TRANSFER PRICING CASE STUDIES
WORKSHOP
SAN JOSE
31 MARCH - 4 APRIL 2014
3-b. Transfer Pricing Methods
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official views of the OECD or of the governments of its member countries.
1
5 TRANSFER PRICING METHODS
OECD Recognised methods
TRADITIONAL TRANSFER PRICING METHODS
•Comparable Uncontrolled Price (CUP) method
•Cost-plus method
•Resale price method
TRANSACTIONAL PROFIT METHODS
•Transactional Net Margin Method (TNMM)
•Profit Split Method
 Contribution Analysis
 Residual Analysis
2
TRADITIONAL
TRANSACTION METHODS
3
CUP METHOD
• Preferred method because it is the “most
direct and reliable way to apply the arm’s
length principle” (OECD TP Guidelines,
para. 2.14)
• Focus on product
• Can reliable adjustments be made for
differences?
4
CUP METHOD
• The market price for comparable goods, services
and loans between independent companies
• Difficulties in finding comparables:
– Goods or Services
– Market (ex. geographical differences)
– Market-level (wholesale or retail)
• If no exact comparables 
adjustments for the differences
comparability
• Method can best be used for commodities, raw
material, agricultural products, chemical base
products, financial products
5
Example
Facts of the Case
A wine producer in France sells champagne to its
associated wholesaler (distributor) in Costa Rica. Under
the contractual arrangement made with the associated
wholesaler, delivery is ex factory
The associated Costa Rican wholesaler
transportation costs of 1.50 EUR per bottle.
incurs
6
Example
Facts of the Case (continued)
The same producer sells the same champagne to an
independent Costa Rican wholesaler for 5 € per bottle. In
the contractual arrangement with the independent
wholesaler, delivery is c.i.f. (cost, insurance, and freight
included, i.e. the seller arranges for the carriage of the
goods and bears the transportation costs).
The other circumstances are the same for the associated
wholesaler and the independent wholesaler. The
associated and the independent wholesaler sell the
champagne to independent retailers at 12.50 € per bottle.
7
Example
Associated
Wholesaler
Costa Rica
Champagne
Producer France
Independent
Wholesaler
Costa Rica
12.50
EUR
12.50
EUR
Retailer
Costa
Rica
Retailer
Costa
Rica
The associated wholesaler incurs transportation costs of 1.50 EUR.
The independent wholesaler incurs no transportation costs.
8
Case 1
Questions
1. Which factors should be taken into account in
determining the arm’s length transfer price?
2. What is the arm’s length transfer price?
9
Example
Purchase price paid by independent wholesaler
5.00
Comparability adjustment to account for difference in
functions and risk (transportation) between associated - 1.50
wholesaler and independent wholesaler
Arm’s length transfer price
3.50
• The example shows that the associated wholesaler
and the independent wholesaler incur the same
costs of goods sold (COGS) of EUR 5 (EUR 3.50
purchase price plus EUR 1.50 transportation costs
equals EUR 5).
10
COST PLUS METHOD
Tested Party
Third Party
Supplier
Multinational
Enterprise Group
Transfer
price
Manufacturer
Costs at
arm’s length
Gross profit
mark-up
=
Distributor
Transfer
Price
• Calculate gross profit mark-up for manufacturer
• Easiest to apply for
– Semi-finished goods
– Services
11
COST PLUS METHOD
P&L Account
Sales
Costs of Goods Sold
• Gross profit level indicator
• Looks at gross profit relative
to costs of goods sold
Gross Profit
Operating Expenses
Net Operating Income
12
COST PLUS METHOD
Calculation of Arm’s length price (ALP):
ALP = Costs + (Cost Plus Mark-up x Costs)
Cost Plus Mark-up = Sales Price - Costs
Costs
13
COST PLUS METHOD
Example:
Manufacturing Costs
Gross Profit Mark-up
$ 100
10%
Determined
from
comparable
companies
Arm’s length price = $ 100 + ($100 x 10%)
= $ 110
14
DIFFICULTIES APPLYING THE
COST PLUS METHOD
• Measurement of cost base:
– Direct costs
– Indirect costs
• Adjust for inconsistencies in accounting
treatment!
• The size of the mark-up
• If applied on full cost basis  company
always profitable (unrealistic)
15
Example
Facts of the case:
• In this case, the French wine producer (the principal) of
case 1 decides to incorporate a new subsidiary in Costa
Rica which shall act as a toll manufacturer. The
production costs incurred by the Costa Rican toll
manufacturer amount to 1.6 € per bottle of white wine.
The Costa Rican toll manufacturer also incurs
transportation costs (transport is done by an
independent enterprise) of 1.50 € per bottle on behalf of
the principal. What is the arm’s length price if you know
that independent champagne toll manufacturers would
earn a 25 percent gross mark up on costs.
16
Example
What is the arm’s length price?
Alternative 1: 1.6 + 0.4 (25 % on 1.6) = 2
Or
Alternative 2: 1.6 + 1.5 + 0.4 (25 % on 1.6) =
3.5
Or
Alternative 3:1.6 + 1.5 + 0.78 (25 % on 3.1 (1.6
+ 1.5)) = 3.88
17
RESALE PRICE METHOD
Tested Party
Transfer
Price
Manufacturer
Distributor
Multinational
Enterprise Group
Sales Price to
Third Party Third Party
Customer
Sales Price to 3rd Party
- Gross Profit Margin
Transfer Price
• Calculate gross margin for distributor/reseller
• Easiest to apply if reseller does not add
substantially to value of product
18
RESALE PRICE METHOD
P&L Account
Sales
Costs of Goods Sold
• Gross profit level indicator
• Looks at gross profit relative
to sales
Gross Profit
Operating Expenses
Net Operating Income
19
RESALE PRICE METHOD
Calculation of Arm’s length price (ALP):
ALP = Resale Price - (Resale Price Margin x Resale Price)
Resale Price Margin = Sales Price - Purchase Price
Sales Price
20
RESALE PRICE METHOD
Sale Price to Third Parties $ 100
Resale Price margin
20%
Determined
from
comparable
companies
Arm’s length price = $ 100 - (20% x $100)
= $ 80
21
DIFFICULTIES APPLYING THE
RESALE PRICE METHOD
• Reseller employs reasonably valuable
and possibly unique intangibles
• Reseller adds significant value to
product
• Exclusive license
22
Example
Facts of the Case
This case is based on the situation in case 1 on the CUP method.
In this case, however, the associated wholesaler is the French
wine producer’s exclusive distributor in Costa Rica. Under the
contractual arrangement made with the associated wholesaler,
delivery is ex factory. The associated wholesaler incurs
transportation costs of 1.50 € per bottle. The champagne is sold
to independent retailers at 12.50 € per bottle.
23
Example
Facts of the Case (continued)
A competitor sells champagne to an independent
wholesaler in Costa Rica for 6 EUR per bottle. Delivery is
c.i.f. This champagne is sold to independent retailers at
15.00 € per bottle. The other circumstances are the same
for the associated wholesaler and the independent
wholesaler.
24
Example
Champagne
Producer France
Independent
Champagne
Producer France
(controlled) transaction
Transfer Price?
Associated 12.50 € Retailer
Wholesaler
Costa
Costa Rica
Rica
(uncontrolled) transaction
Independent
Sales Price 6 EUR
Wholesaler
Costa Rica
15 €
Retailer
Costa
Rica
The associated wholesaler incurs transportation costs of 1.50 €.
The independent wholesaler incurs no transportation costs.
25
Example
Questions
1. Which factors should be taken into account in
determining the arm’s length transfer price?
2. Which company should be selected as tested party
and why?
3. What is the arm’s length transfer price?
26
Example
Solution
Retail price charged by independent wholesaler
15.00
100%
Purchase price paid by independent wholesaler
- 6.00
- 40%
9.00
60%
Retail price charged by independent wholesaler
15.00
100%
Purchase price paid by independent wholesaler
- 6.00
- 40%
Adjustment for CIF – FOB12% of sales price
+1.80
+12%
Gross profit / margin of the independent wholesaler
10.80
72%
Gross profit / margin of the independent wholesaler
27
Example
Calculating the AL price
Retail price charged by dependent wholesaler
12.50
100%
Purchase price paid by dependent wholesaler
TP
???
???
???
Retail price charged by dependent wholesaler
12.50
100%
Purchase price paid by dependent wholesaler
3.50
- 28%
Gross profit / margin of the dependent wholesaler
9.00
72%
Gross profit / margin of the dependent wholesaler
28
TRANSACTIONAL PROFIT
METHODS
29
5 TRANSFER PRICING METHODS
OECD recognised methods
TRADITIONAL TRANSFER PRICING
METHODS
•Comparable Uncontrolled Price (CUP) method
•Cost-plus method
•Resale price method
TRANSACTIONAL PROFIT METHODS
•Transactional Net Margin Method (TNMM)
•Profit Split Method
 Contribution Analysis
 Residual Analysis
30
What is a “profit method”?
• Uses net profitability to judge transfer
pricing
• Must be transactional
– Total profit comparisons can only be used to select cases
but not to examine them
31
What is “net”?
• “Net” profit is gross profit (sales minus
cost of goods sold/manufactured) less
operating expenses
• Operating expenses exclude
– Extraordinary expenses;
– Interest; and
– Taxes
• EBIT = Earnings Before Interest and Taxes
32
Two types of profit methods
• Transactional Net Margin Method (TNMM)
and
• Profit Split
• Last resort status : removed
33
Transactional Net Margin Method
(TNMM)
• Guidelines 2.58
– “[TNMM] examines the net profit margin relative to an
appropriate base (e.g. costs, sales, assets) that a taxpayer
realizes from a controlled transaction….
– Must be applied in a manner consistent with resale price/ cost
plus method
34
TNMM: Comparability Analysis (I)
• What factors influence net profit?
– May be affected by factors unrelated to transfer prices
• Examine
expenses
factors
affecting
operating
– Management efficiency
– Competitive position
– Business experience
– Varying cost structures
35
TNMM: Comparability Analysis (II)
• Measurement must be consistent
– Items included in calculating net profit
– Timing (e.g. depreciation/ amortization)
– Allocation (e.g. overhead, R&D, supervisory, general &
administrative)
– Aggregation (across products/ businesses)
36
TNMM compared to cost plus/
resale price method
• Cost Plus/Resale Price methods use gross
margins computed after direct and indirect
production/selling costs
– no clear line, allowing for some variation in practice, but
generally excludes most operating expenses
– e.g. selling, general, and administrative expenses would be
excluded
• TNMM is a fully net method; net margin
computed after all operating expenses
(except extraordinary items, interest and
taxes)
37
Choosing the right net margin (1)
• Net profit over sales
– useful for distribution, e.g., functions where personnel
rather than capital assets are important to the business
– resale price method analogue
38
TNMM compared to RP METHOD
P&L Account
• Operating income level
indicator
Sales
Costs of Goods Sold
• Looks at operating income
relative to sales
Gross Profit
Operating Expenses
Net Operating Income
39
Choosing the right net margin (2)
• Net profit over costs
– useful for manufacturing
– measurement consistency may be difficult
– cost plus analogue
40
TNMM compared to CP METHOD
P&L Account
• Operating income level
indicator
Sales
Costs of Goods Sold
• Looks at operating income
relative to all expenses
Gross Profit
Operating Expenses
Net Operating Income
41
Choosing the right net margin
• Net profit to assets
– Asset intensive (certain manufacturing activities) and
capital intensive financial activities
– Operating assets only (tangible, intangible and working
capital assets such as inventory and trade receivables)
42
Choosing the right net margin
• Other net indicators
– Case by case
– Floor area of retail points, weight of product transported,
number of employees, time, distance, …
43
Choosing the right net margin
• Berry ratios
– GP/OE
– Case by case
– Sensitive to classification of costs
– Value of functions must be proportional to operating expenses
– Value of functions is not materially affected by the value of the
product
– Function do not include other functions that should be rewarded
using another method or indicator
– May be useful for intermediary activities
44
Choosing the right net margin - Berry ratio
P&L Account
• Operating income level
indicator
Sales
Costs of Goods Sold
• Looks at gross profit to
operating expenses
Gross Profit
Operating Expenses
Net Operating Income
45
Example TNMM: Assumptions
• P and S are associated enterprises in different
countries; P owns S
• P manufactures X, a home video game
• S imports X and distributes it under P’s name on the
wholesale level
• P makes all its sales of X to associated enterprises
that are exclusive distributors for their geographic
markets.
• You are the tax inspector of S
• Assume TNMM is the Most Appropriate Method to
the Circumstances of the Case
46
EXAMPLE: Don’t forget a functional
analysis!
P
S
A
B
manufactures X
imports and distributes X
C
independent retailers
47
Financial data Company S
Sales
COGS
Operating
Expenses
Operating
Income
Margin
2009
80000
-65000
2010
88000
-71500
2011
105000
-88000
-10000
-11250
-14500
5000
5250
2500
6.25%
5.97%
2.38%
48
Return on sales (net profit margin)
of comparables
Company
Company
Company
Company
Company
Range
Company
1
2
3
4
5
2009
5.80%
8.30%
3.90%
4.50%
6.70%
2010
5.60%
8.15%
4.25%
4.65%
6.45%
3.90% - 8.30% 4,25% - 8,15%
S
In/Out Range
2011
5.70%
8.20%
4.05%
4.60%
6.55%
4,05% - 8,20%
6,25%
5,97%
2,38%
IN
IN
OUT
49
EXAMPLE: What to do now?
• 2011 not in range
• Find an appropriate comparable margin
from year under audit (2011)
• Apply the margin to determine proper
level of operating profit
• Calculate arm’s length price
50
EXAMPLE: Make the adjustment
• Suppose all 5 uncontrolled transactions are
equally comparable → average: 5.82%
• Then net profit of S becomes: 5.82% of
105.000 = 6,111
51
Profit Split Method
• Each of the parties contribute unique
intangibles or assume unique risks
• Only 2-sided method
• Also a transactional method
• 2 types of profit split method
– Contribution Analysis
– Residual Analysis
52
Contribution analysis
• Compute combined net profit
• Examine functions
• Determine relative value (value added)
– some factors : expenses incurred, assets used, payroll
• Examine external data
• Assign a profit split percentage
53
Residual analysis (1)
2-step approach
• Compute combined net profit of associated enterprises
• Examine functions performed (routine and non-routine)
1.Step
Use other methods (CUP, Cost Plus, Resale Price, TNMM) to
assign basic return to each (routine) function of each company
– often can assign profit from activities not involving significant intangible
property
– examples: distribution function (resale price); manufacturing function (cost
plus), possibly some TNMM applications
54
Residual analysis (2)
2-step approach
2. Step
Divide residual profit according to a
contribution analysis
– R&D and/or marketing expenditures may be relevant
55
Residual Profit Split Method
Example
Parts, Patents &
Know-how
Parent Company X
R&D
Company Y
Retailers
Production &
Advertisement
56
Residual Profit Split Method
Example
Assumptions
•
•
•
•
•
•
•
Company X’s reported profit on the transaction: 40
Company Y’s reported profit on the transaction: 60
Total profit: 100
Company X’s basic profit: 8
20
Company Y’s basic profit: 12
Residual Profit: 80
Contribution factors & split percentages
Company X (R&D): 70%
Company Y (Production & Advertisement): 30%
57
Residual Profit Split Method
Example
Comp
any
Functions
Profit
Reported
Basic
Profit
Residual
Allocation
Adjusted
profit
X
R&D
40
8
70%X80 = 56
64
Y
Production &
Advertisement
60
12
30%X80 = 24
36
100
20
80
100
Total
58
Profits: anticipated versus actual (1)
• When taxpayer has used profit split method,
tax examiner should begin on same basis,
considering what taxpayer would have
known or reasonably projected.
• Careful to avoid relying on hindsight!
59
Profits: anticipated versus actual (2)
• When taxpayer did not use profit split, tax
examiner would evaluate pricing based on
actual profit, with caution to avoid
hindsight.
• Actual profit split by a taxpayer may prompt
an investigation
60
Cautions
• Difficulties in determining combined net
profit
– need consistency in measurement, accounting
– difficulty in allocating costs, operating expenses
• Attention to risks assumed
• Substance of contribution, not form
61
When to use Profit Split?
• When both enterprises make use of
intangibles / unique valuable contributions
• When functions of both enterprises are highly
integrated
• Suitable in context of Advance Pricing
Arrangements
• Not used :
– Only simple functions
– No significant unique contributions
62
SELECTION OF THE MOST
APPROPRIATE
TRANSFER
PRICING METHOD TO THE
CIRCUMSTANCES OF THE
CASE
63
The OECD transfer pricing methods
• The 1995 OECD TPG establish a preference for
the
traditional
methods
(comparable
uncontrolled price, resale price and cost plus
methods); profit methods are considered as “last
resort” methods, to be used only in the
exceptional cases where there are no or
insufficient data available to rely solely or at all
on the traditional methods.
• In practice however, profit methods (TNMM
and profit split method) are widely used.
64
The OECD transfer pricing methods
• Remove the exceptionality and replace it with a
standard whereby the selected transfer pricing
method should be “the most appropriate
method to the circumstances of the case”
65
Selection of the most appropriate method to
the circumstances of the case
• Based on 4 criteria
¶¶ 2.1-2.9
– Respective strengths and weaknesses of each of the
OECD TP methods;
– Appropriateness of the method in view of the nature
of the controlled transaction, determined in
particular through a functional analysis;
– Availability of reasonably reliable information (in
particular on uncontrolled comparables) to apply
the selected method or other methods
– Degree of comparability, including reliability of any
comparability adjustments needed
66
Selection of the most appropriate method
to the circumstances of the case
• Where, taking account of the criteria in ¶ 2.1:
– The CUP and another transfer pricing method
can be applied in an equally reliable manner 
CUP method is to be preferred
– A traditional transaction method and a
transactional profit method can be applied in an
equally reliable manner  the traditional method
is preferred
67
Selection of the most appropriate method to
the circumstances of the case
Other methods:
¶2.9
• MNE groups retain the freedom to apply methods not
described in the TP Guidelines (hereafter “other
methods”) to establish prices provided those prices
satisfy the arm’s length principle in accordance with
these Guidelines.
• Such other methods should however not be used in
substitution for OECD-recognised methods where the
latter are appropriate to the facts and circumstances of
the case  use of “other methods” needs to be justified
The arm’s length principle does not require the
application of more than one method
¶ ¶ 2.11
68
OECD Transfer Pricing Methods:
Strengths and Weaknesses of Each Method
Comparable Uncontrolled Price Method (CUP)
Strengths
Weaknesses
• Very high degree of
• Most direct and
comparability required
reliable way to apply
the arm’s length
• In practice, often
principle
difficult to find
uncontrolled
transactions similar
enough such that no
differences have a
material effect on the
price
Best applied
• Where the same product is
bought/sold under comparable
circumstances from/to the
associated enterprise &
independent enterprise(s)
(internal comparable)
• Where an independent
enterprise buys/sells the same
product as the associated
enterprise in comparable
circumstances
(external comparable)
• For some commodities and
some financial transactions
69
Strengths and Weaknesses
Cost Plus Method
Strengths
• Since there is a greater
focus on functions
performed, less product
comparability required
compared with CUP
method, i.e. product
differences are less likely
to have material effect on
cost plus margin than on
price.
Weaknesses
Best applied to
• Not always discernible link • Service Providers
between costs incurred
and arm’s length prices / • Contract manufacturer,
in particular of semiprofit margins
finished goods
• In practice, often difficult
to determine appropriate • Contract R&D
cost base (i.e. cost base
must be comparable)
• Accounting consistency
important for
comparability purposes
70
Strengths and Weaknesses
Resale Price Method
Strengths
Weaknesses
Best applied to
• Gross profit margins are affected by • Marketing
• Since there is a
management efficiency, etc which
greater focus on
operations (not
may have an impact on profitability
functions performed,
adding significant
but not on the price of the goods or
less product
value)
services.
comparability
required compared
• Accounting consistency important for
with CUP method, i.e. comparability purposes.
product differences
• Resale price method difficult to use
are somewhat less
when the reseller adds substantial
likely to have
value, eg by further processing goods
material effect on
before resale or contributing to the
resale price margin
creation or maintenance of
than on price.
intangibles associated with the
product (e.g. trademarks, trade
71
names).
Strengths and Weaknesses
TNMM
Strengths
• Net profit indicators (e.g.
return on assets, operating
profit to sales, etc.) are less
affected by transactional
differences than price.
• Net profit indicators may be
more tolerant to some
functional differences than
gross profit margins.
• Net profit indicators avoid
problem of lack of clarity in
public data as regards the
classification of expenses
above or below the gross
profit line.
Weaknesses
• Net profit indicator can be
influenced by factors that
may not have a significant
effect on price or gross
margins, making accurate
and reliable
determinations of arm’s
length net profit indicators
difficult.
• Taxpayers may not have
access to enough timely,
specific information on
the net profits
attributable to
comparable uncontrolled
transactions.
Best applied
Cost Plus Analogue:
•(Contract)
Manufacturer
•Service Provider not
adding significant
unique intangibles
Resale Price Analogue:
•Distributor not adding
significant value to the
product
Asset Based TNMM:
•Manufacturer if
reasonably reliable
comparables for Cost
Plus or cost based 72
Strengths and Weaknesses
Profit Split (1)
Strengths
Weaknesses
• Offers flexibility by
taking into account
specific, possibly
unique, facts and
circumstances of the
associated
enterprises that are
not present in
independent
enterprises.
• Often difficult to have access to
information from foreign affiliates,
especially where the foreign
affiliate is the parent company or a
sister company rather than a
subsidiary of the taxpayer
• Tends to rely less on
information about
independent
enterprises
Best applied to
•Transactions where
both parties make
unique and valuable
contributions (e.g.
intangibles) to the
transaction
• Difficult to measure combined
profits for all the associated
enterprises participating in the
controlled transactions, which
would require stating books and
records on a common basis and
making adjustments in accounting
practices and currencies.
73
Strengths and Weaknesses
Profit Split (2)
Strengths
Weaknesses
• Less likely that either party • When applied to operating
profit, it may be difficult to
to the controlled
identify the appropriate
transaction is left with an
operating expenses
extreme and improbable
associated with the
profit result, since both
transactions and to allocate
parties to the transaction
costs between the
are evaluated.
transactions and the
• Two-sided approach may
associated enterprises'
also be used to achieve a
other activities.
division of the profits from
economies of scale or
other joint efficiencies that
satisfies both the taxpayer
and tax administrations.
Best applied to
•Highly integrated
transactions, e.g. global
trading of financial
instruments
74
Selection of the most appropriate method to the circumstances of the case:
If CUP and another method can be
applied in an equally reliable
manner
 CUP
If not:
Where one party to the transaction  One sided method
performs benchmarkable functions  Choice of the tested party (seller / purchaser)
(e.g. manufacturing, distribution,
services) with no valuable, unique
intangible asset / risk
The tested party is the seller
(e.g. contract manufacturing
or provision of services)
 Cost plus
 Cost based TNMM
 Asset based TNMM
 If Cost plus and TNMM
can be applied in an
equally reliable manner:
Cost plus
The tested party is the buyer
(e.g. marketing / distribution)
 Resale price
 Sales based TNMM
 If Resale price and
TNMM can be applied in
an equally reliable
manner: Resale price
Where each of the parties to the
transaction contribute valuable
unique intangibles / risks
 Two-sided method
 Profit split
75
Appropriateness of the method in view of the
nature of the controlled transaction (functional
analysis)
¶2.109
• Transactional profit split method would ordinarily
not be used in cases where one party to the
transaction performs only simple functions and does
not make any significant contribution
• E.g. contract manufacturing or contract service
activities in relevant circumstances (even though it
may be difficult sometimes to find comparables)
76
Questions and/or
comments?