Transfer Pricing: Traditional Transaction Methods

Wojciech Gadzala | 28 Sep 2023

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Transfer Pricing - Traditional Transaction Methods in a Nutshell 

In a globalized economy, it is a common practice that entities forming part of a multinational enterprise (MNE) transact with each other. The prices set in controlled transactions (i.e., transactions between related parties – members of an MNE) are called “transfer prices”. Most international and domestic tax laws worldwide require that transfer prices are set in line with the arm’s length principle.   

The arm’s length principle requires that transfer prices reflect the prices that would have been set between independent enterprises in comparable transactions and comparable circumstances. To reduce transfer pricing risks, multinational enterprises calculate transfer prices using recognized transfer pricing methods. The OECD TP Guidelines outline five distinct transfer pricing methods. They are divided into two general categories: traditional transaction methods and transactional profit methods.  

Traditional transaction methods comprise:

  • the comparable uncontrolled price method,
  • the resale price method and
  • the cost plus method.

Transactional profit methods include:

  • the transactional net margin method and
  • the transactional profit split method.

Below we outline the traditional transaction methods. Transactional profit methods are described in our separate article on Transactional profit methods. 

Key Legal Issues 

  • To establish the arm’s length price, TP specialists apply transfer pricing methods.
  • TP methods are divided into two general categories: traditional transaction methods and transactional profit methods.
  • Tax authorities may scrutinize the choice of the method, as well as the way it is being applied to the particular transaction.

Comparable Uncontrolled Price Method 

The Comparable Uncontrolled Price (CUP) method compares the price of goods or services in a controlled transaction with prices applied in comparable transactions made between unrelated parties in comparable circumstances. The CUP method may be internal, i.e., comparing the price applied in a transaction under review with prices applied by the same entity in transactions with unrelated entities. The CUP method may also use an external comparison. In this case it would look at comparable transactions where no party is related to the reviewed entity. Applying the CUP method requires the access to data on comparable transactions.   

Example of Comparable Uncontrolled Price (CUP) Method

A Taiwanese company MicroCo forms part of a global MNE group active in the electronics sector.  MicroCo manufactures microprocessors. It then sells the microprocessors to a related company CompCo located in Germany which uses it in assembling laptops, as well as to unrelated distributors of electronic components. Assuming that the conditions in transactions with CompCo and with unrelated distributors were comparable, MicroCo could use the prices charged to unrelated distributors to determine the price for microprocessors in a controlled transaction with its related company CompCo. This is an example of using an internal CUP method.  

Let’s look at an application of an external CUP. An Ethiopian company CoffeeCo sells unbranded coffee beans to its related entity CaféCo operating a chain of coffee roasteries and cafés around Europe. CoffeeCo has no other trading partners. Therefore, to determine the transfer price for coffee in a controlled transaction with CaféCo, CoffeeCo could use prices quoted on an international or domestic coffee exchange market in similar transactions (including the same coffee quality, volume traded, quoting date etc.).  

Resale Price Method 

The resale price method is based on a price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise. This final resale price is then reduced by the resale price margin. The price determined in this way may be considered an arm’s length price. The resale price margin may be established internally, by reference to the resale price margin that the same entity earns when reselling products purchased from unrelated entities. Otherwise, an external comparable may be used, i.e., a resale price margin earned by independent enterprises in comparable uncontrolled transactions.  

Example of Resale Price Method

GardenCo is a Polish company running a chain of home improvement and gardening retailers. GardenCo distributes within its chain a full range of gardening tools purchased from a related manufacturer ToolCo located in Slovakia. Let’s assume that in Poland there are four independent retail chains which operate under similar conditions. They distribute gardening tools purchased from unrelated entities and earn gross margins of 8% on their sales.  

If it was found that there is variance in the characteristics of the products sold by GardenCo and comparable distributors, the CUP method could not be applied. However, assuming that transactions are otherwise comparable, GardenCo could arrive at the arm’s length price to be paid to ToolCo using the resale price method. To do it, GardenCo could deduct from the prices charged to end customers a gross margin of 8% derived by four independent retail chains. In a real-life scenario, it would be very likely that gross margins varied between distributors and basic statistical tools could be used to account for that.  

Cost Plus Method 

The cost plus method uses as a starting point the costs incurred by the supplier of goods or services in a controlled transaction. Subsequently, one should add to the costs a gross profit mark-up (where “gross” means without deducting operating costs). The mark-up should take into account the functions performed, assets used, and risks assumed, as well as market conditions. It can be taken from other comparable transactions between the same supplier and independent entities or established through a benchmarking analysis. By adding the cost plus mark-up to the above costs one arrives at the arm’s length price of the original controlled transaction. 

Example of Cost Plus Method

An international online gaming group headquartered in Sweden set up a shared services centre in Malta that provides legal and payroll services to its German, Dutch and Polish subsidiaries. The Maltese company does not offer its services to unrelated entities. It is established through market research that comparable independent service providers earn a gross profit mark-up of 5% on similar transactions. To determine the arm’s length price to be charged to related parties, the Maltese company can calculate the cost of their provision and mark it up by 5%.  

What this Means for You 

In November 2022, Malta has introduced its first Transfer Pricing Regulations. Starting from year 2024, the Regulations impose transfer pricing documentation obligations on Malta resident companies engaging in intra-group transactions. It is expected that Malta tax authorizes will ramp up their efforts in the fields of transfer pricing. Taxpayers involved in transactions with related entities should make sure that their transfer prices conform with the arm’s length principle. Transfer prices should be calculated using an appropriate TP method and ideally supported by comprehensive TP documentation. 

How We Can Help 

Our team of experienced advisors can help to identify, assess and mitigate potential transfer pricing risks in your business and to develop a sustainable, tax-efficient transfer pricing policy for the future. As a collaborating firm of Andersen, leading global Tax & Legal advisors, we offer the comfort of years of experience in this highly contentious area. 

Get in touch with us to learn how we can help you to manage your transfer pricing risks so that your business remains in compliance with Malta TP laws whilst retaining its operational effectiveness.  

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