Approaches for setting transfer prices

 Introduction

In the current business setting, it is very easy to notice foreign brands gaining huge market shares in local markets or local brands internationalizing. This is fueled by the increase and advancement of globalization. As a result of that, international brands have developed and adopted a number of formulas to ensure successful business operations, and transfer pricing is one of such practices. Generally, transfer pricing is the process of creating an "arm’s length" price that will be paid for or charged for physical or tangible goods that are supplied in a transaction between two companies that operate either within or outside the same tax jurisdiction (country).

Approaches for setting transfer prices

In their discussion, the OECD (2010) presented a number of approaches for setting transfer prices, including:

• The CUP approach—for this approach, the prices chargeable for a product in a controlled transaction are compared with the prices chargeable for a comparable product that has been transferred in an uncontrolled transaction under similar conditions (OECD, 2010). If differences are noticed in such a comparison, it does indicate that the enterprises are not at arm’s length and that the prices obtained from uncontrollable transactions are likely to be substituted for the prices obtained under controllable conditions.
• Resale price approach: in this approach, the resale price is reduced by the right gross margin with reference to the original gross margin obtained from an uncontrollable transaction, and this is used as a way of determining the price that the reseller will need to sell the properties or services in order to obtain both the selling price and other operating expenses that are incurred as well as be able to make an appropriate profit from the same transaction (OECD, 2010).
• The cost plus approach: this approach begins with the cost incurred by the supplier for a given product in a controlled transaction, which has been transferred in an uncontrolled transaction. It requires an understanding of the right mark-up on the cost incurred by referencing the mark-up that the supplier has earned in a comparable uncontrolled transaction and adding up all the costs in order to ensure that the supplier is able to obtain the right profit once the cost of the transaction has been covered (OECD, 2010).
• The "transaction net margin approach" is based on analyzing the net profit margin indicator that a taxpayer drops from a given transaction in a controlled setting while referencing the earned net profit from a different but yet comparable transaction in an uncontrolled setting. This can be very helpful in determining arm's length net profit indicators for taxpayers (OECD, 2010).
• Transactional profit split method: the first step involves creating an understanding of the combined profit that enterprises in a controlled transaction will have to split following the success of such a transaction (OECD, 2010). In any case, it should be noted that in some conditions, the combined profit obtained may be residual profits that cannot be allocated to any of the enterprises involved if other transfer price setting approaches are to be adopted.

Reconciling the use of different approaches between the sellers and buyers

The best way to reconcile these differences is by both the buyers and suppliers adopting the right approach that suits their individual needs, comparing these approaches with a related uncontrollable transaction, and finally deciding on the right approach to be adopted for the controlled transaction. In essence, this implies that the enterprises should adopt a uniform or agreed-upon approach that meets their respective individual needs and ensures that the parties involved will profit from such a transaction in the end.

Reference

The Organization for Economic Co-operation and Development (OECD) (2010), "Transfer Pricing Methods." Available at: http://www.oecd.org/ctp/transfer-pricing/45765701.pdf [Accessed on: 3rd March 2015].