Select a transfer pricing method and determine the arm's length price
You should select the pricing method that is most appropriate for determining the arm's length price.
Some pricing methods require you to select financial key ratios (comparability indicators) when pricing the transaction. The arm's length price is rarely expressed as a specific price but typically falls within a range identified through an analysis of comparable transactions.
Basis for selecting the pricing method
To select the most appropriate pricing method, you should assess:
- the nature of the transaction, how it is delineated, and particularly the FAR analysis
- the identified internal or external comparable transactions, if applicable
- what may be possible to find in terms of comparable results from external third parties, based on comparability indicators
The OECD guidelines recommend using one of five different methods to determine the arm's length price and distinguish between traditional transaction methods and profit-based methods.
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Transfer pricing method |
Traditional transaction-based or profit-based method |
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Comparable Uncontrolled Price (CUP) |
Traditional transaction-based |
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Resale Price Method (RPM) |
Traditional transaction-based |
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Cost Plus Method (CPM) |
Traditional transaction-based |
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Transactional Net Margin Method (TNMM) |
Profit-based |
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Transactional Profit Split Method (TPSM) |
Profit-based |
The Comparable Uncontrolled Price (CUP) method is a traditional pricing method in which the price of the controlled transaction is compared with the market price.
Some pricing methods are unilateral, meaning they relate to one party in the transaction, referred to as the tested party. The Cost Plus Method (CPM), Resale Price Method (RPM), and Transactional Net Margin Method (TNMM) are unilateral methods where the comparison is based on the tested party.
The Transactional Profit Split Method (TPSM) is a bilateral method. This involves the allocation of profits or losses between the parties in the controlled transaction in the same way as independent parties under comparable circumstances. This means you must base your analysis on the comparability factors of all parties in the controlled transaction and of the various parties in the uncontrolled comparable transactions.
The OECD guidelines highlight the CUP method as the preferred method and traditional transaction methods as preferred over profit-based methods. When you have data that allows you to use one of these methods, you should do so. If you lack such data, you must use one of the profit-based methods.
You can use other pricing methods if you believe they are more appropriate. The use of other methods requires that you achieve prices in accordance with the arm's length principle and that both the process and the outcome of the pricing can be verified. When using other methods, you must explain why the standard methods are not appropriate and document how you have determined the arm's length price.
We briefly present the five most common transfer pricing methods below. Further guidance on how to apply the methods is available in the OECD Transfer Pricing Guidelines.
When applying the CUP method, you compare the price of the controlled transaction directly with the price of a comparable transaction between independent parties. In the CUP method, the arm's length price is determined by the price in a market where the product is traded between independent entities.
The CUP method:
- is one of the three traditional methods
- examines price formation between independent parties in an open market
- is applicable when the same type of products are sold both externally and internally within the group
- is relevant when prices are set in a functioning market, such as a commodity exchange
- is referred to in the OECD guidelines as the preferred method
- is challenging to apply in practice, as it requires a high degree of similarity between the product and the conditions of the controlled transaction and those of transactions between independent parties, even after adjustments
When applying the Resale Price Method (RPM), you start with the price achieved from reselling a good or service to an independent party. The gross profit on the resale is the profit expected to be required by parties performing comparable sales to cover their costs (both direct and indirect) and to earn a reasonable profit from the transaction. In RPM, a calculated gross margin from sales to external parties (internal comparable transaction) represents the arm's length profit from the sale of goods/services.
RPM:
- is one of the traditional methods
- initially requires internal comparable transactions with external parties (requires selection of the tested party in the controlled transaction)
- is a gross method, focusing on the margins achieved from sales to external parties
- is sensitive to differences in accounting standards and practices of the controlled party and the uncontrolled comparable party
- is not highly sensitive to product differences, but the profit margin can be affected by factors influencing sales revenue, such as quality, brand, market conditions, or economies of scale
If it is not possible to find internal comparable transactions, it may be relevant to compare the tested party with companies that have comparable transactions.
In such an analysis, it can be challenging to find information about gross margins in uncontrolled comparable companies and whether these companies are comparable to the tested party. In practice, it can be difficult to determine the cost accounting practices of external companies. This means that you may need to consider alternative methods.
When applying the Cost Plus Method (CPM), you start with the actual (direct and indirect) costs incurred by the company related to the production of goods/services. In addition to the actual costs, you should add a markup that corresponds to what independent parties would require, considering the functions performed and market conditions. In CPM, the arm's length price is determined based on costs plus a markup.
The Cost Plus Method (CPM):
- is one of the traditional methods
- initially requires transactions with external parties (internal comparables) where costs are incurred in the production of goods or services
- requires the selection of a tested party in the controlled transaction
- is a gross method, focusing on the margins external parties achieve on costs related to the sale of goods or services
- requires comparable cost bases in the uncontrolled comparable transactions
- can be demanding because it is challenging to obtain data on the cost structure of independent parties conducting comparable transactions
- is sensitive to differences in accounting standards and practices of the controlled party and the uncontrolled comparable party
- is sensitive to differences in geographic markets, various value chains, and production structures that can affect the cost base
If it is not possible to find internal comparable transactions, it may be relevant to compare the tested party with companies that have comparable transactions and cost structures. This is an alternative to the standard Cost Plus Method. Just as with RPM, it can be difficult to ascertain the cost accounting practices of external companies. This means that you may need to consider an alternative method.
When applying the Transactional Net Margin Method (TNMM), you compare the net profit related to the controlled transaction with the net profit achieved in a comparable uncontrolled transaction. It can be challenging to find information on net margins at the transaction level, which means you compare results at the company level.
TNMM:
- is a profit-based method
- can be used when there are no internal comparable transactions
- requires the selection of a tested party in the controlled transaction
- is a net method, meaning the operating profit is the basis for comparison
- involves using various financial key ratios, comparison indicators, for the tested party and corresponding indicators for independent companies with comparable uncontrolled transactions
- is an appropriate method when the tested party has simple functions, and it is possible to find companies with similarly simple functions through database searches
- is sensitive to various factors that can affect net profit, and it can be challenging to identify such individual factors
The Transactional Profit Split Method (TPSM) is a profit-based method that involves the allocation of profit or loss arising from the controlled transaction. The assessment is not about determining the arm’s length price in the controlled transaction, but rather about determining the arm’s length allocation based on the parties’ contributions in terms of functions performed, assets used, and/or risks assumed in the transaction.
You can apply TPSM when:
- multiple parties have valuable contributions, such as intangible assets, or
- multiple parties contribute to transactions that are closely integrated or interrelated, or
- multiple parties share economically significant risks or assume significant risks that are closely related
TPSM:
- depends on a FAR analysis where the contributions of all parties are delineated
- is a net method, meaning the parties' results related to the specific transaction are the basis for allocation
- allocates the result based on the parties' contributions or allocates the residual (negative or positive result) among the parties with valuable contributions in the transaction, after those with routine functions have received an arm's length remuneration
- the allocation depends on the nature of the transaction and available information
When using TPSM, we expect you to explain:
- the criteria set for identifying the parties' surplus/deficit and for allocating the result
- the particularly valuable contributions made by the parties, and that you document ownership/control over valuable contributions
Selection of a comparability indicator
What is a comparability indicator?
If you do not have a specific transaction to base your comparison on, you will look for various financial key ratios of the tested party and compare these with corresponding financial key ratios of independent third parties (companies).
In the comparison, you base your analysis on one or more financial key ratios of the tested party in the controlled transaction and look for corresponding ratios of independent companies.
Different types of comparability indicators
You should use the financial ratio that best describes the business of the selected party.
You start with a known figure in the tested party's accounts, typically operating profit, and compare this with other known figures in the accounts or balance sheet. You can base your analysis on net figures that account for operating expenses, or you can use gross figures that only consider revenue minus the cost of goods sold/direct costs.
Common comparability indicators
When we refer to gross methods and net methods, we are referring to the figures that the various comparability indicators are based on.
Gross profit is the income remaining after the direct costs of producing and selling products/services have been deducted. Gross profit does not account for all company expenses and income sources. It is a measure of how efficiently a company operates based on the direct costs incurred to produce products/services.
Operating profit is the company's net result, represented by total income before tax and interest are deducted. Operating profit represents the income remaining after direct and indirect costs (including depreciation) are deducted from sales revenue. Additionally, EBIT is often used as a basis. EBIT includes, in addition to ordinary operating income, income from the sale of assets and profits from investments.
Comparability indicators that refer to net figures will often be based on operating profit (EBIT).
Common profit level indicators:
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Net Indicators |
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Comparability indicator |
Explanation |
Pricing method |
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Operating profit (EBIT) divided by total revenue |
Operating margin |
TNMM |
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Operating profit (EBIT) divided by total costs |
Return on total cost (ROCT) |
TNMM |
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Operating profit (EBIT) divided by relevant assets
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Return on assets (ROA) |
TNMM |
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Operating profit (EBIT) divided by average capital |
Return on capital employed (ROCE) |
TNMM |
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Gross Indicators |
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Comparability indicator |
Explanation |
Pricing method |
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Gross profit |
Gross profit divided by sales price |
Resale Price Method |
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Gross profit |
Gross profit divided by cost price |
Cost Plus Method |
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Determining the arm's length price – Arm's length range
The final step in the comparability analysis is to make the definitive assessment of whether the price and terms in the controlled transaction are at arm's length. In practice, you use the price or margin found in uncontrolled comparable transactions or companies to establish or test the price in the controlled transaction.
In some cases, it is possible to determine a single price or margin. When this is not possible, you estimate the arm's length price within a range (the arm's length range). The range encompasses observed comparable transactions or companies.
It is common to sort all observed comparables in ascending order and then find the middle observation, known as the median. Further, you identify the middle of the observations above and below the median. The middle observation below the median is called the 1st quartile, and the middle observation above the median is called the 3rd quartile.
Various factors can influence which observations should be included in the range and where the arm’s length price fits within it. You must make a specific assessment of the observations, considering, among other things:
- the number of comparables included in the selection
- whether maximum and minimum values should be included in the selection
- whether the selection consists of observations with greater or lesser degrees of comparability
The OECD guidelines state that you should select the point in the range that is most appropriate. The OECD guidelines refer to a broad practice for selecting a value within the range from the 1st to the 3rd quartile. When there is a high degree of comparability between the controlled transaction/companies and the observed comparables, the arm's length price may be at any point within the range. When there are challenges with comparability in the selection, or the degree of comparability is low, it is recommended to select mid-range values such as the median.
When the Norwegian Tax Administration assesses whether the price is at arm's length, we will consider:
- all elements of the comparability analysis
- information and documentation supporting the analysis
- whether you have followed recommendations for a transparent, verifiable, systematic, and objective pricing process