In practice, when determining the arm’s length price of a transaction – the key question that a transfer pricing analyst would ask is how to apply the arm’s length principle? There are several transfer pricing methods that exists to provide a conceptual framework in determining the arm’s length price.
These methods directly and indirectly relies on the comparable profit margin of similar transactions. The information may be derived from an internal comparable (i.e. similar uncontrolled transaction between the entity and 3rd party) or external comparable (i.e. involving independent parties within the same market / industry).
There are five major transfer pricing methods
- Comparable Uncontrolled Price (CUP)
- Resale Price Method
- Cost Plus Method
- Profit Split Method
- Transactional Net Margin Method
The first three method mentioned above are often referred to as the traditional transaction methods, where the remaining last two methods as the profit-based methods. All of these methods are widely used and accepted by the national tax authorities.
Note: Under the USA regulations, there is an additional transfer pricing method which is applicable at the global level of operations. The additional method is referred to as the Comparable Uncontrolled Transactions (CUT) method. This method is similar applied to CUP method. It determines the arm’s length royalty rate for an intangible by comparing the uncontrolled transfers of comparable intangible property in comparable circumstances.