TP Methods : Traditional Transactional Methods vs. Transactional Profit Methods
Since the introduction of corporate tax in the UAE, MNE businesses are required to consider transfer pricing rules while determining the prices charged on products or services exchanged between its various divisions that are located in different tax jurisdictions. The OECD Guidelines say that the prices charged should be at arm’s length, which means the companies should treat the transactions the same way they would between unrelated companies.
Companies rely on transfer pricing methods to ensure that these transactions are conducted at fair market value to prevent tax evasion, profit shifting, and disputes with tax authorities. There are five transfer pricing methods that can be grouped under two major categories: traditional transactional methods and transactional profit methods.
In this blog post, we will delve into these two approaches, exploring their differences, advantages, and limitations.
Traditional Transactional Methods
Traditional transactional methods focus on comparing the prices charged in intercompany transactions with those of unrelated third parties in open markets. There are three traditional transactional methods:
Comparable Uncontrolled Price (CUP) Method: The CUP method involves comparing the price of a controlled transaction with the price of a similar uncontrolled transaction in an open market. It is considered the most direct and reliable method when there are suitable comparable transactions available.
Resale Price Method (RPM): The RPM starts with the resale price to an unrelated customer and subtracts a gross margin to determine the arm’s length price for the controlled transaction. This method is often used when a distributor resells products purchased from a related party.
Cost Plus Method (CPM): The CPM adds a markup to the total cost incurred by the seller to determine the arm’s length price. This method is commonly used when a manufacturer provides goods or services to a related distributor.
Advantages of Traditional Transactional Methods:
- a. Objective: These methods are based on actual transactional data and are relatively straightforward to apply, making them more objective.
- Accepted by Tax Authorities: Many tax authorities worldwide accept traditional transactional methods as they rely on easily verifiable data.
- c. Common Practice: Traditional methods are widely used, making it easier for companies to find comparable data.
Limitations of Traditional Transactional Methods:
- Limited Comparables: Finding truly comparable transactions in open markets can be challenging, especially for unique or highly specialized products/services.
- Historical Data: Traditional methods rely on historical transaction data, which may not reflect current market conditions or industry trends.
- Inflexible: They may not account for the unique circumstances of a controlled transaction, such as differences in volume, terms, or market conditions.
Transactional Profit Methods
Unlike traditional transactional methods, transactional profit methods focus on the overall profitability of a controlled entity or entities involved in intercompany transactions. These methods attempt to determine the arm’s length price by analyzing the combined profit of the controlled entities in relation to their functions, assets, and risks. The two primary transactional profit methods are:
Profit Split Method (PSM): The PSM divides the combined profit of the controlled entities based on their relative contributions to the value chain. It is often used when it is difficult to isolate and value individual transactions within a complex integrated business.
Transactional Net Margin Method (TNMM): The TNMM compares the net profit margin earned in a controlled transaction to the net profit margin of comparable uncontrolled transactions or entities. This method is widely used and flexible, allowing for adjustments to account for differences between controlled and uncontrolled transactions.
Advantages of Transactional Profit Methods:
- Flexibility: Transactional profit methods can accommodate a wide range of business models and transactions, making them suitable for complex situations.
- Contemporary Data: These methods rely on current financial data, which may better reflect market conditions and changes in the business environment.
- Adaptable: Transactional profit methods can be used when traditional transactional methods do not yield reliable results due to the lack of comparables.
Limitations of Transactional Profit Methods:
- Complexity: Implementing transactional profit methods can be complex, requiring a deep understanding of the controlled entities’ functions, risks, and assets.
- b. Subjective: Determining the contribution of each entity to the overall profit can involve subjectivity and judgment.
- c. Data Challenges: Gathering accurate financial data for both controlled and uncontrolled entities can be challenging, especially for closely held companies.
Choosing the Right Transfer Pricing Method
Selecting the appropriate transfer pricing method is crucial for multinational enterprises (MNEs) to comply with tax regulations and minimize risks associated with transfer pricing audits. The choice between traditional transactional methods and transactional profit methods depends on various factors, including the nature of the controlled transactions, the availability of reliable data, and the level of complexity involved.
In practice, many companies use a combination of both traditional transactional methods and transactional profit methods to arrive at a reasonable arm’s length price for their intercompany transactions. This approach allows for a more comprehensive analysis and may provide a more defensible position in the case of a tax audit.
The Best Transfer Pricing Advisers in Dubai, UAE
Given the complexity of the transfer pricing regime, MNEs may find it tough to choose the most appropriate method. Transfer pricing advisers in Dubai such as Tax Gian can help you navigate the intricate maze of corporate tax. Tax Gian is a brand of Jitendra Tax Consultants (JTC), which is a part of Jitendra Chartered Accountants (JCA). In a rapidly evolving global business landscape, Tax Gian’s highly qualified tax experts can help you stay informed about transfer pricing methodologies and regulations is essential for multinational corporations to navigate the complexities of international taxation successfully.