How to assess the transfer price through comparable uncontrolled price method

The proposed transfer pricing rules require that all related parties’ transactions and transactions with the connected persons should be at arm’s length, which requires that the results of the transaction or arrangement must be consistent with what the results would have been if they had been between parties that are not related to each other.

In our previous article, we recommended that to assess the arm’s length price, businesses need to conduct benchmarking studies by applying any of the following methods given in the Organisation for Economic Cooperation and Development (OECD) transfer pricing guidelines.

• Traditional transaction methods, which include (i) Comparable uncontrolled price method, (ii) Resale price method, and (iii) Cost plus method

• Transactional profit methods, which comprise (i) Transactional net margin method and Transactional profit split method

We will discuss all five methods one by one, and we have started today with the comparable uncontrolled price (CUP) transfer pricing method.

The CUP method compares the price for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. If there is any difference between the two prices, this may indicate that the conditions of the commercial and financial relations of the associated enterprises are not arm's length, and that the price in the uncontrolled transaction may need to be substituted for the price in the controlled transaction.

The CUP method requires identifying the (i) comparable uncontrolled transaction and (ii) comparable uncontrolled arrangement represented by the quoted price. It would not be easy to find a comparable uncontrolled price between two independent parties (external CUP). This means to find two independent parties where the external supplier is in the same business-like an internal supplier and selling the same goods and services under the same terms and conditions to any third independent party. To avoid this, usually, the price charged by the internal supplier to independent parties (internal CUP) is compared with the price charged by the same supplier to the related parties and connected persons.

For the sales of services, while comparing the price under the CUP method, we need to understand the terms and conditions agreed between the parties, the timing of delivery of services, mode of providing services, place of providing services etc. While for the goods, we should not ignore the physical features and quality of the commodity; the contractual terms of the controlled transaction, such as volumes traded, period of the arrangements, the timing and terms of delivery, transportation, insurance, and foreign currency terms. For some commodities, certain economically relevant characteristics (e.g., prompt delivery) may lead to a premium or a discount.

While comparing the price If there is no difference in general terms and conditions, quantity etc. (means the transaction is 100 per cent similar and under similar circumstances) then the price charged to the independent party will be assumed as the transfer price for the related party transactions and transactions with the connected persons. However, if there are variations in any of the terms that have been highlighted in the previous paragraph, then the price charged to the independent party is required to be adjusted to arrive at the price for the related parties’ transactions and transactions with connected persons. So, we can say that “transfer price under the CUP method = external/Internal CUP + adjustment (if any)”.

An illustrative case where adjustments may be required is where the circumstances surrounding controlled and uncontrolled sales are identical, except for the fact that the controlled sales price is a delivered price, and the uncontrolled sales are made f.o.b. factory. The differences in terms of transportation and insurance generally have a definite and reasonably ascertainable effect on price. Therefore, to determine the uncontrolled sales price, adjustments should be made to the price for the difference in delivery terms (quoted from OECD guidelines).

As another example, assume a taxpayer sells 1,000 tonnes of a product for $80 per tonne to an associated enterprise in its group, and at the same time sells 500 tonnes of the same product for $100 per tonne to an independent enterprise. This case requires an evaluation of whether the different volumes should result in an adjustment of the transfer price. The relevant market should be researched by analysing transactions in similar products to determine typical volume discounts (quoted from OECD guidelines).

The CUP method is generally the most appropriate transfer pricing method for establishing the arm’s length price for the transfer of commodities between associated enterprises. The reference to “commodities” shall be understood to encompass physical products for which a quoted price is used as a reference by independent parties in the industry to set prices in uncontrolled transactions.

The CUP method is a traditional, direct and easy method to determine the transfer price, but it is very difficult to find an external CUP. Wherever required, the adjustment to the internal CUP is not an easy job to arrive at the correct transfer price.

In order to assist the Federal Tax Authority in conducting an informed examination of the taxpayer’s transfer pricing practices, taxpayers should provide reliable evidence and document, as part of their transfer pricing documentation, the price-setting policy for commodity transactions, the information needed to justify price adjustments based on the comparable uncontrolled transactions or comparable uncontrolled arrangements represented by the quoted price and any other relevant information, such as pricing formulas used, third party end-customer agreements, premia or discounts applied, pricing date, supply chain information, and information prepared for non-tax purposes. So, keeping in view these requirements, the taxpayers are required to keep proper documentation.

Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official but a personal opinion of the writer based on the public consultation document on corporate tax and OECD transfer pricing guidelines. For any queries/clarifications, please write to him at compliance@kresscooper.com.