) of independent enterprises operating under similar facts and circumstances.
The result approximates the (operating) profit split between unrelated parties in a joint venture relationship. Under this method, both parties either make a profit or a loss. Some countries use it as a secondary method in cases involving comparatively low profits or continuing losses of a taxpayer.
The profit split differs from the global formulary apportionment or the unitary method used in the United States. The unitary method allocates the income of a multinational enterprise among its business units, using a predetermined formula or economic ratio.
The formula or ratio is derived from the various factors of production, e.g. labour employed, payroll costs, capital or assets employed, sales and property values, etc. This method is not based on the arm’s length principle.
It does not consider the facts and circumstances of the transaction or the functions within the enterprise or the group. The Guidelines do not approve the use of the unitary method for transfer pricing purposes.