Transfer pricing happens whenever 2 companies that
are part of the same multinational group trade with each other: when a US-based
subsidiary of TATA Group, for example, buys something from a India-based
subsidiary of TATA Group. When the parties establish a price for the
transaction, this is transfer pricing.
Transfer pricing is not, in itself, illegal or
necessarily abusive. What is illegal or abusive is transfer mis pricing, also
known as transfer pricing manipulation or abusive transfer pricing.
The
Arm’s Length principle
If 2 unrelated companies trade with each other, a
market price for the transaction will generally result. This is known as
“arms-length” trading, because it is the product of genuine negotiation in a
market. This arm’s length price is
usually considered to be acceptable for tax purposes.
But when 2 related companies trade with each other,
they may wish to artificially distort the price at which the trade is recorded,
to minimize the overall tax bill. This might, for example, help it record as
much of its profit as possible in a tax haven with low or zero taxes.
Transfer
Pricing Methodology
Following is a short summary of several applicable
methods:
- Comparable Uncontrolled Price Method- The comparable uncontrolled price (“CUP”) method compares prices charged in controlled transactions with prices charged in comparable transactions with third parties. Comparable sales may be between two third parties or between one of the related parties and a third party. The CUP method is generally the most reliable measure for arm’s length results, if the transactions are identical or if only minor, readily quantifiable differences exist.
- Resale Price Method- The resale price method (“RPM”) evaluates whether the amount charged in a controlled transaction is at arm’s length, by reference to the gross margin realized in comparable uncontrolled transactions. Under this method, the arm’s length price is measured by subtracting an appropriate gross profit from the applicable resale price of the property involved in the controlled transaction. The resale price method is most often used for distributors that resell products without physically altering them or adding substantial value to them.
- Cost plus Method- The cost plus method compares gross margins of controlled and uncontrolled transactions. Under this method, the arm’s length price is measured by adding an appropriate gross profit to the controlled taxpayer’s cost of producing the property involved in the controlled transaction. The cost plus method is most often used to assess the markup earned by manufacturers selling to related parties.
- Profit Split Method- The profit split method allocates operating profits or losses from controlled transactions in proportion to the relative contributions made by each party in creating the combined profits or losses. Relative contributions must be determined in a manner that reflects the functions performed, risks assumed, resources employed, and costs incurred by each party to the controlled transaction.
- Comparable Profits Method- The comparable profits method (“CPM”) evaluates whether the amount charged in a controlled transaction is at arm’s length by comparing the profitability of one of the parties to the controlled transaction (the “tested party”) to that of companies that are similar to the tested party. The Transactional Net Margin Method (acceptable in Europe and in the OECD guidelines) is a method similar to the CPM.