CME Australian Dollar
G. Transfer Pricing Methods for Tax Purposes
When the transfer price does not satisfy tax requirements, the firm can reset its transfer pricing systems. However, this approach requires companies to apply multiple transfer pricing meth- ods fluently. Usually, there are six transfer pricing methods for tax purposes. Exhibit 75 summarizes these six transfer pricing methods and an Other category.
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G.1. Comparable Uncontrolled Price
This price is based on comparable prices through transactions with unrelated parties. The company that focuses on a market-based organization uses this method. In a market-based structure, the company’s segments are autonomic and independent from each other. The managers can decide to make transactions with unrelated parties if the prices offered by other members in the company are not reasonable.
To illustrate the use a comparable uncontrolled method, a parent company sells fiber to its foreign segment and to other parties in its domestic market. On the other hand, its foreign segment buys fiber from the parent company as well as from other manufacturers in the local market. Thus, under a comparable uncontrolled method, the parent company can set a transfer
EXHIBIT 75
Transfer Pricing Methods for Tax Purposes: Tangible Property
Method Description
Comparable Uncontrolled
Price
Resale
Price Cost Plus
Comparable Profits
Profits
Split Other Comparable
factors
Comparable sales between unrelated parties
Price to unrelated party less related gross profit;
nonmanu- facturing
Production costs plus gross profit on unrelated sales
Priced to yield gross profits comparable to those for other firms
Split of combined operating profits of controlled parties
Gross profit reasonable for facts and circumstances
Comparability and Reliability Standards
Similarity of property;
underlying circumstance
Comparable gross profit relative to comparable unrelated transfer
Gross profit from same type of goods in unrelated resale
Gross profit within range of profits for broadly similar product line
Allocation of combined profits of controlled parties
As appropriate
Measures of Comparability
Functional diversity; pro- duct category;
terms in financing and sales;
discounts; and the like
Functional diversity;
product category;
terms in financing and sales;
intangibles;
and the like
Functional diversity;
accounting principles;
direct vs.
indirect costing;
and the like
Business segment;
functional diversity;
different product categories acceptable if in the same industry
Profits split by unrelated parties or splits from transfers to unrelated parties
Fair allocation of profits relative to unrelated party sales
Same Geographic Market
Required Required Required Required Required, but
some flexibility
Required, but some flexibility
Comments Deemed the best method for all firms; minor accounting adjustments allowed to qualify as
“substantially the same”
The best method for distribution operations;
only used where little or no value added and no significant processing
Internal gross profit ratio is acceptable if there are both purchases from and sales to unrelated parties
Not if seller has unique technologies or intangibles because resale price is fixed;
adjust the transfer price from seller
Controlled transaction allocations compared to profits split in uncontrolled transactions
Least reliable;
uncertainty and costs of being wrong are severe INTERNATIONAL TRANSFER PRICING
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price according to both selling and buying comparable prices resulting from transactions with unrelated parties.
However, comparable uncontrolled prices are only acceptable for those global companies who make internal transactions among their segments, and they do not compete with each other in their backyards.
G.2. Resale Price Method
This method is the best for intermediate distributions, such as wholesalers and retailers. It also applies to market-based organizations. Usually these companies add little or no value to goods and do not have a significant manufacturing process.
The formula for this method is:
Computing the gross profit ratio is based on information on the profit ratios in the same product categories used by unrelated parties. However, the information on profit ratios set by competitors is not readily obtainable and may be costly for global companies.
G.3. The Cost-Plus Method
This method is adaptable to manufacturing companies. Under this method the amount of company product cost is adjusted for gross profit ratios. The ratio can be internal gross profit ratio if both sides in the company purchase from and sell to unrelated parties and have comparable price standards, or the ratio can be based on comparable company’s profit ratios for the same broad product category.
The formula of the cost-plus method is:
G.4. Comparable Profit Method
This is a profit markup method. The gross profit part of the transfer price should be compared to others within a range of profits for broadly similar product lines. The profit ratio should be based on some internal profit indicator, such as rate of return. However, if the product or process involved is unique in the market, setting transfer prices under this method is unac- ceptable.
G.5. Profits-Split Method
Under this method, MNCs allocate the combined profits of subsidiaries that are involved in internal transactions. Parent companies compute the combined profits after these goods to customers are sold outside of the group. Also, the profit for each member involved in intercompany transactions is comparable to unit profits where unrelated parties participate in similar activities with comparable products. The profits-split method requires companies to obtain reliable detailed data for comparable products. Usually, it is not difficult for the company to get aggregate profit data for the whole product line, but there is not enough detailed data for analysis and comparison. Thus, appropriate profits-split pricing relies on whether the information on profits is reliable.
Transfer Price = Resale Price to Unrelated Party–Gross Profit Ratio×Resale Price
Transfer Price = Production Cost+Gross Profit Ratio Sales Price to Unrelated Parties
×
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G.6. Other Methods
One of the five transfer pricing methods cannot be adopted all the time. For example, an MNC trades products only among its members. Each member does not purchase from or sell to unrelated parties because those products are unique and no company outside uses them.
Under this situation, when the parent company sets transfer prices, there are no reliability and comparability standards to match because comparable products in the markets do not exist. Therefore, the company cannot use any of the transfer pricing method mentioned above.
When none of the five specific methods can be applied reasonably, the company may choose another method. The method should be reasonable under the facts and circumstances, and should fairly allocate profits relative to unrelated party sales. However, there are no objective guidelines under this approach. The company may face challenges by tax agencies that could result in high costs for noncompliance. To minimize the risk of penalties, companies should have the documents to prove why a method was chosen.