SARS accepts the methods prescribed by the OECD, these being:
- Comparable Uncontrolled Price Method
- The Resale Price Method
- The Cost Plus Method
- The Comparable Profits Method, also known as the transactional net margin method (TNMM)
- The Profit Split Method
SARS has indicated that it will subscribe to the OECD’s view of accepting a best-method approach as long as it is substantiated. SARS may require adjustments to foreign comparable company results used for benchmarking the results of the South African entity to compensate for differences in risks assumed by entities operating in a different jurisdiction.
Transfer pricing Methods
Methods are used to calculate or test the arm’s length nature of prices or profits. Transfer pricing methods are ways of establishing arm’s length prices or profits from transactions between associated enterprises. The transaction between related enterprises for which an arm’s length price is to be established is referred to as a “controlled transaction”. The application of transfer pricing methods helps ensure that transactions conform to the arm’s length standard.
The arm’s length principle is outlined in Article 9 of the OECD Model Tax Convention as follows: where “conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly”.
The term “arm’s length”’ simply means that a transaction between related entities reflects the conditions and remuneration set in comparable transactions between unrelated entities. It means that the price a company pays to purchase goods or services from a related company entity should be the same as if the two entities were unrelated. In other words, there should be no price adjustment or special conditions for the transaction simply because the parties are related legal entities.
It is important to note that although the term “profit margin” is used, companies may also have legitimate reasons to report losses at arm’s length, and transfer pricing methods are not determinative in and of themselves. If an associated enterprise reports an arm’s length amount of income, without the explicit use of one of the recognized transfer pricing methods, this does not mean that its pricing should automatically be regarded as not being at arm’s length and there may be no reason to impose adjustments.
The selection of a transfer pricing method serves to find the most appropriate method for a particular case. Considerations involved in selecting a method can include: the respective strengths and weaknesses of each method; the nature of the controlled transaction; the availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method; and the degree of comparability between the controlled and uncontrolled transactions.
The starting point in selecting a method is an understanding of the controlled transaction (inbound or outbound), in particular based on the functional analysis which is necessary regardless of which transfer pricing method is selected. The functional analysis is a major part of selecting the transfer pricing method as it helps:
- To identify and understand the intra-group transactions;
- To identify the characteristics that would make a particular transaction or function suitable for use as a comparable;
- To determine any necessary adjustments to the comparables;
- To check the relative reliability of the method selected; and
- Over time, determine if modification of the method is appropriate because the transaction, function, allocation of risks, or allocation of assets has been modified.
The five different methods of transfer pricing fall into two categories: traditional transaction methods and transactional profit methods.
While the traditional transaction methods look at individual transactions, the transactional profit methods look at the company’s profits as a whole. Each method takes a slightly different approach and has associated benefits and risks, which we’ll explore in more detail in future articles. There’s no right or wrong method—only the one that best fits a company’s business model. Transfer pricing regulations specify that organizations select the method best suited to their organization.
Traditional Transaction Methods
Traditional transaction methods examine the terms and conditions of uncontrolled transactions made by third-party organizations. These transactions are then compared with controlled transactions between related companies to ensure they’re operating at arm’s length.
There are three traditional transaction methods:
- 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. 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.
- 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 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 comparables with consistent economic circumstances and accounting methods. The uniqueness of each transaction makes it very difficult to meet resale price method requirements.
- 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. 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.
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 markups are at 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.
- 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. Regarding benefits, the CPM is fairly easy to implement because it only requires financial data. This method is 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.
- 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 multiple controlled transactions are happening at a time.
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 very subjective, it poses more risk of being considered a non-arms length outcome and being disputed by the appropriate tax authorities.
Further detail with examples of each method will be discussed in future articles.