Comparable uncontrolled price (CUP) method
The CUP method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. If there is any difference between the two prices, this may indicate that the conditions of the commercial and financial relations of the associated enterprises are not arm’s length, and that the price in the uncontrolled transaction may need to be substituted for the price in the controlled transaction. OECD Guidelines,
Resale price method
The resale price method begins with the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise. This price (the resale price) is then reduced by an appropriate gross margin (the “resale price margin”) representing the amount out of which the reseller would seek to cover its selling and other operating expenses and, in the light of the functions performed (taking into account assets used and risks assumed), make an appropriate profit. What is left after subtracting the gross margin can be regarded, after adjustment for other costs associated with the purchase of the product (e.g. customs duties), as an arm’s length price for the original transfer of property between the associated enterprises. This method is probably most useful where it is applied to marketing operations. OECD Guidelines,
Cost plus method
The cost plus method begins with the costs incurred by the supplier of property (or services) in a controlled transaction for property transferred or services provided to a related purchaser. An appropriate cost plus mark up is then added to this cost, to make an appropriate profit in light of the functions performed and the market conditions. What is arrived at after adding the cost plus mark up to the above costs may be regarded as an arm’s length price of the original controlled transaction. This method probably is most useful where semifinished goods are sold between related parties, where related parties have concluded joint facility agreements or long-term buy-and-supply arrangements, or where the controlled transaction is the provision of services. OECD Guidelines,
Profit split method
Where transactions are very interrelated it might be that they cannot be evaluated on a separate basis. Under similar circumstances, independent enterprises might decide to set up a form of partnership and agree to a form of profit split. Accordingly, the profit split method seeks to eliminate the effect on profits of special conditions made or imposed in a controlled transaction (or in controlled transactions that are appropriate to aggregate under the principles of Chapter I) by determining the division of profits that independent enterprises would have expected to realise from engaging in the transaction or transactions. The profit split method first identifies the profit to be split for the associated enterprises from the controlled transactions in which the associated enterprises are engaged. It then splits those profits between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length. The combined profit may be the total profit from the transactions or a residual profit intended to represent the profit that cannot readily be assigned to one of the parties, such as the profit arising from high-value, sometimes unique, intangibles. The contribution of each enterprise is based upon a functional analysis as described in Chapter I, and valued to the extent possible by any available reliable external market data. The functional analysis is an analysis of the functions performed (taking into account assets used and risks assumed) by each enterprise. The external market criteria may include, for example, profit split percentages or returns observed among independent enterprises with comparable functions. Subsection c) of this Section provides guidance for applying the profit split method. OECD Guidelines,
Transactional net margin method
The transactional net margin method examines the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realizes from a controlled transaction (or transactions that are appropriate to aggregate under the principles of Chapter I). Thus, a transactional net margin method operates in a manner similar to the cost plus and resale price methods. This similarity means that in order to be applied reliably, the transactional net margin method must be applied in a manner consistent with the manner in which the resale price or cost plus method is applied. This means in particular that the net margin of the taxpayer from the controlled transaction (or transactions that are appropriate to aggregate under the principles of Chapter I) should ideally be established by reference to the net margin that the same taxpayer earns in comparable uncontrolled transactions. Where this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise may serve as a guide. A functional analysis of the associated enterprise and, in the latter case, the independent enterprise is required to determine whether the transactions are comparable and what adjustments may be necessary to obtain reliable results. Further, the other requirements for comparability, and in particular those of paragraphs 3.34-3.40, must be applied. OECD Guidelines,
According to the OECD Guidelines, none of the methods described above for establishing an arm’s length price is preferable over another. “No one method is suitable in every possible situation and the applicability of any particular method need not be disproved.” OECD Guidelines,
Pricing Methods Described in Section 482 Regulations
Comparable uncontrolled transaction (CUT)
This pricing method asks the taxpayer to find the price of an equivalent transaction taking place between unrelated companies. For instance, the regulations present an example of a drug company that gives its subsidiary a license to produce a drug that it has patented. In addition, the company gives a similar license to an unrelated company. Because the transactions are comparable, the company can price the license to its subsidiary using the price to the unrelated company. CUT has the benefit of being easy to apply, once a comparable transaction has been identified.
Comparable profits method (CPM)
This method prices a transaction using objective measures of profitability derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances. The method can be summed up by the following example provided in the regulations.
DevCo is a U.S. company that develops a high tech widget (htw), which is manufactured by its foreign subsidiary, ManuCo. ManuCo pays DevCo a 5 percent royalty for use of the htw technology. To test the royalty rate, the profit level of ManuCo is compared to similarly situated companies. Data is gathered on profit levels of other companies, and compared to that of ManuCo. In this example, ManuCo’s profits are found to be too high. Therefore, the regulations conclude that the 5 percent royalty is too low, and will need to be adjusted.
This method derives a company’s share of a combined operating profit or loss by reference to the company’s contribution to that combined operating profit or loss.
XYZ-US, a U.S. company, develops a product, Nulon, which it licenses to its foreign subsidiary, XYZ-Europe. XYZ-Europe’s research people adapt the Nulon technology for sale in the European market. XYZ-Europe markets and sells the new product under its own brand name. The price of the Nulon license is tested by looking at XYZ-Europe’s profits.
XYZ-Europe’s profits on its assets, other than the Nulon license, is calculated as follows. First, an average rate of return on invested assets (using data from similar companies) is applied to XYZ-Europe’s operating assets other than the Nulon license. This calculated profit is subtracted from XYZ-Europe’s total pre-royalty profit (actual profit before the cost of the royalty on the Nulon license), a residual profit is determined, which is assumed to be the profit earned from exploitation of the Nulon license. Using internal data of XYZ-US and XYZ-Europe, it is determined that XYZ-US contributed one third of the cost of developing Nulon for the European market, and that XYZ-Europe contributed the remaining two thirds. Therefore, the appropriate level of royalty to XYZ-US is one third of the profit attributable to Nulon sales. Thus, if XYZ-Europe’s total pre-royalty profit is $200 million ($20 million profit on operating assets and $180 million residual pre-royalty profit), and XYZ-US ‘s share of Nulon development costs is 33 1/ 3 percent, then the royalty to XYZ-US is $60 million.
Other unspecified methods
Where the three methods above fail to produce a reliable price, a taxpayer can use other methods.
The IRS regulations state that the taxpayer is required to choose, from the various pricing methods, one that provides the most reliable measure of an arm’s length result.This is known as the best method rule. No one pricing method will always be the best. The reliability of a particular method depends on facts and circumstances, and the availability of good data