Question

Discuss in detail the various factors that affect the reliability of (1) the comparable uncontrolled price method, (2) the resale price method, and (3) the cost-plus method.

Answer 1

Q.1 Discuss in detail the various factors that affect the reliability of (1) the comparable uncontrolled price method, (2) the resale price method, and (3) the cost-plus method.

Answer : Reliability is defined as the probability that a product, system, or service will perform its intended function adequately for a specified period of time, or will operate in a defined environment without failure.

Various factors that affect the reliability :

The reliability of the measures are affected by the length of the scale, definition of the items, homogeneity of the groups, duration of the scale, objectivity in scoring, the conditions of measuring, the explanation of the scale, the characteristics of the items in scale, difficulty of scale, and reliability ...

1) the comparable uncontrolled price method :

The comparable uncontrolled price (CUP) method is one of the five main transfer pricing methods. It’s used to ensure transactions between related companies are comparable in price to those conducted with unrelated organizations.(For an overview of all five transfer pricing methods, start with this article: 5 Transfer Pricing Methods: Approaches, Benefits & Risks.)

The CUP method is a traditional transaction method. It looks at the terms and conditions of transactions made between both related and unrelated organizations to ensure arm’s-length pricing across the board. In most parts of the world it’s called the CUP method, but in the U.S. it may be referred to as any of the following: the CUP method for pricing tangible goods, the comparable uncontrolled transaction (CUT) method for pricing intangible goods, or the comparable uncontrolled services price (CUSP) method for pricing services. We’ll refer to it as the CUP method in this article.

How The Comparable Uncontrolled Price Method Works

There are generally two different ways to apply the CUP method: the internal CUP and the external CUP. We’ll break them down for you.

Internal CUP

To determine arm’s-length transfer prices using the internal CUP method, a company must find examples of comparable transactions it has made with third parties. In order to be compliant with transfer pricing regulations, the CUP method requires the terms of transactions with related parties must be the same as those of the third-party transactions.

External CUP

To determine arm’s-length transfer prices using the external CUP method, a company may look to the pricing of comparable transactions that take place between third-parties—to the extent that they exist.

While tax authorities accept both the internal and external CUP method, it’s extremely challenging for companies to find external transactions that are sufficiently comparable to their own. That’s why the internal route is almost always preferred to apply the CUP method.

A CUP Method Transfer Pricing Example

Let’s start with the internal CUP method. Say a well-known car rental company is trying to determine how much to charge its Canadian subsidiary for the use of its brand name and logo. To apply the internal CUP method, their transfer pricing team must find examples of licensing agreements between the car rental company and an independent third-party that use their branding. Assuming that the third party arrangement is sufficiently comparable, to be accepted by tax authorities, the car rental company should charge its Canadian subsidiary the same licensing fee that it charges the third party they do business with.

Now we’ll look at an example of the external CUP method. Say a diamond company is trying to determine an appropriate amount to charge its subsidiary for diamonds. The diamond company has no relationships with third parties and thus has no similar internal transactions to use. Its transfer pricing team can apply the external CUP method by identifying comparable transactions between two unrelated companies. Assuming that identifies sufficiently comparable transactions, to be accepted by tax authorities, the diamond company should charge its subsidiary a price comparable to the market price of diamonds.

The resale price method :

The resale price method (RPM) is one of the five primary transfer pricing methods, all of which are used to ensure that transactions between related companies are carried out at an “arm’s length” price. (To get an overview of all five transfer pricing methods, start with this article: 5 Transfer Pricing Methods: Approaches, Benefits & Risks.)

The resale price method is a traditional transaction method. This means its application looks to transactions between unrelated parties as a means to determine an arm’s length price for the intercompany controlled transaction under review. (The arm’s length principle specifies that a company must charge a comparable, fair market price for both controlled and uncontrolled transactions.)

Unlike some of the other methods, which can be used to analyze more than one type of intercompany transaction, the resale price method is always applied to tangible property transactions. We’ll tell you a little bit about how it works.

How The Resale Price Method Works

The first step to applying the resale price method is to determine the gross margin (gross profit divided by net sales) earned by a distributor on the resale of products purchased from one or more third-party suppliers. The resulting gross margins—expressed as a percentage—are then used to determine the appropriate gross margin that should be earned by the controlled entity that you are analyzing (i.e., a distributor that purchases finished goods from related-party suppliers).

Here’s A Resale Price Method Transfer Pricing Example:

Let’s say a U.S. company distributes running shoes purchased from a related company in Ireland, and also purchases very similar—but not identical—running shoes from an unrelated supplier. For purposes of this example, let’s assume that all of the terms and conditions of the related party and unrelated party purchases are comparable.

In an arm’s-length context, an unrelated distributor would want to maximize its profits by keeping the purchasing cost low, while the unrelated supplier would want the price to be as high as possible. However, in a related party context, these incentives can be distorted. For example, because the corporate income tax rate in Ireland is 12.5% and the corporate income tax rate in the U.S. is 21%, a company may find it advantageous to sell the running shoes from the Irish company to the U.S. company at an artificially high price. This would serve to maximize the taxable profits reported in Ireland (i.e., lower-tax jurisdiction) and minimize the taxable profits reported in the U.S. (i.e., higher-tax jurisdiction).

The resale price method can be applied to ensure the prices charged by the Irish supplier to its related U.S. distributor are appropriate. Under the RPM, the gross margin earned by the U.S. distributor must be the same as it is for transactions with its third-party supplier. (In many cases, the RPM yields a “range” of acceptable gross margins rather than a “single” data point.)

Say, for instance, that the U.S. distributor makes a gross profit of $70 for each $100 pair of running shoes purchased from its unrelated supplier.

Here’s how to determine the gross margin on this transaction: 70 / 100 = 70 percent.

The gross margin is 70 percent, so the percentage must be the same in controlled transactions between the U.S. distributor and the related company in Ireland.

Because this method works in percentages, the RPM can be applied even when the underlying products are not identical. In some cases the price of shoes will vary slightly; however, the gross margin earned by the distributor should still be roughly the same. If the cost of the pair of shoes sold from Ireland to the U.S. is $200, the appropriate profit can be determined like this: $200 * 70% = 140. Sometimes the distributor earns $70 on a $100 pair of shoes, while other times it earns $140 on a $200 pair. Either way, the gross margin is 70% and should therefore be deemed acceptable by tax authorities.

The gross margin of the uncontrolled transaction between a distributor and third-party manufacturer is deemed appropriate because the market dictates the price. By applying the resale price method, the distributor can ensure that the transactions are being carried out at arm’s length.

3.The cost-plus method :

The Cost Plus Method compares gross profits to the cost of sales.

Under the Cost Plus Method, the first step is to determine the costs incurred by the supplier in a controlled transaction for products transferred to an associated purchaser. Secondly, an appropriate mark-up has to be added to this cost, to make an appropriate profit in light of the functions performed. After adding this (market-based) mark-up to these costs, a price can be considered at arm’s length.

The application of the Cost Plus Method requires the identification of a mark-up on costs applied for comparable transactions between independent enterprises. An arm’s length mark-up can be determined based on the mark-up applied on comparable transactions among independent enterprises.

Cots Plus Method Example :

With this in mind, let’s look at an example of the application of the Cost Plus Method:

Candy Casing (X) manufactures Iphone cases for associated enterprises. There are many companies around that manufacture Iphone cases, including independent enterprise Ali Accessories (B). B and X manufacture similar Iphone cases.

Now say that X is asked by associated enterprise Y to manufacture 100,000 Iphone cases. X wonders what transfer price it should charge. This means that X should find the terms and conditions (here: the price) of a comparable transaction. Under the Cost Plus Method, X should then first compare its cost base with the cost base of B when manufacturing 100,000 Iphone cases for a third party client.

Provided that the cost base is comparable, the next step is to identify the mark-up on costs applied by B. That mark-up should be added to the cost by X. The result is the arm’s length price.