Transfer pricing is common tax planning scheme to place higher profit on subsidiary in lower tax country, where IRB has formulated a transfer pricing guideline in July 2003 to ensure all companies pay their fair share o tax based on prevailing market value of goods and services.
First may identify the definition of ARM’S LENGTH PRICE
Arm’s length price is the price, which would have been determined if such transactions were made between independent entities under the same or similar circumstances.
Then , THE CONCEPT OF COMPARABILITY
Transactions are deemed comparable if there are no material differences between the transactions being compared or, reasonably accurate adjustments can be made to eliminate any material differences in the transactions.
Where the indicator considered for conditional comparability would be:-
i. Product Feature (Characteristic/form of Services Provided)
ii. Whether good sold at the same points in the production chain
iii. Brand Name (Quality)
iv. Sales Volume (Liquidity)
v. Market Risk (Function carrying)
vi. Timing of Sales
vii. Mode of Transaction(Packaging, Marketing, CIF, FOB…)
viii. Economic Situation (Different country may have different Economic conditional)
7.1 The following methodologies can be used in determining arm’s length price:
Traditional Method
A. Comparable uncontrolled price method
B. Resale price method
C. Cost plus method
Transactional Profit Method
D. Profit split method Other
E. Transactional net margin method
Note : ‘Transactional profit methods’ be used only when traditional methods cannot be reliably applied or exceptionally cannot be applied at all.
In deciding the most appropriate method, the following must be considered:
i. the degree of actual comparability when making comparisons with transactions between independent parties;
ii. the completeness and accuracy of data in respect of the uncontrolled transaction;
iii. the reliability of any assumptions made; and
iv. the degree to which the adjustments are affected if the data is inaccurate or the assumptions incorrect.
A.Comparable Uncontrolled Price Method
Cases applicable: No specific, as long comparable transaction available.
The CUP method is ideal only if comparable products are available or if reasonably accurate adjustments can be made to eliminate material product differences. Other methods will have to be considered if material product differences cannot be adjusted to give a reliable measure of an arm’s length price.
The CUP method is the most direct way of ascertaining an arm’s length price. It involves the direct price comparison for the transaction of a similar product between independent parties.
An uncontrolled transaction is comparable to a controlled transaction for purposes of the CUP method if one of the following conditions is met:
i. None of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions could materially affect the price in the open market; or
ii. Reasonably accurate adjustments can be made to eliminate the material effects of such differences.
Weakness of method: What if there is no comparable transaction? [note: please refer indicator considered for comparable transaction definition]
Make the transaction to be unique(namely branded, functionally different or alternate product feature into non available in the current market)
B.Resale Price Method
Cases applicable: Only applied for end product distributor to [buy] and [selling] of product to different parties.
The usefulness of the method largely depends on how much added value or alteration the reseller has done on the product before it is resold, or the time lapse between purchase and onward sale.
The starting point in the resale price method is the price at which a product that has been purchased from an associated enterprise is then resold to an independent enterprise.
Formula, ==========================================================
Arm’s length price = Resale price – (Resale price x Resale price margin)
* Resale price margin = Sales price - Purchase price/Sales price
Note: * Resale price margin must be comparable to margins earned by other independent enterprises performing similar functions, bearing similar risks and employing similar assets.
Weakness of method: Can obviously saw that the Resale price margin is the only focus on this method, thus the focus would be the main weakness where no one could compare a unique product distributor. What if the distributor they themselves not to distribute the unique product to unrelated parties or distribute in “arm’s length price” to unrelated parties.
[Note: arm’s length price here is controllable factor to justified the comparable resale price margin]
C. Cost Plus Method
Cases applicable: Often useful for semi-finished goods sold between associated parties.
The appropriate mark-up should ideally be established by reference to the mark-up earned by the same supplier from comparable uncontrolled sales to independent parties, due to the fact that similar characteristics are more likely found among sales of product by the same supplier, than among sales by other suppliers.
Formula, ==========================================================
Arm’s length price = Costs + (Cost x Cost plus mark-up)
* *Cost plus mark-up = Sales price – Costs/ Cost
Note: *Cost plus mark-up must be comparable to mark-ups earned by independent parties performing comparable functions, bearing similar risks and using similar assets.
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Weakness of method: Similar to resale price method if the distributor (the manufacturer) they themselves not to distribute the unique product to unrelated parties or to distribute in “arm’s length price” to unrelated parties, there are no comparable determination would exist for each transaction they made.
[Note: arm’s length price here is controllable factor to justified the comparable cost plus mark-up]
E.Transactional Net Margin Method
Cases applicable: used only when traditional methods cannot be reliably applied or exceptionally cannot be applied at all
Similar to the cost plus and resale price methods in the sense that it uses the margin approach which examines the net profit margin relative to an appropriate base such as costs, sales or assets attained by the MNE from a controlled transaction.
Since net margins (unlike gross margins or prices) tend to be significantly influenced by various factors other than products and functions (e.g. competitive position, varying cost structures, differences in cost of capital etc), it is stressed that usage of TNMM be confined to cases where functions have a high degree of similarity, so as to eliminate the effects of these other factors.
Note: content been summarized from IRBM Transfer pricing guideline announced dated 2 July 2003
Further reading source please refer to:
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