Navigating through Transfer Pricing mechanism

Controlled transactions:

These take place between related parties or parties, which operate under one parent head. It is important to note that such transactions must be done under the Arm’s length principle, which advocates that the prices charged between related companies or under a controlled transaction would be similar to that which is charged to companies that are not under the same parent, which is referred to as the fair market value (FMV).

Uncontrolled transactions.

These transactions are made purposely from unrelated parties or the third parties

Associated enterprises.

Entities are associates enterprise with respect to each other if one of the enterprises meets the conditions of Article 9 sub-paragraph 1(a) or (b) of the OECD Model Tax Conventions with respect to the other enterprises.

Arm’s length Principle

The basis of transfer pricing is the Arm's Length Principle. This principle states that the price agreed in a transaction between two related parties must be the same as the price agreed in a comparable transaction between two unrelated parties.

Comparable uncontrolled transaction

It is a transaction between two independent parties that is comparable to controlled transaction under examination.

Cost Contribution Arrangement (CCA)

It is a contractual arrangement among business enterprises to share the contributions and risks involved in a joint development, products or in obtaining of intangible assets or services, which are expected to create benefits for the business of the participants.

Direct costs.

These are costs incurred directly in production of a product or rendering of a service i.e. the cost of any raw materials purchased.

Direct charge method

It is a method of charging directly of specific intra-group service on a clearly identified basis.

Functional analysis

These are costs incurred specifically from economically significant activities and responsibilities undertaken, assets used or contributed and risks assumed by the parties to the transactions.

Transfer Pricing Methods

The transfer pricing methods are of two major categories as named below.

(i) Traditional transaction Method

This looks at the individual transactions in regards to terms and conditions of each transaction, which is not controlled. Third parties make these transactions and where such transactions are made, they are compared with those of affiliates. The major rationale for such comparison is to ensure that they are in conformity with the arm’s length principle.

The traditional transaction method is further segmented into there are further categories as below;

(a) Comparable Uncontrolled Price method. (CUP)

This method compares the prices and conditions of products and services in a controlled transaction with those in an uncontrolled transaction between unrelated parties. It is taken as the most effective and reliable way to apply the arm’s length principle to a controlled transaction.

Its application requires the comparable data to be available so that it can be consistently regarded as a comparable price. The uncontrolled transaction has to meet the highest standards of comparability. Hence, all the transactions have to be similar so that they can be considered comparable in nature under this method.

Application of the CUP method

Internal Comparable uncontrolled Price

This relies on examples of the comparable transactions the company has made with unrelated third parties.

External Comparable uncontrolled Price

It looks at pricing of comparable transactions made between two unrelated third parties.

(b) The resale price Method.

This method uses the selling price of a product or service that is why it denotes the name Resale price. Comparison is done for the gross margins in any comparable transactions, which are being made by the same but unrelated entries so that any number will be derived by reducing the gross determined by comparing the gross margins in comparable transactions made by similar but unrelated entities. It must be noted that the gross margins earned by the company for any item purchased from the related party must be the same margins to be earned from unrelated suppliers or parties.

This method is well applied by comparing a firm’s gross profit with its overall cost of sales. A market-based markup is added to the total cost to ensure that an appropriate profit is determined.

It is more appropriate in determining routine, low risk activities for example the manufacturing of any intangible goods.

(ii) Transaction profit method

This method measure the net profits from the controlled transaction operations. Which is later compared to the profits of unrelated companies or third parties but dealing in any comparable transactions. The objective of this application is to make sure that any transaction is done at an arm’s length.

These methods of transaction profits include the following;-

(a) The comparable profit methods.

This method is also known as the transaction net margin method. It helps to determine transfer prices by looking at the net profits of controlled transactions between related entities. It requires the availability of financial data and it is more reliable to manufactures of products with accurate and reliable transactions based on the extracts of financial data. The only challenge with this method is that it does not recognize the data from the third party and this may create biasness by any tax authority deriving comparisons of any data using such method.

(b) The Profit Split Method

Under this method two associated enterprises do transactions which are interconnected and, it is difficult to single handedly observe the performance and transactions of each of them if they are operating under a similar brand.

In this case, these companies may decide to split the profits. This is done to examine the terms and conditions of interrelated, controlled transactions by figuring out how profits would be divided between third parties making similar transactions.

The profit split method would be beneficial in that, it looks at the profit allocation in a very different and wholesome nature. When it comes to intangible assets like intellectual property (IP) this is the best method.

Competitiveness in the international market.
Minimisation of foreign exchange risk.
It is used for Tax planning and strategy formulation.

The Transfer pricing is in line with the arm's length principle, which is the international consensus on transfer pricing, highlighting on the valuation for tax purposes of cross border transactions between associated enterprises.

Companies dealing in cross border transactions must take care of how their related parties’ dealings are priced in line with the fair market values or, as it would have done with the third parties. This would help them in tax planning and not leading to government revenue loss through profit shifting under transfer pricing mechanism.