Transfer Pricing

Transfer pricing

Transfer pricing is the setting of the price for goods and services sold between controlled (or related) legal entities within an enterprise. For example, if a subsidiary company sells goods to a parent company, the cost of those goods paid by the parent to the subsidiary is the transfer price. Legal entities considered under the control of a single corporation include branches and companies that are wholly or majority owned ultimately by the parent corporation. Certain jurisdictions consider entities to be under common control if they share family members on their boards of directors. Transfer pricing can be used as a profit allocation method to attribute a multinational corporation’s net profit (or loss) before tax to countries where it does business. Transfer pricing results in the setting of prices among divisions within an enterprise.

Transfer pricing multi-nationally has tax advantages, but regulatory authorities frown upon using transfer pricing for tax avoidance. When transfer pricing occurs, companies can book profits of goods and services in a different country that may have a lower tax rate. In some cases, the transfer of goods and services from one country to another within an interrelated company transaction can allow a company to avoid tariffs on goods and services exchanged internationally. The international tax laws are regulated by the Organization for Economic Cooperation and Development (OECD), and auditing firms within each international location audit financial statements accordingly.

Arm’s Length Transaction:

Article 9 of the OECD Model Tax Convention is dedicated to the Arms Length Principle (ALP). It says that the transfer prices set between the corporate entities should be in such a way as if they were two independent entities.

A framework has been provided by the OCED in the Transfer Pricing Guidelines issued by it which provides details regarding the arm’s length price.

ALP is based on real markets and provides the MNE’s and the governments a single international standard for the contracts that allows various different government entities to collect their share of tax at the same time creating enough room for the MNE’s to avoid the double taxation.

Risks and benefits

However, some of the risks and benefits associated with transfer pricing are as follows:


  1. Transfer pricing helps in reducing the duty costs by shipping goods into high tariff countries at minimal transfer prices so that the duty base associated with these transactions is low.
  2. Reducing income taxes in high tax countries by overpricing goods that are transferred to units in those countries where the tax rate is comparatively lower thereby giving them a higher profit margin.


  1. There can be a disagreement among the organizational division managers as what the policies should be regarding the transfer policies.
  2. There are a lot of additional costs that are linked with the required time and manpower which is required to execute transfer pricing and help in designing the accounting system.
  3. It gets difficult to estimate the right amount of pricing policy for intangibles such as services, as transfer pricing does not work well as these departments do not provide measurable benefits.
  4. The issue of transfer pricing may give rise to dysfunctional behavior among managers of organizational units. Another matter of concern is the process of transfer pricing is highly complicated and time-consuming in large multi-nationals.
  5. Buyer and seller perform different functions from each other that undertake different types of risks. For instance, the seller may or may not provide a warranty for the product. But the price a buyer would pay would be affected by the difference. The risks that impact prices are as follows
      • Financial & currency risk
      • Collection risk
      • Market and entrepreneurial risk
      • Product obsolescence risk
      • Credit risk 

1. Comparable Uncontrolled Price Method

The comparable uncontrolled price (CUP) method compares the price and conditions of products or services in a controlled transaction with those of an uncontrolled transaction between unrelated parties. To make this comparison, the CUP method requires what’s known as comparable data. In order to be considered a comparable price, the uncontrolled transaction has to meet high standards of comparability. In other words, transactions must be extremely similar to be considered comparable under this method.

The OECD recommends this method whenever possible. It’s considered the most effective and reliable way to apply the arm’s length principle to a controlled transaction. That said, it can be very challenging to identify a transaction that’s appropriately comparable to the controlled transaction in question. That’s why the CUP method is most frequently used when there’s a significant amount of data available to make the comparison.

2.The Resale Price Method

The resale price method (RPM) uses the selling price of a product or service, otherwise known as the resale price. This number is then reduced with a gross margin, determined by comparing the gross margins in comparable transactions made by similar but unrelated organizations. Then, the costs associated with purchasing the product—such as customs duties—are deducted from the total. The final number is considered an arm’s length price for a controlled transaction made between affiliated companies.

When appropriately comparable transactions are available, the resale price method can be a very useful way to determine transfer prices, because third-party sale prices may be relatively easy to access. However, the resale price method requires comparable with consistent economic circumstances and accounting methods. The uniqueness of each transaction makes it very difficult to meet resale price method requirements.

3. The Cost Plus Method

The cost plus method (CPLM) works by comparing a company’s gross profits to the overall cost of sales. It starts by figuring out the costs incurred by the supplier in a controlled transaction between affiliated companies. Then, a market-based markup—the “plus” in cost plus—is added to the total to account for an appropriate profit. In order To use the cost plus method, a company must identify the markup costs for comparable transactions between unrelated organizations.

The cost plus method is very useful for assessing transfer prices for routine, low-risk activities, such as the manufacturing of tangible goods. For many organizations, this method is both easy to implement and to understand. The downside of the cost plus method (and really, all the transactional methods) is the availability of comparable data and accounting consistency. In many cases, there are simply no comparable companies and transactions—or at least not comparable enough to get an accurate, reliable result. If it’s not an apples to apples comparison, the results will be distorted and another method must be used.

4.Transactional Profit Methods

Unlike traditional transaction methods, profit-based methods don’t examine the terms and conditions of specific transactions. Instead, they measure the net operating profits from controlled transactions and compare them to the profits of third-party companies making comparable transactions. This is done to ensure all company mark-ups are arm’s length.

However, finding the comparable data necessary to use these methods is often very difficult. Even the smallest variations in product features can lead to significant differences in price, so it can be very challenging to find comparable transactions that won’t raise red flags and be questioned by auditors.

5. The Comparable Profits Method

The comparable profits method (CPM), also known as the transactional net margin method (TNMM), helps determine transfer prices by looking at the net profit of a controlled transaction between associated enterprises. This net profit is then compared to the net profits in comparable uncontrolled transactions of independent enterprises.

The CPM is the most commonly used and broadly applicable type of transfer pricing methodology. As far as benefits go, the CPM is fairly easy to implement because it only requires financial data. This method is really effective for product manufacturers with relatively straightforward transactions, as it’s not difficult to find comparable data.

The CPM is a one-sided method that often ignores information on the counterparty to the transaction. Tax authorities are increasingly likely to take the position that the CPM is not a good match for organizations with complex business models, such as high-tech companies with intellectual property. Using data from companies that do not meet the OECD’s standards of comparability creates audit risk for organizations.

6. The Profit Split Method

In some cases, associated enterprises engage in transactions that are interconnected—meaning they can’t be observed on a separate basis. For example, two companies operating under the same brand might use the profit split method (PSM). Typically, the related companies agree to split the profits, and that’s where the profit split method comes in.

This approach examines the terms and conditions of interrelated, controlled transactions by figuring out how profits would be divided between third parties making similar transactions. One of the main benefits of the PSM is that it looks at profit allocation in a holistic way, rather than on a transactional basis. This can help provide a broader, more accurate assessment of the company’s financial performance. This is especially useful when dealing with intangible assets, such as intellectual property, or in situations where there are multiple controlled transactions happening at a time.

However, the PSM is often seen as a last resort because it only applies to highly integrated organizations equally contributing value and assuming risk. Because the profit allocation criteria for this method is so subjective, it poses more risk of being considered a non-arm’s length outcome and being disputed by the appropriate tax authorities.

If you’re struggling to determine which of the five transfer pricing methods is an ideal fit for you, we can help. Our team of transfer pricing experts has the know-how and firsthand experience to help guide you in the right direction. Get in touch to learn more about how we partner with tax teams to help them achieve the best financial outcomes possible. Among the biggest changes in transfer pricing documentation and reporting over the past few years are the maintenance of both master and local files as specified in the Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Sharing (BEPS) action items. Prior to the introduction of BEPS in 2017, the OECD standards were nebulous, specifying only that documentation should “reasonably” demonstrate that the arm’s length standard was used to establish transfer pricing. Under this subjective standard, some companies provided minimal information to tax authorities, complicating efforts to ensure compliance. In addition, many jurisdictions required primarily documentation related to the local company and thus lacked the context of the parent enterprise’s transfer pricing practices. The OECD’s goals in adopting new BEPS guidelines were to increase transparency and standardize the documentation taxpayers are required to provide to ensure tax authorities have the necessary information to assess transfer pricing policies. To address these goals, the BEPS guidelines established a three-tiered approach for documenting intercompany transactions, requiring companies to prepare a master file, a local file, and a country-by-country report. This tiered documentation is intended to provide tax authorities in all jurisdictions with the context required to verify compliance. This standardized approach also seeks to achieve three objectives. The first is for companies to self-assess compliance with the arm’s length principle. The second is to provide tax authorities with a means of identifying potentially risky transfer pricing, while the third is to provide them with a specified level of information about the taxpayer in the event of an audit. In this article, we’ll review the local file and transfer pricing master file requirements and look at how transfer pricing local file templates may vary from one jurisdiction to another.

The master file provides a global overview of the enterprise’s transfer pricing. It includes high-level information about the company’s global operations and transfers pricing policy. The OECD has developed an outline of the information that should be included in the master file. For the most part, every country has adopted the OECD master file guidelines:

      • Organizational structure
      • Geographic locations of operations
      • Main value/profit drivers
      • Descriptions of business activities of business units (products and services)
      • Intangible assets
      • Intercompany financing
      • Enterprise financials and tax positions

The master file is compiled at the enterprise level, typically the parent company. BEPS guidelines suggest that the master file be made available to tax authorities in the jurisdictions where the enterprise has business operations and many tax authorities have adopted the master file as a requirement in their own legislation.

While the BEPS guidelines stipulate the required information, there is some flexibility in how companies can present or format the information. The enterprise’s OECD master file may, for example, be presented by a line of business, as long as centralized functions and transactions are thoroughly documented. Although the master file needs to be available to local tax authorities, it does not have to be compiled by each business entity—only by the parent company.

The master file represents an opportunity to explain the transfer pricing policy to tax authorities. Although following the guidelines requires some taxpayers to provide much more extensive information than they previously had, the transfer pricing master file requirements introduced a level of security for companies that carefully apply the arm’s length principle in their intercompany transactions.

What’s most important in preparing the master file, aside from including the required documentation, is avoiding risk. Discrepancies or contradictions between information in the master and local files increase audit risk, so it’s critical to make sure the descriptions that are provided in the files are consistent.

The local file preparation is specific to each country to document the activities of the business units operating in that specific jurisdiction. The local file provides detailed information about the local company’s intracompany transactions. Local files are filed with the tax authority for the jurisdiction.

As with the master file, BEPS has guidelines for the information that should be included in local files. BEPS local file requirements include these details:

  • Management structure of the local entity
  • Intracompany transactions executed during the tax year
  • Related intercompany agreements
  • Transfer pricing methodology and application
  • Local entity financials

While many countries have adopted the OECD’s transfer pricing local file template, some have tweaked it with requirements for additional information or with a specific format for ordering the information. In these jurisdictions, the information stipulated for OECD requirements will be the same; the difference is that the specific jurisdiction may require additional information or have unique stipulations as to how the information is presented.

As already noted, ensuring that the information in the local file is consistent with information in the master file is crucial. Disparities can create audit risks.

Country-by-Country Reports

The country-by-country reports that comprise the other tier of BEPS documentation essentially summarize the activities of all the enterprise’s related entities doing business within the jurisdiction. These may be compiled from information already assembled for the master and local files—but require a designated person or team to ensure that the required documents are collected, assembled, and filed on time.

The first step in avoiding audits and penalties is to make sure all required documentation is prepared on time,  and submitted to the tax authority if necessary.

Due to the increased complexity of the three-tiered approach introduced by BEPS, a detailed work plan to meet important deadlines and successfully manage the compliance process is critical. Developing this plan is a challenge in itself, so GSPU has designed a scalable work plan with timelines and task lists to serve as a work plan template.

Although the OECD BEPS requirements introduced a more complex documentation regimen, companies can more easily assess their compliance with the arm’s length principle in their transfer pricing plan—and reduce their risk of an audit by complying with all requirements. However, companies with complex international business structures that conduct large volumes of intracompany transfers may want to seek out the guidance of third-party transfer pricing specialists—like the team at GSPU—to ensure all BEPS requirements are being addressed.

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