Transfer Pricing Methodologies

Methodologies Used in Determining Arm’s Length Price

Determining the arm’s length price is a crucial aspect of transfer pricing, which involves setting the price for transactions between related entities in different countries. Various methodologies are used to ensure that the price is fair and in line with market conditions. In this article, we will explore some common methodologies employed in determining the arm’s length price.

1. Comparable Uncontrolled Price (CUP) Method

The CUP method relies on comparing the prices of similar transactions between unrelated parties. By analyzing comparable transactions, we can establish a benchmark price for the controlled transaction. This method is often used when sufficient data on comparable transactions is available.

2. Resale Price Method (RPM)

The RPM focuses on the resale price of goods or services purchased from related parties. It assesses the gross margin earned by the reseller and deducts an appropriate markup to determine an arm’s length price. The RPM is commonly used in distribution and retail industries.

3. Cost Plus Method (CPM)

The CPM takes into account the costs incurred by the supplier of goods or services and adds an appropriate profit margin. This method ensures that the supplier is adequately compensated for their costs and receives a reasonable profit. The CPM is frequently used in manufacturing industries.

The above three methods are commonly known as “traditional transactional methods”. Although the taxpayer is given the right to choose any method, the emphasis should be on arriving at an arm’s length price.

4. Transactional Net Margin Method (TNMM)

The TNMM compares the net profit margin of a controlled transaction with that of comparable uncontrolled transactions, considering factors like functions performed, assets used, and risks assumed. It is a flexible method applicable to various industries.

5. Profit Split Method (PSM)

The PSM allocates profits between related parties based on their respective contributions to the overall value creation. It considers factors like functions performed, risks assumed, and assets employed by each party. The PSM is particularly relevant for transactions involving the joint development of intangible assets or complex business arrangements.

The methods for TNMM and PSM are commonly referred to as “transactional profit methods”, be used only when traditional transactional methods cannot be reliably applied or exceptionally cannot be applied at all.

It is important to note that selecting the most appropriate methodology depends on various factors, including the availability of data, the nature of the controlled transactions, and the industry in which the entities operate.

In practice, multiple methodologies may be used to ensure the arm’s length principle is properly applied. Where both the traditional transactional method and transactional profit method cannot be applied at all, the Director General may allow the application of other methods provided the prices arrived at is in accordance with the arm’s length principle.

Understanding and applying these methodologies is essential for multinational companies to comply with transfer pricing regulations and ensure sustainable international business operations. By adopting sound transfer pricing practices, companies can mitigate the risk of transfer pricing adjustments and enhance their overall tax compliance.

Comparable Uncontrolled Price Method (CUP)

The CUP method compares prices of similar transactions between unrelated parties to establish a benchmark price. There are two sources for identifying a CUP: internal and external comparable transactions.

Internal comparable transactions occur within the same multinational enterprise (MNE) group. For example, if an MNE subsidiary sells a product to another subsidiary at a certain price, this internal transaction can serve as a CUP for a similar transaction between unrelated parties.

External comparable transactions involve analyzing transactions between unrelated parties in the open market. This can be done by referring to databases, industry publications, or other reliable sources. For instance, if there are public records of similar transactions between unrelated companies in the same industry, these transactions can be used as CUPs.

To ensure comparability, consider factors such as the nature of the product or service, contractual terms, economic conditions, and performed functions. By carefully analyzing these factors, you can identify comparable transactions.

For example, let’s say Company A, a multinational manufacturing company, sells a component to its subsidiary, Company B, at RM100. To determine if this price is at arm’s length, search for external comparable transactions where similar components are sold between unrelated companies. If Company A finds an external transaction where a similar product is sold for RM90, they can use this price as a benchmark. By comparing prices and considering relevant factors, the reliability of the internal CUP can be assessed.

It’s important to note that data availability is crucial for applying the CUP method effectively. In Malaysia, companies must maintain proper documentation to support their transfer pricing analysis, including the selection of comparable transactions and determination of the arm’s length price.

Resale Price Method (RPM)

The Resale Price Method (RPM) is used to determine the fair price of goods or services sold by a company to an associated enterprise. This method is most suitable when the final transaction involves an independent distributor.

The RPM involves a comparability analysis that compares the company’s price to the price charged by an independent enterprise for similar goods or services. This analysis examines the functions, risks, and assets of both the company and the independent enterprise.

Here’s an example:
Company A, located overseas, sells a product to its Malaysian subsidiary, Company B, a distributor. Company B then resells the product to an independent enterprise, Company C, for RM 7.60 per unit.

To determine if the transfer price charged by Company A to Company B is fair, a comparability analysis is conducted. This analysis compares the gross profit margin of the controlled transaction to that of uncontrolled transactions. If the gross profit margin falls within the range of uncontrolled transactions, then the transfer price is considered fair.

Cost Plus Method (CPM)

The Cost Plus Method (CPM) is used to determine the price of goods or services sold between related parties. It adds a reasonable profit margin to the cost incurred by the seller to arrive at the transfer price.

The Comparability Analysis compares controlled and uncontrolled transactions to ensure the transfer price is arm’s length. It considers factors like functions, risks, terms, conditions, strategies, and adjustments.

Cost Structure Consideration is important in determining the transfer price using CPM. It analyzes the seller’s cost structure, including direct and indirect costs.

Example: Company A (a subsidiary of Company B) purchases a product from Company B for resale in Malaysia. The total cost per unit is RM80. Company B sells the product to Company A for RM100 per unit, with a 25% mark-up. An independent company has a 40% mark-up on cost.

In this example, the transfer price using CPM is RM100 (cost of RM80 + 25% mark-up). However, a comparability analysis should be performed to ensure the transfer price is arm’s length.

Transactional Profit Method

Transactional Profit Method (TPM) is a transfer pricing method that compares the profits earned from a controlled transaction with the profits earned from an uncontrolled transaction. The TPM is used to determine whether the price of a controlled transaction is arm’s length. The TPM is based on the premise that the profits earned from a controlled transaction should be similar to the profits earned from an uncontrolled transaction.

Example: A company in Malaysia sells a product to a related company in Singapore. The Malaysian company earns a profit of MYR 100,000 from the sale. The Singaporean company sells the product to an unrelated company in Singapore and earns a profit of MYR 120,000. The TPM would require the Malaysian company to adjust its price to earn a profit of MYR 120,000, which is the profit earned from the uncontrolled transaction.

Transactional Profit Split Method (TPSM) is a transfer pricing method that splits the profits earned from a controlled transaction between the associated enterprises. The TPSM is used when the TPM is not applicable or when the controlled transaction involves unique intangible assets or services. The TPSM is based on the premise that the profits earned from a controlled transaction should be split between the associated enterprises in a manner that reflects their respective contributions to the transaction.

Example: A company in Malaysia and a related company in Singapore jointly develop a new product. The Malaysian company contributes MYR 500,000 to the development, while the Singaporean company contributes MYR 1,000,000. The product is sold to an unrelated company in Singapore for MYR 3,000,000, earning a profit of MYR 1,000,000. The TPSM would require the profit to be split between the Malaysian and Singaporean companies in a ratio of 1:2, reflecting their respective contributions to the development.

Residual Profit Split Approach (RPSA) is a transfer pricing method that splits the residual profit earned from a controlled transaction between the associated enterprises. The RPSA is used when the TPM and TPSM are not applicable or when the controlled transaction involves unique intangible assets or services. The RPSA is based on the premise that the residual profit earned from a controlled transaction should be split between the associated enterprises in a manner that reflects their respective contributions to the transaction.

Example: A company in Malaysia and a related company in Singapore jointly develop a new product. The Malaysian company contributes MYR 500,000 to the development, while the Singaporean company contributes MYR 1,000,000. The product is sold to an unrelated company in Singapore for MYR 3,000,000, earning a net profit of MYR 170,000. The RPSA would require the residual profit of MYR 146,000 to be split between the Malaysian and Singaporean companies in a ratio that reflects their respective contributions to the development.

Transactional Net Margin Method (TNMM)

The TNMM (Transactional Net Margin Method) is similar to the cost plus and resale price methods in that it uses the margin approach. This method is particularly useful when comparing gross profit margins is challenging due to different accounting treatments.

The TNMM analyzes the net profit margin relative to a suitable base, such as costs, sales, or assets, achieved by a multinational enterprise (MNE) from a controlled transaction. Ideally, this margin should be derived from comparable uncontrolled transactions between the same taxpayer and independent parties. If there are no comparable uncontrolled transactions involving the MNE, reference can be made to the net profit margin that an independent person would have earned in comparable transactions. To determine comparability, a functional analysis of both the associated person and the independent person must be conducted.

Application of TNMM:
Net margins, unlike gross margins or prices, can be significantly influenced by various factors other than products and functions, such as competitive position, cost structures, and differences in cost of capital. Therefore, whenever possible, the TNMM should be used in cases where these factors are highly similar, in order to eliminate the effects of these other conditions.

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