Transfer pricing methods

Overview of Transfer Pricing Methods

method comparable pricing data perspective advantages problems/things to consider

CUP (Comparable Uncontrolled Prices) price of comparable products transaction specific products both buyer and seller (supplier) -favored under old (and also current?) Sec. 482 by IRS: most objective evidence.
-uses results that are clearly the product of direct nego between independent parties.
-seemingly simple to implement in that it consists of taking a price observed.
-promote divisional evaluation and structure.
-useful in litigation and competent authority nego. --lack of the detailed data on specific transactions needed for CUP versus restrictive reg.
-perfect competition (i.e., a lot of substitutes: commodity, very little discretion over price) under economic model does not fit into MNCs' behavior.
- similarity of the economic circumstances.
e.g. systematic factors, different geographic markets
-most often used by U.S. firms.

RPM
(Resale Price Method)
gross margin (full cost or variable cost as a markup criterion). a mix of different products or a number of transactions covering the same product¹ buyer only² -may be able to use Berry Ratio, thus broaden the range of comparables.
-may be used as a surrogate for divisional profit for purposes of a profit split.
-do not need the detailed data on specific transactions.
-may be used by IRS audits. -no direct analogue under economic, accounting or managerial model.
-benchmarks for determining gross margin
-sales price covers COS, operating expenses, capital costs, etc.³
-accounting classification

Cost Plus Method mark-up (implies full cost plus margin) a mix of different products or a number of transactions covering the same product seller (supplier) only -do not need the detailed data on specific transactions. -seemingly the equivalent of economic MC which is VC + markup; however, here it is implied that IRS allows only full cost pricing....?: ignore the role of VC + markup pricing structure.
-benchmarks for determining mark-up (cost plus margin)
-generally good for manufacturing....
-seems to ignore the existence of manufacturing scale of economy, etc., and associated transfer pricing behavior by MNCs.
- reliable data and assumptions particularly emphasized by IRS.
-accounting classification

Profit Split Method⁴ 1. comparable profit split
2. residual profit split method⁵
both buyer & seller (?) -good for situation where each of entities involved contributes substantial intangibles to the transaction(s).⁶
-"memo credit back" may be allowed.
-usually occurs when VC or VC + markup is employed with some reallocation of FC. -seems to be negatively viewed by IRS as a "formulary method".
-which profit to split?
-share of total profit to be realized between each entity: 50:50 or what?
-timing of income and expenses.
-determination of the boundaries of the business activities at issues
-popular in Japan.

CPM (Comparable Profit Method) operating margin -can compare between companies with different levels of operating expenses
-IRS continues to employ this general methodological approach.
-less rigorous comparability standards, thus may potentially apply in many cases.

^1. Therefore, these two (i.e., Retail and Cost Plus methods) generally do not require the collection of detailed product specific data on arm's length comparables.
^2.All residual profits (or losses) are placed with the supplying location. under the RPM method. In contrast, all residual profits (or losses) are placed with the purchasing location under the Cost Plus Method.
^3.distributorship: business that buys products solely for the purpose of reselling those products at a profit.
^4.Consolidated profit of the entities involved is split between them.
^5.Another way of split would be by relative capital inputs...
^6.Intangibles are difficult to measure, thus the most intuitive solution is to simply split the resultant profit.

Source: BNA Tax Management Portfolio No. 889, Chs. 4 and 5.

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method	comparable	pricing data	perspective	advantages	problems/things to consider
CUP (Comparable Uncontrolled Prices)	price of comparable products	transaction specific products	both buyer and seller (supplier)	-favored under old (and also current?) Sec. 482 by IRS: most objective evidence. -uses results that are clearly the product of direct nego between independent parties. -seemingly simple to implement in that it consists of taking a price observed. -promote divisional evaluation and structure. -useful in litigation and competent authority nego.	--lack of the detailed data on specific transactions needed for CUP versus restrictive reg. -perfect competition (i.e., a lot of substitutes: commodity, very little discretion over price) under economic model does not fit into MNCs' behavior. - similarity of the economic circumstances. e.g. systematic factors, different geographic markets -most often used by U.S. firms.
RPM (Resale Price Method)	gross margin (full cost or variable cost as a markup criterion).	a mix of different products or a number of transactions covering the same product¹	buyer only²	-may be able to use Berry Ratio, thus broaden the range of comparables. -may be used as a surrogate for divisional profit for purposes of a profit split. -do not need the detailed data on specific transactions. -may be used by IRS audits.	-no direct analogue under economic, accounting or managerial model. -benchmarks for determining gross margin -sales price covers COS, operating expenses, capital costs, etc.³ -accounting classification
Cost Plus Method	mark-up (implies full cost plus margin)	a mix of different products or a number of transactions covering the same product	seller (supplier) only	-do not need the detailed data on specific transactions.	-seemingly the equivalent of economic MC which is VC + markup; however, here it is implied that IRS allows only full cost pricing....?: ignore the role of VC + markup pricing structure. -benchmarks for determining mark-up (cost plus margin) -generally good for manufacturing.... -seems to ignore the existence of manufacturing scale of economy, etc., and associated transfer pricing behavior by MNCs. - reliable data and assumptions particularly emphasized by IRS. -accounting classification
Profit Split Method⁴	1. comparable profit split 2. residual profit split method⁵		both buyer & seller (?)	-good for situation where each of entities involved contributes substantial intangibles to the transaction(s).⁶ -"memo credit back" may be allowed. -usually occurs when VC or VC + markup is employed with some reallocation of FC.	-seems to be negatively viewed by IRS as a "formulary method". -which profit to split? -share of total profit to be realized between each entity: 50:50 or what? -timing of income and expenses. -determination of the boundaries of the business activities at issues -popular in Japan.
CPM (Comparable Profit Method)	operating margin			-can compare between companies with different levels of operating expenses -IRS continues to employ this general methodological approach. -less rigorous comparability standards, thus may potentially apply in many cases.