Understanding the arm’s length principle is only the first step. The next challenge is determining whether a transaction between related companies actually meets that standard.
There is no single formula or fixed price that businesses can use for every transaction. Instead, U.S. transfer pricing rules require businesses to follow a structured analysis to determine whether the price charged between related companies is consistent with what independent businesses would have agreed to under similar circumstances.
The IRS follows this same approach when reviewing transfer pricing during an audit.
Although every business is different, applying the arm’s length principle generally involves several steps.
Next, let’s understand the first step: identifying the controlled transaction.
The first step is to identify the controlled transaction. It is basically the transaction between related parties that needs to be analyzed.
A controlled transaction may involve the following kinds of transactions:
However, identifying the transaction is only the beginning. The IRS also looks at the actual conduct of the parties, not just the written agreement. In other words, the transaction should reflect its economic substance, rather than simply how it has been described in an intercompany contract.
For example, a U.S. parent company pays its Irish subsidiary an annual “management fee” of $2 million under a written intercompany agreement.
On paper, the transaction is described as high-value management services provided by the Irish subsidiary to the U.S. parent company.
However, when the parties’ actual conduct is examined, the IRS finds the following:
The true controlled transaction of the Irish subsidiary is therefore routine support services, not high-value management services. Accurately identifying this difference sets the correct scope for the rest of the transfer pricing analysis.
Therefore, the goal of accurately identifying the transaction is to define the scope of the transfer pricing analysis and to form the foundation for every step that follows.
Once the controlled transaction has been accurately identified, the next step is to perform a functional analysis. This analysis evaluates the functions performed, assets used, and risks assumed by each related party. It provides the foundation for determining how value is created and how profits should be allocated in accordance with the arm’s length principle.
Next, let’s understand functional analysis.
Once the controlled transaction has been identified, the next step is to understand what each related company contributes to that transaction.
This process is known as a functional analysis and focuses on three important areas:
The purpose of the functional analysis is to determine which company creates value and how profits should be allocated between the related parties. Generally, businesses that perform more complex functions, own valuable assets, or assume greater risks are expected to earn higher returns.
A functional analysis also helps identify the tested party, which is the company involved in the controlled transaction that can be evaluated most reliably using available information. This is usually the entity that performs simpler functions and assumes fewer risks.
Once the tested party has been identified, the next step is selecting the most appropriate transfer pricing method. This is because the tested party’s functions, assets, and risks determine which method is most likely to produce the most reliable arm’s-length result.
Next, let’s understand the different transfer pricing methods used to determine the arm’s length price.
After understanding the transaction, the next step is deciding how to determine an arm’s length price.
U.S. transfer pricing rules require businesses to choose the method that provides the most reliable result based on the facts of the transaction. This is known as the Best Method Rule.
The right method depends on the following factors:
The IRS recognizes several transfer pricing methods. Each works best in different situations. First, let’s understand the comparable uncontrolled price method.
The Comparable Uncontrolled Price (CUP) method compares the price charged by related companies with the price charged in a similar transaction between independent businesses.
The idea is to find a comparable deal between two independent businesses and use that price as the benchmark for what related companies should charge one another.
For example, suppose a U.S. company sells phone cases to its foreign sister company for $5 each. However, independent companies are selling the same phone cases for $8. Under the CUP method, the $8 price serves as the benchmark, as it is what unrelated parties actually pay for a comparable product. This method likely suggests that $8, not $5, is the fair, arm’s-length price the related companies should have used.
Now that we have understood the comparable uncontrolled price method, let’s understand the cost-plus method.
The Resale Price Method (RPM) is used to determine whether the price charged between related companies is consistent with the arm’s length principle. It is commonly applied when one related company purchases products from another related company and then resells them to independent customers.
The method starts with the price at which the distributor sells the product to its customers after buying it from a related company. From that selling price, you subtract a normal gross profit margin that an independent distributor performing similar functions would typically earn. The remaining amount represents the arm’s length price that the distributor should have paid its related supplier.
Here, a gross profit margin is the percentage of the selling price that an independent distributor typically keeps to cover its operating costs and earn a profit.
This method is commonly used for distributors that simply purchase and resell products without making significant changes or adding substantial value. Comparing its gross profit margin with that of independent distributors can provide a reliable measure of whether the transfer price is consistent with the arm’s length principle.
For example, a U.S. distributor purchases shoes from its foreign parent company and sells each pair to customers for $100. Independent shoe distributors performing similar functions typically earn a 25% gross profit margin. This means they keep $25 from each sale to cover their operating costs and earn a profit.
Using the Resale Price Method, you start with the distributor’s selling price of $100 and subtract the normal gross profit margin of $25. The remaining $75 is the arm’s length purchase price that an independent distributor would typically pay its supplier. Therefore, the U.S. distributor should have paid approximately $75 to its foreign parent company for the shoes.
Now that we have understood the resale price method, let’s understand the cost-plus method.
The Cost Plus Method (CPM) is used to determine whether the price charged between related companies is consistent with the arm’s length principle. It is commonly used when one related company manufactures products or provides services for another related company.
The method starts with the cost of the company that manufactures the product or provides the service for its related company. A normal profit markup is then added. This markup is the extra amount an independent manufacturer or service provider would typically charge to cover its costs and earn a profit. The total is the arm’s length price that should be charged to the related company.
For example, an Ireland company manufactures electronic components exclusively for its U.S. parent company. The Ireland company spends $40 to manufacture each component. Independent manufacturers performing similar work typically earn a 20% markup on their production costs to cover their operating expenses and make a profit.
Using the Cost Plus Method, you start with the manufacturing cost of $40 and add the normal profit markup of 20% ($8). The resulting $48 is the arm’s length price that the Indian company should charge its U.S. parent company for the component.
This method is commonly used for routine manufacturing and service activities where reliable cost information is available. Comparing its profit markup with that of independent manufacturers or service providers helps determine whether the transfer price is consistent with the arm’s length principle.
Now that we have understood the cost-plus method, let’s understand the comparable profits method.
The Comparable Profits Method (CPM) is used to determine whether the profits earned by a related company are consistent with the arm’s length principle. Instead of comparing the price of a specific transaction, this method compares the company’s overall profitability with that of independent companies performing similar functions under similar circumstances.
The method begins by selecting the tested party, which is usually the related company with the simplest functions and the most reliable financial information. The tested party’s profit level is then compared with the profits earned by similar independent companies. If its profits fall within the arm’s length range, the transfer prices are generally considered to be at arm’s length.
For example, a U.S. company purchases products from its foreign parent company and resells them to customers. The Comparable Profits Method compares the U.S. distributor’s operating profit margin with the operating profit margins earned by independent distributors performing similar activities. Let’s say that the comparable distributors typically earn operating profit margins between 3% and 5%. On the other hand, the U.S. distributor earns 4%. In that case, the U.S. distributor’s transfer prices will likely be considered to be consistent with the arm’s length principle.
This method is one of the most commonly used transfer pricing methods in the United States. This is because financial information for comparable independent companies is often publicly available. It is particularly useful when reliable data on comparable prices is not available.
Now that we have understood the comparable profits method, let’s understand the profit split method.
The Profit Split Method (PSM) is used to determine whether the profits earned by related companies are consistent with the arm’s length principle. It is commonly used when two or more related companies work so closely together that it is difficult to evaluate each company separately.
This method looks at the combined profit earned by the related companies from their controlled transactions. That combined profit is then divided between the companies based on the value of the functions they perform, the assets they use, and the risks they assume. The goal is to allocate the profits as independent companies would have shared them under similar circumstances.
For example, a U.S. company and its foreign subsidiary jointly develop a new software product. The U.S. company contributes the technology, while the foreign subsidiary develops the software and manages global marketing. Together, they earn $10 million in profit from the product. Using the Profit Split Method, the $10 million is divided between the two companies based on the value of each company’s contributions. If both companies contributed equally, each may be allocated $5 million. If one company made a greater contribution, it would receive a larger share of the profits.
This method is often used when related companies both make unique and valuable contributions, such as owning intellectual property, conducting research and development, or jointly developing products. Since each company plays an important role in creating value, evaluating them separately may not produce a reliable arm’s length result.
After selecting the appropriate method, the next step is to determine whether the controlled transaction is comparable to transactions between independent businesses.
This process is known as comparability analysis or benchmarking.
The Treasury Regulations require taxpayers to compare the controlled transaction with similar uncontrolled transactions or companies by considering factors such as:
In practice, businesses often use commercial databases to identify comparable independent companies or transactions. If material differences exist, reasonable adjustments may be made to improve comparability.
The reliability of the transfer pricing analysis depends heavily on the quality of the comparable data. Better comparables generally produce a more reliable arm’s length result.
Once the analysis is complete, the selected method should produce an arm’s length result.
It is important to understand that there is not always one correct transfer price. Independent businesses often negotiate different prices depending on the facts and circumstances of each transaction.
For this reason, the Treasury Regulations recognize an arm’s length range rather than a single acceptable price. If the taxpayer’s transfer price falls within a reliable arm’s length range, it will generally be regarded as consistent with the arm’s length standard. If it falls outside that range, the IRS may adjust the taxpayer’s income to reflect an arm’s length result.
The final step is preparing and maintaining contemporaneous transfer pricing documentation.
Although taxpayers are not required to submit transfer pricing documentation with their tax return, they should prepare documentation explaining:
Maintaining proper documentation is essential because it helps taxpayers support their transfer pricing position during an IRS examination. It may also reduce exposure to the substantial accuracy-related penalties that apply when transfer pricing adjustments are made, and adequate documentation is not maintained.