Transfer pricing methods

Are you engaging in or planning transactions with group companies? It is crucial to determine a price for these transactions that aligns with what independent third parties would establish. Establishing a fair and compliant price is not just a regulatory requirement; it is also a best practice for maintaining transparent and equitable business operations. Did you know there are specific methods to ascertain this arm’s length price? For each transaction, selecting the most suitable method is essential. Ensure you choose the method that best fits your unique transaction to achieve compliance and fairness.

What are the transfer pricing methods

Transfer pricing methods are different ways of arriving at an arm’s length price. The OECD defines five methods in its transfer pricing guidelines:

1. The ‘comparable uncontrolled price method’ (CUP);
2. The ‘cost plus method’ (CPLM);
3. The ‘resale price method’ (RPM);
4. The ‘transactional net margin method’ (TNMM); en,
5. The ‘profit split method’ (PSM).

Our team at Crowe Peak is dedicated to simplifying these methods and guiding you through the process to ensure compliance and accuracy in your transfer pricing documentation. Rely on our expertise to navigate the complexities and select the best method tailored to your needs. In the rest of this article, we provide detailed explanations of the different transfer pricing methods. Additionally, you can download our whitepaper for more comprehensive information on transfer pricing rules in the Netherlands.

Download: Requirements for Dutch transfer pricing

Section 29b-h of the Dutch Corporate Income Tax Act (“CITA”) specifies that the documentation requirements for taxpayers who meet certain standards are a Local File, a Master File, and relevant Country by Country Reporting. We have condensed these requirements into a clear table. Download the document here!

1. Comparable Uncontrolled Price Method

The CUP method compares the price charged in the related-party transaction with the price charged in a comparable transaction between either:

• two independent parties, or
• one of the parties involved in the related-party transaction and a third party.

In practice, the CUP method is typically applied to bulk commodities with known market prices or to loans.

2. Cost Plus Method

The Cost Plus Method (CPLM) is utilized in transactions between a supplier and an affiliated group company. Under the CPLM, the total cost of producing the goods is increased by a cost mark-up. This combined amount forms the transfer price to the affiliated group company. The appropriate cost mark-up is determined through an analysis of comparable transactions between independent third parties.

For example, consider You B.V., which manufactures machine parts. You B.V. purchases raw materials from Y GmbH, a third party, for 100. The direct and indirect production costs for You B.V. amount to 50. Transfer pricing consultants have determined that independent third parties typically apply a cost mark-up of 30%. Therefore, the transfer price to Group Y GmbH would be 195 (i.e., production costs of 100 + 50, plus a 30% mark-up, totaling 195).

3. Resale Price Method

The Resale Price Method (RPM) is applied in situations where a product is purchased from a related group company and subsequently resold to an independent third party. The transfer price—the price the reseller pays on an arm’s length basis for the product—is determined by subtracting an arm’s length gross margin from the sales price to the third party. The arm’s length gross margin is derived from the gross margins achieved in transactions between independent third parties.

For example, consider You B.V., which sells machine parts manufactured by Groepsmij GmbH for 100 to Y GmbH, an independent third party. You B.V. must report an arm’s length profit. Transfer pricing analysis indicates that independent third parties achieve a gross margin of 25% on similar transactions. Therefore, an arm’s length transfer price between Groepsmij GmbH and You B.V. is 75 (25% of 100 equals 25; thus, 100 – 25 equals 75).

4. Transactional net margin method

The TNMM compares the operating profit margin (i.e. EBIT margin) achieved on the transaction with the group company with the operating profits achieved by independent companies in similar transactions/activities.

To calculate a margin, you need to be able to plot operating profit against something. When using the TNMM, there are many balance sheet and financial statement items against which to measure operating profit. Usually, operating profit is set against sales or total costs. As with selecting the most appropriate transfer pricing method, when selecting the balance sheet or financial statement item(s) against which operating profit is measured, you need to choose the most appropriate items for the specific situation. Crowe Peak’s specialists can advise you on this.

To illustrate: Groepsmij GmbH sells machine parts to its Dutch group company You B.V. You B.V. sells these products to independent third parties on the Dutch market. You B.V.’s advisers have determined that the TNMM is the most appropriate transfer pricing method to determine an operating profit for You B.V.. The operating profit should be set against revenue. The transfer pricing advisers have determined that independent third parties achieve an operating profit equal to 6% of turnover. If You B.V. has €1 million turnover, then an arm’s length operating profit for You B.V. will be €60,000 (i.e. 6% of €1 million).

5. Profit split method

When group companies apply the Profit Split Method (PSM), the operational profit from the transaction is allocated among the involved entities. For a proper application of the PSM, the profit must be divided in a manner that independent third parties would agree upon in a similar context.

We occasionally observe clients utilizing this method. Although it may seem equitable to share risks, and consequently profits and losses, among group companies, this approach is often incorrect from a transfer pricing perspective. The PSM is only the most appropriate method in a limited number of scenarios. Additionally, employing the PSM is frequently undesirable. While the method may appear operationally straightforward, substantiating the arm’s length nature of the allocation key used is highly challenging. The allocation key can be approximated but never determined with complete objectivity, leading to potential disputes with tax authorities. Therefore, it is crucial in these—and other—instances to consult an advisor to review the chosen transfer pricing method.

Ensuring compliance: the importance of correct transfer pricing methodology

If you do not select the most appropriate transfer pricing method, several consequences can arise. You must justify in your transfer pricing documentation why you believe the chosen method is the most suitable. During an investigation, tax authorities will initially consider the transfer pricing method selected by the taxpayer.

You have the freedom to choose your transfer pricing method, provided it leads to an arm’s length outcome for the specific transaction. However, if the tax authorities determine that the chosen method does not produce an arm’s length result, they will impose a transfer pricing adjustment.

A transfer pricing adjustment impacts not only your taxable profit but also requires reflecting the adjustment in your accounts. This can involve recording a fictitious transaction, such as through a current account position or a (disguised) dividend distribution. These notional transactions can further affect your profit or taxation. For instance, a current account position with an arm’s length interest rate can influence your profit, while a disguised dividend may result in a dividend tax liability.

Need guidance?

Do you need help choosing the most appropriate transfer pricing method for your situation? Please feel free to contact our transfer pricing specialists by filling out the form below.