What are various transfer pricing methods to establish arm’s length price

In the OECD guidelines, five TP methods have been proposed to assess the arm-length price, which can be categorised into traditional transaction methods, and transactional profit methods



By Mahar Afzal/Compliance Corner

Published: Sun 25 Sep 2022, 6:33 PM

In the UAE corporate tax regime, it has been mentioned that all related parties’ transactions and transactions with the connected persons should comply with Transfer Pricing (TP) rules and the arm’s length principle as given in the OECD transfer pricing guidelines.

In the OECD guidelines, five TP methods have been proposed to assess the arm-length price, which can be categorised into traditional transaction methods, and transactional profit methods. Traditional transactions methods can further be classified into comparable uncontrolled price (CUP) method, resale price method (RPM) and cost-plus method while transactional profit methods can be segregated into transactional net margin method (TNMM) and transactional profit split method (PSM).

The comparable uncontrolled price (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 at arm's length and that the price in the uncontrolled transaction may need to be substituted for the price in the controlled transaction. While making the comparison entities uses the internal comparables and external comparables. The CUP method is the most appropriate transfer pricing method for establishing the arm’s length price for transferring commodities between associated enterprises. 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.

Under the resale price method (RPM), the price at which the same product is resold to an independent buyer is adjusted to arrive at the transfer price between the related parties or with the connected persons. The adjustment factors are resale price margin and other costs directly associated with the purchase and sales price of the product. In simple words, we can say that the transfer price under the RPM is resale price less resale profit margin less costs directly associated with the purchase and sales of the goods and services. The RPM is typically most appropriate for distributors and resellers. However, it involves information from third parties, which is difficult to get. Moreover, if the parties have divergent functions and activities, it is particularly challenging to assess the resale price margin.

The cost-plus markup method of TP requires that the cost-plus markup of the supplier in the controlled transaction should be compared with the cost-plus markup of the same supplier in the uncontrolled transactions (internal comparable) and cost-plus markup of the third-party supplier involved in the similar transaction under the similar circumstances (external comparables). If there are any differences, an adjustment should be made. Under this method, the actual cost (direct and indirect) involved in the controlled transaction is calculated. An appropriate markup is added to the above-calculated cost based on the functions performed, the risk involved, and the market conditions involved. The cost-plus method is a very traditional method and, this method is applicable where it involves the transfer of semi-finished products to the related party, where joint facility agreements have been concluded, or where the controlled transaction is the provision of services. The biggest challenge in this method is to get the mark up from the other party, which is not easily available.

The transactional net margin method (TNMM), an alternative method of TP, examines the net profit relative to an appropriate base (e.g., costs, sales, assets) that a taxpayer realizes from a controlled transaction. The net profit indicators [ratio of net profit to an appropriate base (e.g., costs, sales, assets)] of the controlled transaction should be compared with the net profit indicators (NPIs) of the uncontrolled transaction. Ideally, the NPIs of the controlled transaction should be the same as the NPIs of the uncontrolled transaction. Where the NPIs of the controlled transaction are different from the NPIs of the uncontrolled transaction, then an adjustment should be made in the controlled transaction price to arrive at the arm’s length price. By following the general principle of comparability, the NPIs of the controlled transaction should be compared with the NPIs of transactions by the same supplier to any third party (internal comparables). Where this is impossible, the net margin that would have been earned in comparable transactions by an independent enterprise (external comparables) may serve as a guide. The TNMM can be applied to any type of transaction, but businesses should be careful, and they need to make sure the same basis has been used to calculate the NPI of the controlled transaction and uncontrolled transaction.

The profit split method (PSM) requires the combined profits to be identified, and it should be divided between the associated enterprises based on the comparables where comparables are not available, profit should be divided based on the functions performed, the risk involved, and the assets utilized. The resultant profit would be an indicator to assess whether the transaction was affected by conditions that differ from those that would have been made by independent enterprises in otherwise comparable circumstances. If the profits have been fairly allocated to each party based on an economically valid basis, then we can assume the transaction has been executed at arm’s length. There are two main approaches to divide the profits named contribution analysis and residual analysis. Under the contribution analysis, the total profits from the transaction under the examination are divided between the associated enterprises based on comparable data. In the residual analysis, the combined profits from the transaction under examination are divided into two stages. In the first stage, profits are allocated to each party based on routine functions. In the second stage, the residual profits are divided between the parties based on allocation keys like assets-based allocation, cost-based allocation, incremental sales, headcounts, time spent etc. This method is applicable where there are highly integrated operations, and functions are extensively interrelated, but it is not a go-to method due to its complexity.

Considering the nature of the business, companies should have a proper benchmarking study and adopt the appropriate TP method to set the arm’s length price.

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. For any queries/clarifications, please write to him at compliance@kresscooper.


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