Part 2.2: OECD - Key terms and transfer pricing methods

Question 1

Difference Operational Transfer Prices (OTPs) versus OECD Transfer Pricing?

Answer 1

Operational transfer prices is the MNE determined transfer price on a daily transactional basis

OECD transfer price determined by taxpayers (MNE) or tax authorities are used to test whether transfer prices are in line with the functions being performed/assets being deployed.

Question 2

On what basis are the operational transfer prices determined? (3)

Answer 2

• Price lists: price with margin deducted
• Standard cost price: wirh a margin mark-up.
• Budgets

Question 3

What are ‘true ups’?

Answer 3

When there is need for an adjustment of the OTP, once a year is the bear minimum to do a periodic adjustment!

Question 4

What are the two kind of business models discussed? and explain them.

Answer 4

1. Service provider model: one of the members decides what happens in the group, other entities have to listen.
   - Sales: Limited risk distributor (LRD), commissionaire or agent
   - Production: contract or toll manufacturer
2. Entrepreneurial model: Business model that is being used by a multinational whereby the group members are conducting themselves as entrepreneurial, operating by fully bearing the risks.
3. Risk-sharing model (not used in practice):
   The entities operate in effect as joint venture partners. They collaborate on entrepreneurial efforts and divide total profits => More decentralized model

Question 5

On what basis can we compare companies?

Give the five comparability factors and explain them.

Answer 5

1. Characteristics: with kinds of goods are we comparing? types: intangible, tangibles or service
2. Functional analysis: They should conduct the same or similar functions and bear same or similar risks.
3. Contractual terms: take into account the difference between the contractual terms and the conduct of parties.
4. Economic circumstance: geography, size of market, date and time
5. Business strategy: New product, market penetration, plausible expectation of return.

Question 6

What three elements are taken into account when determining the transfer price?

Answer 6

1. Business model ~ functional analysis
2. Transfer pricing policy
3. Transfer pricing method

Question 7

Transfer pricing policies

Answer 7

1. Transactional: intercompany transactions (e.g. goods and services) are charged on a transactional basis between entities
2. Cost allocation: Costs are being allocated on the base of various methods.
3. Book entries/ true-ups: In order to align the outcome of the OTP’s you need to account for true ups or adjustments.

Question 8

What are the OECD transfer pricing methods? (5)

Answer 8

Traditional Transaction Methods

1. Comparable Uncontrolled Price (CUP):
2. Resale Price Method (RPM)
3. Cost Plus Method (CPLM)

Transactional Profit Methods

4. Profit Split Method (PSM)
5. Transactional Net Margin Method (TNMM)

Question 9

What is the Comparable uncontrolled price method? How does it work?

Answer 9

1. Comparable Uncontrolled Price (CUP): compare TP in a controlled transaction to the TP in a comparable uncontrolled transaction.

• Internal Cup: The organization sells goods to a subsidiary but also to an unrelated distributor, these to prices can be compared!
  But: same market? same volume? => needs to be same conditions!
• External Cup: Look for references/prices which have been applied between unrelated parties for the same or similar products on the market. Look at competitors in the same market!

Question 10

What is the Resale price method? How does it work?

Answer 10

2. Resale Price Method (RPM): Deduct a gross margin from the selling price to arrive the transfer price.
   => Need an end sale to a third party, with the intra-group transaction earlier in the chain.

Question 11

What is the Cost plus method? How does it work?

Answer 11

3. Cost Plus Method (CPLM): start from a defined cost base on top of which we add a mark-up.
   => Mainly used as OTP’s

Question 12

What is the Profit split method? How does it work?

Answer 12

4. Profit Split Method (PSM): Overall profit will be allocated to each company in the supply chain. The allocation of profits is based on evaluating the economic contribution made by each group member. Herefore, we take into account assets used and risks assumed by each company.
   => PSM is useful where transactions are very inter-related and cannot be evaluated on separate basis
   => Liked by tax authorities because enables them to see how much profit/loss/break-even is attributed to each of the parties in the supply chain.

Question 13

What is the Transactional Net Margin Method? How does it work?

Answer 13

5. Transactional Net Margin Method (TNMM):
   This method looks at the net profit margin compared to appropriate bases for a particular transaction. We look for KPI’s that are obtained by independent companies that are showing identical activities with the company that we are analyzing. Looks at the net operating profit and puts this in function of different KPI’s. (instead of looking at the total profit or profit margin)

Different types of transaction, need to look at the transactions individually, e.g. contract manufacture, sales and marketing etc. In practice rarely based on an individual basis, we can bundle transactions.

=> In practice the most often applied method is the TNMM.

Question 14

What are the difficulties with the Resale price method?

Answer 14

Difficulties Resale price method:

1. Less useful where goods are further processed or incorporated into a more complicated product so that their identity is lost or transferred
2. Difficulties where reseller contributes substantially to the creation or maintenance of intangible property (e.g. trademarks/tradenames)
3. Practical issues
   - Define and determine gross margin (very difficult to do these) => Based on databases
   - Accounting differences

Question 15

What are the difficulties with the Resale price method? (3)

Answer 15

Difficulties Resale price method:

1. Less useful where goods are further processed or incorporated into a more complicated product so that their identity is lost or transferred
2. Difficulties where reseller contributes substantially to the creation or maintenance of intangible property (e.g. trademarks/tradenames)
3. Practical issues
   - Define and determine gross margin (very difficult to do these) => Based on databases
   - Accounting differences

Question 16

What are the difficulties with the Cost plus method? (2)

Answer 16

1. Determening the cost base: unstable costs, heavy capital expenditure, bad management (is a cost!)
2. Determine an ALP gross margin => hard to find in databases due to differences in accounting methods.

Question 17

What are the three strict conditions to apply the Profit split method?

Answer 17

1. Fully fledged companies.
2. All the group entities participating in the supply chain need to own or have valuable intangibles. Entities that do not own valuable intangibles: commissionaires/sales agent.
3. Complex supply chain.

Question 18

What are the two kinds of profit split methods?

Answer 18

1. Split of the combined profit: Calculate total profit or loss and split that result over the participating group member. (top-down approach)
2. Split of residual profit: Over the year we allocate a routine profit towards the participating parties. The residual profit will be split at the end of the year.

Question 19

What are the strengths (2) and weaknesses (2) of the profit split method?

Answer 19

Strengths:

• Generally does not rely directly on closely comparable transactions
• Less likely that either party to transaction will be left with an extreme or improbable profit result

Weaknesses:

• Need for detailed information
• Differences in accounting methods and standards in different jurisdictions may cause difficulties

Question 20

What are the typical profit Level Indicators of TNMM? (4)

Answer 20

1. Operating margin (= operating profit/ Net sales):
   Profit level indicator that we use to test/analyze related distributors. Try to find independent companies that are doing similar (not identical) functions to the company that we are testing. Mainly used for bench marking.
2. Net cost plus (= operating profit/ (COGS+ operating expenses)): Profit level indicator used in order to benchmark contract/ toll manufacturers or service providers. Or to analyze distribution centers (not selling), logistic centers or service providers.
   COGS (= Cost of goods sold)
3. Rate of return on capital employed, or Return on Assets (RoA) (= operating profit/ operating assets):
   => Secondary methods in order to support the methodologies operating margin and net cost plus.
4. Berry rate (= Gross profit/ operating expenses):
   Profit level indicator that defines in function of the gross profit. In practice rarely applied.

Question 21

Summary of the transfer price methods (product comparability, functional comparability, approach and remark)

Answer 21

1. Cup
   - Product comparability: Very high
   - Functional comparability: Medium
   - Approach: Prices are benchmarked
   - Remark: Very difficult to apply as very high degree of comparability required.
2. RPM
   - Product comparability: High
   - Functional comparability: Medium
   - Approach: GPM (on sales) benchmarked
   - Remark: Difficult to apply as very high degree of comparability required.
3. CPLM:
   - Product comparability: High
   - Functional comparability: High
   - Approach: GPM (on cost) benchmarked
   - Remark: Difficult to apply as very high degree of comparability required.
4. PSM
   - Product comparability: Medium
   - Functional comparability: Very High
   - Approach: profit margins
   - Remark: Complex method, not used so often
5. TNMM
   - Product comparability: Medium
   - Functional comparability: Very High
   - Approach: Net profit margin
   - Remark: Most commonly used