TP Chapter5 Methods

AgendaItem5

WorkingDraft

Chapter5

TransferPricingMethods

[This paper is based on a paper prepared by Members of the UN Tax Committees Subcommittee on Practical

Transfer Pricing Issues, but includes some Secretariat drafting and suggestions not yet considered by them the

Secretariat takes responsibility for any relevant errors and omissions. Formerly, Methods were dealt with in

Chapters 4 and 5, which are now combined hence the reference, on a temporary basis, to Parts 5A and 5B of this

paper].

[TableofContentstobeadded]

Chapter5ATraditionalMethods

1. Introduction

This part of the Chapter describes several transfer pricing methods that can be used to

determineanarms lengthpriceand itdescribeshowtoapplythesemethods inpractice. In

general, the OECD Transfer Pricing Guidelines are followed, with emphasis on practicality

solutions when using and applying transfer pricing methods. In response to practical

difficultiesthatmayexistinapplyingtheOECDTPGuidelines,forexamplewhennoaccessto

databaseswithrelevantinformationoncomparablesarereadilyavailable,somerequirements

for applying the arms length standard are softened or more flexibly applied, [and some

deviations/departures are suggested from the OECD TP Guidelines in this Chapter. These

deviations/departures from theOECD TPGuidelinesmay assistwith allowing governments

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and taxpayers inUNMember Countries to gain experiencewith the application of transfer

pricingmethodswhileseekingwaystogetmoreconformitywiththeOECDTPGuidelines.]

1.1 Useofmethods

Inordertocalculateortestthearmslengthnatureofpricesorprofits,useismadeoftransfer

pricingmethodsormethodologies.Transferpricingmethodsarewaysofcalculatingtheprofit

marginoftransactionsoranentireenterpriseorofcalculatingatransferpricethatqualifiesas

beingatarms length.Theapplicationof transferpricingmethods isrequired toassure that

transactions between associated enterprises conform to the arms length standard. Please

note that although the term profitmargin is used, companiesmay also have legitimate

reasons to report losses at arms length. Furthermore, transfer pricing methods are not

determinative in and of themselves. If an associated enterprise reports an arms length

amountofincome,withouttheexplicituseofoneofthetransferpricingmethodsrecognized

intheOECDTransferPricingGuidelines,thisdoesnotmeanthatitspricingisautomaticallynot

atarmslengthandtheremaybenoreasontoimposeadjustments.

1.2 Selectionofmethods(how,whyanduseofmethods)

Somemethodsaremoreappropriateand indicativetoprovideforanarms lengthresultfor

certaintransactionsthanothers.Forexample,acostbasedmethod isusuallydeemedmore

useful for determining an arms length price for services andmanufacturing, and a resale

pricebasedmethod isusuallydeemedmoreusefulfordetermininganarms lengthpricefor

distribution/sellingfunctions.

[ThefollowingoverlapswiththeComparabilityChaptertobesynthesised]

Thestartingpointtoselectamethodisthefunctionalanalysiswhichisnecessaryregardless

of what transfer pricing method is selected. Each method may require a deeper analysis

focusingonaspectsinrelationwiththemethod.Thefunctionalanalysishelps:

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toidentifyandunderstandtheintragrouptransactions, tohaveabasisforcomparability todetermineanynecessaryadjustmentstothecomparables, tochecktheaccuracyofthemethodselectedand overtime,toconsideradaptationofthepolicy ifthefunctions,risksorassets

havebeenmodified.

Assuchthefunctionalanalysisisamajorpartofthedocumentation.

Themajorcomponentsofafunctionalanalysisare:

Functions performed: It describes the activities performed such as design, purchasing,

inbound logistics, manufacturing, R&D, assembling, inventory management, outbound

logistics, marketing and sales activities, aftersale services, supporting activities, services,

advertising,financingandmanagement,etc. Itmustbespecifiedwhichpartyperformseach

activityandincasebothpartiesareinvolvedinperforminganactivityitshouldprovideforthe

relevantdifferences;forexamplebothhaveinventoriesbutCompanyAholdsinventoriesfora

periodofupto2yearswhereascompanyBonlyholdsinventoriesforaperiodof1month.The

activitiesthataddmostvaluemustbeidentifiedandbediscussedmoreindetail.

Risks undertaken: The functional analysis should identify risk undertaken. Examples are:

financialrisk(currency,commodity,interestrate,fundingrisksetc),creditandcollectionrisk

(tradingcreditrisk,commercialcreditrisk),operationalrisk(systemsfailurerisk,reliabilityof

customers, inventory risk and carrying costs,R&D risk,environmental andother regulatory

risks),marketrisk (countrypoliticalrisk,reliabilityofcustomers, fluctuation indemandand

prices),productrisk(productliabilityrisk,warrantyriskandcosts,contractenforceability).A

riskbearingpartyshouldhaveachanceofhigherearningsthananonriskbearingparty,and

willincurtheexpensesandperhapsrelatedlossifandwhenriskmaterializes.

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Assets used or contributed: the functional analysis must identify and distinguish tangible

assetsandintangibleassets.Tangibleassetssuchasaproperty,plantandequipmenthaveto

be financed and capital assets would usually be expected to earn a long term rate

commensuratewith thebusiness risk assumed. Someassets couldbe specific andmustbe

identifiedandquantifiedwheneverpossible.Itshouldbespecifiedwhichpartybearstherisk

in the legal termsandwhichpartybears the riskbasedon theeconomic substanceof the

transaction.

Intangibleassetsareveryimportantassustainablecompetitiveadvantageisoftenachievedby

the use of intangible assets. Some intangibles have legal protection (patents, trademarks,

trade names) but others without legal protection may be equally important and valuable

(knowhow,tradesecrets,corporategoodwill,exclusiveimportorexportrights,etc).Aparty

thatdeveloped the intangibles shouldbeable toobtainbenefit from the intangibleseither

throughasaleor licensingofthe intangiblesorthroughan increase inpricesofproductsor

serviceswith imbedded intangibles. It is important todeterminewhichpartyhasdeveloped

the intangiblesand inwhatcapacity,whichhas the legalownershipandwhich receives the

benefitoftheintangibles.

Todayinamultinationalgroup,operationstendtobemoreintegratedandfunctions,risksand

assetsareoftenshared.Thefunctionalanalysisprovidesanswerstoidentifywhichfunctions

risksandassetsareattributable to thevarious relatedparties. In somecasesonecompany

mayperformone functionbut the cost thereof is incurred/paidby theotherparty to the

transaction.Thefunctionalanalysiscouldemphasisethatsituation.

The functionalanalysis includes reference to the industryspecifics, thecontractual termsof

the transaction, the economics circumstances and the business strategies. The functional

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analysishelps to identify if theoperationsare complex justifyingahigher levelofprofitor

morelimitedandconsequentlygeneratingalowerprofit.

Achecklistwithcolumnsforeachrelatedpartyandifneededforthecomparablepartiescould

beusedtosummarizethe functionalanalysisandgiveaquick ideaofwhichpartyperforms

each relevant function, useswhat assets and bearswhich risk.But this shortcutoverview

shouldnotbeusedbytaxauditorstocountthenumberofenumerated functions,risksand

assetsinordertodeterminethearmslengthcompensation.Itshouldbeusedtoconsiderthe

relativeimportanceofeachfunction,riskandasset.

Once the functionalanalysis isperformedand the functionalityof theentityas regards the

transactions subject to review (or the entity as a whole) has been completed, it can be

determinedwhattransferpricingmethodismostsuitabletodeterminethearmslengthprice

forthetransactionsunderthereview (ortheoperatingmargin fortheentityunderreview).

Foralltransferpricingmethodsaccesstoinformationoncomparablesisnecessaryanditmay

bethatduetodifficultyingettingaccesstoreliabledataoncomparables,incertaininstances,

othermethodsmayneedtoberesortedtothanthosethatwouldseeminitiallypreferredand

mostreliable.

Although independentunrelatedcomparablesareusuallyusedfortransferpricingpurposes,

in practice, it is often observed that for certain countries it is not possible to identify

comparables or reliable company data that meet the comparability requirements. In such

cases, practical solutions must be sought in good faith by taxpayers and the tax

administration.Withoutanypreference,solutionsmayincludethefollowing:

Search for comparables in other geographical regions that share certain keysimilaritieswith the country inwhich a company conducts its business (e.g.,

depending on the industry, for manufacturers established in, for example,

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Africa, a search for comparables could be carried out in Asia or Eastern

Europe).

Use of industry analysis (publiclyavailable or internally conducted by thecompany)to identifyprofit levelsthatcanreasonablybeexpected forvarious

routinefunctions(e.g.,production,services,distribution,etc.).

Undertake an analysis that demonstrates the general applicability of acompanys transferpricingpolicygiven the specificeconomicenvironment in

whichthecompanyconductsitsbusiness.

Pleasenotethatthe listabove isnot intendedasanexhaustive listofsolutions.Rather,the

solutionsarepresentedasexamplesandareincludedforinformationpurposesonly.

Itmayalsobe thatdue todifficulty ingettingaccess to (publiclyavailable)data, in certain

instances,othermethodsmaythantheonespresentedabovemayneedtobeused.

1.3 Choiceofavailablemethods

Thesocalledtraditionaltransactionmethods(ComparableUncontrolledPrice,CostPlusand

ResalePriceMethod)arepreferredincertaincountries,althoughnohierarchyofmethodsis

beingadvocated in thisTransferPricingManual,other thanapplyingamethod that reliably

calculates or tests the companys transfer pricing and application of the arms length

standard.1

Considering thedifficultyandcostofgettingaccess to reliabledata, taxpayersmaywant to

make use of industry margins when applying the chosen and appropriate transfer pricing

method.However,theuseofindustrymarginsmayraisetheriskthatnotonlyunrelatedbut

also related party transactions are included in the comparability analysis. Therefore, it is

preferredthatwhenusingindustrymargins,themajorityofparticipantsintheindustrydonot

1TheOECDTransferPricingGuidelinesasrevisedin2010alsogivenoformalhierarchyinmethods.Referenceismadeto

paragraphs2.12.10oftheOECDTransferPricingGuidelines.

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havesignificantrelatedpartydealingsandthatthe industriescanbeconsideredcomparable

Onceamethod ischosenandapplied,taxpayersaregenerallyexpected touseandapplya

method in a consistent fashion. Assuming an appropriate transfer pricingmethod is being

applied,onlyiffactsorfunctionalitieschangeandthosechangesrequireachangeinmethods,

isachangeinmethodsenvisagedoralternativelywhentheavailablecomparabledatachange

suchthatamethodchangeisrequired.

2. TraditionalTransactionMethods

2.1.1 ComparableUncontrolledPrice

TheComparableUncontrolledPrice(CUP)methodcomparesthepricechargedforproperty

orservicestransferredinacontrolledtransactiontothepricechargedforpropertyorservices

transferred inacomparableuncontrolledtransaction incomparablecircumstances. Itshould

beobservedthattheCUPmethodisalsousedinpracticewithrespecttoroyalties.TheCUP

method applies to controlled transactionsofproperty and services.CUPsmaybe found as

internaltransactionsorasexternaltransactions.Figure1belowexplainsthisdistinction.

WorkingDraftEditorialnote:Onepossibilitywouldbe that taxpayersneednotbenchmark their transferpricingwitha

formalbenchmarksearchincaseswherefunctionsandtransactionssubjecttothebenchmarkdonotexceedastatedvolume

oramountonafiscalyearbasis.The industrymarginsreferredtoshouldbe:basedonobjectivecriteria,regularlyupdated

and readilyavailableatnocost. Apossibleexamplecouldbemarginspublishedor formallyapprovedat theappropriate

functionalleveloftheUNsystem,butthesedonotcurrentlyexist.

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The controlled transaction in this figure concern the transfer of cars between Associated

Enterprise 1, a car producer in country 1, and Associated Enterprise 2, a car importer in

country2,which resells thecars tocardealers incountry2. AssociatedEnterprise1 is the

parentcompanyofAssociatedEnterprise2.

Inapplying theCUPmethod todeterminewhether thepricecharged forcars transferred in

thiscontrolledtransactionisarmslengthreferencecanbemadeto:

The price charged for cars transferred in a comparable uncontrolledtransaction, ifany,betweenAssociatedEnterprise1andUnrelatedParty (i.e.

transaction#1);

The price charged for cars transferred in a comparable uncontrolledtransaction,ifany,betweenAssociatedEnterprise2andanunrelatedparty(i.e.

transaction#2);and

Thepricepaidforcarstransferredinacomparableuncontrolledtransaction,ifany,betweenUnrelatedPartyAandUnrelatedPartyB(i.e.transaction#3)

Associated Enterprise 1

Unrelated Party A


Unrelated Party

Unrelated Party B

(External)

1 (Internal)

3

Figure 1: Comparable Uncontrolled Price Method

2 (Internal)

Controlled transaction

Uncontrolled transaction

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Comparableuncontrolled transactions similar to transaction#1or#2 canbe referred toas

internal comparables. Comparable uncontrolled transactions similar to transaction #3 are

called external comparables, because the uncontrolled transaction involves two parties,

neitherofwhichisoneoftheassociatedenterprises.

The application of the CUP method based on internal comparables involves a detailed

transactional comparison, whereby the controlled and uncontrolled transactions are

comparedbasedon the five comparability factorsmentioned inChapter [7].Thedetailsof

thesefactorsarenecessarytoperformsuchacomparison.Usuallyallofsuchdetailsarenot

availablewhenothermethods (CostPlus,ResalePriceMethodetc.)arebeingapplied.The

latterareusuallyappliedusingabenchmarkinganalysis(asearchforcomparablecompanies

inpublicallyavailabledatabases).

2.1.2 Comparability

Whenapplying theCUPmethod,anuncontrolled transaction isconsideredcomparable toa

controlledtransactionif:

There are no differences in the transactions being compared thatmateriallyaffecttheprice;or

Reasonable [Reliable] adjustments can be performed to account for productandotherdifferencesthatarematerial.

In performing the comparability analysis the controlled transactions and uncontrolled

transactionsshouldbecomparedbasedon thecomparability factorsmentionedearlierand

addressed in detail in Chapter [ 7 ]. In determining the degree of comparability between

controlledtransactionsinFigure1anduncontrolledtransaction#1,forexample,thefollowing

factors should be taken into account: characteristics of property or services, contractual

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terms,economiccircumstancesandbusinessstrategies.Forfunctionalanalysis,itisnecessary

toanalysethefunctionsperformed,therisksassumedandtheassetsused.

ProductcomparabilityshouldbecloselyexaminedinapplyingtheCUPmethod.Apricemaybe

materially influenced by differences between the goods transferred in the controlled and

uncontrolled transactions, although the functions performed and risks assumed (e.g.

marketingandselling function)aresimilarsoas to result insimilarprofitmargins.TheCUP

method is appropriate especially in cases where an independent enterprise sells products

similar to those sold in the controlled transaction. Reference is made to the Coffee case

examplebelow.

Although product comparability is important in applying the CUP method, the other

comparabilityfactorsshouldnotbedisregarded.Contractualtermsandeconomicconditions

arealsoimportantcomparabilityfactors.

Technically,therearetwotypesofCUPs:CloseCUPsandinexactCUPs.Thesearetheresultof

(unrelatedparty)transactionsthatareadjustedtotakeaccountofmaterialdifferences.

Reliableadjustmentsmaybepossiblefor:

difference regarding the source of the products: unbranded Kenyan ascomparedwithunbrandedBraziliancoffeebeans;

difference indelivery terms: forexample,AssociatedEnterprise1 inFigure1sellssimilarcarstoAssociatedEnterprise2andanUnrelatedParty.Allrelevant

information on the controlled and uncontrolled transactions is available to

AssociatedEnterprise1,andhence it isprobable thatallmaterialdifferences

between the transactions can be recognized. It is assumed that the

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circumstances relating to the controlled and uncontrolled transactions are

similar. The only material difference that could be identified between the

transactionsisthatthepricerelatingtothecontrolledtransactionisadelivered

price (i.e. including transportation and insurance), while the uncontrolled

transaction#1ismadeexwarehouse.AssociatedEnterprise1sfactory(i.e.ex

works with the buyer taking responsibility from named place of delivery,

which isAssociated Enterprise1s factory). It ispossible toperform reliable

adjustmentsforthisdifference.Theuncontrolledpriceshouldthenbeadjusted

forthedifferenceindeliverytermstoeliminatetheeffectofthisdifferenceon

theprice;

volume discounts: for example, Associated Enterprise 1 sells 5000 cars toAssociatedEnterprise2for$20,000percar,whileitsells1000similarcarstoan

UnrelatedParty. Itshouldbeanalyzedwhetherdifferences involumehavea

materialeffectonprice,and ifso,how toperformadjustmentsbyexamining

volumediscountsinsimilarmarkets;

product modifications: for example, the uncontrolled transactions to anUnrelatedParty inFigure3 involvecarsonwhichproductmodificationshave

been made. However, the cars sold in the controlled transactions do not

include these product modifications. If the product modifications have a

materialeffectonprice,thentheuncontrolledpriceshouldbeadjustedtotake

intoaccountthisdifferenceinprice.

riskincurred,forexample,AssociatedEnterprise1carriesinventoryriskrelatedtosalesbyAssociatedEnterprise2andbaddebtriskasregardscustomersof

Associated Enterprise 2, whereas as between Associated Enterprise 1 and

UnrelatedParty,theUnrelatedPartycarriesinventoryriskandbaddebtriskas

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regardsitscustomers.Itshouldnowbeanalyzedandquantifiedwhattheeffect

oftheriskallocationisbeforeAssociatedParty2spricesandUnrelatedPartys

pricescanbeconsideredcomparable.

Reliableadjustmentmaynotbepossiblefor:

trademarks: for example, Associated Enterprise 1 in Figure 1 attaches itsvaluable trademark Ferrori on the cars transferred in the controlled

transaction, while uncontrolled transaction #1 concerns the transfer of cars

withoutthetrademarkFerrori.Itisknownthattheeffectofthetrademarkon

thepriceofthecarismaterial.However,itwillbedifficult,ifnotimpossible,to

perform an adjustment to account for the trademark Ferrori, an intangible

propertythatisunique.Asreliableadjustmentscannotbemadetoaccountfor

thismaterialproductdifference,theCUPmethodmaynotbetheappropriate

methodinsuchacase;

effectsofgeographicaldifferences: forexample,AssociatedEnterprise1 sellscarstoAssociatedEnterprise2locatedinSouthAfrica,whileanUnrelatedParty

to which it also sells the same cars is located in Egypt. The only material

difference that could be identified between the controlled and uncontrolled

transactionsconcernsthegeographicaldifference.Toperformadjustmentsto

account for this difference one should consider, for example, differences in

inflation rates between South Africa and Egypt, the competition in the two

countriesandgovernmentalregulations;and

major product differences. If reliable adjustments cannot be performed toaccountforproductdifferencesthatarematerial,thentheCUPmethodwillnot

leadtoareliablemeasureofanarmslengthresult.

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Difficultiesresultingfromperformingreasonablyaccurateadjustmentstoremovetheeffectof

materialdifferencesonpricesshouldnotautomaticallypreventtheuseoftheCUPmethod.

Oneshouldtryhardtoperformreasonableadjustments.

If reasonable adjustments cannot be performed, the reliability of the CUP method is

decreased. Anothertransferpricingmethodmaythenbeused incombinationwiththeCUP

methodorconsideredinsteadoftheCUPmethod.

2.1.3 StrengthsandWeaknesses

ThestrengthsoftheCUPmethodinclude:

it isnotaonesidedanalysisastheprice isarrivedatbetween twopartiestothetransaction;and

avoiding the issue ofwhich of the related parties involved in the controlledtransactionshouldbethetestedpartyfortransferpricingpurposes.Thisissue

arises if the other two traditional transaction methods are applied.2 These

methods determine a transfer price based on the perspective of the tested

party in the analysis. For example, if the resale price method is used, the

relatedpartysalescompanyisthetestedpartyinthetransferpricinganalysis.

However, if thecostplusmethod isused,therelatedpartymanufacturerwill

bethetestedparty.Theresultingtransferpricesbasedonthesetwomethods

willprobablydifferfromeachother;and

itinvolvesadetailedtransactionalcomparison.

2Also,ifthetransactionalnetmarginmethodisusedorthecomparableprofitsmethod.

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TheweaknessesoftheCUPmethodinclude:

itwillveryoftenbehardtofindcloselycomparableuncontrolledtransactionsasstrictcomparabilitystandardisrequiredparticularlywithrespecttoproduct

comparibility;and

internal comparables frequently dont exist and external comparables aredifficulttofindinpractice.

2.1.4 WhentousetheCUPMethod?

In cases where comparable uncontrolled transactions can be found, the CUP method is a

directand soundmethod todeterminewhether theconditionsofcommercialand financial

relations between associated enterprises are at arms length. This implies that when

examining a transfer pricing issue the analysis could startwith the application of the CUP

method.Thatis,oneshouldprobablyalwaysconsiderstartingwithlocatingpossibleinternal

comparables and external comparables. A standard question that should be asked in any

analysisiswhetheroneoftheassociatedenterprisesinvolvedisengagedintransactionswith

independent enterprises. In our example of Figure 1 above, the question is whether

Associated Enterprise 1 sells comparable cars to an Unrelated Party. Furthermore, does

AssociatedEnterprise2purchasecomparablecarsfromanunrelatedcarmanufacturer.Ifthe

answerisyestoanyoneofthesequestions,thenthenextstepintheanalysisistodetermine

thedegreeofcomparabilitybetweenthecontrolledanduncontrolledtransactionsbasedon

thecomparability factors. Ifno internalcomparablescanbe found, thenone should try to

locateexternal comparables.Dataonexternal comparableswillbehard to find inpractice,

maybeonlywhenthetransactionsinvolveahomogeneousproductorservice.However,the

Guidelines indicate thatone should strive tomake itpossible that theCUPmethod canbe

appliedpossiblyincombinationwithanothertransferpricingmethod.

Basedonpracticalexperience,theCUPmethodwillbemostusefulinthefollowingsituations:

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one of the associated enterprises involved is engaged in comparableuncontrolled transactions with an independent enterprise (i.e. an internal

comparable is available). In such a case, all relevant information on the

uncontrolled transactions is available and it is therefore probable that all

materialdifferencesbetweencontrolledanduncontrolled transactionswillbe

identified;

the transactions involve commodity type products, but only those in whichproductdifferencesare[negligible][verylimited];and

theinterestratechargedforanintercompanyloan.

IftheCUPmethodcannotbeapplied, othertraditionaltransactionmethodsavailableunder

theGuidelinesaretheresalepricemethodandthecostplusmethod.

2.1.5 CaseExamples

[tobeinserted]

2.2.1 ResalePriceMethod

The resalepricemethod isoneof the traditional transactionmethods that canbeused to

apply the arms length principle. The resale price method focuses on the related sales

companywhichperformsmarketingandselling functionsas the testedparty in the transfer

pricinganalysis.

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2.2.2 MechanismofResalePriceMethod

Themechanismof the resalepricemethod reduces thepriceofaproduct that the related

salescompany(i.e.AssociatedEnterprise2inFigure2)chargestoanunrelatedcustomer(i.e.

theresaleprice)byanarms lengthgrossmargin,whichthesalescompanyusestocover its

selling, general and administrative (SG&A) expenses, and still make an appropriate profit,

takingintoaccountitsfunctionsperformedandrisksincurred.Theremainderisregardedas

anarms lengthtransferpriceforthe intercompanytransactionsbetweenthesalescompany

(i.e.AssociatedEnterprise2)andarelatedcompany3(i.e.AssociatedEnterprise1).

Undertheresalepricemethod,thestartingpointoftheinternalpricesettingprocedureisthe

salescompany.

Theformulaforthetransferpriceinintercompanytransactionsofproductsisasfollows:

TP=RSPx(1GPM),where:

TP = the Transfer Price of a product sold between a sales company and arelatedcompany;

3Usuallyamanufacturingcompanyowningvaluablepatentsortheprincipalinacommissionairearrangement.



Independent Enterprise

Figure 2: Resale Price Method

Arms Length Price?

Price is Given

Given price = 10,000 - Resale price margin (25%) = 2,500 Arms Length Price = 7,500

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RSP = the Resale Price at which a product is sold by a sales company tounrelatedcustomers;and

GPM = the Gross Profit Margin that a specific sales company should earn,definedastheratioofgrossprofittonetsales. Grossprofit isdefinedasNet

SalesminusCostofGoodsSold.

Asanexample, letusassume that the resaleprice inFigure2 is$10,000. Thismeans that

AssociatedEnterprise2 resells the car to the IndependentEnterprise for$10,000. Assume

that an arms length gross profitmargin that Associated Enterprise 2 should earn is 25%.

AssociatedEnterprise2shouldcoveritsSG&Aexpensesandmakeanappropriateprofitwith

this 25% gross margin. The resulting transfer price between Associated Enterprise 1 and

AssociatedEnterprise2 (i.e.thecostofgoodssoldofAssociatedEnterprise2) is$7,500 (i.e.

$10,000x(10.25).

Ifthesalescompanyactsasasalesagentthatdoesnottaketitletothegoods,itispossibleto

use the commission earned by the sales agent represented as a percentage of the

uncontrolledsalespriceof thegoodsconcernedas thecomparablegrossprofitmargin.The

resale price margin for a reseller performing a general brokerage business should be

establishedconsideringwhetheritisactingasanagentoraprincipal.

2.2.3 ArmsLengthGrossProfitMargin

Thefinancialratioanalysedundertheresalepricemethodisthegrossprofitmargin,whichis

definedasthegrossprofittonetsalesratioofthesalescompany.

Asdiscussedabove,grossprofitequalsnetsales/costofgoodssoldofasalescompany.The

net sales of a sales company concern the sales revenue obtained by selling products to

unrelated customers, while the cost of goods sold includes the transfer price paid to the

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relatedmanufacturer.Foradistributioncompany,costofgoodssold represents thecostof

purchasingthegoodssold.

Accountingconsistencyisimportantinapplyingtheresalepricemethod.Grossprofitmargins

willnotbecomparableifaccountingprinciplesand/orpracticesdifferbetweenthecontrolled

transactionandtheuncontrolledtransaction.Forexample,thecomparabledistributorsmay

differfromtherelatedsalescompanyinreportingcertaincosts(e.g.,discounts,transportation

costs, insuranceandcostsofperformingthewarranty function)asoperatingexpensesoras

cost of goods sold. Differences in inventory valuation methods will also affect the gross

margins. It is thus important that theanalysisdoesnotcompareappleswithbananasbut

rather,appleswithapples.Therefore,appropriateadjustmentsshouldbeperformedtothe

data used in computing the gross margin to make sure that similar gross margins are

compared.

[Possibilityof includingmorespecific instances inwhichappropriateadjustmentsshouldbe

made.]

2.2.4 Transactionalcomparisonversusfunctionalcomparison

The arms length (range of) grossprofitmargin to be earned by the sales company in the

controlledtransactionisdeterminedinthefollowingtwoways:

transactionalcomparison:thegrossprofitmarginthatAssociatedEnterprise2earns when reselling cars purchased from an independent manufacturer in

comparable uncontrolled transaction. This uncontrolled transaction should

initiallyhavebeenrejectedasaninternalcomparable;and

functional comparison: the gross profit margins earned by independentcompanies incomparableuncontrolled transactionsperforming functionsand

incurring risks comparable to the functions performed and risks incurred by

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Associated Enterprise2. Functional comparison thus involves a search for

comparabledistributioncompanies.

In practice the application of the resale price method is often based on a functional

comparison. The benchmarking analysis under functional comparison is performed

usingcomparabledata.Thosedatemaybeavailableviapubliclyavailabledatabases.

Basedon thebenchmarking and financial analyses, anarms length rangeof grossmargins

earnedbycomparableindependentdistributorsisestablishedandfallbetweenx%andy%.If

thegrossmarginearnedbyAssociatedEnterprise2iswithinthisrange,thenitstransferprice

willbeconsideredarmslength.

2.2.5 Comparability

Inapplyingtheresalepricemethod,anuncontrolledtransactionisconsideredcomparableto

acontrolledtransactionif:

there are no differences between the transactions being compared thatmateriallyaffectthegrossmargin;or

reasonablyaccurateadjustmentscanbeperformed toeliminate theeffectofsuchdifferences.

Under the resale price method, functional comparability is important, while product

comparabilityislessimportant.Productdifferencesarelesscriticalfortheresalepricemethod

thanfortheCUPmethod,becauseitislessprobablethatproductdifferenceshaveamaterial

WorkingDraftEditorialnote:Asnotedabove,onepossibilitywouldbethattaxpayersneednotbenchmarktheirtransfer

pricingwithaformalbenchmarksearchincaseswherefunctionsandtransactionssubjecttothebenchmarkdonotexceeda

stated volume or amounton a fiscal year basis. The industrymargins referred to should be:basedonobjective criteria,

regularlyupdatedandreadilyavailableatnocost.Apossibleexamplecouldbemarginspublishedorformallyapprovedatthe

appropriatefunctionalleveloftheUNsystem,butthesedonotcurrentlyexist.

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effectonprofitmarginsthanonprice.Onewouldexpectasimilarlevelofcompensationfor

performingsimilarfunctionsacrossdifferentactivities.

TheOECDGuidelinespresentanexamplewherethecompensationforadistributioncompany

shouldbe the samewhether it sells toastersorblenders,because the functionsperformed

(including risks incurred and assets used) are similar for the two activities. The price of a

toasterwill,however,differ from thepriceofablender,as the twoproductsarenotclose

substitutes.Althoughproductcomparabilityislessimportantundertheresalepricemethod,

it stillapplies thatcloserproduct similaritywill lead tobetter resultsof the transferpricing

analysis. In this respect, product comparability will become more important when the

transaction involves intangible property. This means that it is not necessary to conduct a

resale price analysis for each individual product line distributed by the sales company.

Instead,theresalepricemethod isgenerallynotappliedonspecificproductlines,butrather

usedtodefinethegrossmarginasalescompanyshouldearnoveritsfullrangeofproducts.

Asthegrossprofitmarginremuneratesasalescompanyforperformingmarketingandselling

functions, the resalepricemethodespeciallydependson comparability regarding functions

performed, trisks assumed and assets used. The resale price method thus focuses on

functional comparability.A similar levelof compensation isexpected forperforming similar

functions across different activities. If there arematerial differences that affect the gross

marginsearned in the controlledand theuncontrolled transactions,adjustments shouldbe

madetoaccount forsuchdifferences.Adjustmentsshouldbeperformedonthegrossprofit

margins of the uncontrolled transactions. The operating expenses in connection with the

functions performed and risks incurred should be taken into account in this respect as

differencesinfunctionsperformedarefrequentlyconveyedinoperatingexpenses.

Thefollowingfactorsmaybeconsideredindeterminingwhetheranuncontrolledtransaction

iscomparabletothecontrolledtransactionforpurposesofapplyingtheresalepricemethod:

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Thereliabilityoftheresalepricemethodcanbeinfluencedbyfactorsthathavelesseffectonprice.Thesefactorsincludecoststructures(e.g.,theageofplant

andequipment),businessexperience(e.g.,startupphaseormaturebusiness),

ormanagementefficiency.

A resale price margin requires particular attention in case the reseller addssubstantiallytothevalueoftheproduct (e.g.,byassistingconsiderably inthe

creation ormaintenance of intangible property related to the product (e.g.,

trademarks or tradenames) and goods are further processed into a more

complicatedproductbytheresellerbeforeresale).

Theamountoftheresalepricemarginwillbeaffectedbythelevelofactivitiesperformedbythereseller.Forexample,thedistributionservicesprovidedbya

reselleractingasasalesagentwillbe lessextensivethanthoseprovidedbya

reselleractingasabuyselldistributor. Thebuyselldistributorwillobviously

obtainahighercompensationthanthesalesagent.

If the reseller performs a significant commercial activity besides the resaleactivity itself,or if itemploysvaluableanduniqueassets in itsactivities (e.g.,

valuablemarketingintangiblesofthereseller),itmayearnahighergrossprofit

margin.

Incasethereisasetoftransactionsinwhichgoodsaredistributedthroughanintermediatecompany, taxadministrationsmaynotonlyanalyse thepriceof

goodsthatareboughtfromtheintermediatecompany,butalsothepricepaid

bythe intermediarycompanyto itsownsupplierandthefunctionsperformed

bytheintermediatecompany,ifthatinformationisavailable.

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The comparabilityanalysis should take intoaccountwhether the resellerhastheexclusiverighttoresellthegoods,becauseexclusiverightsmayaffectthe

resalepricemargin.

Theanalysis should considerdifferences inaccountingpracticesbetween thecontrolledanduncontrolledtransactionsthatmateriallyaffecttheresaleprice

margin.

Thereliabilityoftheanalysiswillbeaffectedbydifferencesinthevalueoftheproductsdistributed,forexample,asaresultofavaluabletrademark.

Inpractice,significantdifferenceinoperatingexpensesisoftenanindicationofdifferencesin

functions, assets or risks. Thismay be remedied if operating expense adjustments can be

performedontheunadjustedgrossprofitmarginsofuncontrolledtransactionstoaccountfor

differences infunctionsperformedandthe levelofactivitiesperformedbetweentherelated

party distributor and the comparable distribution companies. Since these differences are

oftenreflectedinvariationoftheoperatingexpenses,adjustmentswithrespecttodifferences

intheSG&Aexpensestosalesratioasaresultofdifferencesinfunctionsandlevelofactivities

performedmayberequired.


Thestrengthsoftheresalepricemethodinclude:

it isbasedon theresaleprice,amarketprice,and thusrepresentsademanddrivenmethod[tobedevelopedfurther,includingwhetherinmanydeveloping

countries resalepricemethodmaybemoreaccurate than costplusalso to

considersituationofhighcostsuppliers];

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it can be used without forcing distributors to make unrealistic profits. Thedistributor should earn an arms length gross profitmargin, however, it can

makeoperatinglossesduetohighsellingexpensescausedbystrategiessuchas

amarketpenetrationstrategy;

the application of the transactional net margin method, which analyses afinancialratiobasedonoperatingprofits,willgenerallyresultinanarmslength

rangeofpositiveoperatingprofits.Thetestedpartyintheanalysisshouldthen

probablyalsoearnapositiveoperatingprofitwithintherange. However,the

resalepricemethoddoesnotnecessarilyresult inpositiveoperatingprofitsto

beearnedbythetestedparty.[Asaresultitcanbeseenasmorerealistic.]

Theweaknessesoftheresalepricemethodinclude:

it isaonesidedanalysis,as its focus ison the related sales companyas thetestedparty inthetransferpricinganalysis.Itispossiblethatthearms length

grossprofitmarginandhencetransferprice,whichisbasedonabenchmarking

analysis,canleadtoanextremeresult(i.e.lossmaking)fortherelatedsupplier

ofthesalescompany;and

the data on gross margins may not be comparable due to accountinginconsistencies.

2.2.7 WhentousetheResalePriceMethod?

Ifcomparableuncontrolledtransactionscanbe identified,theCUPmethodmayverywellbe

themostdirect and soundmethod to apply the arms lengthprinciple. If theCUPmethod

cannotbeapplied,however,other traditional transactionmethods toconsiderare thecost

plusmethodandtheresalepricemethod.

The resalepricemethod isnormallyused incaseswhich involve thepurchaseand resaleof

tangiblepropertyinwhichtheresellerdoesnotaddsubstantialvaluetothetangiblegoodsby

wayofphysicallymodifying theproductsbefore resaleor inwhich the reseller contributes

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substantiallytothecreationormaintenanceofintangibleproperty.[Theresalepricemethodis

thustypicallyappliedtosalesordistributionactivities.]

Inatypical intercompanytransaction involvingafullyfledgedmanufacturerowningvaluable

patents or other intangible properties and affiliated sales companies which purchase and

reselltheproductstounrelatedcustomers,theresalepricemethodisamethodtouseifthe

CUP method is not applicable and the sales companies do not own valuable intangible

properties.

ConsidertheexampleofFigure2.AssumethatAssociatedEnterprise1ownsvaluablepatents

tomanufacture thecarsandavaluable tradename. AssociatedEnterprise2purchases the

carsfromAssociatedEnterprise1andresellsthecarstounrelateddealersinthelocalcountry.

Insuchacase,theresalepricemethodwillbeselectedtodetermineanarmslengthtransfer

pricebetweenAssociatedEnterprise1andAssociatedEnterprise2iftheCUPmethodcannot

beapplied.Thecostplusmethodwillnotbeselected,becausethefullyfledgedmanufacturer

(i.e.AssociatedEnterprise1)ownsvaluableintangibles,performsR&Dactivitiesandgenerally

has operations that are more complex than those of the sales company (i.e. Associated

Enterprise2),theresultsobtainedfromapplyingthecostplusmethodwillnotbeasreliable

astheresultsobtainedfromapplyingtheresalepricemethodthatusesthesalescompanyas

the tested party. It will be very difficult, if not impossible, to identify manufacturers

comparable to Associated Enterprise 1 owning comparable intangible properties when

applying thecostplusmethod. The resalepricemethodwillestablish the transferpriceby

referencetotheresaleorgrossmargins(grossprofit/netsales)earnedbythirdpartyresellers

(assuming that internalcomparison isnotpossible)andcompares them to thegrossmargin

earnedbyAssociatedEnterprise2onthecarspurchasedfromrelatedparties.

The resale price method is also typically applied in a commissionaire / commission agent

structureinvolvingaprincipalandrelatedcommissionaires/commissionagents.Inthiscase,

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the resale price method will establish an arms length commission to be earned by the

commissionaires/commissionagents.

2.2.8 CaseExamples

[tobeinserted]

2.3.1 CostPlusMethod

Inacontrolled transaction involving tangibleproperty, thecostplusmethod focuseson the

relatedmanufacturingcompanyas thetestedparty inthetransferpricinganalysis.Thecost

plusmethodmayalsobeusedinthecaseofservicesrendered.

Thecostplusmethodbeginswiththecostsincurredbythesupplierofproperty(orservices)

in a controlled transaction for property transferred or services provided to a related

purchaser. An appropriate cost plus mark up is then added to this cost, to make an

appropriateprofitinlightofthefunctionsperformed,risksassumed,assetsusedandmarket

conditions.

Thecostplusmethod isusedtoanalysetransferpricing issues involvingtangiblepropertyor

services both under the OECD Transfer Pricing Guidelines and the US transfer pricing

regulations.Itismostusefulwhereitisappliedtomanufacturingorassemblingactivitiesand

relatively simple service providers. The cost plus method focuses on the related party

manufacturer or service provider as the tested party in the transfer pricing analysis. The

method evaluates the armslength nature of an intercompany charge by reference to the

gross profit mark up on costs incurred by suppliers of property (or services) for tangible

property transferred (orservicesprovided). Itcompares thegrossprofitmarkupearnedby

thetestedpartyformanufacturingtheproductorforprovidingtheservicetothegrossprofit

markupsearnedbycomparablecompanies.

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Figure 3 explains this further.Associated Enterprise 1, an electrical goodsmanufacturer in

country1,manufactures[undercontractfor]AssociatedEnterprise2.AssociatedEnterprise2

will instruct Associated Enterprise 1 about the quantity and quality of the goods to be

manufactured. AssociatedEnterprise1willbeguaranteed sales toAssociatedEnterprise2

andwillfacelittlerisk.IftheCUPmethodcannotbeapplied,thentheresalepricemethodand

thecostplusmethodarethenextmethodstobeconsidered.BecauseAssociatedEnterprise1

islesscomplexintermsoffunctionsandrisksincomparisonwithAssociatedEnterprise2,the

analysis would focus on Associated Enterprise 1 as the tested party. Since Associated

Enterprise1 canbe regardedas (a simple)manufacturer, the costplusmethod is thebest

methodofanalysisinthiscase.Thecostplusmethodanalyseswhetherthegrossprofitmark

upearnedbyAssociatedEnterprise1isarms lengthornot.Thecostplusmethodthusdoes

notdirectlytestwhetherthetransferpriceisarms lengthbycomparingprices.Assuch, itis

anindirectmethodcomparedtotheCUPmethod.

2.3.2 MechanismoftheCostPlusMethod

Under the cost plus method, an armslength price equals the controlled partys cost of

producingthetangiblepropertyplusanappropriategrossprofitmarkup,definedastheratio



Figure 3: Cost Plus Method

Arms Length Price?

Costs for Associated Enterprise 1 = $500 + Gross Profit Mark Up (50%) = $250 Arms Length Price = $750

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of gross profit to cost of goods sold (excluding operating expenses) for a comparable

uncontrolledtransaction.

Theformulaforthetransferpriceinintercompanytransactionsofproductsisasfollows:

TP=COGSx(1+costplusmarkup),where:

TP= theTransferPriceofaproduct soldbetweenamanufacturing companyandarelatedcompany;

COGS=thecostofgoodssoldofthemanufacturingcompany Costplusmarkup=grossprofitmarkupdefinedastheratioofgrossprofitto

costofgoodssold.Grossprofitisdefinedassalesminuscostofgoodssold.

Asanexample,letusassumethattheCOGSinFigure3is$5,000.Assumethatanarmslength

grossprofitmarkupthatAssociatedEnterprise1shouldearn is50%. Theresultingtransfer

pricebetweenAssociatedEnterprise1andAssociatedEnterprise2is$7,500(i.e.$5,000x(1+

0.50)).

2.3.3 ArmsLengthGrossProfitMarkup

Thefinancialratioconsideredunderthecostplusmethodisthegrossprofitmarkup,whichis

definedasthegrossprofittocostofgoodssoldratioofamanufacturingcompany.

Asdiscussedabove,grossprofitequalsnetsales/costofgoodssoldofasalescompany.For

amanufacturingcompany,costofgoodssoldshowthecostofproducingthegoodssold. It

includesdirectlabour,directmaterialandfactoryoverheadsassociatedwithproduction.

Gross profit markups will not be comparable if accounting principles differ between the

controlled transaction and the uncontrolled transaction. Gross profit markups should

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thereforebecalculateduniformlybetweenthetestedpartyandthecomparablecompanies.

Forexample,thecomparablemanufacturersmaydifferfromtherelatedpartymanufacturer

inreportingcertaincosts(e.g.,costsofR&D)asoperatingexpensesorascostofgoodssold.

Differencesininventoryvaluationmethodswillalsoaffectthecomputationofthegrossprofit

markup.Appropriateadjustmentsshouldthereforebeperformedtoensurethatgrossprofit

markupiscalculatedinaconsistentway.

Thecostsandexpensesofacompanynormallyconsistofthe following threegroups:direct

costofproducingaproductorservice(e.g.,costofrawmaterials),indirectcostsofproduction

(e.g., costs of a repair department that services equipment used tomanufacture different

products),andoperatingexpenses(e.g.,SG&Aexpenses). Thecostplusmethodconsidersa

profit margin that is calculated after direct and indirect costs of production have been

subtracted. A net margin analysis also considers operating expenses. Due to differences

betweencountries,theboundariesofthethreegroupsofcostsandexpensesarenotclearcut

ineachandeverycase. Inasituation inwhich it isnecessary toconsidercertainoperating

expenses to obtain consistency and comparability, the cost plusmethod of analysis comes

closetoanetmarginanalysisinsteadofagrossmarginanalysis.

Forexample,assumethatAssociatedEnterprise1,thecarmanufacturerwhichmanufactures

thecarsundercontractforAssociatedEnterprise2,earnsagrossprofitmarkupof15percent

onitscostofgoodssoldandclassifiesSG&Aexpensesasoperatingexpensesthatarenotpart

ofcostofgoodssold.Fourcomparableindependentmanufacturersareidentifiedwhichearn

gross profit markups between 10 to 15 percent. However, these comparable companies

account for SG&Aexpensesas costofgoods sold.Theunadjustedgrossprofitmarkupsof

thesecomparablesare thusnotcalculatedsimilar to thegrossprofitmarkupofAssociated

Enterprise1. Adjustmentsshouldbemadeonthegrossprofitmarkupsoftheuncontrolled

transactionsforpurposesofaccountingconsistency.

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The arms length (rangeof) grossprofitmarkups canbe establishedby the following two

ways:

transactionalcomparison:thegrossprofitmarkupearnedbytherelatedpartymanufacturerwhensellinggoodstoanindependententerpriseinacomparable

uncontrolled transaction, which previously has been rejected as an internal

comparable;and

functional comparison: the gross profit markups earned by independentcompanies performing functions and incurring risks comparable to the

functions performed and risks incurred by the related party manufacturer.

Functional comparison involves a search for comparable manufacturing

companies.

Inpractice,thecomparabilitystandardoftransactionalcomparisonwillbemuchhigherthat

thatoffunctionalcomparison. Inatransactionalcomparison,muchmore informationabout

the controlled and uncontrolled transactions is available (e.g., contractual terms). In a

functionalcomparison that isbasedon informationprovided inpubliclyavailabledatabases

and the annual reports of comparable companies and the tested party,much less specific

information is availablewith respect to the functions performed and risks incurred by the

companies.

However, functional comparison isusedmostoften inpractice.The search for comparable

companiesunderfunctionalcomparisonwillbeperformedusingpubliclyavailabledatabases.

Basedonthisbenchmarkingandfinancialanalyses,anarmslengthrangeofgrossprofitmark

upsearnedbycomparableindependentmanufacturerswillbedetermined(e.g.,between30%

and45%). Ifthegrossprofitmarkupearnedbytherelatedpartymanufacturer fallswithin

thisrange(e.g.,40%),thenitstransferpricewillbeconsideredarmslength.

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2.3.5 Comparability

Inapplyingthecostplusmethod,anuncontrolledtransaction isconsideredcomparabletoa

controlledtransactionif:

there are no differences between the transactions being compared thatmateriallyaffectthegrossprofitmarkup;or

reasonablyaccurateadjustmentscanbeperformedtoadjust for theeffectofsuchdifferences.

Similar to the resalepricemethod, close similarityofproductsbetween the controlledand

uncontrolled transactions is less importantunder thecostplusmethod thanunder theCUP

method,while functional comparability (including risksassumedandassetsused) is crucial.

However, because significant product differences may point out significant functional

differences, the controlled and uncontrolled transactions should ideally involve the

manufacturingofproductswithinthesameproductfamily.

As the gross profit markup remunerates a manufacturing company for performing

manufacturing function, the cost plusmethod especially relies on functional comparability

(takingintoaccountthefunctionsperformed,therisksassumedandassetsused).Ifthereare

materialdifferencesthataffectthegrossprofitmarkupsachievedonthecontrolledandthe

uncontrolledtransactions,adjustmentsshouldbemadetoaccount forsuchdifferences.The

adjustments shouldbemadeon thegrossprofitmarkupsof theuncontrolled transactions.

Theoperatingexpensesinconnectionwiththefunctionsperformedandrisksincurredshould

betaken intoaccount inthisrespectasdifferences infunctionsperformedmayverywellbe

conveyedinoperatingexpenses.

2.3.6 DeterminationofCosts

Nexttoaccountingconsistency,theapplicationofthecostplusmethodentailsanumberof

potentialdifficultiesassociatedwiththedeterminationofthecosts:

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costsmaynotberelevant indeterminingtheprofit foraparticularyear. Thelink between costs incurred and themarket price can be veryweak (e.g., a

company has incurred few R&D expenses in developing a very valuable

technology);

itis importanttoapplyacomparablemarkuptoacomparablecostbasis. Onthispoint,thefollowingcanbenoted:

o differencesbetweenthepartiesbeingcompared,whichmay influencethe

markup level,shouldbeexamined. Inthisrespect, it iscrucialtoconsider

differences in the level and types of expenses in connection with the

functions performed and risks assumed between the controlled and

uncontrolled transactions. If differences represent inefficiencies or

efficienciesofthepartiesbeingcompared,noadjustmenttothegrossprofit

markupshouldbemade.Ifdifferencesrepresentadditionalfunctionsthat

are different from the activities being analysed, it may be required to

establish a separate remuneration for these additional functions. If

differences reflect functionaldifference,anadjustment to thegrossprofit

markup should be made, although it is acknowledged that publicly

available data often do not provide sufficient information to make

adjustments.

o somecostsshouldbeexcludedfromthecostbasisandothercostsshould

includeamarkup.A thirdcategory includedisbursements incurred in the

provision of services, which should simply be reimbursed by the service

recipients,andnotincludedinthecostbasisonwhichamarkupisapplied.

For example, in the process of renderingmarketing services to a related

subsidiary, a service provider incurs advertisement expenses paid to an

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unrelatedadvertisementagency.Theseexpensesshouldbereimbursedby

therelatedsubsidiaryandshouldnotincludeamarkup.However,thecost

incurredbytheserviceproviderinrenderingtheseservicesshouldincludea

markup.

o the cost plus method is typically applied on controlled transactions

involvingacontractmanufacturerwhichdoesnotownproduct intangibles

andobtains instructions from a related customer about thequantity and

quality to produce.

A distinction can be made between a contract manufacturer in which the

related customer puts raw materials in consignment with the manufacturer

(consignment manufacturer) and a contract manufacturer which purchases

therawmaterialsitself(turnkeymanufacturer).Therawmaterialsareusedto

perform manufacturing functions. The consignment manufacturer does not

incur inventory risk relating to the raw materials, while the turnkey

manufacturerdoestaketitletotherawmaterialsanthereforeincursthisrisk.

Thecostplusmethod isapplicable inbothcases iftheCUPmethodcannotbe

applied. However,thecostbasisandthemarkupwillbedifferent. Thecost

basisoftheconsignmentcasewillincludethevalueaddedcostofthecontract

manufacturer.Hence,themarkupisappliedonlytothesevalueaddedcost.In

theturnkeycase,thecostbasis includethetotalcostofgoodssold(including

rawmaterials)ofthecontractmanufacturer.

Thetotalcosts(TC)oftheturnkeymanufacturerequalthesumofrawmaterial

cost(RMC)andvalueaddedcost(VAC):TC=RMC+VAC.

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Thearmslengthmarkupwillbeequalto:

(RMC/TC) * markup on RMC + (VAC/TC)* markup on VAC

The markup on VAC will generally be higher than the markup on RMC.

The arms lengthmarkup for the consignmentmanufacturer is equal to the

markuponvalueaddedcost.

In searching for comparable contractmanufacturerswhen applying the cost

plusmethod, it is important to distinguish among the two types of contract

manufacturersasdiscussedabove,becauseofthedifference incostbasisand

hence the level of the markup. The markup on total cost of the turnkey

manufacturer will generally be lower than the markup of a consignment

manufacturer,becausethecostbasisoftheturnkeymanufacturerincluderaw

materialcost,whichgenerallygeneratealowermarkupthanthevalueadded

cost.

Forexample,assumethatAssociatedEnterprise1inFigure3isaconsignment

manufacturer,whichmeansthatarelatedpartycustomerplacesrawmaterials

on consignment with Associated Enterprise 1. A benchmarking study found

three independent turnkeymanufacturerswhichpurchase rawmaterials and

incur inventory risks with respect to these raw materials. If this difference

materiallyaffectthegrossprofitmarkup,adjustmentsshouldideallybemade

on the unadjusted gross profit markups earned by the three comparable

companies.However, incasethedeterminationofthegrossprofitmarkupis

basedonexternal comparison, itwillbeverydifficult todistinguishbetween

rawmaterialcostandvalueaddedcostfromtheinformationoncostofgoods

soldpresentedintheannualreportsofthepotentiallycomparablecompanies.

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As comparabledatamaynotdisclose thepreferred levelofdetail,one could

alsochecktheproportionofmaterialcosttovalueaddedcost.

If the determination of the gross profit markup is based on internal

comparison, however, which means that Associated Enterprise 1 is

engagedincomparabletransactionswithindependententerprises,then

muchmore information isavailabletoperformtheadjustmentsonthe

gross profit markups earned by Associated Enterprise 1 on the

uncontrolled transactions.

accounting consistency is important. Gross profit markups should becalculated uniformly by the associated enterprise and the independent

enterprises.

historicalcostsshouldinprinciplebeascribedtoindividualunitsofproduction.Ifcostsdifferoveraperiod,averagecostsovertheperiodmaybeused.

Onediscussionregardswhetherbudgetedcostoractualcostshouldbeusedinapplyingthecostplusmethod. Ontheonehandusingactualcostswillbetter

reflectthefewrisksfacedbythecontractmanufacturer.4 Ontheotherhand,

thirdpartieswillusuallyusedbudgetedcostsinsellingproductstothemarket.

That is,youwillnotcharge thecustomeranadditionalamountat theendof

theyearifactualcostsarehigherthanbudgetedcosts.Disbursementsonwhich

nomarkupisappliedwilloftenbebasedonactualcosts.

4Notethatifthecontractisbasedonactualcosts,thecontractualtermsmayincludeincentivesorpenaltiesdependingon

theperformanceofthecontractmanufacturer.

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asthecoststhatmayberegardedinusingthecostplusmethodareonlythoseofthemanufacturerofthegoodsortheserviceprovider,aproblemmayarise

with respect to the allocation of some costs between the manufacturer /

serviceproviderandthepurchaserofgoods/services.


Thestrengthsofthecostplusmethodinclude:

thirdpartiesarefoundthatindeedusecostplusmethodtosetprices;and it isbasedon internal costs, the informationofwhich isavailable to the

multinationalenterprise.

Theweaknessesofthecostplusmethodinclude:

theremaybenolinkbetweenthelevelofcostsandthemarketprice; accounting consistency is required between the controlled and

uncontrolledtransactions;

it is a onesided analysis as the analysis focuses on the related partymanufacturer. Hence, the arms length grossprofitmarkup foundmay

lead to an extreme result for the other related parties involved in the

controlledtransaction(e.g.,operatinglosses);and

if method is based on actual costs, there may be no incentive for themanufacturertocontrolcosts.

2.3.8 WhentoUsetheCostPlusMethod?

Thecostplusmethodistypicallyapplied incasesinvolvingtheintercompanysaleoftangible

propertywheretherelatedpartymanufacturerperformslimitedmanufacturingfunctionsand

incurslowrisks,becausethelevelofthecostswillthenbetterreflectsthevaluebeingadded

and hence themarket price. The cost plusmethod is thus generally used in transactions

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involvingacontractmanufacturer,atollmanufactureroralowriskassemblerwhichdoesnot

ownproductintangiblesandincurslittlerisks.Therelatedcustomerinvolvedinthecontrolled

transactionwillgenerallybemuchmorecomplexthanthecontractmanufacturerintermsof

functions performed (e.g., conducting marketing and selling functions, coordination of

production and sales, giving instructions to contractmanufacturer about the quantity and

qualityofproduction,andpurchasingrawmaterialsinsomecases),risksincurred(e.g.,market

risk, credit risk and inventory risk) and assets owned (product intangibles). The contract

manufacturer isthusthe lesscomplexandassuchshouldbethetestedparty inthetransfer

pricinganalysis.

Thecostplusmethodisusuallynotasuitablemethodtouseintransactionsinvolvingafully

fledgedmanufacturerwhichownsvaluableproduct intangiblesas itwillbeverydifficult to

locateindependentmanufacturersowningcomparableproductintangibles.Thatis,itwillbe

hard to establish a profit markup that is required to remunerate the fullyfledged

manufacturerforowningtheproductintangibles.Inatypicaltransactionstructureinvolvinga

fullyfledged manufacturer and related sales companies (e.g., commissionaires), the sales

companieswillnormallybethe leastcomplexentities involved inthecontrolledtransactions

andwill thereforebe the testedparty in theanalysis.The resalepricemethod isapplied in

suchcases.

As well as simple manufacturing activities, the cost plus method can also be used in the

followingcases:5

the intragroup provision of services (e.g., legal, accounting, informationtechnology,marketing, tax, andmanagement services) if the services canbe

consideredtoprovideabenefittotheservicerecipient;

5Itshouldbenotedthatforservices,ofteninpracticeuseismadeoftheTransactionalNetMarginMethodaswell,witha

costbasedprofitlevelindicator.

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the provision of contract research services by Associated Enterprise 1 toAssociated Enterprise 2. Associated Enterprise 2 incurs the risks that the

research activities do not lead to any results. However, it will own the

intangible properties developed under the research services rendered by

AssociatedEnterprise1;

the administration of licenses (i.e. the administration and enforcement ofintangiblepropertyrightsasopposedtotheexploitationoftheserights).

Chapter5BTransactionalProfitMethods

1. Introduction

This part of the chapter discusses transactional profit methods, which analyse the profits

arisingfromparticularcontrolledtransactions,inordertodeterminewhetheratransferprice

is arms length. Transactional Profit Methods can be divided into two categories; the

TransactionalNetMarginMethod(TNMM)andtheTransactionalProfitSplitMethod(PS)

Thesemethodsdifferfromtraditionalmethodsinthattheanalysisisnotnecessarilybasedon

particularcomparableuncontrolled transactions. Often, theanalysis isbasedon the return

realized by various companies engaged in a particular line of business or, as it is more

commonly called, a function (that is, a series of transactions that are appropriate to be

aggregated). Typically, these methods are applied when one or more of the associated

enterprises uses valuable intangible assets (such as technology intangibles) in transactions

with other associated enterprises and the appropriate return for the use of the intangible

assetmustbedetermined.

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Although it is rare that enterprises use transactional profitmethods to actually determine

theirprices,theprofitresultingfromacontrolledtransactionmightbequiteagoodsignalto

establishwhetheraspecialconditionaffectedthistransactionandreducesittoatransaction

thatisnotatarmslength.Itshouldbeacknowledgedthatwherethecomplexitiesofreallife

businessputpracticaldifficulties in thewayof theapplicationof the traditional transaction

methodsaddressed inthepreviouschapter,transactionalprofitmethodsmayprovetobea

goodsolution.

Transactionalprofitmethodsandparticularly the transactionalnetmarginmethodarealso

commonly used by taxpayers for practical reasons. The transactional net margin method

often provides a useful check on accuracy/ reasonableness of the traditional transaction

methods or is used to supplement thesemethods. It is also easier to find comparables in

applyingthetransactionalnetmarginmethod.

2. TransactionalNetMarginMethod

2.1.1 DefinitionandChoiceofTestedParty

TheTNMMexaminesthenetprofitmargin6relativetoanappropriatebase(e.g.,costs,sales,

assets) that a taxpayer realizes from a controlled transaction (or transactions that are

appropriate tobe aggregated). Theprofitmargin indicators arediscussed inparagraph 2.3

below.

TheTNMMcomparesthenetprofitmargin (relativetoanappropriatebase)thatthetested

partyearnsinthecontrolledtransactionstothesamenetprofitmarginsearnedbythetested

party in comparableuncontrolled transactionsor alternatively,by independent comparable

6Forexample,returnontotalcosts,returnonassets,andoperatingprofittonetsalesratio.

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companies.As such, theTNMM isamore indirectmethod than the costplus / resaleprice

method thatcomparesgrossmargins. It isalsoamuchmore indirectmethod than theCUP

methodthatcomparesprices,becauseitusesnetprofitmarginstodetermine(armslength)

prices.Oneshouldbearinmindthatmanyfactorsmayaffectnetprofitmargins,butmayhave

nothingtodowithtransferpricing.

TheTNMM isused to analyze transferpricing issues involving tangibleproperty, intangible

property or services. However, it is more typically applied when one of the associated

enterprisesemploysintangibleassets,theappropriatereturntowhichcannotbedetermined

directly. In such a case, the arms length compensation of the associated enterprise(s)not

employing the intangible asset is determined by determining the margin realized by

enterprises engaged in a like function with unrelated parties. The remaining return is

consequently left to theassociatedenterprisecontrolling the intangibleasset; the return to

theintangibleassetis,inpractice,aresidualcategorybeingthereturnleftoverafterother

functionshavebeenappropriatelycompensatedatarmslength

This impliesthattheTNMM isappliedtotheleastcomplexoftherelatedparties involved in

thecontrolledtransaction.Thetestedpartyshouldnotownvaluableintangibleproperty.This

approachhastheaddedbenefitofresultingin,becausegenerallymorecomparabledatawill

thenbeing inexistenceandfeweradjustmentswillbeingrequiredtoaccountfordifferences

infunctionsandrisksbetweenthecontrolledanduncontrolledtransactions.Inaddition,the

testedpartyshouldnotownvaluableintangibleproperty.This,bytheway,isalsothereason

whyit isrecommendedtoselecttheleastcomplexentityfortheapplicationofthecostplus

methodorresalepricemethod.

TheapplicationoftheTNMMissimilartotheapplicationofthecostplusmethodortheresale

pricemethod,buttheTNMMinvolvescomparisonofnetprofitmargins.Figure1andtherest

ofthissectionwillfurtherillustratethisdistinction.

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AssociatedEnterprise1,acarmanufacturerincountry1,sellscarstoAssociatedEnterprise2

whichresellsthecarstotheIndependentEnterprise,acardealerincountry2.Basedonthese

facts,AssociatedEnterprise1 is likelytobethemorecomplexparty,controllingavarietyof

technologyandoperating intangibles.TheCUPmethodwouldcomparethepricecharged in

thecontrolledtransactionbetweenAssociatedEnterprise1andAssociatedEnterprise2with

the price charged in comparable uncontrolled transactions. If the CUP method cannot be

applied,thenextmethodstoconsiderarethecostplusandtheresalepricemethods.

TheresalepricemethodwillbeconsideredifAssociatedEnterprise1ownsvaluableintangible

property. Under the resalepricemethod, thesalescompany, the leastcomplexof the two

entities involved in the controlled transaction,willbe the testedparty. The analysiswould

entailasearchfordistributorswhichperformfunctionsandincurriskscomparabletothoseof

AssociatedEnterprise2.

Sometimes,itmaybebettertochoosetheTNMM.If,forexample,thereisdifferentreporting

of the costofgoods soldandoperatingexpenses for the testedpartyand the comparable

distributors, so that the gross profit margins reported are not comparable and reliable



Unrelated Party

Figure 1: Transactional Net Margin Method

Tested Party? Least Complex

Price is Given

Given price = $10,000 Cost of goods sold = $ ? Gross Profit = $ ? Operating Expenses = $2,000 Net Profit (5 % of Price) = $500 Comparable

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adjustmentscannotbemade,theresalepricemethodmayberelativelyunreliable.However,

this type of accounting inconsistency will not affect the reliability of the TNMM, as this

methodexaminesnetprofitmarginsinsteadofgrossprofitmargins.

Also,as furtherdiscussed in section2.3.2below, theability touseprofit level indicators to

comparefunctionsratherthantransactionscanbeasignificantpracticalbenefitofusing

TNMM.

Similartotheresalepricemethod,theapplicationoftheTNMMwouldentailanalysisofthe

least complex party the distributor. Consequently, analysis would entail a search for

comparabledistributorstakingintoaccountthecomparabilitystandardofthismethod.

AnapplicationoftheTNMM focusingontherelatedpartymanufacturerasthetestedparty

wouldbethesituationinwhichAssociatedEnterprise1isacontractmanufacturer.Insucha

case, the contract manufacturer will typically be the least complex entity as MNEs often

separatetheownershipofvaluabletechnology intangiblesfromthemanufacturingfunction.

Thecostplusmethodwouldnormallybeconsidered if theCUPmethodcannotbeapplied.

However, due to the accounting inconsistencymentioned above, itmay be appropriate to

apply theTNMMusinga financial ratiobasedonnetprofitmargin that isappropriate fora

manufacturer(e.g.,returnontotalcosts).

2.2 MechanismofTNMM

How shouldonedetermine the transferpricebasedon theapplicationof theTNMM? The

mechanismoftheTNMMisgenerallyconsistentwiththemechanismsoftheresalepriceand

costplusmethodsascanbeseeninthefollowingexamples.

2.2.1 Relatedpartydistributor

In applying the resalepricemethod toestablish an arms length transferprice, themarket

price of products resold by the related party distributor to unrelated customers (i.e. sales

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price) is known, while the arms length gross profit margin is determined based on a

benchmarkinganalysis.Thetransferpriceorcostofgoodssoldoftherelatedpartydistributor

istheunknownvariable.

Assuming a resale price of $10,000 and a gross profit margin of 25%, the transfer price

amountsto$7,500:

Table1:MechanismofResalePriceMethod7

Initially Benchmarkinganalysis

Resaleprice $10,000$10,000

Costofgoodssold $? $7,500

Grossprofit $? $2,500(25%ofresaleprice)

The determination of an arms length transfer price based on the TNMM is more or less

similar. The main difference with a gross margin analysis is that operating expenses are

considered incalculatingbacktoatransferprice. InapplyingtheTNMMonthetestedparty

distributor, the resalepriceand theoperatingexpensesof the relatedpartydistributorare

known,whilethearmslengthnetprofitmargin(i.e.netprofittosalesratio)8isfoundonthe

basisofabenchmarkinganalysis.Thecostofgoodssoldandthegrossprofitaretheunknown

variables.

7Forpurposesofcompleteness,itshouldbenotedthatthelistedmarginisprovidedsolelyasanexampleandisnotbasedon

anactualbenchmarkorcomparabilitysearch.8Netprofitequalsoperatingprofitbeforeinterestandtaxes.

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Assuming a resalepriceof$10,000,operating expensesof$2,000 and an arms lengthnet

profitmarginof5%, the transferpriceof$7,500 isdeterminedbyworkingbackwardsusing

theavailableinformation:

Table2:MechanismofTNMMappliedonRelatedPartyDistributor


Resaleprice$10,000$10,000

Costofgoodssold $? $7,500

Grossprofit $? $2,500

Operatingexpenses $2,000 $2,000

Operatingprofit$?$500(5%ofresaleprice)

2.2.2 Relatedpartymanufacturer

Inapplyingthecostplusmethodtoestablishanarmslengthtransferprice,thecostofgoods

sold of the related partymanufacturer is known. The arms length gross profitmarkup is

basedonabenchmarkinganalysis. The transferpriceorsales revenueof the relatedparty

manufactureristheunknownvariable.

Assumingcostofgoodssoldof$5,000andagrossprofitmarkupof50%,thetransferprice

amountsto$7,500:

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Table3:MechanismofCostPlusMethod


Salesprice$?$7,500

costofgoodssold $5,000$5,000

Grossprofit $?$2,500(50%ofcostofgoodssold)

InapplyingtheTNMMtothetestedpartymanufacturerinsteadofthecostplusmethod,the

costofgoodssoldandtheoperatingexpensesoftherelatedpartymanufacturerareknown.A

benchmarking analysis will determine the arms length net profit of the related party

manufacturerusingaprofit level indicatorsuchas the ratioofnetprofit to totalcost. The

salespriceandthegrossprofitaretheunknownvariables.

Assumingcostofgoodssoldof$5,000,operatingexpensesof$1,000andanarmslengthnet

profittototalcostratioof25%,thetransferpriceamountsto$7,500byTable4illustratesthat

workingbackwardsusingtheavailable information leadstothedeterminationthatthesales

priceis$7,500.

Table4:MechanismofTNMMappliedonRelatedPartyManufacturer

InitiallyBenchmarkinganalysis

Resaleprice$?$7,500

costofgoodssold $5,000 $5,000

Grossprofit $? $2,500

Operatingexpenses $1,000 $1,000

Operatingprofit$?$1,500(25%oftotalcost)

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2.3 ArmsLengthNetProfitMargin

2.3.1 DefinitionofNetProfitMargin

Incomparisonwiththeresalepriceandcostplusmethods,severalprofitlevelindicators(PLIs)

areallowedunder theTNMM,whichare typicallybasedoneithergrossprofitoroperating

profit.Morespecifically,thePLIwillbethegrossoroperatingprofitrelativetoanappropriate

base (e.g., costs, sales and assets). With the help of profit level indicators, the net

profitability of the controlled transaction is compared to the net profitability of the

uncontrolledtransactions.

Grossprofitmeanstotalsalesminusthecostofsales.Thus,ittakesintoaccountonlydirect

expenses.

Operating profit or operating income basically equals the income net of direct and

indirect expenses but before deduction for interest and taxes of a company. Operating

profitisabettertermthannetprofit,becausenetprofitisalsousedtorepresenttheprofit

of a company after interest and taxes have been subtracted. Furthermore, the term

operating profit indicates better that only profits resulting from operating activities are

relevantfortransferpricingpurposes.

APLIisameasureofacompanysprofitabilitythatisusedtocomparecomparableswiththe

testedpartyAPLImayexpressprofitabilityinrelationto(i)sales,(ii)costsorexpenses,or(iii)

assets.

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Table5:Overviewofvariousprofitlevelindicators:

returnonassets(ROA)

operatingprofitdividedbytheoperatingassets(normally,onlytangibleassets)

returnoncapitalemployed(ROCE)

operatingprofitdividedbycapitalemployedwhichusuallycomputesasthetotalassetsminuscashandinvestments

operatingmargin(OM)

operatingprofitdividedbysales

grossmargin(GM)

grossprofitdividedbysales

returnontotalcost(ROTC)

operatingprofitdividedbytotalcosts

returnoncostofgoodssold

grossprofitdividedbycostofgoodssold

BerryRatio

grossprofitdividedbyoperatingexpenses

Although all the above PLIs are possible, the three PLIs of (i) return on capital employed

(ROCE)(ii)operatingmargin(OM)and,(iii)BerryRatioaremostused inpractice.[Suggested

additionincommentsmade:AnOMistypicallyusedfordistributionactivities,aBerryratiois

typically used for service of distribution activities,whereas full cost plus, ROCE or ROA are

typicallyusedformanufacturingactivities]

ThetwoPLIsoftheROAandROCEdivideoperatingprofitbyabalancesheetfigure.ThePLIs

are based on assets actively employed in the business. Such tangible assets consist of all

assets,minusinvestments(e.g.,insubsidiaries),minuscashandcashequivalentsbeyondthe

amountneededforworkingcapital,and,forROA,minusintangibleassetssuchasgoodwill.

ThistypeofPLImaybemostreliableifthetangibleoperatingassetshaveahighcorrelationto

profitability. For example, amanufacturers operating assets such as property, plant, and

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equipmentcouldhavemoreimpactonprofitabilitythanadistributorsoperatingassets,since

oftentheprimaryvalueaddedbyadistributorisbasedonservicesitprovides,whichareoften

lessdependentonoperatingassets.

Thedifferencebetween theROAand theROCE is that theROA focuseson theassetsused,

while the ROCE focuses on the amount of debt and equity capital that is invested in the

company.

OtherPLIs listedaboveare ratiosbetween income statement items. PLIsbasedon income

statement items areoftenusedwhen fixed assetsdonotplay a central role in generating

operatingprofits.Thisisoftenthecaseforwholesaledistributorsandserviceproviders.

Operatingmarginhasoftenbeenusedwhen functionsof the testedpartyarenot close to

thoseof the comparables, sincedifferences in functionhave lesseffectonoperatingprofit

thanongrossprofit.

Conceptually, theBerryRatio representsa returnonacompanysvalueadded functionson

the assumption that the companys value added functions are captured in its operating

expenses.ObservedinpracticetheBerryRatioisfrequentlyusedasaPLIfordistributorsand

serviceproviders.TheBerryRatioassumes that there isa relationshipbetween the levelof

operatingexpensesandthelevelofgrossprofitsearnedbydistributorsandserviceproviders

ontheassumptionthattheirvalueadded functionsarecaptured intheoperatingexpenses.

Consequently, it isappropriate touse theBerryRatio if the sellingormarketingentity isa

distributor and is entitled to a return on its operating expenses alone or if it is a service

providerentitledtoareturnonitscostsofprovisionofitsservicesalone.

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In general, gross margin has not been favoured as a PLI because the categorization of

expenses asoperatingexpensesor costof goods soldmaybe somewhat arbitraryoreven

subjecttomanipulation.

ThechoiceofPLIdependsonthefactsandcircumstancesofaparticularcase.Thus,itmaybe

usefultoconsidermultiplePLIs. Iftheresultstendtoconverge,thatmayprovideadditional

assurancethattheresultisreliable.IfthereisabroaddivergencebetweenthedifferentPLIs,

itmaybeusefultoexamineimportantfunctionalorstructuraldifferencesbetweenthetested

partyandthecomparables.

In certain countries, the Berry Ratio is often used in the cases of distribution of tangible

property.TheOECDTransferPricingGuidelinesdiscusstheBerryRation inparagraphs2.100

through2.102.TheBerryRatioisdeemedparticularlyusefulforintermediaryactivitieswhere

ataxpayerpurchasesgoodsfromarelatedpartyandonsellsthemtoanotherrelatedparty.

Insuchcases,theresalepricemethodorthecostplusmethodisnotappropriatelyapplicable

withtheabsenceofpertinentcomparables.


Thearmslength(rangeof)netprofitmarginscanbedeterminedbywayof:

transactionalcomparison:thenetprofitmarginthatthetestedpartyenjoysinacomparableuncontrolledtransaction,which initiallyhasbeenrejectedasan

internalcomparable;and

functional comparison: the net profit margins enjoyed by independentcompaniesperformingfunctionsand incurringriskscomparabletothoseofof

thetestedparty.

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Muchmoredetailed informationwill existwith respect to the controlled and uncontrolled

transactionsiftransactionalcomparisonispossible,becausetherelatedpartiesinvolvedhave

participated in these transactions.Thedegreeof comparability can thenbeanalysedmore

carefully than functional comparison in which only public information is available (e.g.,

businessdescriptionsindatabase,annualreports,andinternetdata).Thismayimplythatthe

reliabilityof transactionalcomparisonswillbehigher than thatof functionalcomparisons in

practice.

However,functionalcomparisonwillbemoreoftenusedinpracticeasthedatanecessaryfor

functionalcomparisonmaybeavailablewhenthedataneededfortransactionalcomparisonis

not.Letusassumethatarelatedpartydistributoristhetestedpartyintheexamplepresented

in Table 6. The TNMM is applied and the profit level indicator is the operatingmargin. A

benchmarking analysis was performed, which identified four comparable independent

distributorsconsideringthecomparabilitystandardoftheTNMM.Thearms lengthrangeof

operatingmarginearnedbythesecomparabledistributorsfallsbetween2%and6%.Because

theoperatingprofitmarginearnedbytherelatedpartydistributorfallswithinthisrange(e.g.

4%),itstransferpriceisconsideredarmslength.

Table6:FunctionalComparisonExample

ComparableA

ComparableB

ComparableC

ComparableD

TestedParty

Revenue

100,000

120,000

125,000

130,000

122,000

COGS 80,000 92,400 95,000 89,700 92,720GrossProfit 20,000 27,600 30,000 40,300 29,280OperatingExpenses

18,00024,000

25,000

32,500

24,400

OperatingProfit 2,000 3,600 5,000 7,800 4,880OperatingProfitMargin

2%

3%

4%

6%

4%

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2.4 Comparabilitystandard

ProductcomparabilityisimportantinapplyingtheCUPmethod,asdifferencesinproductswill

result in different prices. The cost plus method and the resale price method focus on

functionalcomparability,becausedifferences infunctionsthatarereflected indifferences in

operatingexpensesmay leadtoabroadrangeofgrossmargins.However,theTNMM is less

dependent on product comparability and functional comparability as the traditional

ransactionmethods,becausenetmarginsare less influencedbydifferences inproductsand

functions.TheTNMMfocusesonbroadproductandfunctionalcomparability.

However, thecomparability standard tobeapplied to theTNMM requiresahighdegreeof

similarity in several factorsbetween the testedpartyand the independententerprises that

mayadverselyaffectnetmargins.Netmarginsmaybeaffectedbyfactorsthathavenoeffect

or a less significant effect on gross margins or prices due to the variation of operating

expensesbetweencompanies.Thesefactorsmaybeunrelatedtotransferpricing.

Specificfactorsaffectingnetmarginsinclude,butarenotlimitedto:

barrierstoentryintheindustry; competitiveposition; managementefficiency; individualbusinessstrategies; threatofsubstituteproducts; varyingcoststructures(e.g.,theageofplantandequipment);and thedegreeofbusinessexperience(e.g.,startupphaseormaturebusiness).

If therearematerialdifferencesbetween the testedpartyand the independententerprises

that affect the netmargins, appropriate adjustments should bemade to account for such

differences.

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2.5 OtherGuidanceforApplication

TheTNMMshouldnotbeappliedontheaggregateactivitiesofacomplexenterpriseengaged

invariousanddifferent transactionsor functions. It shouldanalyseonly theprofitsof the

associatedenterprisethatareattributabletosimplercontrolledtransactionsorfunctions.The

TNMMshould thusnotbeappliedonacompanywidebasis if thecompany is involved ina

numberofdifferentcontrolledtransactionsorfunctionswhicharenotproperlyevaluatedon

anaggregatebasis.TheTNMM shouldbeappliedonemploying transactionsor functionsof

independent enterprises,which are comparable to the controlled transactions or functions

beingexamined.Furthermore, resultsattributable to transactionsbetween the testedparty

and independent enterprises should be excluded when evaluating controlled transactions.

[SuggestionunderconsiderationthatTNMMbeappliedtoaggregateddata]

ThelatterpointisillustratedinFigure2below.RelatedPartyDistributorpurchasesproducts

frombothRelatedPartyManufacturerandUnrelatedManufacturerandresellstheseproducts

to customers. The tax authorities in the country of Related Party Distributor applies the

TNMMtodeterminewhetherthetransferpricesofRelatedPartyDistributorisarmslength.A

benchmarkingstudyperformedbythetaxauthoritiesshowthatcomparabledistributorearn

anoperatingprofitmarginbetween2%to6%.ThetaxauthoriesapplytheTNMMtotheP&L

ofRelatedPartyDistributorasawhole.AstheoperatingprofitmarginearnedbyRelatedParty

Distributoris1%basedonaggregatetransactionsandthereforedoesnotfallwithinthearms

lengthrange,thetaxauthoritiesdeterminethatthetransferpriceisnotatarmslength.Ifthe

TNMMwasappliedonlytothecontrolledtransactions,however,theconclusionswouldhave

beenverydifferent.TheoperatingprofitmarginearnedbyRelatedPartyDistributoron the

controlledtransactionsis5%,whichfallswithinthearmslengthrangeofcomparablesand,in

many jurisdictions would not be subject to adjustment. It appears from the P&L that the

uncontrolled transactions themselves generated operating losses, which resulted in lower

consolidatedresultsforthecompanyasawhole.

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Measurementconsistencyisimportant.Netmarginsshouldbecalculateduniformlybetween

thetestedpartyandtheindependententerprises.

An analysisconsideringmultipleyeardata isbetterabletotake intoaccounttheeffectson

profits of product life cycles and shortterm economic conditions. However, as discussed

[elsewhere inthisManual]differentcountriestakedifferentviewsaboutwhenmultipleyear

datashouldbeanalysed,andindeedwhetherthatisallowedunderacountrysdomesticlaw.

Useofanarms lengthrangeshouldalsobeconsidered,toreducetheeffectsofdifferences

between the controlled and uncontrolled entities. However, the use of a range may not

sufficientlytake intoaccount circumstanceswheretheprofitsofataxpayer isaffectedbya

factoruniquetothattaxpayer.

Related Party Manufacturer

Unrelated Manufacturer

Related Party Distributor

Figure 2: Specific Transactions versus Company as a Whole

Customers

Controlled Transactions

Uncontrolled Transactions

Aggregate Transactions

Sales

100,000

100,000

200,000

Cost of Goods Sold

80,000

90,000

170,000

Gross Profits

20,000

10,000

30,000

Operating Expenses

15,000

13,000

28,000

Operating Profit

5,000

(3,000)

2,000

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2.6 StrengthsandWeaknesses

ThestrengthsoftheTNMMincludethefollowing:

net margins are less affected by transactional differences (than price) andfunctional differences (than gross margins). Product and functional

comparabilityarethuslesscriticalinapplyingtheTNMM;

lesscomplexfunctionalanalysisneeded,asTNMMisappliedtoonlyoneoftherelatedpartiesinvolved;

becauseTNMMisappliedtothelesscomplexparty,itcanbeusedeventhoughoneoftherelatedpartiesholdsintangibleassetsforwhichcomparablereturns

cannotbedetermined;

itisapplicabletobothsidesofthecontrolledtransaction(i.e.eithertherelatedpartymanufacturerordistributor);and

theresultsresembletheresultsofamodifiedresaleprice/costplusmethodofanalysis.

TheweaknessesoftheTNMMincludethefollowing:

netmarginsareaffectedbyfactors(e.g.variabilityofoperatingexpenses)thatdo not have an effect, or have a less significant effect on, price or gross

margins. These factorsaffectnetprofitsandhencetheresultsoftheTNMM,

butmayhavenothingtodowiththecompanystransferpricing.Itisimportant

toconsiderthese(nonpricing)factorsinthecomparabilityanalysis;

information challenges, including the unavailability of information on profitsattributabletouncontrolledtransactions;

measurement challenges: may make it difficult to determine sales revenue,operating expenses and assets relating only to the relevant controlled

transactionsorfunctionsinorder

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