Transfer Pricing Methods Explained Simply

Knowledge • Transfer Pricing Methods Explained Simply

Transfer Pricing Methods Explained Simply.

This Article is a series of article that aims to provide a background on transfer pricing methods. In this first article we will discuss the differences between transactional and traditional methods and considerations to be taken into account.

1. What are Transfer Pricing methods?

Transfer pricing methods refer to methods that are used in a transfer pricing analysis for setting or determining an arm’s length price for transactions between related parties.

Transfer pricing methods are commonly differentiated by 2 sets of categories known as the

Traditional methods and
Transactional methods.

The 2 sets of categories combined include 5 transfer pricing methods.

2. What is the difference between Traditional methods and Transactional methods?

The traditional methods and transactional methods include 5 transfer pricing methods, which are grouped between the 2 as follows:

Traditional methods (i.e. transaction based)	Transactional method (i.e. profit based)
Comparable Uncontrolled Price (“CUP”) method	Profit Split Method (“PSM”)
Resale Price Method (“RPM”)	Transactional Net Margin Method (“TNMM”)
Cost Plus (“CP”) method

The difference between the 2 sets of categories is the approach that each of the method takes to determine the arm's length price for transactions between related parties. These differences are discussed below

Traditional methods in transfer pricing

The traditional method in transfer pricing is also referred to as the transaction based methods. The focus of the traditional methods is the price or the cost of the goods or services being transferred between the related parties.

The traditional methods heavily rely on external data and comparables to determine the arm's length price in a transaction between related parties. The type of method within the traditional method category will dictate the type of data or comparable to be used. For example:

Method	Explanation	Data / Comparable
CUP method	The CUP method relies on the specific transactions that is being considered and looks at a similar transaction entered into between independent parties.	The price being charged by independent parties is considered as the arm’s length price.
RPM	The RPM relies on the Gross Profit Margin (“GPM”) earned by independent parties in a transaction similar to the related party transaction.	The GPM earned by independent parties is considered as the arm’s length GPM.
CP method	The CP method relies on the mark up that is being earned by independent parties on a transaction that is similar to the related party transaction.	The mark up earned by independent parties is considered as the arm’s length mark up.

Transactional methods in transfer pricing

The transactional method in transfer pricing is also referred to as the profit based methods. The focus of the transactional methods is on the profitability of the related parties involved in the transaction. These methods compare the net profit margin of the related party to the net profit margin of comparable independent enterprises engaged in similar transactions under similar circumstances.

Similarly, the type of method within the transactional method category will dictate the type of data or comparable to be used. For example:

Method	Explanation	Data / Comparable
TNMM	The TNMM relies on the net profitability (i.e. such as net cost plus, operating margin, and other profitability indices) earned by independent parties in a transaction similar to the related party transaction.	Various profitability indices earned by independent parties is considered as the arm’s length profitability.
PSM	The PSM first looks at the profit generated from a transaction and secondly how that profit is split between related parties. The PSM can be subjective as the split between the parties is largely based on the contributions of each party to the transaction.	The ideal comparable will be a similar structure that is implemented by independent parties.

3. What method shall I choose?

The choice of transfer pricing method to be applied is a highly context-specific exercise and one-size-fits-all approaches are seldomly appropriate. The choice for a method will depend on the nature of the transaction, the degree of control and influence that each related party has over the transaction, and the availability of reliable data to support the calculation of an arm's length price.

4. More Questions?

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