Transfer Pricing 101: What Is Transfer Pricing and Why Should I Care?

By February 21, 2020 May 18th, 2020 International, Tax, Transfer Pricing
Transfer Pricing 101: What is transfer pricing, why is it important and more | Venice, Italy

Published: January 8th, 2020 at 08:02 AM PST | Updated: May 8th, 2020 at 3:07 PM PST

For information on the potential impact of the COVID-19 pandemic on your transfer pricing policies, please visit our latest Transfer Pricing article.

In today’s global environment, international and cross-border tax matters have become a crucial discussion point for all corporate taxpayers. Multinational businesses face increasing scrutiny from tax authorities as newly introduced guidelines broaden regulatory requirements.

In light of revised guidance from the Organisation for Economic Co-Operation and Development (“OECD”) relating to base erosion and profit sharing (“BEPS”), the need to have effective documentation and transfer pricing is as high as it has ever been. Regardless of size, any company operating as a multinational business must address the heightened regulations and scrutiny and ensure they have taken the proper steps for compliance.

What is transfer pricing?

Transfer pricing refers to ways in which a group of commonly-controlled companies prices or values its intercompany/intragroup transactions. These transactions may include goods, services or even intangible property. These policies and procedures are significant for both the taxpayers and tax administrations because transfer pricing affects the allocation of profits from intra-group transactions, which impacts reported income and expenses, and therefore taxable profits of related companies that operate in different taxing jurisdictions.

Under Article 9 of the OECD Model Tax Convention, it describes the “arm’s length principle.” More specifically, it states that transfer prices between two commonly controlled entities must be treated as if they are two independent entities. Establishing arm’s length prices is one of the most challenging issues that arise from an international tax perspective.

Transfer pricing affects more than large multinational enterprises, but instead potentially touches every company engaging in cross-border transactions with related parties. The need for transfer pricing emerges when related parties engage in intracompany transactions regarding:

  • Tangible property (e.g. manufacturing and distribution);
  • Intangible property (e.g. royalties, licenses, cost sharing transactions, platform contribution transactions);
  • Services (e.g. management, sales support, contract R&D services);
  • Financing (e.g. intercompany loans, accounts receivable, debt capacity and guarantees).

What is the “arm’s-length principle”?

Per OECD guidance, the “arm’s-length principle” attempts to measure the value of a transaction “as if” the related parties were independent, unrelated parties. It is the standard used globally to resolve transfer pricing disputes.

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What is the importance of sufficient transfer pricing policies?

Globalization presents both tremendous opportunities for business, but also significant challenges. It is imperative for corporations operating across various jurisdictions to meet the different laws and regulations required for each locale. It can be a daunting task, especially for tax purposes. Transfer pricing is not only important for accurate accounting, but also mandatory for most multinational entities to report.

The guiding principle of most transfer pricing regimes is to ensure that the income taxed in a particular jurisdiction is determined using sound economic and business practices. No government wants to allow businesses to evade taxes by inappropriately sourcing profits to low-tax jurisdictions, or so-called tax havens.

Almost all advanced economies around the world have transfer pricing rules that allow tax authorities to adjust items of income, expense, credit or allowance in connection with related party transactions. Most jurisdictions with transfer pricing regimes require businesses with related party transactions to prepare and retain documentation supporting the arm’s length nature of these transactions.

This is where the value of engaging transfer pricing services comes into play. Failure to make reasonable efforts to maintain contemporaneous transfer pricing documentation (i.e., an explanation of why your intercompany, cross-border prices are arm’s length) can result in a tax authority enforcing adjustments.

As a result, these adjustments may lead to additional tax payable, interest, penalties, double tax (without an inverse adjustment in the corresponding jurisdiction), prolonged disputes, loss of reputation, and wasted internal resources. In addition, if required documentation is not available, the company may face significant penalties.

What are the rules in the United States?

In the United States, Section 482 of the Internal Revenue Code (“IRC”) provides several methods to test whether a price meets the arm’s-length standard and requires that a company applies the “best method.” Section 482 also authorizes the Internal Revenue Service (“IRS”) to adjust the income, deductions, credits, or allowances of commonly controlled taxpayers to prevent the evasion of taxes or to clearly reflect their income.

Under Section 6662(e), the transfer pricing penalty generally equates to 20% of the underpayment of tax attributable to the transfer pricing misstatement, but increases to 40% of the underpayment for larger adjustments. However, penalties do not apply if the taxpayer has prepared and documented a reasonable transfer pricing analysis supporting its reported intercompany transactions.

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What does a transfer pricing analysis consist of?

To determine arm’s-length pricing, there are three key steps in a transfer pricing analysis:

  1. Functional analysis
  2. Identification of comparable transactions and relationships
  3. Selection and application of the “best” and most appropriate transfer pricing method

What is Transfer Pricing |Functional Analysis

The functional analysis is the process by which you assemble the economically relevant facts for the overall transfer pricing assessment. These facts may pertain to a number of key elements, including:

  • The overall process by which the MNE generates value;
  • Relevant cross-border transactions between associated parties;
  • Specific terms for intracompany transactions (e.g. written contracts, invoices, payments); and
  • Functions performed, assets used, and risks assumed by each party in relation to the identified intracompany transactions.


In order to apply the arm’s-length principle, there must be comparisons of the conditions of the controlled transaction with the conditions of transactions between independent parties.

This comparison is only useful if the actual transaction is economically comparable. Typically, evaluating comparability requires consideration of different factors, such as:

  • Characteristics of the goods or services in question;
  • Functions performed by each party;
  • Terms of the transaction;
  • Risks assumed by each party;
  • Economic circumstances of the parties; and
  • Business strategies followed by each party.

Method Selection

Following a functional analysis and determination of comparables, you must select the most appropriate transfer pricing method. This method is the one that will most reliably lead to the identification of the arm’s-length price, given the relevant facts and availability of the relevant data. See below for more details on each method.

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What are the different transfer pricing methods?

Generally, there are two approaches to determine the arm’s-length price for cross-border, intracompany transactions: 1) transaction-based, and 2) profit-based.

Transaction-based methods require the identification of prices or margins from individual transactions or groups of transactions involving related entities, and comparing these results to the price or margin information obtained involving independent third parties.

The profit-based methods benchmark the overall profitability earned by controlled entities and unrelated parties performing similar functions and incurring similar risks.

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

1. Comparable Uncontrolled Price (“CUP”) Method

The CUP approach is the most common method and most preferable for the OECD. It compares the price of goods or services in an intercompany transaction to the price charged between independent parties. In order to gather an accurate price (and one accepted by tax authorities), you must assess goods and services under comparable conditions.

Unlike other methods that focus on margins, the CUP Method focuses on fair market price. For example, if a company manufactures a product, they have to consider what they would sell it for in 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.

2. Cost-Plus-Percent Method

Generally, manufacturers prefer this approach. It is 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.

3. Resale Price Method

This approach assesses 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 (“TNMM”)

The 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 all rely 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.

5. Profit-Split Method

Similar to TNMM, the profit-split approach relies on profit, not comparable market price. For this method, companies derive transfer prices by assessing how the profit arising from a particular transaction would have been divided between the independent businesses involved in the transaction.

The Profit-Split method considers the relative contribution of each associated business party to the transaction as established by the functional profile, and as available, external market data.

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What are the benefits of a transfer pricing study?

As you tackle transfer pricing matters for your own business, there are significant benefits to engaging a third party to conduct a thorough review of your transfer pricing policies and documentation. Bringing in outside transfer pricing professionals can help your company by:

  • Ensuring that your company’s transfer pricing policies comply with all requirements in the relevant tax jurisdictions, including meeting documentation rules;
  • Providing support for transfer pricing related deferred tax assets and deferred tax liabilities recorded in the company’s financial statements;
  • Identifying opportunities to reduce the company’s global effective tax rate by restructuring multinational operations; and
  • Identifying ways to increase global supply chain efficiency by relocating operations or reorganising legal entities.

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How can Squar Milner help?

With evolving regulations and increased scrutiny from regulatory bodies, you need a partner by your side who understands the ins and outs of the intricate ecosystem of transfer pricing. Squar Milner can be that partner.

We have an experienced specialty practice dedicated exclusively to Transfer Pricing Services. Our team is prepared to help you handle documentation, valuation and a number of other transfer pricing services to ensure that you are in compliance with guiding regulations.

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Robena Jafari
International Partner-in-Charge, Tax Services

Varagana Punchihewa
Principal, Transfer Pricing Services

Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.

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