Analyzing the advantages and disadvantages of each method of pricing
The Chapter 2 of the OECD’s Guidelines on intragroup pricing of Enterprises (version July 2010) shows the methods that can be used to determine whether the conditions imposed in the commercial or financial relations between “Affiliated” companies comply with the ‘arm’s length’ principle.
The latter are divided into traditional and transactional.
The traditional methods are:
1. The method of Comparable Uncontrolled Price (CUP),
2. The method of Resale Price (RPM) and
3. The method of cost plus margin profit (Cost Plus Method, CPM)
The transactional methods are:
1. The Transactional Net Margin Method (TNMM) and
2. The Transactional Profit Split Method (PSM)
It seems that traditional methods are better than transactional methods; however, the OECD Guidelines do not require the use of some as definitely better than the other. In fact, enterprises could use other methods which are not included in the OECD Guidelines.
One extra division in the used methods is the unilateral and bilateral methods. The first examine the transactions between the “related” parts only from the side of the trader part, usually from the part with the simpler structure and the simpler operations, whereas the bilateral examine the transactions between the “ Affiliated” parts taking into consideration the results from the perspective of the buyer and seller respectively. The three traditional methods and the first from the transactional methods are unilateral methods while The Transactional Profit Split Method belongs to the category of bilateral methods.
Below are the methods of determining intercompany transaction prices and described their main advantages and disadvantages. Finally, there is the mapping of the most suitable methods that have to be chosen for the documentation of intergroup transactions by category “affiliated” (controlled) companies and controlled transactions.
The method of Comparable Uncontrolled Price (CUP)
The method of Comparable Uncontrolled Price compares the price that is charged for the sale of goods or services between “affiliated” enterprises (controlled transaction) with the price charged for the sale of goods or services in uncontrolled transactions (that means transactions between a related with an independent enterprise or transactions between third independent firms) always in comparable circumstances, that are taking into consideration comparability factors mentioned above. The existence of differences between controlled and uncontrolled transaction could mean that that the conditions imposed on commercial and financial transactions of the related firm are not consistent with the ‘arm’s length’ principle.
For the application of the method mentioned must be satisfied one of the two conditions:
- No difference between the compared transactions or in the kind of the contracting parties should have substantial effect in the price of the product or service, or
- Relatively accurate adjustments can be made to eliminate these differences.
This method can be used in the comparison of transactions based on internal or external comparable transactions.
The method of Comparable Uncontrolled Price is the most direct and reliable way to examine if the transactions between the “Affiliated” enterprises comply with the ‘arm’s length’ principle. In fact, it is preferable from all the other methods in the case that can be applied with the same reliability with the rest.
However, can be difficult to find a transaction between unrelated enterprises which could be quite similar to a controlled transaction so that any difference would not affect substantially the price of goods sold and services provided. The characteristics of the product or the service that should be similar according to the first comparable factor constitute a stringent condition, which is not found, since any difference in the characteristics of the product or service may have substantial effect on the price. In that case, are not always capable accurate adjustments that can be made to eliminate this difference.
The method of Resale Price (RPM)
The method of Resale Price starts calculating the price to be resold a product in an independent business which has been bought by a “linked” (controlled) enterprise. This price (the resale price) reduced subsequently by an appropriate gross margin (the resale margin), taking into account the gross margins in comparable uncontrolled transactions, representing the amount of profit that would ensure the reseller (distributor) to cover the cost of goods sold and operating expenses, combined with achieving a profit rate according to the risk taken and the actual functions. The price that remains after deducting the gross profit margin regarded as consistent with the ‘arm’s length’ principle for transactions between “affiliated” parties. Subsequently, when applying the method, the gross profit margin collected by the reseller (distributor) in a controlled transaction comparing to the gross profit margin collected in internal or external comparable uncontrolled transactions.
The method of Resale Price is useful when applying in cases of resale of products or services of marketing like the ones that are provided in distribution companies.
The advantage of this method relates to the fact that compares gross profit margins instead of prices. This means that fewer adjustments should take place in order to eliminate differences in product characteristics that have substantial effect in the price. In fact, small differences in the characteristics of the products are less possible to have substantial effect in the gross profit margins than in the price. In this way the method of resale price could give a more reliable measurement of conditions prevailing on the open market than the method of Comparable Uncontrolled Price.
Despite the fact that gross profit margins are not significantly affected by differences in the characteristics of the products, the credibility of the use of the method of resale price can be affected if there are differences in the way that “Affiliated” and Independent enterprises carry out their activities. These differences could affect the level of the cost taking into account due to differences in business efficiency, which does not affect necessarily the price of the product to be resold. Furthermore have to be taking into consideration the comparability of functions performed by the contracting parties, while resellers that contribute significantly in the increase of the product’s cost reselling, will demand bigger gross profit margins, than those that just distribute the product (agents).
In any case if the accounting practices differ between the controlled and uncontrolled transactions between firms should ensure that they have included the same types of costs in the calculation of gross profit margin.
The method of cost plus margin profit (CPM)
The method of cost plus margin profit starts with the expenditures that incurred by the producer of goods or supplier of services in a controlled transaction for the transfer of goods or services in “Affiliated” buyer. A proper margin profit added in the cost which is appropriate to the functions performed, risks assumed and market conditions. The sum of the profit margin and the expenditures can be considered as the value that is consistent with the ‘arm’s length’ principle for the controlled transaction. This sum compared with the profit reaching to the producer of goods or the supplier of services in comparable transactions with independent enterprises (internal comparable) or comparable transactions between other independent firms (external comparable).
Therefore, applying the method of cost plus margin profit, the gross margin that is received from the provider (producer) in a controlled transaction is comparing with the gross margin that is received in internal and external comparable uncontrolled transactions.
The method of cost plus margin profit is useful in cases of production of goods from producers and rendering of services from providers. Actually, should be applied in cases where the producer of goods or the provider of services does not contribute in their production with unique intangible assets or takes unusually high risks, because this will not provide sufficient comparability of the transactions concerned.
The advantages of the method of cost plus margin profit are similar to those of the method of Resale Price as the differences in the characteristics of the products are less possible to have so substantial effect in gross profit margin than they have in the price, so the method of cost plus margin profit would have given a more reliable measurement of conditions that are prevailing on the open market from the method of the comparable uncontrolled price.
The disadvantages of the cost plus margin profit method have to do with the right determining the cost between controlled and uncontrolled transactions and are similar to the disadvantages of the method of Resale Price as there should be identical accounting practices in the management of expenditure items, in calculating of gross profit margin, between controlled and uncontrolled transaction between firms to ensure consistency in comparing them.
The Transactional Net Margin Method (TNMM)
The transactional Net Margin Method examines the net profit of a taxpayer from a controlled transaction comparing the net profit that would be having the taxpayer from internal or external comparable transactions. There are two commonly used variants of the method according to the balance of the profits every time. When the net profit that weigh against sales, then the method of Transactional Net Margin pertains to the method of the resale price, except that take into account the net profit instead of gross. When profit that weigh against the costs, creating the ratio of net profit to costs, then the transactional Net Margin Method pertains to the method of cost plus margin profit, except that take into account the net profit instead of gross. The method of transactional Net Margin Profit that weigh net profit against sales is used most of the times in cases of product resale or rendering of marketing services like those of distribution companies, and the method of transactional Net Margin Profit that weigh net profit against costs is used most of the time in cases of production of goods from producers and in cases of rendering of services from providers.
In the choice of the most suitable variation of the method of net profit transaction will have to be taking into consideration the functional similarities of the Contracting Parties (functional analysis) despite the similarities of produced or distributed products and services.
One of the main advantages of the Transactional Net Margin Method is that net profit margins does not affect from differences in the characteristics of products, like those affecting the price by applying the method of the comparable uncontrolled value.
Additionally they are not affected by functional differences encountered between the contracting parties. The functional differences usually reflected in different business operating costs, which directly alter the gross margin levels, leaving the net margin markers without significant change.
In addition, lack of accuracy in the calculation of costs (breakdown of costs) from published data from companies leads to a quite difficult calculation comparable gross margin ratios. Thus, the use of net margin methods may solve the problem.
The main disadvantage of the Transactional Net Margin Method is that many factors that may not be related to intra-group transactions, may affect the net profit of a controlled company.The main disadvantage of the Transactional Net Margin Method is that many factors that may not be related to intra-group transactions, may affect the net profit of a controlled company.
The Transactional Profit Split Method (PSM)
The Transactional Profit Split Method is a bilateral method for the intragroup invoicing of businesses. Firstly determines the profits allocated to the “affiliated” companies from controlled transactions between them, then allocates an economic basis that approximates the division of profits that would be expected from contracts between independent firms in conditions that have effect the ‘arm’s length’ principle. In fact the apportioned profits between enterprises in controlled transactions mapped to proportionally contribution of each company in the transaction. The economic basis can be determined by market factors, which means from allocation of profits between independent companies in uncontrolled transactions between them (external comparable factors).
However, this allocation can be done by internal comparable factors.
The main advantage of the Transactional Profit Split Method is that can offer a complete solution for functions of businesses in cases that a unilateral method would not be suitable. This applies to the case that both contracting parties of a transaction contribute uniquely to the transaction, e.g. providing unique tangible goods, as in a situation like this the contracted parties may wish to share the profits from the transaction in proportion to their corresponding contributions to the transaction. The two contracted parties are being evaluated for their contribution in the transaction, which results in not taking into consideration the profits of the just one (controlled) enterprise.
In addition, the method of Transactional Profit Split offers flexibility in analysis, as taking into account the special, unique characteristics of transactions between “Affiliated” companies, which do not exist in transactions between independent enterprises, including the behavior of independent enterprises in similar transactions and conditions, in light of ‘arm’s length’ principle.
The Transactional Profit Split Method would not be suitable if any of the contracted parties performing simple functions in the transaction and does not contribute individually, e.g. through unique intangible goods, in the transaction.
Additionally, it is not easy to draw independent business behavior data by sharing profits from comparable transactions. There may be difficulty in accessing information on the allocation of profits between independent enterprises. Also, it might be difficult to measure combined revenue and costs for associated enterprises in the controlled transaction, which would require the use of common accounting practices between “affiliated” domestic and foreign enterprises.
The choice of the most suitable documentation method of intercompany transactions
The choice of the appropriate method intends in searching for the appropriate intercompany transaction documentation method, examining the data to any specific transaction and the type of ongoing operations by the contracted parties. No method is suitable in any case and it is not necessary to prove that a process is not suitable for the respective conditions.
The selection of the appropriate method takes into account the following four (4) criteria:
- The appropriateness of each method considering the functional analysis of the controlled transaction and business.
- The degree of comparability between controlled and uncontrolled transactions, taking into account the necessary adjustments that should take place during the application of the chosen method.
- The availability of reliable information necessary for the implementation of each method.
- The advantages and disadvantages of any applicable method.
For cases where two or more methods meet the above criteria, the traditional preferred towards transactional, in the order they are presented herein.
The following table summarizes the selection of the most appropriate of the range and profit margins calculation method that are in accordance with the ‘arm’s length’ principle in the documentation of transactions between “affiliated” companies.
|Data||The best method (from the first best to the second best, etc.).|
|The method of the comparable uncontrolled value is applied with the same reliability as any other.||The method of Comparable Uncontrolled Price (CUP).|
|When one contracted party performs to the transaction non-unique functions (manufacturer, distributor, services for which there are comparable transactions) and does not contribute uniquely to the transaction (ie that does not provide a unique intangible asset).||§ Selected unilateral methods§ The choice of the controlled part of the transaction is based on the part performing the simplest functions.|
|The controlled company is the vendor (eg manufacturer or supplier).||§ The method of cost plus margin profit (CPM)§ The Transactional Net Margin Method – TNMM (weighted at cost, Net Cost Plus).If they can be both applied reliably, we applie the first.|
|The controlled company is the purchaser (eg distributor or marketing service provider).||§ The method of Resale Price (RPM).|
§ The Transactional Net Margin Method – TNMM (weighted at profit, Return on Sales).
If they can be both applied reliably, we applie the first.
|When each contracted party performs to the transaction unique functions and contribute uniquely to the transaction (e.g., provides a unique intangible asset).||§ bilateral method§ Transactional Profit Split Method (PSM).|