The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines) released on July 22, 2010, specifies methods to evaluate the pricing of related party transactions. Most countries generally endorse the methods in the OECD Guidelines in their own transfer pricing regulations. This article summarizes the transfer pricing methods under the OECD Guidelines and their convergence with the methods specified under section 482 of the U.S. Internal Revenue Code (482 Regulations).
Methods under The OECD Guidelines
Chapter 2 of the OECD Guidelines presents five main transfer pricing methods to determine the arm’s length nature of a controlled transaction. The methods are divided into two categories: traditional transaction methods and transactional profit methods.
|Traditional Transactional Methods|
|Comparable Uncontrolled Price (CUP)||The CUP method compares the price charged in a controlled transaction to the price charged in a comparable uncontrolled transaction in comparable circumstances.|
|Resale Price Method (RPM)||The RPM evaluates whether the amount charged in a controlled transaction is arm’s length by reference to the gross profit margin realized in comparable uncontrolled transactions.|
|Cost Plus Method (CPL)||The CPL method evaluates a controlled transaction by reference to the markup earned in comparable uncontrolled transactions.|
|Transactional Profit Methods|
|Profit Split Method (PSM)||The PSM allocates operating profits or losses from controlled transactions in proportion to the relative contributions made by each party in creating the combined profits or losses or in proportion to allocation of profits in arm’s length transactions.|
|Transactional Net Margin Method(TNMM)||The TNMM compares the net profit margin of a taxpayer arising from a non-arm’s length transaction with the net profit margins realized by arm’s length parties from similar transactions.|
In prior versions of the OECD Guidelines, there was preference for the traditional transaction methods; the Guidelines noted that use of the profit-based methods should be considered only under those circumstances when traditional transactional methods cannot be reliably applied alone, or cannot be applied at all. The 2010 OECD Guidelines, however, provide no particular hierarchy for the application of the specified methods. Rather, it is necessary to select the “most appropriate” method given the facts and circumstances.
Methods under 482 Regulations
The 482 Regulations prescribe transfer pricing methods that are in principle similar to the methods under the OECD Guidelines. However, one distinction is that the 482 Regulations prescribe specific methods to each type of transaction. The table lists the methods specified in the 482 Regulations by transaction type.
|Tangible Transactions||Intangible Transactions||Service Transactions|
|CUP||Comparable Uncontrolled Transaction (CUT)||Comparable Uncontrolled Service Price (CUSP)|
|RPM||N.A.||Gross Service Margin Method|
|CPL||N.A.||Cost of Service Plus Method|
|Comparable Profit Method (CPM)||CPM||CPM for Services|
|Services Cost Method (SCM)|
There is significant similarity between the OECD methods and the 482 methods for the different transaction types. For example, the CUP under both the OECD and 482 Regulations, the CUT and the CUSP methods all generally follow the same principles whereby prices charged in uncontrolled transactions are evaluated as being arm’s length by reference to prices charged in the transactions with third parties. The same can be said for the remaining OECD methods, including the TNMM, which is the close equivalent of the CPM under the U.S. regulations.
The one exception is the services cost method, which is an elective method under the 482 Regulations that allows the taxpayer to charge out services at cost if the services are either on a list of routine and non-core services published by the Internal Revenue Service (IRS), or if they have a median comparable markup of seven percent or less. These are referred to as covered services. The taxpayer must also determine that these services do not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in the business.
In addition, the temporary regulations governing cost sharing arrangements issued in December 2008 (2008 Regulations) introduced additional transfer pricing methods for evaluating the compensation derived by each party for its contribution to the arrangement. The 2008 Regulations provide five methods for valuing buy-in payments for pre-existing intangibles (referred to as platform contribution transactions) with respect to cost sharing arrangements, and the IRS has since publicly advised that the principles behind these methods are also applicable to licenses and other intangible transactions.
|Methods for Evaluating Cost Sharing Arrangements under The 2008 Regulations|
|CUT||The arm’s length payment for a platform contribution transaction (PCT) is determined by reference to comparable cost sharing arrangements with uncontrolled parties.|
|Income Method||Under the income method, the arm’s length PCT amount is the present value of the projected income from the contributing participant’s best realistic alternative.|
|Acquisition Price Method (APM)||The APM determines the arm’s length price to be charged in a PCT by reference to the price paid to acquire the stock or assets of a business (i.e. target) in an uncontrolled transaction.|
|Market Capitalization Method (MCM)||The MCM is similar to the APM, except that the value of the relevant business enterprise is determined by reference to stock market prices rather than acquisition prices.|
|Residual Profit Split (RPS)||The RPS method allocates the present value of the residual profits projected from the cost sharing arrangement among the participants based on their contribution of non-routine intangibles.|
Similar to the OECD Guidelines, no particular hierarchy exists for the application of the specified methods under the 482 Regulations. A “best method” is selected by examining the degree of comparability between the controlled transactions and any uncontrolled comparables, and the quality of the data and assumptions used in the analysis.
In addition, both the OECD Guidelines and 482 Regulations allow for the use of unspecified methods where the specified methods set forth are not applicable or do not produce a meaningful result. An unspecified method can be any quantitative analytical framework that yields a reliable measure of an arm’s length result. Any unspecified method must be applied in accordance with the general rules applicable to all specified methods. Thus, the OECD Guidelines and 482 Regulations provide flexibility in applying alternative analyses where the taxpayer can demonstrate that an unspecified method provides the most reliable measure of an arm’s length result.