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Transfer pricing methods

Available methods

Which transfer pricing methods are used in your jurisdiction and what are the pros and cons of each method?

In general, US transfer pricing regulations recognise:

  • transactional transfer pricing methods;
  • profit-based transfer pricing methods; and
  • ‘unspecified’ transfer pricing methods.

Transactional transfer pricing methods include the comparable uncontrolled price (CUP) method, which applies only to controlled transfers of tangible property (Treasury Regulation Section 1.482-3(b)(1)). Methods similar to the CUP method apply to:

  • service transactions (the comparable uncontrolled service price (CUSP) method, under Treasury Regulation Section 1.482-9 (a)(2)); and
  • transfers of intangible property (comparable uncontrolled transaction (CUT) method, under Treasury Regulation Section 1.482-4(a)(1)).

The US regulations also authorise the use of the resale price method under Treasury Regulation Section 1.482-3(b)(2) and the cost plus method under Section 1.482-3(b)(3). Methods similar to resale price and cost plus also apply to service transactions (the gross services margin method under Treasury Regulation Section 1.482-9(a)(3) and the cost of services plus method under Section 1.482-9(a)(4)).

Profits-based transfer pricing methods recognised by the US regulations include:

  • the comparable profits method (CPM) (Treasury Regulation Section 1.482-5);
  • the profit split method (Section 1.482-6); and
  • the income method, which applies to platform contribution transactions under the cost-sharing provisions (Section 1.482-7(g)(4)).

The CPM is the most common transfer pricing method used by Internal Revenue Service (IRS) economists, taxpayers and taxpayers’ advisers. The CPM is applied using publicly available data that can be readily accessed and relaxed standards of comparability. Application of the CPM through database screening techniques, statistical data narrowing techniques (ie, the interquartile range) and multi-year averaging is well understood by both IRS economists and taxpayers’ advisers. The drawback to using the CPM is that it is a ‘rough justice’ method which produces industry average type results that may not reflect unique circumstances facing a specific taxpayer, such as losses caused by a precipitous drop in turnover.

Preferred methods and restrictions

Is there a hierarchy of preferred methods? Are there explicit limits or restrictions on certain methods?

No, instead the so-called ‘best method’ criteria under Treasury Regulation Section 1.482-1(c) is applied to select a transfer pricing method. The regulations require consideration of the following criteria to determine the best transfer pricing method:

  • comparability with the controlled transaction(s) being analysed;
  • the reliability of the data used for the analysis;
  • the assumptions needed to apply the method;
  • the sensitivity of the results to deficiencies in data or changes in assumptions; and
  • the confirmation of results of one method by application of another method.

Comparability analysis

What rules, standards and best practices should be considered when undertaking a comparability analysis?

The US transfer pricing regulations contain a set of general rules for analysing comparability, as well as rules that are specific to certain kinds of transactions or transfer pricing methods.

The general comparability criteria under Treasury Regulation Section 1.482-1(d) take into account the comparability of:

  • functions (determined through a functional analysis);
  • actual or imputed (through conduct) contractual terms;
  • risks assumed;
  • economic conditions of the transactions being compared;
  • property (assets) used to consummate the transaction; and
  • services performed in connection with the transactions being analysed.

The regulations also take into account special circumstances, including:

  • market share strategies (ie, losses due to market penetration);
  • differences in prices or profits due to comparing prices or profits from different geographic markets; and
  • cost differences due to location savings or dissavings.

In general, a more relaxed set of comparability criteria applies to the use of the comparable profits method, which requires only the generalised comparability of functions, assets and risks (Treasury Regulation Section 1.482-5(c)). More strict comparability criteria apply to the use of:

  • the CUP method for transfers of tangible property (Treasury Regulation Section 1.482-3 (b));
  • the CUT method for transfers of intangible property (Section 1.482-4 (c)); and
  • the CUSP method for analysing controlled service transactions (Section 1.482-9 (c)).

In addition, strict comparability criteria apply to using the profit split methods (Treasury Regulation Section 1.482-6 (c)).

It is good practice to consider whether the controlled transactions being analysed are routine in nature or have unusual characteristics. In general, routine distribution, manufacturing or service activities can be analysed using the CPM with a cursory functional and comparability analysis. High-value transactions – especially licences of valuable intangible property or the provision of high-value added services (or both) – should be analysed with a rigorous functional analysis, taking into account all of the general comparability criteria set out above, and the specific comparability criteria required by the transfer pricing method chosen for the analysis.

Special considerations

Are there any special considerations or issues specific to your jurisdiction that associated parties should bear in mind when selecting transfer pricing methods?

There are two classic types of transfer pricing case that require special considerations when selecting or applying transfer pricing methods in the United States.

The first classic case is recurring losses or low profits incurred by a foreign-controlled US entity marketing and distributing products on behalf of a foreign-related party. The second classic case is where high profits are earned by a foreign affiliate of a US entity in a low-tax jurisdiction when the foreign affiliate is a licensee of intangible property licensed from the United States, including cases where the foreign affiliate participates in a cost-sharing arrangement with a US entity.

In the classic foreign controlled distribution case, IRS economists typically apply the CPM to impute a normal operating profit (generally 2% or higher) – even in cases where there are consolidated losses on the products being sold. Taxpayers need to be aware of these IRS practices and be prepared to document and explain why losses or low profits are due to arm’s-length market forces and not improper transfer pricing.

In the second type of classic transfer pricing case, IRS economists are generally reluctant to agree to use the CUT method as a basis for evaluating royalty rates. Instead, IRS economists typically apply the CPM to treat the foreign affiliate as a contract manufacturer or routine distributor, which has the effect of limiting any upside profit potential from the licence transaction. Accordingly, taxpayers using the CUT method must be prepared to discuss and justify why it, and not the CPM, is the best transfer pricing method.

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