Transfer pricing is a vital concept in the tax and accounting strategies of multinational companies. It involves determining fair prices for goods, services, or intellectual property exchanged between companies within the same group. In this blog, we’ll break down the basics of transfer pricing, explore key methods, and share tips for effective management.

What is Transfer Pricing?

Transfer pricing refers to the method by which one company within a multinational group charges another for goods or services. For example, if a parent company owns both a manufacturer and a distributor, the pricing for their internal transactions must be fair to ensure compliance with tax laws and avoid penalties.

Global rules, such as those from the OECD (Organisation for Economic Co-operation and Development), require companies to follow the arm’s length principle. This principle states that prices between related companies should reflect what independent businesses would agree to in a free market.

Five Main Methods of Transfer Pricing

Here’s a simplified explanation of the primary transfer pricing methods, including their uses, pros, and cons:

1. Comparable Uncontrolled Price (CUP) Method

• Description: This method compares the prices charged between related companies to those in similar transactions between unrelated companies. It can be an internal CUP or an external CUP.
• Example: A company licenses its brand to a subsidiary. To set a price, it checks a similar license agreement with an independent party.
• Pros: Reliable when comparable data is available; reflects  true market values.
• Cons: Challenging to find similar transactions; requires detailed and comparable information.

2. Resale Price Method (RPM)

• Description: This method calculates a product’s resale price, subtracts the distributor’s margin, and uses the result to determine the original transfer price.
• Example: A distributor sells shoes purchased from its Irish parent company and an unrelated supplier in Ireland. The distributor’s gross margin derived from the resale of shoes purchased from unrelated supplier becomes the reference point.
• Pros: Effective for resale businesses; easy if data is available.
• Cons: Not suited for unique or specialized products; requires consistent data practices.

3. Cost Plus Method (CPM)

• Description: This approach adds a standard markup to the costs incurred by the supplier to determine a fair transfer price.
• Example: A simple manufacturer in France produces goods for a German affiliate, ALP is derived by adding  profit margin based on market benchmarks to the cost incurred.
• Pros: Suitable for simple manufacturing activities; easy to apply.
• Cons: Hard to use for complex or unique goods; limited by available data.

4. Transactional Net Margin Method (TNMM)

• Description: TNMM compares the net profits of a company’s controlled transactions to similar deals between unrelated businesses.
• Example: A U.S. clothing brand evaluates its Canadian distributor’s profit margin against independent Canadian distributors.
• Pros: Flexible and broadly applicable; easier to apply than traditional methods.
• Cons: Focuses only on one side of the transaction; less precise for intangible or complex deals.

5. Profit Split Method (PSM)

• Description: PSM divides profits or losses from joint operations based on the contribution of each company.
• Example: Two pharmaceutical companies develop a drug together, and profits are split based on each company’s share of the contribution.
• Pros: Ideal for tightly integrated activities; holistic approach.
• Cons: Can be subjective in determination of relative contributions; not suitable for all scenarios.

Picking the Right Method

Choosing the best transfer pricing method depends on your company’s operations, available data, and specific needs. It’s crucial to follow international guidelines to ensure compliance and avoid costly mistakes.

Need Help with Transfer Pricing?

Our experts can guide you through these methods, tailoring solutions to your unique situation. Contact us today to ensure your intercompany pricing is accurate and compliant.