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Summary TP pricing methods (EXAM SCHEMES)
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Summary of 7 pages for the course transfer pricing and attribution of income at UM (tp pricing methods)
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TP pricing methods Before assessing the functioning of the PT methods, it is important to understand the structure of a
profit & losses financial statement
o A profit and loss statement (P&L), or income statement or statement of operations, is a
financial report that provides a summary of a company’s revenues, expenses, and
profits/losses over a given period of time.
The P&L statement shows a company’s ability to generate sales, manage expenses,
and create profits.
The structure of a P/L is as follows:
- Revenues -> Sales revenue is the income received by a company from its sales of goods or the
provision of services.
- Direct operating costs (COGS) -> Cost of Goods Sold (COGS) measures the “direct cost” incurred
in the production of any goods or services. It includes material cost, direct labor cost, and direct
factory overheads, and is directly proportional to revenue.
- Indirect operating costs (SG&A) -> Selling, General & Administrative (SG&A) expense includes all
non-production expenses incurred by a company in any given period. This includes expenses
such as rent, advertising, marketing, accounting, litigation, travel, meals, management salaries,
bonuses, and more.
- Gross profit -> gross profit equals to revenue - COGS
- Gross margin -> gross margin is the difference between COGS and revenue (COGS/revenue x
100)
- Operating income (EBIT) -> EBIT stands for Earnings Before Interest and Taxes and is one of the
last subtotals in the income statement before net income. EBIT is also sometimes referred to as
operating income and is called this because it’s found by deducting all operating expenses
(production and non-production costs) from sales revenue.
- Cost of debt finance -> Interest expense is one of the core expenses found in the income
statement. Interest is a tax-deductible item on the income statement. Thus, there is a tax
savings, referred to as the tax shield.
- Tax -> after deducting costs from the operating income, tax is calculated
- Net income -> Net income is the amount of accounting profit a company has left over after
paying off all its expenses. Net income is found by taking sales revenue and subtracting COGS,
SG&A, depreciation, and amortization, interest expense, taxes and any other expenses.
, Once a transaction has been accurately delineated and recognised, it will be necessary to select the
most appropriate TP method in order to determine the arm’s length remuneration for the transaction
The purpose of a TP method is to find out a way to set or test transfer prices for the intercompany
transactions between associated enterprises.
o All TP method have the objective of setting the price in accordance with the arm’s length
principle
o The OECD recognises 2 categories of method, which are then further divided:
Traditional transaction method Transactional profit method
1. Comparable Uncontrolled Method (CUP) 1. Transactional Net Margin Method (TNMM)
2. Resale Price Method (RPM) 2. Transactional Profit Split Method (TPSM)
3. Cost Plus Method (CPM)
Some of these methods (RSP, CPM, TNMM) are ‘one-sided’ methods -> this means that they apply to
only one party to a transaction
o Accordingly, the ‘tested party’ (ie the party performing the less complex functional analysis) will
be subject to the method
The other (CUP and PSM) are ‘two-sided’ methods -> this means that they apply to two or more parties
to a transaction
A. Traditional transaction methods
1. The CUP Method
- The CUP method is a two-sided TP pricing method
o Its rationale is to set the price of a controlled transaction on the basis of an
uncontrolled transaction (it may then be adjusted to take into account the differences
in the comparability factors of the two transactions).
The CUP is the favoured method by the OECD as it sets intercompany prices in
the closest possible way to prices actually paid in uncontrolled transactions
- The CUP can be based on:
(i) Internal comparables -> prices of a good or a service charged between a group member
and an independent party
(ii) External comparables -> prices of a comparable good or service between two unrelated
parties
2. The Resale Price Method (RPM)
- The RPM is a one-sided TP pricing method
o It applies mostly to the sale of tangible property to a related party (a distributor – being
the tested party) that is involved in the resale of such tangible property to independent
companies
The rationale of the RPM is to set the TP of certain good based on the gross
margin that should be earned by the distributor at arm’s length
- The RPM works as follows:
To compute the purchase price of the goods, the price on the resale of the product by the
distributor to a third party is reduced by an arm’s length gross margin to let the distributor
cover the remaining of its costs (ie the costs left after the COGS) and possibly earn a profit.
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