Transfer price is defined as the price at which two parties transact with each other. For example, during the trade of supply or labor between the two departments. These prices are used when two individual parties of a big multi-entity firm are treated as though they are run separately. This is common in very large corporations. A transfer price is also called transfer cost.
There are five types of transfer pricing methods that can be applied. Three of the five are traditional pricing methods while the last two are transactional pricing methods.
Traditional Pricing Methods
Traditional transaction methods work by measuring the terms and conditions of actual transactions between independent entities and compares them to a control transaction. There are three types of transfer pricing under this method:
1) The CUP Method
The CUP method is a method that compares the terms, conditions and the price of a controlled transaction to those of a third party transaction. In this method, there are two types of third party transactions. The first type is a transaction between the taxpayer and an independent enterprise. This is known as internal Cup. While the second type is a transaction between two enterprises known as external Cup.
2) The Resale Price Method.
This is also called the “Resale Minus Method.” The beginning of this method takes note of the price at which an associated enterprise sells products to a third party. This price is known as the “resale price.” This resale price is then altered with a gross margin, this is done by comparing gross margins in comparable uncontrolled transactions.
When this is done, the costs associated with the purchase or the products, such as custom duties are deducted from the price. After all the deductions, what is left is the arm’s length price for the controlled transaction between associated enterprises.
3) The Cost Plus Method.
This method compares gross products to the cost of sales. The first thing to do is to determine the costs incurred by the supplier in a controlled transaction for products sold to a related purchaser. After that, an appropriate mark-up is added to the cost in order to make a profit.
After adding this markup to the cost, it can then be considered at arm’s length. When applying this method, you are required to identify a mark-up on costs applied for comparable transactions between independent entities. This has to be done before this method can be applied.
Transactional Pricing Methods
Unlike the traditional method, this method does not measure actual transactions. Rather this method measures the net operating profits that are gotten from controlled transactions and compares them to profit level realized by independent enterprises that are engaged in comparable transactions. There are two types of price transfer methods under this.
1) The Transactional Net Margin Method (TNMM).
In the TNMM, you will need to calculate the net profit of a controlled transaction of a related enterprise. This net profit is then compared to the net profit realized by comparable uncontrolled transactions of independent entities.
This method requires that the transactions are broadly similar before they can be compared. For this method, a comparable uncontrolled transaction can be between a related enterprise and an independent enterprise or between two independent enterprises.
2) The Profit Split Method.
There are times when associated enterprises engage in transactions that are interrelated. This means that these transactions cannot be examined on separate basis. For transactions in this category, associated enterprises just split the profits realized.
This method looks at the terms and conditions of these transactions by extrapolating the division of profits that independent enterprises would realize from participating in those transactions.
These are the different types of transfer pricing.
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