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Transfer pricing: A primer

Globalization presents both tremendous opportunities for business, but also significant challenges.

On one hand, multinational corporations have access to assets across all their geographies — natural resources, manufactured products, lower-cost labor and skilled talent, for example. On the other hand, corporations operating across various jurisdictions have to meet the different laws and regulations required for each geography. It can be a daunting task, especially for tax purposes.

Take calculating cost of goods and services sold across divisions or locations. Accounting for goods or services from a third-party supplier is fairly straightforward, but what about transactions within the corporation? An automaker, for example, knows the price it pays for tires from an outside vendor, but also needs to determine a price for engine parts, brake pads and alternators manufactured by divisions or subsidiaries within the parent company – often across different regions or countries.

Determining the exact cost of transactions between related entities within a company — a process known as transfer pricing — is not only important for accurate accounting but mandatory for most multinationals to report. That’s because the Organization for Economic Cooperation and Development has developed transfer pricing guidelines and is bringing leading nations together to stop companies from evading taxes by shifting profits to low-tax jurisdictions. Member countries include the U.S., Canada, Mexico, the EU and most other European nations, Japan, South Korea and Australia, meaning nearly every multinational company is required to share transfer pricing information through country-by-country reports.

GAO chart on OECD BEPS transfer pricing and country-by-country reporting

On a positive note, sourcing goods from lower-cost markets can help companies to maximize profitability and optimize the allocation of resources worldwide. Through effective transfer pricing, companies can maximize after-tax profits while reducing customs payments for goods delivered across borders. They can reduce overall exchange exposure by managing exchange controls and profit repatriations. On an operational front, transfer pricing can help companies transfer funds across different departments or divisions to meet working capital needs.

How to determine transfer pricing

The first challenge is to implement a successful process to determine and manage transfer pricing. In fact, creating a reporting structure among divisions that can measure the allocation of company resources in detail is one of the most critical factors for success. This helps for future planning as well. To start, a corporation needs to decide how it will determine the actual transfer prices for particular goods and services.

There are five basic methods for establishing transfer prices outlined in the OECD guidelines:

1. The Comparable Uncontrolled Price, or CUP, Method, is the most common method and preferred in most cases by the OECD. The CUP Method compares the price of goods or services in an intercompany transaction to the price changed between independent parties. It’s important that goods and services are assessed under comparable conditions to get an accurate price that tax authorities will accept.

This can also be referred to as market-set pricing because, unlike other methods that focus on margins, the CUP Method is based on fair market price. If an organization manufactures a product, they have to consider what they could earn by selling it to the “outside world.” The company wants to maximize profit margins, so it should obviously exercise good habits, including charging fair market prices for goods or services delivered within the organization.

A drawback to this approach is when the external market doesn’t match the criteria for internal transfer pricing. Sometimes the comparison is off. Commodity prices can be highly volatile. Prices fluctuate significantly for oil, for example, so for organizations that rely on oil for manufacturing, this might not be the best transfer pricing model.

2. Cost-Plus-Percent Method is an approach favored by some manufacturers and is popular with the aerospace industry. It’s a transaction method that compares gross profit to costs of sales. The division supplying goods or services determines the cost of the transaction, then adds a markup for profit on the goods or services delivered. The markup should be equal to what a third party would earn for transactions in a comparable situation, including similar risks and market conditions.

One drawback is this method doesn’t necessarily encourage the supply division to be efficient in manufacturing practices and, in fact, it can be less efficient when it comes to limiting things like material labor and overhead variances. Internal teams can get lazy, receiving cost over time but not really getting competitive pricing.

3. The Resale Price Method looks at the gross margin, or the difference between the price at which a product or service is purchased and the price at which it is sold to a third party. While similar to the Cost-Plus-Percent Method, the Resale Price Method only counts the margin (minus associated costs such as customs duty) as the transfer price. For this reason, it is most appropriate for distributors and resellers, as opposed to manufacturers.

4. Transaction Net Margin Method, or TNMM, recently emerged as a favored model for many multinationals because transfer pricing is based on net profit as opposed to comparable external market pricing. The CUP, Cost-Plus-Percentage and Resale Price Methods are all based on the actual cost of comparable goods or services for external transactions. TNMM instead compares net profit margin earned in a controlled intercompany transaction to the net profit margin earned by a similar transaction with a third party. It can also look at the net margin earned by a third party on a comparable transaction with another third party.

This is comparing profit margin versus actual costs, and is especially appealing when external pricing data is not available to determine the market price. With TNMM, organizations can measure net profit against sales, costs or assets. It is typically applied by targeting an operating margin within a set range. While taxing authorities have preferred the CUP Method, TNMM is emerging as a new standard.

5. The Profit-Split Method, like TNMM, is based on profit, not comparable market price. For this method, transfer pricing is determined by assessing how the profit arising from a particular transaction would have been divided between the independent businesses involved in the transaction. This is based on the relative contribution of each associated business party to the transaction as established by the functional profile, and as available, external market data.

There are pros and cons to each method, and every organization should evaluate what works best for its unique requirements. In some cases, an organization might even use different methods for different types of transactions. The CUP Method, for example, could be used for transactions trading for manufactured goods, and the Resale Price Method for transactions between distributors or resellers. While the OECD doesn’t require organizations to apply multiple methods for transfer pricing, it does allow it and some organizations can benefit.

How to implement transfer pricing

With a methodology (or a mix of methodologies) in place, the corporation can determine a strategy to collect, analyze and report transfer pricing data. This requires a review of the ERP systems, enterprise data warehouse architecture and, most importantly, the right corporate performance management platform to execute transfer pricing across multiple subsidiaries and ERP systems While much of the actual transaction data resides in and comes from the ERP systems, a robust CPM platform is critical to collecting, processing and reporting this information. For example, whichever method a company selects, there must be a profit elimination step as part of the consolidation process to remove the effects of such sales from the consolidated financial statements. The elimination should occur in the same period that the sale occurs. Of course, this includes all intercompany sales and costs of sales recorded by the transfer partner affiliates.

The transfer pricing strategy needs to factor in how centralized the organization is. An organization that is highly autonomous and decentralized poses greater challenges. For example, an organization that has multiple ERP systems or multiple instances of the ERP system, has a more difficult task to streamline and standardize the transfer pricing policy. This is especially challenging if the sales order and purchasing modules are configured differently between platforms.

Unfortunately, many multinational corporations are somewhat decentralized with highly autonomous units, especially those that experience M&A activity. A best practice here is to walk before trying to run. Corporations that start small and focus on testing the transfer pricing method to understand how complicated it is to execute will often develop a successful solution they can scale. To that point, the corporation should consider how it will adapt as the business continues to grow, evolve and possibly acquire new companies.

Determining the best transfer pricing method and developing a successful pilot project that can be pushed out organization-wide is the best approach for implementing a solution that will not only meet regulatory needs, but also provide great insight and business benefits. It’s not an easy process, but if done right, transfer pricing can deliver tremendous efficiency and even business advantage.