Transfer Pricing Methods

COMPARABLE UNCONTROLLED
PRICE (CUP) METHOD

 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.
OECD TRANSFER PRICING GUIDELINES

PRICE (CUP) METHOD
The proper application of this method is contingent upon
two premises:
1. That none of the differences between the transactions or

the companies being compared is likely to materially
affect the price agreed in an open market;
2. That should any difference exist, reasonable and reliable

adjustments may be made which eliminate the effects
of such differences on price.
PRICE (CUP) METHOD
• Method adopts the price used by an arm’s-length third
party in a similar transaction
• Internal comparable
• External comparable
– Assumes availability of open market
– Few or no adjustments
TYPES OF CUP
Internal CUP
Subsidiary
Country Y
Manufacturer in
Country Y Independent company
Country Y
Manufacturer in
Country X
Subsidiary Country
Independent Y
manufacturer
in Country X
TYPES OF CUP
External CUP
(controlled)
Manufacturer Country transfer price
X Subidiary Country Y
(uncontrolled)
Independent Independent Company
arm’s length price
manufacturer Country Country Y
X
Comparability (Identical Vs. Similar Goods)
cont’d
To use the CUP method, there must be similitude
between the products or services to be purchased.
Among others, the assessable characteristics are:
 Product quality: consistency (e.g.: precious metals,
minerals, etc.) durability (e.g.: long lasting assets).
 Contractual conditions: the product warranty, the sales
volume, the credit modalities, replacement policies,
shipping modality, specific legal clauses, the time
where ownership is vested in client (CIF, FOB), etc.
Comparability (Identical Vs. Similar Goods)
cont’d
 Market level: wholesale, retail and other distribution
clauses, target consumption
 Segment (e.g.; luxury goods), degree of
development of the consumer country.
 Transaction days. (Flowers – Valentine, Mother’s Day)
 Sale-related intangibles (e.g.: two watches give the
same time, but an unbranded watch cannot be
compared against so-called high-end watches).
 Monetary exchange risk.
Pros & Cons
• Pros
– Provides the most direct comparison
– Can be used to arrive at arm’s length outcome for a

wide range of transactions: royalty rate, interest rate,
service fees, etc.
– It is not a one-sided analysis as the price is arrived
at between two parties to the transaction
• Cons
– Not appropriate where no open market price exists
– Strict product comparability
Pros & Cons
– Accuracy of information (competitors).
– Presence of planted comparables (internal)
– Given its characteristics, it is not a method that
aligns easily with the company’s objectives e.g.
Company may sale a product within an unprofitable
line, only for the purposes of presenting a full range
of products and/or to prevent the competitors from
occupying that space.
– Huge administrative costs if there is a large number
of heterogeneous/diverse transactions for validation.
Example
Company D sells canned Pineapples to an overseas

subsidiary and part to local market.
The product costs Kshs. 500 to produce and is sold
locally at Kshs.1000 but exported at Kshs. 550.
Are the prices Comparable?
Note: Local sales are inclusive of advertising and
promotion costs, distribution costs and VAT.
We should make reliable adjustments of these costs
should before any comparisons can be made.
Example
Company D sells canned Pineapples to an overseas

subsidiary and part to local market.
The product costs Kshs. 500 to produce and is sold
locally at Kshs.1000 but exported at Kshs. 550.
Are the prices Comparable?
Note: Local sales are inclusive of advertising and
promotion costs, distribution costs and VAT.
We should make reliable adjustments of these costs
should before any comparisons can be made.
Reliability of adjustments
There is need to ascertain the effects of:

 Difference in delivery terms (CIF, C&F, FOB)
 Volume discounts
 Minor product modifications
 Risk incurred
Trademark: The effect of the trademark on the price of

a product or service is material. It will be difficult, if not
impossible, to perform a reliable adjustment to account
for the trademark, a unique intangible property.
As reliable adjustments cannot be made to account for

this material product difference, the CUP method may
not be the appropriate method in such a case;
Effects of geographical differences:
To perform adjustments to account for this difference
one should consider, for example, differences in
inflation rates between the two countries, the
competition levels in the two countries and
governmental regulations;
Major product differences.

If reliable adjustments cannot be performed to account
for product differences that are material, then the CUP
method will not lead to a reliable measure of an arm’s
length result.
Q
&
A
7/26/2018
TULIPE USHURU ... TUJITEGEMEE
RESALE PRICE
METHOD
(RPM)
www . K R A . g o. k e
ISO 9001:2008 Certified
7/26/2018
RESALE PRICE METHOD (RPM)

The resale price method (RPM) is used to
determine the market value of a product acquired
from a related taxpayer that is sold to an unrelated
taxpayer.
This method begins with the price at which a
product purchased from an associated enterprise is
resold to an independent customer.
www . K R A . g o. k e
RESALE PRICE 7/26/2018
METHOD
Illustration
Manufacturer Distributor
7/26/2018
Conti…
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 expenses and make an appropriate profit in
the light of functions performed, assets used and
risks assumed.
w w w . K R A . g o. k e
7/26/2018
RPM Illustrated
Arm’s length
Transfer
Resale margin!
Price?
Third
Supplier Reseller
party
(Related) (Related)
Arm’s length
price
 Reseller and supplier are related

 Sales price to third party is known.
 Gross margin on sale to third party is known.
 What is the transfer price?
7/26/2018
Conti…
What is left after deducting 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.
7/26/2018
Areas of Use
The method is best suited for distributing
companies that resell products without adding
significant or any value at all, parts or altering
them physically. The fewer the modifications in the
product, the more confident the method .e.g. in the
Pharmaceutical industry, electronics, telecoms–
(i) Phillips Pharmaceuticals;
(ii) Glaxo
(iii)Samsung (TVs, Phones)
(iv)LG
7/26/2018
Comparability
The resale price margin earned by an independent
enterprise in comparable uncontrolled transactions
may serve as a guide.
ISO 9001:2008Certified
7/26/2018
Challenges in application of RPM

The resale price method is most appropriate in a
situation where the seller adds relatively little or no
value to the goods.
The greater the value-added to the goods by the
functions performed by the seller, the more
difficult it will be to determine an appropriate
resale margin. This is especially true in a situation
where the seller contributes to the creation or
maintenance of an intangible property, such as a
marketing intangible, in its activities. e.g. very
unique ways of marketing – advertisements.
7/26/2018
Calculation of Arm’s length price (ALP):
ALP = Resale Price - (Resale Price Margin x

Resale Price)
Resale Price Margin = Sales Price - Purchase Price

Sales Price
7/26/2018
Example
Sale Price to Third Parties $ 100

Resale Price margin 20%
Arm’s length cost price = $ 100 - ($100 x 20%)
(Transfer price) = $ 80
(Check: Resale Price Margin = $ 100 - $ 80 =

20%)
$ 100
7/26/2018
Challenges in application
The resale price method may NOT be
applicable if the reseller:
adds significant value to product

owns valuable intangible property (such
as marketing intangible)
takes and manages significant risk
7/26/2018
Advantages of RPM
1. The differences between products are less
relevant to the analysis (two products may
be comparable without being necessarily
substitutes).
2. As a consequence, this usually requires
fewer adjustments than does the CUP
method.
3. It is the most appropriate for the resale of
goods.
7/26/2018
Disadvantages of RPM
1. Products with valuable intangibles
(although two resellers may sell soft
drinks, if one of them is a well-known
worldwide brand in the market and uses
state of-the-art technology, they will very
much likely expect to obtain a greater
profit, even though the developed tasks
and functions may appear the same.
7/26/2018
2. Sensitivity to the degrees of activity
displayed by the comparable parties e.g.
the differences that may arise between
two resellers, where only one of them
redistributes the goods and the other is
engaged in advertising and promoting the
product (even though the marketing costs
are below gross profits, it is reasonable to
conceivable that the latter will require a
greater profit to afford this type of
expenditure).
7/26/2018
3. It cannot be used where any difference is
detected in the accounting practices which
may not be properly corrected by means
of reliable comparability adjustments.
7/26/2018
The End
7/26/2018
COST PLUS
METHOD
(CPM)
COST PLUS METHOD
7/26/2018
Introduction
This is the third traditional transaction method of
determining arm’s length price.
The cost plus method (CPM) is used to determine the
market value of goods that are transferred to related
companies usually in semi-finished state.
The comparable under this method is the mark-up;
CPM = The production costs of a related company,

plus the profit mark-up that an unrelated
company would obtain.
Introduction (cont’d)
This method is used for goods and services sold (exported) to
related parties, using the production cost of the
controlled company as base, and adding an appropriate
mark-up, which should be equal to the sales price that would
have been agreed in an arm’s length operation.
The information required in respect of the intended mark-up

can be obtained from the mark-up charged by the company
(or other companies within the group) to third parties
(internal comparable) or the margin obtained by other third
parties in comparable uncontrolled operations (external
comparable)
Introduction (Cont’d)
This method is useful where semi finished 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
involves provision of services.
The aim is to ascertain whether the enterprise

making the product or service is adequately
rewarded for the functions performed, assets deployed
and risks assumed. That, the rewards are equivalent to
those it would have obtained had it been dealing with an
independent third party, at arm’s length.
COST PLUS METHOD
7/26/2018
Introduction (cont’d)
The costs incurred by the (tested) supplier of goods,
services or rights in a related transaction for the
property transferred or the services rendered to a
related party are added to an arm’s length mark-up
according to the functions performed and the market
conditions.
In summary:
Cost*(1+ % of market gross profit) = Comparable
Price
Where: % of gross profit = gross profit/cost of sale
= mark-up
COST PLUS METHOD
(Cont’d) 7/26/2018
The comparable gross mark-up earned by a member of

the group
is determined in two ways, by reference to:
 the cost plus mark-up earned by a member of the

group in comparable uncontrolled transactions
(internal comparable); or
 the cost plus mark-up earned by an arm’s length
(independent) enterprise in comparable uncontrolled
transactions (external comparable)
COST PLUS METHOD
(Cont’d) 7/26/2018
Where the transactions are not comparable in all

ways and the differences have a material effect on
price, taxpayers must make adjustments to eliminate
the effect of those differences, such as differences in:
 business experience: start-up, maturity phase; and
 any advantage that the activity creates for the group.
The more comparable the functions, risks and assets,

the more likely it is that the cost plus method will
produce an appropriate estimate of an arm’s length
result.
7/26/2018
Relevant cost base: CPM

In general, for purposes of applying a cost-based
method, costs are divided into three categories:
1) Direct costs such as direct raw materials and
direct labour;
2) Indirect costs such as repair & maintenance
which may be allocated among
several products; and
3) Operating expenses such as selling, general,
and administrative expenses (e.g. salaries, rent,
IT & marketing)
The cost plus method is based on mark-up calculated
after direct and indirect costs of production.
COST PLUS METHOD
7/26/2018
(Cont’d)
Advantages;
- The method demands fewer adjustments than does

the comparable uncontrolled price (CUP) method.
- It is less dependent on the characteristics of the
goods and is based mainly on the parties’ functions
in the transaction.
- Applicable both to goods and services.
COST PLUS METHOD
7/26/2018
(Cont’d)
Disadvantages;
- The determination is difficult when there are
accounting differences related to the cost
exposure and composition, which may not be
easily corrected by way of adjustments on account
of their complexity.
- It is not easily applied in cases where the
producer assumes significant risks.
EXAMPLE – COST PLUS 7/26/2018
A is a domestic manufacturer of timing mechanisms

for clocks.
A sells this product to its foreign subsidiary B.
A earns a 5% mark up with respect to its
manufacturing operation.
X, an unrelated domestic manufacturer of timing
mechanisms for clocks sells to unrelated foreign
purchasers. X earn a gross profit mark up of 3%. A
accounts for supervisory, general, and administrative
costs as operating expenses, and thus these costs are
not reflected in cost of goods sold. The gross profit
mark up of X, however, reflect these costs as part of
costs of goods sold. Therefore, the gross profit mark up
of X, must be adjusted to provide accounting
consistency.
PLUS METHOD 7/26/2018
The company “YYY SA” is a local producer of electronic

devices for the mobile telephony market and sells its
products to its foreign branch, “YYY limited”.
CHIP 1, CHIP 2, and CHIP 3 also manufacture the same

devices and sell them to unrelated foreign buyers.
These companies are comparable based on the functional

study performed, the risks assumed and the assets used.
CPM (cont’d) 7/26/2018
Below is a summary of the YYY SA’s

operations/performance;
ITEM
AMOUNT
Sales (price of devices) 210
Cost (200)
Gross profit 10
Gross margin: (gross profit/cost)
5%
We note that the firm sells at $210 and obtains a gross
margin over cost of 5%.
Because it is an operation between related companies, the
firm must demonstrate that it’s sales were at arm’s length
prices.
Practical Illustration – CPM7/26/2018
(cont’d)
 There are no valuable intangibles incorporated.

 The firm concludes that Cost Plus method is consistent
with the reality of its operations and therefore the most
suitable.
Comparability Analysis:
 CHIP 1 and CHIP 3 include the costs related to the
plant administration in their manufacturing costs,
whereas YYY S.A. and CHIP 2 account for them under
operating expenses.
Comparability Analysis - 7/26/2018
CPM (cont’d)
The operations of the companies selected for comparison are;
ITEM CHIP 1 CHIP 2 CHIP 3
Sales 200 200 200
Sales costs (190) (185) (180)
Gross profit 10 15 20
% gross profit/cost (Raw)
5% 8% 11%
Adjustments for comparability
Administrative expenses
+10 +10
Adjusted gross profits
20 15 30
% gross profit/cost
11% 8% 17%
COST PLUS METHOD
7/26/2018
(Cont’d) Analysis (cont’d)

Comparability
Findings and conclusion:
In light of the results obtained, it may be noted that

the range of arm’s length gross margins is between
8% and 17%. Therefore “YYY S.A.” 5% is below the
expected comparable profit range, the tax
administration of its country will be entitled to
demand the fiscal correction of profits.
(median, Q1 – Q3)
TRANSACTIONAL
METHODS
(TNNM & PROFIT SPLIT)

Transactional TP
methods
Methods examine profits arising from
particular controlled transactions
Rarelythe ‘preferred approach’- usually

viewed as method of last resort
Should only be used if traditional

methods are inappropriate or
inapplicable
51
Net profit
 Uses net profitability to test transfer
pricing. Net profit is gross profit (sales
minus cost of goods sold) less operating
expenses.
 Operating expenses should exclude interest
expense and taxes.
 The methods are;
 Transactional Net Margin Method
 Profit Split
 These methods are “last resort”.

TRANSACTIONAL
NET MARGIN
METHOD
Transactional Net Margin
Method (TNMM)
 “[TNMM] examines the net profit margin
relative to an appropriate base (e.g.. costs, sales,
assets) that a taxpayer realizes from a controlled
transaction and compares this to that of
independent transactions.
 Other bases are margin ratios
 Operating margin (Operating Profits [OP]/Sales)
 Net Cost Plus Margin (OP/Operating Exp +
COGS)
 Berry ratio (GP/Operating Expenses)
Transactional Net Margin Method…cont/d
The profit margin made by a related party

selling to the other related party is compared to
the profit margin realized in a similar
transaction between independent parties, to
arrive at arm’s length net profit margin.
The method is commonly referred to as
Comparable Profits Method
Difficult to use where financial data is
consolidated
55
TNMM compared to cost
plus/ resale price
 TNMM is a fully net method; use margin
computed after all expenses (direct, indirect and
operating costs)
 TNMM is applied in a manner consistent with
resale price/ cost plus.
 CP/RP use margins computed after direct and
indirect costs
 no clear line, allowing for some variation in practice,
but generally excludes most operating expenses
 e.g. selling, general, and administrative expenses
would be excluded
TNMM compared to CP
METHOD
P&l Account  Operating income level
indicator
Sales
 Looks at operating income
Costs of Goods Sold
relative to all expenses
Gross Profit
Operating Expenses
Net Operating Income

TNMM compared to RP
METHOD
P&l Account  Operating income level
indicator
Sales
 Looks at operating income
Costs of Goods Sold
relative to sales
Gross Profit
Operating Expenses
Net Operating Income

TNMM: Comparability
Analysis
***Which of the following factors affect net margins, gross
margins, both or neither?
 new entrants?
 competitive position?
 management efficiency and individual strategies?
 substitute products?
 varying costs structures (age plant/equipment)?
 depreciation and amortisation policies?
 differences in cost of capital (equity or loans)?
 degree of business experience (start-up or
mature)?
 Accounting differences for inclusion of specific
items in COGS or operating expenses?
TNMM: when used?
 Where comparable data at gross margin level is not
available or unreliable. Databases; Amadeus, Orbus,
KT Mine (for comparison of net profit)
 Where the use of net margins can overcome

difficulties in adjusting for functional differences or
measurement consistency.
 As with other “one sided” methods, it is particularly

difficult to apply to taxpayers with unique qualities
(e.g. valuable intangible property) – which may not
be “benchmarkable”.
Choosing the right net
profit indicator
1. Return on sales = net operating income/sales

 Where, at arm’s length, there is likely to be a
positive relationship between sales and
operating income (i.e. operating income
increases with sales)
 Useful for services and distribution, e.g..,
functions where personnel rather than capital
assets are important to the business.
profit indicator (2)
2.Return on costs = net operating income / total
costs
 Likely to be appropriate where, at arm’s
length, there is likely to be a positive
relationship between operating income and
total costs.
 May be useful for distributors (investment in
aggressive advertising may drive profits) and
for some services.
 measurement consistency may be difficult
profit indicator (3)
3. Return on assets = net operating income/
operating assets
 likely to be useful where there is a positive
relationship between operating income and
operating assets i.e. assets play the greatest role
in generation of income
May suit a manufacturing set up.
 Lesssensitive to functional differences
 Caution on valuation (includes intangibles)
TNMM method – Pros & Cons
 Pros
 Margins are less affected by transactional differences

than in the case with price, as used in the CUP method.
Net profit indicators may be more tolerant to some
functional differences than gross profit margins.
 as with any one-sided method, it is necessary to
examine a financial indicator for only one of the
associated enterprises
 Useful in complex business situations involving
diversified cross-border dealings
64
TNMM method – Pros & Cons
 Cons
 Far less precise than traditional methods

 Information on uncontrolled transactions
may not be available at the time of the
controlled transactions making it particularly
difficult to apply the transactional net margin
method at the time of the controlled
transactions.
65
PROFIT SPLIT
METHOD
Profit Split Method
This method seeks to eliminate the effect on profits
of special conditions made or imposed in a
controlled transaction(s) by determining the
division of profits that independent enterprises
would have expected to realize from engaging in the
similar transaction(s). It is a two-sided approach.
This method is particularly useful where
transactions are highly integrated/inter-related that
they cannot be evaluated separately, or where both
parties contribute valuable intangible assets making
it difficult to find exact comparables.
The Profit Split Method
The transactions may be too complex,
intertwined and/or involve unique
intangibles making it difficult to evaluate
separately.
Approached in different ways;

 Contribution Analysis
 Residual Analysis
Contribution analysis
 Divide the combined net profits from the controlled
transactions between the associated enterprises
based on:
 reasonable approximation of division of profits
that independent enterprises would have
expected to realize from engaging in
comparable transactions (use comparable data
if available) or
 functions performed by each of the associated
enterprises participating in the controlled
transactions, taking account assets used and risks
assumed. Where the relative value of the
contributions can be measured directly, no need
to estimate market value of participant's
contributions.
Contribution analysis
 Compute combined net profit.
 Examine functions (routine, non-routine functions,
intangibles – where intangible is one sided).
 Determine relative value of each function.
 FAR
 Examine external data where available and reliable
 Assign a profit split percentage for each function,
then aggregate for each party.
 Work back to a transfer price.
Residual analysis
The approach is suitable where both parties contribute
valuable intangibles.
We start by identifying the operating profit to be split in
two stages.
 First stage, each participant is allocated an arm’s
length remuneration for its non-unique contributions
in relation to the controlled transactions in which it is
engaged. This can be benchmarked using any of the
traditional methods or TNNM by reference to the
remuneration of comparable transactions between
independent enterprises. - FAR
Residual analysis - cont’d
 Second stage the residual profit amount
(usually associated with the use of valuable and
unique intangibles) remaining after the first
stage division would be allocated among the
parties based on an analysis of the facts and
circumstances.
7/26/2018
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COMPARABLE UNCONTROLLED

PRICE (CUP) METHOD

OECD TRANSFER PRICING GUIDELINES

1. That none of the differences between the transactions or

2. That should any difference exist, reasonable and reliable

– Assumes availability of open market

– Can be used to arrive at arm’s length outcome for a

Company D sells canned Pineapples to an overseas

Company D sells canned Pineapples to an overseas

There is need to ascertain the effects of:

Trademark: The effect of the trademark on the price of

As reliable adjustments cannot be made to account for

Major product differences.

RESALE PRICE METHOD (RPM)

 Reseller and supplier are related

Challenges in application of RPM

Calculation of Arm’s length price (ALP):

ALP = Resale Price - (Resale Price Margin x

Resale Price Margin = Sales Price - Purchase Price

Sale Price to Third Parties $ 100

(Check: Resale Price Margin = $ 100 - $ 80 =

adds significant value to product

CPM = The production costs of a related company,

The information required in respect of the intended mark-up

The aim is to ascertain whether the enterprise

The comparable gross mark-up earned by a member of

 the cost plus mark-up earned by a member of the

Where the transactions are not comparable in all

The more comparable the functions, risks and assets,

Relevant cost base: CPM

- The method demands fewer adjustments than does

A is a domestic manufacturer of timing mechanisms

The company “YYY SA” is a local producer of electronic

CHIP 1, CHIP 2, and CHIP 3 also manufacture the same

These companies are comparable based on the functional

Below is a summary of the YYY SA’s

 There are no valuable intangibles incorporated.

(Cont’d) Analysis (cont’d)

In light of the results obtained, it may be noted that

(TNNM & PROFIT SPLIT)

Rarelythe ‘preferred approach’- usually

Should only be used if traditional

 These methods are “last resort”.

The profit margin made by a related party

Net Operating Income

Net Operating Income

 Where the use of net margins can overcome

 As with other “one sided” methods, it is particularly

1. Return on sales = net operating income/sales

 Margins are less affected by transactional differences

 Far less precise than traditional methods

Approached in different ways;

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