Selecting an Appropriate Transfer Pricing Method; Putting the Taxpayer’s Best Foot Forward (Part 2 of 2)
Cost Plus Method
The cost-plus method compares the markup on the cost incurred by the controlled entity on goods and services in a controlled transaction with that of a comparable uncontrolled transaction. The cost-plus method is appropriate where semi-finished goods are sold between connected parties, where connected parties have concluded joint facility agreements or long-term buy-and-supply arrangements, or where the controlled transaction relates to the provision of services.
The key element for comparison under the cost-plus method is the “mark-up”. For this to be appropriate and effective, the mark-up from a controlled transaction should be comparable with that of an uncontrolled comparable transaction. Any differences in the transactions that would affect the mark-up should be adjusted for. The differences can arise from accounting treatment, that is, how different costs are being recognized. Adjustments should be made to streamline the nature of costs adopted for the application of the mark-up.
One of the pitfalls of the cost-plus method is that it is usually not an appropriate method to use in transactions involving a fully-fledged manufacturer that has its own valuable product intangibles. The reason for the latter is that it will be hard to identify independent manufacturers that also owns comparable product intangibles. This will make it challenging to determine a profit mark‐up that would be required to remunerate the fully‐ fledged manufacturer for owning the merchandise intangibles. Employing a more suitable method during this instance would help to avoid this pitfall.
Transactional Net Margin Method (TNMM)
The TNMM compares the net profit margin derived in a controlled transaction to the net profit margin that would have been derived in a comparable uncontrolled transaction of an independent entity. This net margin is then considered against an appropriate base such as costs, sales, or assets.
One feature of the TNMM is that net profit indicators (e.g. return on assets, operating income to sales, and possibly other measures of net profit) are less affected by transactional differences. Net profit level indicators can accommodate some functional differences between the controlled and uncontrolled transactions because these differences would be accommodated as part of operating expenses. Hence, this may lead to a wide range of gross profit margins but still broadly similar levels of net operating profit indicators. In cases where the net profit level indicator is affected by factors that do not have an effect on the gross margins realized by the independent entities, it may make the accurate and reliable determination of the arm’s length net profit level indicators difficult.
Transactional Profit Split Method
The transactional profit split method identifies the combined profit or loss to be split in a controlled transaction between related parties. A comparable transaction between uncontrolled parties where a profit split has occurred is then selected and analyzed to confirm how comparable the facts and circumstances are. The combined profit or loss from the controlled transaction is then split based on the division of profits that results from the chosen comparable uncontrolled transaction.
There are two kinds of transactional profit split methods; the contribution profit split method and the residual profit split method. The contribution profit split method splits profit among related parties according to the functions performed and risks assumed, and it also considers the allocation of cost, expense, earnings and capital of the related parties involved in the transaction. The residual profit split method requires the identification of the routine profit for an entity and any remaining profit is then split based on each party’s contribution to the earning of the non-routine profit, for example, the ownership of intangibles.
The transactional profit split method can be used for highly integrated operations in cases where one-sided method would not be suitable. It can also offer flexibility by considering specific, possibly unique, facts and circumstances of the related parties that may not be present in the case of independent entities. One common pitfall of the transactional profit split method relates to difficulties in its application. It may be difficult to measure the relevant revenue and costs for all the related parties involved in the controlled transactions, which could require stating books and records on a common basis and adjusting for differences in accounting practices and currencies.
Conclusion
The transfer pricing cases in Nigeria and some parts of the world illustrate how important it is for taxpayers to properly assess and select the most appropriate transfer pricing method when analyzing transactions with related parties to determine whether they comply with the arm’s length principle. This will be a stronghold for taxpayers in the event of a transfer pricing review or audit by the tax authority. Taxpayers can also employ the services of knowledgeable transfer pricing specialists that can help them prepare and maintain a robust transfer pricing documentation which considers the most suitable transfer pricing method to apply.
