When it comes to proving arm’s-length transactions, selecting the right transfer pricing method is key. Of course, when you consider transfer pricing methods are becoming one of the most challenged areas of transfer pricing documentation by tax authorities, the “right” method is debatable. Transfer pricing methodology is often at the heart of transfer pricing disputes.

So, if your goal is impeccable transfer pricing compliance—and it is—then you’ll not only need to choose the most appropriate method for your transaction, but you’ll need to explain why it works—and why other methods don’t. Where do you begin? Understanding what each method is and where it’s most applicable seems like a great place to start. To help, we’re going back to basics with a review of traditional transactional methods. Here’s what you need to know.

The Big Picture

Transfer pricing methods are used to determine arm’s-length transfer prices between related parties. In most cases, the OECD prefers five transfer pricing methods, which are divided into two groups: The traditional transactional methods are the Comparable Uncontrolled Price (CUP), Cost Plus, and Resale Price, while the remaining two—the Transactional Net Margin Method (TNMM) and Profit-split—are profit-based methods. Transactional methods are the most straightforward methods, which is why they’re sometimes preferred by tax authorities. They compare unit price, gross margin, or markups, whereas profit-based transactions compare profitability.

Many jurisdictions follow the OECD’s recommendation to enlist “the most appropriate method” to determine the arm’s-length transfer prices in a specific transaction. To do this, you’ll need to consider the nature of the controlled transaction based on each party’s functions, assets, and risks. You’ll also need to consider how much reliable information is available about your comparable companies. Not every method works for every transaction, so knowing the pros and cons of each one helps, too. In fact, we’re outlining them right here.

Comparable Uncontrolled Price (CUP) Method

How it works: The CUP method compares the price for goods or services in an intercompany transaction to the price charged for the same goods or services between unrelated parties. The OECD considers it, “the most direct and reliable way to apply the arm’s-length principle.” Tax authorities are often big fans, too.

Pros: The CUP method is a straightforward comparison based on the fair-market price. Tax authorities love it because it’s a direct comparison: If you sell a lawn mower to a related party, the arm’s-length price would be what you would charge a third party for that same lawn mower–an internal CUP. External CUPs are also clean comparisons: Take the related-party lawnmower sale and compare the price to an independent company that sells a competing lawn mower to another independent company. Either way, you’ll find the fair-market price.

Cons: While many tax authorities love the CUP method, in practice, it’s one of the least used transfer pricing methods. Why? Because the data needed to employ it doesn’t always exist, and when it does, it can be unreliable. Using the CUP, uncontrolled transactions must meet high comparability standards, and even a small difference in circumstance–markets, volumes, or positions in the supply chain–between two transactions can significantly impact the price.

Uses: Group loans work well with the CUP method, because there is a lot of data available—banks work with the same formulas to determine terms and conditions.

Cost-Plus Method

How it works: The cost-plus method compares gross profits to the overall cost of sales. Using this method, companies essentially ask themselves, “what is the markup that I’m earning as the service provider or as the manufacturer?” That markup should be the same as what a third party would earn in a comparable situation.

Pros: The cost-plus method is an ideal option when assessing routine, low-risk activities. When cost is easy to identify, this method is easy to implement and offers a reliable comparison.

Cons: Like the CUP method, the cost-plus method requires a higher standard of comparability, which can prove to be challenging. Also, “cost” can mean different things to different companies. Many allocate line items differently in their accounting, which can make determining the cost markup tricky. For example, one company may record items under “cost of goods sold” and other companies may record the same item under “operating expenses,” which can throw off the whole analysis.

Uses: Transactions involving manufacturers, because costs and markups are easily identified.

Resale Price Method

How it works: The resale price method, also known as the resale minus method, looks at the gross margin, or the difference between the cost of the purchase and the price at which it’s sold to a third party. It’s basically the flip side of the coin to the cost-plus method.

Pros: The comparability requirements are less stringent than other transactional methods. With the right data, the method can be an effective way to determine arm’s-length pricing.

Cons: While the cost-plus method relies on a definitive cost base, the resale price is negotiated and can include other intangible costs–marketing, volume, seasonality, geography–which could make it difficult to identify true third-party comparables. For example, a distributor selling a product with a warranty will make a higher gross profit than a distributor that sells a similar product without one. The uniqueness of each transaction can make meeting the requirements of the resale price method challenging. Even small product differences can largely impact the gross margin and so, the resale price method isn’t used very often.

Uses: Distributors and resellers.

Want to learn more about transfer pricing methods? Check out this episode of our podcast, The Fiona Show, about profit-based methods.