The 5 OECD Transfer Pricing Methods Explained


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Say you are involved in an internationally operating company engaging in cross-border transactions with group entities. You’re familiar with the importance of adhering to the OECD Transfer Pricing Guidelines (‘TP Guidelines’) and the ‘at arm’s length principle’. Now, the spotlight is on you to set a fair remuneration for a sales support service between two group companies.

The solution involves conducting an examination of the intercompany transaction and a functional analysis of the companies involved. But the question remains: how do you go about selecting the most appropriate Transfer Pricing [TP] method? Do you trust your gut feeling or make an informed decision?

In this article, we delve into the various OECD-recognized TP methods and equip you with some tools to choose the most suitable one.

Figure 1: the intercompany sales support service we’ll be looking at later.

Understanding the Arm’s Length Principle

To arrive at an appropriate TP method for the transaction at hand, we must first of all understand the at arm’s length principle.

The arm’s length principle [codified in Dutch tax law as Article 8b of the Dutch CIT Act, with a direct reference to the OECD’s Transfer Pricing Guidelines] ensures that the valuation of intercompany transactions reflects the price that would be agreed upon between unrelated companies [the transfer price]. It’s mission? To prevent group companies from cooking up conditions that only serve tax purposes.

The example below illustrates the importance of the arm’s length principle in combating profit shifting to low-tax jurisdiction. Picture this: the group decides to set the transfer price artificially high at ’90’. What happens next? Well, the high-taxed company sees a dip in profits, while the low-taxed company inflates its profits. As a result, the group’s overall tax bill is lower [4] than it would be in situations where the companies would be dealing with an unrelated party [7]. This is where the arm’s length principle comes in, which states that the group ‘transfer price’ should be (roughly) equal to the external and fair market price of 80.

Figure 2: the arm’s length principle prevents profit shifting.

For a more comprehensive understanding of the arm’s length principle, we recommend referring to our TP 101 article here, which also provides further wording on hown the different ‘sources’ of TP regulation work and interact:

Where it starts: the Functional analysis

Now that we have a basic understanding of the arm’s length principle, let’s zoom in on the functional analysis.

In the context of an intercompany transaction, the remuneration should reflect the functions performed, considering the assets used and the risks assumed. This evaluation is referred to as the ‘functional analysis’. It includes how the functions contribute to the overall value creation within the group to which the involved companies belong. The million dollar question: “Which function and asset contributes what value and assumes what level of risk”?

Transfer prices have to correspond to the nature of the functions performed and risks assumed in a transaction. This should ensure that profits end up being taxed where they are created. To achieve this alignment, various OECD recognized TP methods are employed for different types of transactions and entities within a group.

For routine and low-risk gigs, a modest but consistent margin is generally deemed most appropriate. This ensures that entities engaged in tasks with minimal complexity or risk are adequately remunerated. On the other hand, high-risk functions or those that are challenging to evaluate [often key value drivers] should be rewarded substantially; high risk = high reward. This approach acknowledges the significance and unique contributions that play a pivotal role in the overall success of the group.

In a nutshell, a functional analysis involves a comprehensive understanding of the functions, assets, and risks involved in an intercompany transaction, while recognizing the broader value generation within the group.

Figure 3: in American football, the quarterback is often the highest paid player of the team. They are considered the leader on the field and play a crucial role in the team’s success.

Then: the 5 TP Methods

TP methods serve as an evaluative compass, ensuring that conditions used in intercompany transactions adhere to the at arm’s length principle. This involves scrutinizing the outcomes of such transactions by comparing them to what would have been if third parties had partaken in similar dealings under similar circumstances.

Various metrics such as prices, gross profit margins, operating profit margins, cost-plus mark-ups, and financial ratios come into play, depending on the chosen TP method. The crux lies in determining whether the transfer price aligns with the arm’s length range derived from comparable uncontrolled transactions or financial data of similar companies.

In the quest for the most fitting TP method, it’s crucial to weigh the strengths and weaknesses of each option. This decision-making process hinges on the appropriateness of each method, as determined by the nature of the transaction through the functional analysis. The availability of reliable information for applying the selected method is also a key consideration, along with assessing the degree of comparability between controlled and uncontrolled transactions. This assessment includes evaluating the reliability of any necessary comparability adjustments to eliminate substantial differences from the equation. One thing is clear: trusting on gut feeling to select a TP is not sufficient.

Ultimately, the goal is to pinpoint the most suitable TP method tailored to the specifics of each case. While it’s not required to employ more than one method for a given transaction (nor is it necessary to explain why other TP methods were not selected), a selection process is essential, taking into account the factors above.

Figure 4: An overview of the various TP methods and the at arm’s length range.

The TP Guidelines describe five different methods to arrive at an appropriate remuneration for a given transaction, which can be categorized under the ‘traditional transaction methods’ and the ‘transactional profit methods’. Traditional transaction methods use comparable transactions to establish an at arm’s length remuneration of intercompany transactions , whereas transactional profit methods take into account profit margins resulting from comparable transactions.

Traditional transaction methods are the Comparable Uncontrolled Price (‘CUP’) Method, Cost-Plus Method, and Resale Price Method (‘RPM’). Transactional profit methods are the Transactional Net Margin Method (‘TNMM’) and the Profit Split Method (‘PSM’).

The ‘Traditional Transaction’ Methods

1: The CUP or Comparable Uncontrolled Price Method

The CUP method serves as a yardstick for assessing the arm’s length nature of intercompany transactions involving the transfer of property or services. It involves comparing the price in the intercompany transaction with the price in a comparable uncontrolled transaction in comparable circumstances. Any disparities between the two prices may signify a misalignment in the commercial and financial relations of the associated companies, prompting substituting the intercompany transfer price with that of the uncontrolled transaction.

The CUP method shines when comparable uncontrolled transactions can be identified [through extensive database analyses]. It is the most straightforward and reliable approach in applying the arm’s length principle. An uncontrolled transaction is deemed comparable if either none of the differences between the compared transactions could materially affect the open market price or if reasonably accurate adjustments can be made to eliminate the material effects of such differences.

For the CUP method to be applicable, the details of the comparable must align with the OECD’s five comparability factors:

  1. Characteristics of the property or service.
  2. Functional analysis.
  3. Contractual terms.
  4. Economic circumstances.
  5. Business strategies.

Despite its theoretical soundness, practical application of the CUP method can be challenging. Unique goods, services, and intangibles sold or licensed to associated companies pose difficulties in finding direct comparables. Additionally, a stringent requirement for comparability hinders the widespread use of the CUP method, leading to the dominance of other TP methods in practice.

The CUP method is most apt for transactions involving goods (especially if identical goods are sold to third parties), loans, and listed commodities. It comes in two forms: the internal CUP, which compares prices with a group company and between a group company and a third party, and the external CUP, which compares prices with similar transactions between unrelated companies. Choosing the appropriate variation depends on the specifics of the transaction at hand.

Figure 5: Internal and external CUP.

2: The RPM or Resale Price Method

The RPM unfolds as the selling price, at which a product is initially purchased from an associated company and subsequently resold to an external party. This resale price is then reduced by an appropriate gross margin [the resale price margin], representing the amount of which the reseller would seek to cover its selling and other operating expenses, and in the light of the functions performed, make an appropriate profit.

 So, when is the RPM most suitable? Picture a scenario where a distributor acquires goods both internally and externally, reselling without any further processing and without any incorporation into more complicated products so that their identify is lost or transferred. The RPM shines brightest in such contexts. Timeliness is a crucial factor – the RPM thrives when the transfer occurs shortly after the reseller’s initial purchase, ensuring accuracy of the transfer price.

Much like the CUP, the RPM relies on the feasibility of a reliable calculation based on a comparable transaction. In practice, it is often difficult to ensure that accounting standards don’t influence the calculation. Gross profit margins may mirror each other, but differences in operating expenses and profits can tilt the scales. Gross profit data can therefore rarely be relied upon. Even if deemed reliable, tax authorities may advocate for a reasonable net margin – so one may opt to use a net margin method in advance.

Figure 6: the RPM.

3: The Cost-Plus Method

The cost-plus method begins by scrutinizing the costs incurred by the supplier in an intercompany transaction, involving the transfer of property or provision of services to an associated purchaser. An appropriate cost-plus mark-up is then applied to these costs, creating a profit margin that reflects the functions performed and the market conditions. What is arrived at after adding the cost-plus mark-up to the costs may be regarded as an arm’s length remuneration of the original intercompany transaction.

When to apply? The cost-plus method is most useful where semi-finished products are sold between associated companies, where companies have concluded joint facility agreements or long-term buy-and-supply arrangements, or where the intercompany transaction relates to the provision of services. Typically, it is the preferred approach for limited-risk manufacturers and service providers.

 The cost-plus method shares limitations much like the RPM. The method’s efficacy relies heavily on comparable transactions. 

Figure 7: the cost-plus method.

The Transactional Profit Methods

4: The TNMM or Transactional Net Margin Method

The TNMM assesses net profit in relation to an appropriate base, known as the profit level indicator (‘PLI’), such as costs, sales, or assets, that a taxpayer realizes from an intercompany transaction. In essence, the TNMM functions similar to the cost-plus and RPM. To ensure reliable application, the TNMM must be applied consistent with the manner in which the cost plus-method is applied.

The TNMM may be applied where one party undertakes routine or non-unique functions [the least complex entity, or the tested party], such as distribution or manufacturing, while the other makes unique and valuable contributions to the group.

The PLI of a taxpayer is subject to influence from various factors, some of which may not exert a comparable impact on prices or gross margins between independent companies. As a result, the determination of accurate and reliable PLIs may pose a challenge. Limited access to specific information on profits attributable to comparable uncontrolled transactions further complicates the application, with relevant comparables often identified through database analyses.

Below, an example illustrates the application of the TNMM in the context of a distributor.

Figure 8: the TNMM is appropriate for a transaction between an owner of IP and a limited-risk distributor.

5: The PSM or Profit Split Method

Useful and famous as it may be, the TNMM is unlikely to be reliable if each party to a transaction makes unique and valuable contributions. Enter: the PSM. The PSM is the only two-sided method, which seeks to eliminate the effect on profits of special conditions made or imposed in an intercompany transaction by determining the division of profits that independent companies would have expected to realize from engaging in the transaction(s).

The PSM may also be found to be the most appropriate method in cases where both parties to a transaction make unique and valuable contributions, because in such case independent parties might wish to share the profits in proportion to their respective contributions and a two-sided method might be more appropriate in these circumstances than a one-sided method. All in all, the PSM may be the most appropriate method if one or more of the following indicators apply:

  • Each party makes unique and valuable contributions.
  • The business operations are highly integrated such that the contributions of the parties cannot be reliably evaluated in isolation from each other.
  • The parties share the assumption of economically significant risks, or separately assume closely related risks.

The PSM employs two approaches.

  • Contribution analysis: the combined profits are divided between the associated companies based upon a reasonable approximation of the division of profits that independent companies would have expected to realize from engaging in comparable transactions. This division can be supported by comparables data where available, or the relative value of the functions performed by each of the associated companies in the intercompany transactions considering their assets used and risks assumed.
  • Residual analysis: the combined profits are divided in two stages. Remunerate routine and non-unique activities first. Then allocate the residual profit remaining to the parties based on an analysis of the facts and circumstances.

Figure 9: the residual PSM allocates routine and non-unique profits before splitting the residual profit.

If the PSM is employed, it needs to be determined what both group companies contribute, and the contribution per company must be calculated. By definition, the PSM may prove difficult to find a reliable way to split the residual profit. A tool which may be helpful is the so-called RACI [Responsible, Accountable, Consulted, Informed] model, which helps to determine the contribution on a step-by-step basis by identifying the roles of key personnel, key value drivers and business operations.

Zoom in: Profit Split Method using a RACI-Based Contributions Analysis

To provide a little more concrete perspective on how a PSM can be used, we highlight our RACI-based approach. RACI stands for ‘Responsible, Accountable, Consulted, Informed’. The analysis under this approach is built up as follows:

  1. After an analysis of the Group, we establish the different ‘business processes’ that make the Group tick, and award ‘cruciality points’ to them on a questionnaires-basis to establish the Key Value Drivers;
  2. We then establish teams [larger businesses] or persons [smaller businesses] involved and see whether they are Responsible, Accountable, Consulted or Informed on the sub-processes identified;
  3. Based on the RACI-scores, we can establish which of the entities contributes which percentage to the weighted Key Value Drivers and other processes, and the resulting percentage is a ‘large-n’ consensus on how the Group Profit should be split between the involved entities.


Figure 10: an example of Archipel’s TP RACI Model, hypothetically filled out for Archipel itself.

So: how do you select the right TP method for our Sales Support Case?

Figure 11: sales support service.

Returning to the case at hand. You are asked to set a fair remuneration for a sales support service between two group companies.

Step 1: Make the Functional Analysis

You conduct a functional analysis, which can be summarized as follows:

  • Company A BV’s [Netherlands] functional complexity is relatively low due to its supporting sales role and limited involvement in core function such as management and marketing. It employs few people and has a simple managerial structure. Limited risk assumption.
  • Company A Corp’s [United States] functional complexity is high due to it performing key functions for the group, such as management, marketing, sales, and business development. It holds the group’s intellectual property and employs a significant amount of people. It is exposed to intellectual property and market risk.

Step 2: Select and Apply the appropriate TP Method

The CUP method is hard to apply to the provision of services in general, because the nature of services rendered is never fully comparable to that of external parties. Seeing that a sales support service is provided, you conclude that this method is inappropriate and inferior to other methods.

The RPM is principally unapplicable because Company A BV do not partake in reselling activities. This simply does not apply to the functional profile of the entities.

You find that the PSM is also inappropriate, as it is mainly applicable to cases where each of the companies make unique and valuable contributions in relation to the transaction. From the functional analysis, it is clear that Company A BV does not make unique or valuable contributions to the overall success of the group.

The methods that remain are the cost-plus method and the TNMM. Seeing as Company A BV does not sell goods itself, it generally avails of few assets, and the nature of the services Company A BV provides is support. Given limited public data on the various costs of comparable companies, you choose to apply the TNMM over the cost-plus method.

The Back-end: Transfer Pricing Documentation

Under Dutch Tax Law, taxpayers must have a substantiation of their Transfer Pricing on file and display that their intercompany conditions reflect the Arm’s Length principle. The documentation requirements become more demanding as materiality increases, and specific additionl requirements can be triggered when companies hit certain revenu thresholds.

For instance: companies in groups with over €50m of annual revenu must have a Master File [group summary] and Local Files [interlinking subsidiary pricing overview] whilst companies in group woth over €750m of annual revenu must also have a Country-by-Country Report [overview of footprint and taxes paid per country]

A concise summary derived from the Dutch Transfer Pricing Decree:

First, there is the documentation requirement as described in Article 8b, third paragraph, of the Dutch Corporate Income Tax Act 1969 (CITA). This documentation includes a description of the five comparability factors for related transactions as outlined in Chapter I of the OECD Guidelines, a justification for the chosen transfer pricing method, and a substantiation of the terms, including the price, under which the transactions were conducted. When codifying the documentation requirement per Article 8b, third paragraph of the CITA, a conscious decision was made not to provide an exhaustive list of documents needed to support the arm’s-length nature of the transactions. In this sense, it is an open standard.

Second, Articles 29b to 29h of the CITA contain legislation regarding documentation for taxpayers that meet certain criteria. This documentation requirement pertains to the country-by-country report, the master file, and the local file. The regulation on additional transfer pricing documentation requirements of December 30, 2015 (DB2015/462M) sets out further rules for the form and content of these reports and files.

Article 8b, third paragraph, of the CITA applies to both domestic and cross-border transactions with related entities, while the obligations of Articles 29b to 29h of the CITA pertain to cross-border transactions between related group entities and the substantiation of an arm’s-length profit allocation to permanent establishments.

Paragraph 13 of the Dutch Transfer Pricing Decree

We summarize these compliance obligations as follows:

Something to Consider: Advance Certainty [Tax Ruling / Advance Pricing Agreement] on your TP Policy and Documentation

If you want to be sure that your Transfer Pricing policy is acceptable, and/or whether you are fulfilling your Reporting Obligations, the Dutch Tax Authorities have dedicated teams available to grant Advance Certainty.

Advance Certainty can be a valuable part of Cooperative Tax Compliance, which is a trending approach to tax compliance under which the Taxpayer implements a ‘Tax Control Framework’ in return for quicker certainty and decreased audits and scrutiny from the Tax Authorities.

For further reading on this topic, we refer to our long read:

Want to Talk about Transfer Pricing? Book a Calendly-slot; it’s On the House!

Happy to chat. A Transfer Pricing Policy is a tax compliance requirement anyway, but a well designed Policy can be a real business enhancer. As a Tax Economist, I love diving in, so feel free to use my time to bounce some thoughts!

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