Module 4 - TRANSFER PRICING METHODS: SELECTION AND APPLICATION OF
THE MOST APPROPRIATE METHOD
Welcome to Module 4 of the World Bank’s Transfer Pricing Electronic Learning Tool.
Slide 3
In this module, we’re going to take a closer look at the transfer pricing methods available to taxpayers
and tax administrations and how those methods are used to establish arm’s length pricing. That is, to
determine the actual pricing to be applied in a controlled transaction or to retrospectively test whether
the actual pricing applied meets the arm’s length principle.
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Taxpayers in practice use either of these approaches. In some cases, they use both – that is, they may
apply a transfer pricing method to set prices proactively, and then, at a later stage, carry out another
transfer pricing analysis to test the actual outcome of applying those prices. This is normal practice and
acceptable to most tax authorities.
Slide 4
The OECD Transfer Pricing Guidelines describe five basic transfer pricing methods. These methods are
incorporated in the transfer pricing rules of nearly every country that has adopted transfer pricing rules.
The methods, which we will describe in this Module, are:
1. The Comparable Uncontrolled Price Method commonly referred to as CUP
2. The Cost Plus Method
3. The Resale Price Method
4. The Transactional Net Margin Method known as the TNMM
5. The Profit Split Method
Most countries, the OECD and the United Nations transfer pricing guidelines have all built in a degree of
flexibility into their approaches, allowing other methods to be used in specific cases, provided that they
approximate an arm’s length result and are acceptable to all the parties involved - that is acceptable to
the tax administration, the taxpayer and to the treaty partner in cases where a Double Tax Agreement
comes into play.
Some countries have introduced additional methods to apply in specified circumstances – for example,
some countries have introduced a ‘sixth method’, which can apply where market pricing data (For
example, for the pricing of agricultural products or other commodities) is publicly available. This module
will focus on the five basic methods. A later module will discuss supplementary approaches, such as the
sixth method, simplifications and targeted anti-avoidance rules.
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Slide 5
The first four transfer pricing methods have a fundamental characteristic in common.
They all look to the market to establish arm’s length pricing. This is the basis of ‘comparability’,
described in an earlier module, which compares the tested transaction with one or more comparable
uncontrolled transactions.
Depending on the type of profit split method adopted, comparability may also play a major role. In
practice, the profit split method often relies on economic analyses to determine a division of profit
between related parties. This is because comparable transactions, or data on the split of profit in
comparable transactions, is often not available.
Where the methods fundamentally differ, however, is in the type of financial or benchmarking data used
for each method.
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Slide 6
Test your existing knowledge by matching the method with the type of data the method employs.
Slide 7 CUP - Phương pháp giá thị trường có thể so sánh được
If you are new to transfer pricing, it might surprise you to learn that only in some cases does transfer
pricing analysis require knowledge of actual prices.
Such knowledge is only necessary when the CUP method is used – which in practice is sometimes
applied to set royalty rates, determine interest rates and price commodities. In fact, many transfer
pricing audits are conducted without the tax auditor knowing – or needing to know – the actual prices
used in the tested related party transaction.
This is because most of the methods work at the level of a gross or net profit margin or with a profit split
rather than an actual price.
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Slide 8
The World Bank Transfer Pricing Handbook describes the CUP method as one that ‘involves a
comparison of the prices charged in the controlled transactions with the prices charged for comparable
goods or services - including the provision of finance and intangible property- in uncontrolled
transactions.’
This price comparison may be made between internal uncontrolled transactions or external
uncontrolled transactions, depending on the existence of such transactions and availability of reliable
information.
For the CUP, the financial indicator under examination is the price, and it can be expected that even
minor differences between the product and functions relating to controlled transactions and those in
uncontrolled transactions may have a material impact on those prices. In this regard, the required
standard of comparability for applying the CUP method is generally considered to be very high relative
to the other transfer pricing methods.
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Slide 9
This method requires a very high level of comparability between the controlled and uncontrolled
transactions.
In our example we will examine the application of the CUP to determine an arm’s length price of roller-
ball pens sold by a manufacturing entity to a related distributor.
To be reliable, the method would require identifying the prices of comparable pens sold between
independent persons in comparable circumstances. This would require:
the ‘comparable’ pens to be identical in specifications, design and the value of any branding or
other intangible
the markets to be comparable
the functional profiles of the independent buyers and sellers to be comparable
the contractual relations between the parties to be sufficiently similar
In practice, such comparability would be very difficult to find, and even if it could be found, there may
be difficulties in identifying the prices and other terms of the uncontrolled transactions.
This requirement for high comparability means that the CUP is available only in a limited number of
circumstances. These are discussed in the next slide.
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Slide 10
Despite the practical limitations of the CUP, predominately due to the lack of reliable publicly available
data, there are circumstances when it will be feasible and preferable to apply the CUP method, for
example: where the products in question are of a commodity nature and pricing information is publicly
available.
This might be the case for the sale of minerals or agricultural products for which transparent regional or
global markets exist.
However, it is important to note that even where such markets exist, the CUP may not be the most
appropriate method. On the next slide there is a case to illustrate this point.
The CUP method may be used for pricing of financial transactions such as the rate of interest applied to
debt or in establishing a royalty rate.
In some cases, internal comparables with sufficient comparability may also be available to apply the CUP
method.
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Slide 11
It should be noted that CUP will not be always the most appropriate method for related party sales
involving commodities. Let's look at a brief example.
In this case, a large mining enterprise was granted a concession to mine copper in an African country
(Country A). The concession agreement was negotiated, and entered into, by the ultimate head office
company situated in Country B. About the same time a mining subsidiary was established in Country A
to carry out the mining operations. Once production began, the copper ore produced was sold by the
Country A mining company to the head office company (in Country B) for distribution to third party
customers.
The sales price between the mining company and head office was determined according to the CUP
method, based on transparent world market prices for the type and quality of the copper ore. Because
of a downturn in the market for copper, the mining company made significant losses.
The factual analysis showed that the key intangible in this case was the concession agreement between
the government of Country A, and the Country B mining company. It further showed that third party
sales activities were carried out only by the head office, where all key commercial market and pricing
decisions were made (such as hedging activities, production stop/go decisions, and production
quantities).
The Country A tax administration took the view that the mining company’s losses were related to
market risks, which were managed and controlled only at the head office level. In addition, the key
intangible was owned by the head office company. In reality, the local mining company’s functions were
restricted to mining copper on behalf of, and on the instruction of, the head office.
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Country A tax administration successfully argued that, in substance, the Country A mining company was
akin to a ‘contract miner’ on behalf of the head office, and that, at arm’s length, it would not share in
losses related to market risk. Instead, it would be rewarded in a manner consistent with the ‘routine’
functions it carries on. The tax administration substituted, for tax purposes, a cost-plus method for the
CUP method and, as a result, the tax losses for the relevant periods were replaced by taxable profits.
Slide 12 Cost plus : Giá bán = Chi phí + Mark up (dựa trên tỷ suất lợi nhuận của các giao dịch
độc lập tương đương)
The World Bank Transfer Pricing Handbook states that the cost-plus method ‘starts with the costs
incurred by the supplier of the property or services that are the object of the controlled transaction,
which are then appropriately marked up in order to determine an arm’s length price’.
In this context, ‘appropriately marked up’, means the mark-ups observed in the market– that is, the
mark-up on costs earned in comparable uncontrolled transactions.
It is important to note that the cost-plus method is a gross-margin method in which the mark-up is
intended to be applied to the direct and indirect costs of production of the products in question.
Click here for a diagrammatic illustration of this.
The method is often appropriate to establish or test an arm’s length return to contract manufacturers or
service providers selling products or providing services to related persons.
Later we will see that, in practice, the information required to apply this method is often not available or
unreliable. For this reason, we often observe that taxpayers and tax administrations apply a mark-up on
total costs – although similar in concept, this method is actually a TNMM rather than a cost-plus
method.
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Slide 13 Resale price method = Giá bán lại cho bên độc lập − Gross margin phù hợp
The World Bank Transfer Pricing Handbook describes the resale price method as starting with the price
at which the product that is the object of the controlled transaction is resold to an independent
enterprise (the “resale price”), which is then reduced by an appropriate gross profit margin (the “resale
price margin”) in order to determine an arm’s length price’.
In this context the ‘appropriate gross margin’ is that earned by resellers conducting comparable
uncontrolled transactions. The method is most often used to test the return to entities such as
distributors that purchase from related parties and sell on to unrelated parties, but it can be adapted to
test pricing in other buy or sell activities.
In common with the cost-plus method, the resale price method is a gross-margin method.
In this case the gross margin (which in the financial accounts is normally the sale price less the cost of
goods sold) is expressed as a percentage of sales.
We will see in the next screen that, in practice, the information required to apply this method is often
unavailable or unreliable. A detailed illustration of this can be found in the case study in Module 6.
Because of these challenges, taxpayers and tax administrations often test distributors and
manufacturers using for example a net profit to sales ratio, which you recall is the TNMM.
Click here to see a diagrammatic illustration of the method.
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Slide 14
It is useful at this stage to discuss a number of characteristics common to the cost-plus and resale price
methods.
A first point to make is that, in common with the TNMM, these are one-sided methods. That is, they test
the arm’s length pricing of a transaction by reference to a profit margin earned by one of the parties.
Such an approach of course makes sense only where one of the parties can in fact be tested against
comparable entities, which is possible only if the tested party carries out functions for which comparable
entities can be identified. This is sometimes described as ‘routine’ or ‘benchmarkable’ functions. It is
very difficult to find comparables for entities that, for example, use valuable intangibles in their business,
or assume extraordinary risks. Such entities, which have unique profit-earning capabilities are, by
definition, non-benchmarkable, and thus should not, and in practice, cannot, be the tested party.
The next point to make is that when a one-sided method is used, the tested party is allocated a ‘routine’
return, while the other party recognises the residual total profit or loss from a transaction. It is thus
possible that one party to the transaction records a profit even if this leaves the other party a residual
loss.
Now let’s turn our attention to use of the gross margin methods in practice.
In principle, gross margin methods can be more reliable than net margin methods because a gross
margin should not be affected by factors that affect overhead or operating costs. Such costs will
probably be reflected in financial accounts as operating expenses also referred to as OPEX or SGA
(Selling, General and Administrative costs) which do not affect gross margins.
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In the case of a manufacturer, for example, a gross margin method such as cost-plus will take into
account only those costs incurred in the manufacturing process. Prices will not be affected by cost
variances reflected in operating expenses or those costs, which may be due, for example to
inefficiencies or arrangements that are unrelated to production costs. For example, a company that
owns its premises will not incur rental costs, but it would not be expected that the market prices of the
goods it produces would be lower than that of a manufacturer of comparable goods that does incur
such rental expense.
For these reasons a gross margin method is likely to give rise to a result that is closer to an arm’s length
outcome than a method that sets pricing by means of a mark-up on all costs.
Slide 15
We have seen that in order to apply the resale price method and the cost-plus method we require data
on gross margins earned by independent entities conducting comparable functions under similar
circumstances. In practice this information can sometimes be very difficult for tax administration and
taxpayers to obtain.
Taxpayers and tax administrations sometimes rely on commercial databases to search for, and extract
financial data on, potential comparables. Such databases, however, contain limited gross-margin data.
There are two main reasons for this:
gross profit data may not be captured in publicly available financial accounts on which the
databases rely
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there may be accounting practice variances between countries and entities in the reporting of costs
between ‘the cost of goods sold’ (which affect the gross margin) and operating expenses (which
affect the net margin, but not gross margin). These are difficult to identify and adjust for.
The requisite data may be available, however, if taxpayers and the tax administration have access to
detailed publicly available financial accounts of potential comparable entities or if internal comparables
are available.
For these reasons, tax auditors are likely to encounter net margin methods much more frequently than
gross margin methods.
Click here for an illustration of the use of internal comparables in applying the resale price method.
Slide 16
The World Bank Transfer Pricing Handbook states that the transactional net margin method (“TNMM”)
‘examines an appropriate financial indicator (based on net profit) that the tested party realizes in
controlled transactions and compares it with that realized in uncontrolled transactions’.
This means that the TNMM is very similar to the resale price method and the cost-plus method, except
that a return to the tested party is established or tested by utilising a net profit margin.
The most common net profit margins which are also referred to as financial indicators or ‘profit level
indicators’ or ‘PLIs’ likely to be encountered by tax auditors are:
- net profit return to sales (net profit/sales revenue x 100)
- net profit return to costs (net profit/costs x 100)
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- net profit return to assets (net profit/value of assets x 100)
It should be noted that, in this context, ‘net profit’ normally refers to earnings before interest and
taxation or EBIT.
Now let’s focus on the use of TNMM in practice. The TNMM is frequently used by tax administrations
and taxpayers, and there are several examples of its use in later modules. The method’s popularity is
partly because, in comparison to methods that use gross profit data, net profit data is less likely to be
subject to distortion arising from differences in accounting practices. But it is also because there is more
availability of reliable net profit data compared to than gross profit data, especially where commercial
databases are used.
In common with the resale price method and cost-plus method, the TNMM is a one-sided method and
the principles for determining the selection of the tested party are the same for all three methods.
Once it is established that the TNMM is an appropriate method and the tested party is selected, it is
necessary to select the appropriate profit level indicator. This should be the indicator for which a
correlation between a) net profit and b) the level of the indicator (e.g. costs, sales etc) is observed (or
expected to be observed) in the market.
Click here for some examples of financial indicators, and how they are commonly used when applying
the TNMM.
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Slide 17
Drag the statement (on the right) to correctly complete the statement (on the left).
Slide 18
The World Bank Transfer Pricing Handbook states that the profit split method begins ‘with the combined
profit (or loss) arising from the controlled transaction(s) and then attempts to split the profits between
the associated enterprises party to those transactions on an economically valid basis. Where possible,
this economically valid basis should be supported by market data’.
This profit split method is often most appropriate when the parties to the transaction both conduct non-
routine value-added functions and/or both exploit valuable intangible assets or the operations carried
on by the parties are highly integrated. This means that market comparables would not be available to
test the return to either party, and a ‘one-sided’ method is therefore not generally applied to these
cases.
Where the method is appropriate, it involves dividing the combined profit deriving from the transaction
between the parties. Ideally, the basis for the split should be derived from external market data.
However, this is not always possible and thus internal data, applied objectively using allocation keys, for
example, may be relied upon by necessity.
Click here to view allocation keys sometimes used.
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Slide 19
There are two variations of the profit split method:
A contribution analysis. The World Bank Transfer Pricing Handbook states that, under this
variation, ’combined profits from the controlled transaction(s) are determined and then allocated
between the associated parties on the basis of their relative contributions to the derivation of those
combined profits’. This allocation should be based on sound economic principles or, where available,
with reference to similar splits of profits observed between independent parties.
A residual analysis. This involves a two-step approach for determining the allocation of the combined
profits from the controlled transaction(s):
Step 1: Each party is allocated profits based on their non-unique (or routine) contributions (for example,
basic manufacturing or distribution activities) by reference to comparable uncontrolled transactions (or
entities); and
Step 2: The residual profits (profits remaining after Step 1) are allocated on an economic basis with
reference to the particular facts and circumstances.
Let’s discuss some further considerations on the profit split method.
The profit split method is particularly appropriate, and sometimes the only realistic option, where non-
routine and non-benchmarkable value-adding activities are conducted in multiple related persons. Such
activities may involve: the right to a return from valuable intangibles; a strong and protected market
position (such as a monopoly); unique skills and capabilities and the management of the key
entrepreneurial activities of the business.
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Compared to the other methods, a contribution analysis variant of the profit split method is less
dependent on the availability of comparable data. This can be an advantage of the method, but in many
cases, it would not always make sense to select this method solely because of the non-availability of
accurate comparables data.
Profit split methods can be difficult to apply in practice. For example, in more complex businesses, the
method requires the computation of combined profit arising from of a specific business-line, business
segment or even product. And the determination of the split of that profit (or residual profit) can be
subjective in nature. For these reasons, the method is most often used in larger and more complex
businesses.
A diagrammatic illustration of a residual analysis can be viewed here.
Slide 20
The selection of the most appropriate method according to the facts of each case is very important and
will have a significant effect on the reliability and outcome of any transfer pricing analysis. It needs to be
central to any transfer pricing audit or analysis. In many cases, the reliability of the selection of the most
appropriate method, in the light of a factual analysis, will be as significant, or more significant, than the
reliability of comparables data employed in that method.
The following describes a framework for the selection of the most appropriate method. Many of the
modules in this e-Tool provide additional examples and case studies of this process.
The steps of a high-level framework for selecting the most appropriate method in the light of a factual
analysis of the transactions under consideration are:
A starting point is to consider whether the comparable uncontrolled price method is available.
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If the CUP method is not available, the next step is to consider whether one of the parties to the
transaction conducts routine functions to which a routine return can be attributed. If so, one of the one-
sided methods is likely to be appropriate. In such a case, the tested party will be the party carrying out
the routine or benchmarkable functions.
If a one-sided method is not possible, the next step is to consider whether a profit split is appropriate.
This will be the case if both (or multiple) related parties carry out non-routine (non-benchmarkable)
value-added activities.
In exceptional cases it may be possible for the tax administration and the taxpayer to agree another
method acceptable to both, and the treaty partners, if a treaty is in place.
Click here to view an illustration of the selection of the most appropriate method.
Slide 21- 27
Do you agree with the following statement? For each statement. click on ‘Agree’ or ‘Disagree.
1. A transfer pricing method is appropriate only if independent comparable entities use the same
method to set their third-party prices.
2. The four basic transfer pricing methods are scientific in nature and, if correctly applied, always
produce an accurate measure of third-party pricing.
3. The choice of method to test a particular transaction is in practice of little consequence.
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4. A transfer pricing method that utilises a mark-up on all costs is a variant of the [Link] a one-
sided method is appropriate, the tested party should be the party for which comparable independent
entities are available.
5. Where a one-sided method is appropriate, the tested party should be the party for which comparable
independent entities are available.
6. Where a one-sided method is appropriate, it does not normally make sense to test a party which is
able to exploit valuable intangible assets or manages the key value-adding entrepreneurial risks in the
business.
7. Where a one-sided method is used, the tested party is rewarded in accordance with a benchmarking
analysis. The other party to the transaction is allocated the residual profit or loss deriving from the
transaction.
This brings us to the conclusion of Module 4 of the World Bank’s Transfer Pricing Electronic Learning
Tool, refer to other modules for more in-depth discussion on various tax technical issues raised in
Module 4.
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