<Portfolio 886-2nd: Transfer Pricing: The Code, the Regulations, and Selected Case Law>
 D. Benchmarking – The Best Method Rule, Comparability, and the Arm’s Length Range
o 1. The Best Method Rule
 a. In General –
 factors:
o The degree of comparability between controlled and
uncontrolled transactions;
o The quality of available data;
o The reliability of assumptions necessary to apply the
method;
o The sensitivity of results to deficiencies in the data or
assumptions used.
 c. Examples of the Best Method Rule
 Reg. §1.482-8(b) contains 18 examples
 E. The Comparable Profits and Profit Split Methods
o 1. Comparable Profits Method
 d. Selecting and analyzing the Comparable Parties
 (2) Functional and Risk Considerations: Because the PLIs used in
the CPM in general are based directly or indirectly on operating
profit comparisons, the regulations provide that comparability for
CPM purposes “is particularly dependent on resources employed
and risks assumed.”553 Different resources and risks are
associated with functional differences, and the regulations require
consideration of such differences. However, because operating
profit levels tend to be more similar throughout the economy
than are gross profit levels, the regulations provide that
reliability of results under the CPM is less dependent on
functional comparability than it is under the RPM and the cost
plus method. The regulations also note that product differences
have a much less significant impact on operating profit than on
gross profit, so that product comparability is less critical under the
CPM than under the RPM or the cost plus method.554
<Reg. 1.482-3 Methods to determine taxable income in connection with a transfer of tangible
property>
 (b) Comparable uncontrolled price method
o (2) Comparability and reliability consideration
 (ii) Comparability – (A) In General…. similarity of products generally will
have the greatest effect on comparability under this method. In addition,
because even minor differences in contractual terms or economic
conditions could materially affect the amount charged in an uncontrolled
transaction, … Further, if there are material product differences for which


reliable adjustments cannot be made, this method ordinarily will not
provide a reliable measure of an arm’s length result.
(c) Resale price method
o (1) In general…. The resale price method measures the value of functions
performed, and is ordinarily used in cases involving the purchase and resale of
tangible property in which the reseller has not added substantial value to the
tangible goods by physically altering the goods before resale. For this purpose,
packaging, repackaging, labelling or minor assembly do not ordinarily constitute
physical alteration.
o (3) Comparability and reliability considerations
 (ii) Comparability –
 (A) Functional comparability…. A reseller’s gross profit provides
compensation for the performance of resale functions related to
the product or products under review, including an operating
profit in return for the reseller’s investment of capital and the
assumption of risks…. comparability under this method is
particularly dependent on similarity of functions performed, risks
borne, and contractual terms, or adjustments to account for the
effects of any such differences. If possible, appropriate gross
profit margins should be derived from comparable uncontrolled
purchases and resales of the reseller involved in the controlled
sale, because similar characteristics are more likely to be found
among different resales of property made by the same reseller
than among sales made by other resellers.
 (B) Other comparability factors. Comparability under this method
is less dependent on close physical similarity between the
products transferred than under the comparable uncontrolled
price method…. Thus, it ordinarily would be expected that the
controlled and uncontrolled transactions would involve the
distribution of products of the same general type (e.g., consumer
electronics)…. Finally, the reliability of profit measures based on
gross profit may be adversely affected by factors that have less
effect on prices. For example, gross profit may be affected by a
variety of other factors, including cost structures (…the age of
plant and equipment), business experience (such as whether the
business is in a start-up phase or is mature,), or management
efficiency (as indicated, for example, by expanding or contracting
sales or executive compensation over time).
 (C) Adjustments for differences between controlled and
uncontrolled transactions…. For this purpose, consideration of
operating expenses associated with functions performed and
risks assumed may be necessary, because differences in functions
performed are often reflected in operating expenses.
(d) Cost plus method –
o (1) In general. The cost plus method evaluates whether the amount charged in a
controlled transaction is arm’s length by reference to the gross profit markup
realized in comparable uncontrolled transactions. The cost plus method is
ordinarily used in cases involving the manufacture, assembly, or other
production of goods that are sold to related parties.
<Section 1.482-5 Comparable profits method>
 (c) Comparability and reliability considerations.
o (2) Comparability
 (ii) Functional, risk and resource comparability. An operating profit
represents a return for the investment of resources and assumption of
risks. Therefore, although all of the factors described in Section 1.4821(d)(3) must be considered, comparability under this method is
particularly dependent on resources employed and risks assumed.
Moreover, because resources and risks usually are directly related to
functions performed, it is also important to consider functions performed
in determining the degree of comparability between the tested party
and an uncontrolled taxpayer. The degree of functional comparability
required to obtain a reliable result under the comparable profits
method, however, is generally less than that required under the resale
price or cost plus methods. For example, because differences in functions
performed often are reflected in operating expenses, taxpayers
performing different functions may have very different gross profit
margins but earn similar levels of operating profit.
 Gross profit: Net sales (Revenue) – COGS
 Operating profit: Gross profit – Operating expenses –
Depreciation & Amortization
 Operating margin has often been used when functions of the
tested party are only broadly similar but not close to those of the
comparables, since differences in functions have less effect on
operating profit than on gross profit.1
<Etc>
 As far as benefits go, the CPM is easier to implement because it relies on external
financial data that is accessed using various public data sources.2
 UN Practical Manual on Transfer Pricing
o The functions performed: The functional analysis describes the activities
performed such as design, purchasing, inbound logistics, manufacturing,
1
2
United Nations Practical Manual on Transfer Pricing (2021), 4.5.6.4
https://www.valentiam.com/newsandinsights/comparable-profits-method
research and development (R&D), assembling, inven- tory management,
outbound logistics, marketing and sales activities, after sale services, supporting
activities, services, advertising, financ- ing and management, etc. The functional
analysis must specify which party performs each activity and in case both parties
are involved in performing an activity it should provide for the relevant
differences; for example if both have inventories but Company A holds
inventories for a period of up to two years whereas Company B holds
inventories for a period of one month. The activities that add most value must
be identified and should be discussed in more detail.3
o 6.1.2.5. Interplay of above factors: Today, in a multinational group, operations
tend to be more integrated across jurisdictional boundaries and the functions,
risks and assets are often shared between entities in different jurisdictions. This
makes functional analyses both more difficult and more necessary. The
functional analysis can help identify which functions, risks and assets are
attributable to the various related parties. For example, the functional analysis
may reveal that one com- pany performs one particular function but the cost of
this is borne by the other party to the transaction. The functional analysis could
highlight that situation and consider the legal allocation of risk and the economic
substance of the transaction. Another example would be where a company
performs one particular function and bears the cost thereof but the benefit also
accrues to the other party to the trans- action. The functional analysis could
emphasize that situation and consider which party bears the risk in legal terms
and which party bears the risk according to the economic substance of the
transaction. The functional analysis typically includes a discussion of the industry
in which the tested party operates, the contractual terms of the transaction at
issue, the economic circumstances of the parties and the business strategies
they employ. The functional analysis helps to identify the operations that benefit
a related party and require an arm’s length return.4
o Sometimes it may be more reliable to choose the TNMM and compare net
profits. If, for example, there is different reporting of the cost of goods sold and
operating expenses for the tested party and the comparable distributors, so that
the gross profit margins reported are not comparable and reliable adjustments
cannot be made, the Resale Price Method may be relatively unreliable. However,
this type of accounting inconsistency will not affect the reliability of the TNMM,
as this method examines net profit margins instead of gross profit margins. 5
Also, as further discussed below, the fact that the TNMM requires less product
comparability than the traditional transaction methods (and as such has a
greater tolerance to product differences and cost accounting differences
compared to traditional transaction methods) can be a significant practical
benefit of using TNMM.
3
https://assets.kpmg/content/dam/kpmg/ua/pdf/2016/12/UN_Manual_TransferPricing%20(6).pdf
https://assets.kpmg/content/dam/kpmg/ua/pdf/2016/12/UN_Manual_TransferPricing%20(6).pdf
5
United Nations Practical Manual on Transfer Pricing (2021), 4.5.3.3
4