The selection of a transfer pricing method must comply with the Director-General’s Notification No. 400, Clause 6, which outlines four simple criteria for choosing a method. Although the Notification does not provide detailed explanations, I’d like to elaborate on these criteria to help us better understand and apply them appropriately.
The Four Criteria for Selecting a Transfer Pricing Method:
(1) Strengths and Weaknesses of Each Method
Each of the five transfer pricing methods has its own strengths and weaknesses based on its inherent characteristics. For example, the Comparable Uncontrolled Price (CUP) method aligns most closely with the Arm’s Length Principle and provisions under Section 71 bis of the Revenue Code, making it the most reliable method. However, it is rarely used due to the unavailability of public information and the difficulty in comparing price of every controlled transaction with that of independent transaction. Also, it often requires significant efforts to adjust data for comparability. On the other hand, the Transactional Net Margin Method (TNMM) is an indirect method but easier to apply. It uses operating profit margins, which are less affected by differences in product or service characteristics than gross margins used in methods, like Resale Price Method (RPM) and Cost-Plus Method (CPM). Operating margins are also less sensitive to differences in transactional functions, which affect operating expenses.
(2) Appropriateness of the Method to the Nature of the Controlled Transaction
This involves analyzing the functions performed by each party, including assets used and risks assumed. Each method has a different calculation formula and is suitable for different business models and functional profiles. For example, the Resale Price Method calculates the transfer price by deducting an arm’s length gross margin from the resale price. It suits trading firms with limited functions and limited risks that buy from related companies and sell to third-party customers. Although the resale prices declined with the market conditions, the trading firm would continue to earn the same margin because the transfer prices are determined by deducting the arm’s length margin off the declining prices. Hence, the use of Resale Price Method reflects its limited risks. Conversely, the use of the Resale Price Method by a manufacturing company acting as a contract manufacturer with limited functions and limited risks will result in a shrinking margin if the production costs rise while the resale prices remain the same. In such cases, the Cost-Plus Method is more appropriate, as it allows transfer prices to adjust with rising production costs, reflecting the limited risk profile of the contract manufacturer.
(3) Availability of Reliable Data
This is the most straight-forward criterion. If reliable data required for a method is unavailable, that method cannot be used. For example, the CUP method requires comparable prices between independent companies under similar conditions and timeframes. If such data is unavailable, it is not possible to apply such a method. Even if a company knows competitors’ prices, it must have documentary evidence acceptable to tax authorities or courts. Additionally, the company must be able to obtain such data consistently in future years. In practice, the reliable data typically comes from public databases, such as financial statements, government websites, trade associations, or commercial data providers.
(4) Degree of Comparability between Controlled and Uncontrolled Transactions
Despite the availability of reliable data, it doesn’t guarantee the applicability of a method like CUP. We must carefully inspect that such data is comparable to avoid obtaining misleading and wrong results. For example, the product data available might differ significantly from the characteristics of the product being priced—like comparing the prices of an apple with the prices of a pineapple.
In such cases, the TNMM may be more suitable, comparing net margins instead. This is because the tested company’s functional profile may match that of an independent company for which data is available. Checking product characteristics for price comparison and functional profiles for margin comparison aligns with OECD guidelines. The rationale behind this approach will be discussed further when we explore the TNMM method in detail.
[Contact Person: Mr. Phongnarin Ratarangsikul | Partner]