My previous blog of 4 July 2018 set out that, to comply with transfer pricing rules, connected parties should undertake transactions between themselves at “arm’s length”. However, the determination of what is an arm’s length price is often complex and can be subjective.
Five methods are set out by the Organisation for Economic Co-operation and Development (“OECD”, an intergovernmental organisation of which the UK is a member) as potentially offering assistance in setting intercompany prices in order to meet the arm’s length requirement. In the UK, these methods are recognised and respected by HMRC and, in high level summary, are as follows.
Comparable uncontrolled price (“CUP”) – this is the simplest method to use. It bases the price for a connected party transaction on that applying in a comparable transaction involving an unconnected party. The CUP is usually the preferred method for setting connected party prices but it relies on there being similar transactions with unconnected parties and this is often not the case.
Resale price minus – this method is typically used when a company purchases goods for distribution from a connected party. The resale price method starts with the third-party sales price which is then reduced by an appropriate gross margin on this price to give the connected party purchase price (the “resale price minus”). This gross margin represents the amount which the reseller would seek in order to cover its selling and other operating expenses and make an appropriate profit.
Cost plus – this method is most commonly seen where services are provided to a connected customer (often when this is the only customer). Under this method, the price charged to the connected party is based upon the costs involved in the provision of the service to which an appropriate margin (the “plus” element) is added. When this method is used, it is necessary to ensure that the full cost base related to the provision of the service is considered when calculating the margin.
Profit split – this is generally used in complex situations where it is difficult to split the contributions made by connected parties on a separate basis. It looks at how profits in such a situation would be split between unconnected parties. This method is complex and can require a high degree of judgement. It also relies on a view being taken on the “value” of the overall transactions being undertaken by the parties.
Transactional net margin method (‘TNMM’) – this is the most commonly used of the methods. It bases the transfer price on either the net margin made on similar transactions with unconnected parties or, in the absence of such transactions, looks at the net margins made by comparable companies undertaking similar transactions with unconnected parties – these net margins are often obtained from an examination of published company accounts. A particular difficulty when other companies’ results are used is ascertaining whether these companies are truly comparable.
It should be noted that it is possible to use methods other than those set out above if they are considered more appropriate – however the use of such other methods is relatively uncommon. Ultimately, the method which is used needs to be that which is most appropriate for the transaction at issue. In addition, it is necessary to consider the functions carried out, resources and risks borne by the respective parties when setting a transfer price – please see my next blog in this regard.