Transfer pricing – IAS 12 Best complete read

Transfer pricing
transactions between related parties

A transfer price is the price charged between related parties (e.g., a parent company and its controlled foreign corporation) in an inter-company transaction. Although inter-company transactions are eliminated when consolidating the financial results of controlled foreign corporations and their domestic parents, for preparation of individual tax returns each entity (or a tax consolidation unit of more than one entity in the group in one and the same tax jurisdiction) prepares stand-alone (or a tax consolidation unit) tax returns.

See also:

IAS 24 Related parties narrative IFRS 15 Revenue narrative IAS 12 Income tax narrative

Transfer prices directly affect the allocation of group-wide taxable income across national tax jurisdictions. Hence, a group’s transfer-pricing policies can directly affect its after-tax income to the extent that tax rates differ across national jurisdictions.

Arm’s length transaction principle

Most OECD countries rely upon the OECD TP Guidelines for Multinational Enterprises and Tax Administrations, that were originally released in 1995 and subsequently updated in 2017 (OECD TP Guidelines). The OECD TP Guidelines reaffirmed the OECD’s commitment to the arm’s length transaction principle.

In fact, the arm’s length transaction principle is considered “the closest approximation of the workings of the open market in cases where goods and services are transferred between associated enterprises.” The arm’s length principle implies that transfer prices between related parties should be set as though the entities were operating at arm’s length (i.e. were independent enterprises).

The application of the arm’s length transaction principle is generally based on a comparison of all the relevant conditions in a controlled transaction with the conditions in an uncontrolled transaction (i.e. a transaction between independent enterprises).

OECD Transfer pricing methods

To comply with the OECD TP Guidelines, a taxpayer must use appropriate transfer pricing method(s) to determine the arm’s length transaction standard in relation to transactions with related parties. The methods specified in the OECD TP Guidelines are split into traditional transaction methods and transactional profit methods, as outlined below:

  • Traditional transaction methods: compare the prices or gross margins charged in controlled transactions to that of uncontrolled transactions. These methods are the comparable uncontrolled price (CUP) method, resale price method (RPM), and the cost plus method.
  • Transactional profit methods: examine the profits that arise from particular controlled transactions and compare them to profits that arise from uncontrolled transactions. These methods are the transactional net margin method (TNMM) and the profit split method.

The OECD TP Guidelines do not require the application of more than one method to arrive at the arm’s length transaction result although they do provide guidance on the use of more than one method in complex cases. (OECD TP Guidelines #2.11) The pricing of the transactions under review was therefore considered in accordance with the methods set out by the OECD TP Guidelines. The selection of a transfer pricing method should take account of the following factors:

  • The respective strengths and weaknesses of each of the OECD recognized methods.
  • The appropriateness of the method considered in view of the comparability (including functional) analysis of the controlled transaction under review.
  • The availability of sufficiently reliable information (in particular on uncontrolled comparables) to apply the selected method and / or other methods.
  • The degree of comparability of controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate differences between them.

Traditional Transaction Methods

Traditional transaction methods examine the terms and conditions of uncontrolled transactions made by third-party organizations. These transactions are then compared with controlled transactions between related companies to ensure they’re operating at arm’s length. There are three traditional transaction methods:

Something else -   Step 3 Determining Transaction Price

1. Comparable Uncontrolled Price Method

The comparable uncontrolled price (CUP) method compares the price and conditions of products or services in a controlled transaction with those of an uncontrolled transaction between unrelated parties. To make this comparison, the CUP method requires what’s known as comparable data. In order to be considered a comparable price, the uncontrolled transaction has to meet high standards of comparability. In other words, transactions must be extremely similar to be considered comparable under this method.

The OECD recommends this method whenever possible. It’s considered the most effective and reliable way to apply the arm’s length transaction principle to a controlled transaction. That said, it can be very challenging to identify a transaction that’s appropriately comparable to the controlled transaction in question. That’s why the CUP method is most frequently used when there’s a significant amount of data available to make the comparison.

CUP example

An example of the CUP transfer pricing method:

There are actually two ways to apply the CUP method: the internal CUP and the external CUP. The internal CUP relies on examples of comparable transactions the company has made with unrelated third parties. The external CUP looks at pricing of comparable transactions made between two unrelated third parties—which can be difficult to find. For this reason, the internal CUP method is preferred. The following is an example of the internal CUP method:

A U.S. car rental company needs to determine how to price the use of its brand name and logo by its CanadianTransfer pricing subsidiary. The company’s transfer pricing team must find an example of a licensing agreement the company has made with an independent third party to use their branding. If that arrangement is sufficiently comparable, the car rental company can apply the same price it charges the independent third party to its Canadian subsidiary for the use of the brand and logo.

2. The Resale Price Method

The resale price method (RPM) uses the selling price of a product or service, otherwise known as the resale price. ThisTransfer pricing number is then reduced with a gross margin, determined by comparing the gross margins in comparable transactions made by similar but unrelated organizations. Then, the costs associated with purchasing the product—such as customs duties—are deducted from the total. The final number is considered an arm’s length transaction price for a controlled transaction made between affiliated companies.

When appropriately comparable transactions are available, the resale price method can be a very useful way to determine transfer prices, because third-party sale prices may be relatively easy to access. However, the resale price method requires comparables with consistent economic circumstances and accounting methods. The uniqueness of each transaction makes it very difficult to meet resale price method requirements.

Resale price example

An example of the resale price transfer pricing method:

A U.S. company that distributes running shoes buys shoes from a related company in Ireland. It also purchases similar shoes from another, unrelated supplier. Assuming that the terms and conditions of the related and unrelated party transactions are comparable, the RPM can be applied to ensure the Irish company charges its related U.S. distributor a price comparable to the price charged by the unrelated third-party supplier.

The RPM stipulates that the gross margin earned by the U.S. distributor on shoes purchased from the related company must be the same as the margin earned on sales of shoes purchased from the unrelated supplier. If the distributor makes a gross profit of $65 on each pair of shoes from the unrelated supplier sold for $100, the gross profit margin is 65%. This is the gross margin which must be used to determine the price of the shoes the distributor purchases from its related Irish supplier.

Something else -   Step 5 Recognise the revenue when the entity satisfies each performance obligation

3. The Cost Plus Method

The cost plus method (CPLM) works by comparing a company’s gross profits to the overall cost of sales. It starts by figuring out the costs incurred by the supplier in a controlled transaction between affiliated companies. Then, a market-based markup—the “plus” in cost plus—is added to the total to account for an appropriate profit. In order to use the cost plus method, a company must identify the markup costs for comparable transactions between unrelated organizations.

The cost plus method is very useful for assessing transfer prices for routine, low-risk activities, such as the manufacturing of tangible goods. For many organizations, this method is both easy to implement and to understand. The downside of the cost plus method (and really, all the transactional methods) is the availability of comparable data and accounting consistency. In many cases, there are simply no comparable companies and transactions—or at least not comparable enough to get an accurate, reliable result. If it’s not an apples to apples comparison, the results will be distorted and another method must be used.

Cost plus example

An example of the cost plus transfer pricing method:

A French corporation produces products under contract for its German-based parent company and needs to determine Transfer pricingthe appropriate markup (gross cost plus) for the goods it sells to its German partner. If the French company has made similar comparable transactions with third parties, the markup used for those transactions can be applied to the sales the company makes to the related German company. If the French company has made no comparable third party transactions, then the transfer pricing team can identify several companies similar to the French manufacturer and apply those companies’ average gross cost plus to the transactions with the related German company.

Transactional Profit Methods

Unlike traditional transaction methods, profit-based methods don’t examine the terms and conditions of specific transactions. Instead, they measure the net operating profits from controlled transactions and compare them to the profits of third-party companies making comparable transactions. This is done to ensure all company mark-ups are arm’s length transactions.

However, finding the comparable data necessary to use these methods is often very difficult. Even the smallest variations in product features can lead to significant differences in price, so it can be very challenging to find comparable transactions that won’t raise red flags and be questioned by auditors.

4. The Comparable Profits Method

The Comparable profits method, also known as the transactional net margin method (TNMM), helps determine transfer prices by looking at the net profit of a controlled transaction between associated enterprises. This net profit is then compared to the net profits in comparable uncontrolled transactions of independent enterprises.

The Comparable Profits Method is the most commonly used and broadly applicable type of transfer pricing methodology. As far as benefits go, the Comparable Profits Method is fairly easy to implement because it only requires financial data. This method is really effective for product manufacturers with relatively straightforward transactions, as it’s not difficult to find comparable data.

The Comparable Profits Method is a one-sided method that often ignores information on the counterparty to the transaction. Tax authorities are increasingly likely to take the position that the Comparable Profits Method is not a good match for organizations with complex business models, such as high-tech companies with intellectual property. Using data from companies who do not meet the OECD’s standards of comparability creates audit risk for organizations.

Comparable profits transfer example

An example of the comparable profits transfer pricing method:

A U.S.-based clothing company with global reach establishes a Canadian distribution affiliate. The U.S. parent company supplies products, sets business strategies, finances the global operations, and owns the intellectual property (trademarks, designs, and operational know-how) for its global affiliates. The parent company needs to determine how much profit the Canadian distributor should earn for its operations.

Something else -   Entity-specific value

The transfer pricing team identifies similar distributors in Canada, calculates their pre-tax profit margins, and establishes a typical profit margin range. Prices are set to allow the related Canadian distributor to earn a pre-tax profit that falls within that typical margin range.

5. The Profit Split Method

In some cases, associated enterprises engage in transactions that are interconnected—meaning they can’t be observed on a separate basis. For example, two companies operating under the same brand might use the profit split method (PSM). Typically, the related companies agree to split the profits, and that’s where the profit split method comes in.

This approach examines the terms and conditions of interrelated, controlled transactions by figuring out how profits would be divided between third parties making similar transactions. One of the main benefits of the PSM is that it looks at profit allocation in a holistic way, rather than on a transactional basis. This can help provide a broader, more accurate assessment of the company’s financial performance. This is especially useful when dealing with intangible assets, such as intellectual property, or in situations where there are multiple controlled transactions happening at a time.

However, the PSM is often seen as a last resort because it only applies to highly integrated organizations equally contributing value and assuming risk. Because the profit allocation criteria for this method is so subjective, it poses more risk of being considered a non-arm’s length outcome and being disputed by the appropriate tax authorities.

Profit split transfer example

An example of the profit split transfer pricing method:

A pharmaceutical company affiliate performs research and development (R&D) to bring a new drug to market. The affiliate bears the costs and risks of launching the new drug. The two related parties need to determine the right profit split and decide that they’ll use the contribution PSM to divide profits from sales of the new drug.

The two parties have invested a total of $500 million in bringing the medication to market. The R&D company invested $375 million—or 75% of the total investment. Therefore, 75% of the profits will go to the R&D company, with the remaining 25% going to the pharmaceutical manufacturer.

OECD/G20 Inclusive Framework on BEPS

The OECD on January 31 released a “Statement by the OECD/G20 Inclusive Framework on BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising from the Digitalization of the Economy.”


The statement affirmed the commitment of the 138-member Inclusive Framework to reach an agreement on a
consensus-based solution by the end of 2020, while deferring a decision on US Treasury Secretary Mnuchin’s December 2019 proposal for a “safe harbor” approach to Pillar One until other elements of the solution have been

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Something else -   Step 5 Recognise the revenue when the entity satisfies each performance obligation

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