Transfer Pricing Methods
Seven short lessons, one per method. Each shows how the method works, the data it needs, and a worked example you can change.
What a method is
Related companies set prices between themselves. Tax rules say those prices must match what independent companies would agree, the Arm's length principleThe rule that related companies should price their dealings the way unrelated companies would in the same situation. It is the foundation of both Section 482 and the OECD Guidelines.Open in the Glossary. A transfer pricing method is a way to test that. Each method compares the deal between related companies with something from deals between unrelated ones: a price, a margin, or a split of profit.
Two families
Transactional methods
CUP, resale price and cost plus. They test the price itself, or a gross margin on the deal. They are the most direct tests, but need very close comparables and data booked the same way.
Price or gross marginProfit-based methods
The comparable profits method (CPM) and profit split. They test the profit that comes out of the deal. They can work with less exact comparables, and the CPM is the method used most often in practice.
Net profit or profit splitUS rules sort methods by what is transferred: goods (§ 1.482-3), intangibles (§ 1.482-4, where CUP becomes the Comparable uncontrolled transaction (CUT)The US method for intangibles that compares the royalty in a related-party license with the terms of a comparable license between unrelated parties (Treas. Reg. § 1.482-4(c)). It is the intangibles version of CUP.Open in the Glossary) and services (§ 1.482-9, with its own versions and the Services cost methodA US option to charge certain routine support services at cost with no mark-up. It covers services on the IRS list (Rev. Proc. 2007-13) and services whose usual mark-up is 7% or less, but not excluded work such as R&D or manufacturing, and not services that are key to the business's success (Treas. Reg. § 1.482-9(b)).Open in the Glossary). The CPM and profit split work for all three.
Which method? Two rules, one idea
US: the Best method ruleThe US rule that the arm's length result must be set using the method that gives the most reliable measure on the facts. There is no strict order of methods (Treas. Reg. § 1.482-1(c)).Open in the Glossary
Use the method that gives the most reliable measure on the facts. There is no strict order. Two things decide it: how comparable the outside data is, and how complete and accurate that data and its assumptions are.
Treas. Reg. § 1.482-1(c)OECD: the most appropriate method
Pick the most appropriate method for the case, weighing each method's strengths and weaknesses, the facts from the FAR (functions, assets, risks)The analysis of what each company does, what it owns, and what risks it bears. It decides which entity is routine and which is the principal, and drives method selection.Open in the Glossary and the data available. If two methods are equally reliable, prefer a traditional method over a profit method, and CUP over the rest.
OECD Guidelines, paras 2.2 and 2.3In practice both land in the same place most of the time.
The seven lessons
0 of 7 done
- CUP: Comparable Uncontrolled PriceTransactionalCompare Mexico Plant's resin price with what unrelated factories pay, take out freight, and see how much profit moves. Plus internal vs external CUPs.7 min
- Resale Price MethodTransactionalUse it for a distributor that resells without changing the goods: resale price less an arm's length gross margin.7 min
- Cost Plus MethodTransactionalUse it for a maker or service provider: its costs plus an arm's length gross markup.7 min
- CPM and TNMMProfit-basedThe workhorse: test the simpler company's net profit against comparable companies.8 min
- Profit SplitProfit-basedUse it when both sides bring something unique: split the combined profit by what each contributes.7 min
- CUT: Pricing a RoyaltyIntangiblesUse it for a license of a patent: start from the royalty an outsider pays for the same patent, then adjust for differences such as exclusivity.7 min
- Intra-Group ServicesServicesUse it for support services such as payroll and IT: who pays, and at cost or cost plus 5%.7 min
The methods side by side
| Method | Tests | Needs | Typical use |
|---|---|---|---|
| CUP | The price itself | Prices in comparable deals between unrelated parties | Commodities, the same goods sold to outsiders |
| Resale price | The reseller's gross margin | Gross margins of comparable resellers, with costs booked the same way | Distributors that resell without changing the goods |
| Cost plus | The gross markup on the maker's costs | Markups of comparable makers, with the same cost base | Contract makers, simple services |
| CPM | The tested party's net profit | Operating results of comparable companies | Routine distributors, makers and service providers |
| Profit split | How the combined profit is shared | The combined profit and what each side contributes | Both sides bring something unique |
| CUT | The royalty or price for an intangible | Royalties in comparable licenses | Licenses of patents, brands and know-how |
| Services cost method | Whether a routine service may be charged at cost | The cost of the service and who benefits | Payroll, accounting, IT support |
CUP
- Tests
- The price itself
- Needs
- Prices in comparable deals between unrelated parties
- Typical use
- Commodities, the same goods sold to outsiders
Resale price
- Tests
- The reseller's gross margin
- Needs
- Gross margins of comparable resellers, with costs booked the same way
- Typical use
- Distributors that resell without changing the goods
Cost plus
- Tests
- The gross markup on the maker's costs
- Needs
- Markups of comparable makers, with the same cost base
- Typical use
- Contract makers, simple services
CPM
- Tests
- The tested party's net profit
- Needs
- Operating results of comparable companies
- Typical use
- Routine distributors, makers and service providers
Profit split
- Tests
- How the combined profit is shared
- Needs
- The combined profit and what each side contributes
- Typical use
- Both sides bring something unique
CUT
- Tests
- The royalty or price for an intangible
- Needs
- Royalties in comparable licenses
- Typical use
- Licenses of patents, brands and know-how
Services cost method
- Tests
- Whether a routine service may be charged at cost
- Needs
- The cost of the service and who benefits
- Typical use
- Payroll, accounting, IT support