3 METHODS FOR DETERMINING THE PRICE OF RELATED-PARTY TRANSACTIONS
Currently, "Transfer pricing" is no longer an unfamiliar concept to accountants. Tax authorities have also conducted extensive inspections on companies displaying transfer pricing indications.
The responsibility of businesses is to present and substantiate the prices of their transactions to align with market prices. To persuade the tax authorities, the selection of "Transfer pricing methods" and "Data sources" is of utmost importance in providing compelling evidence.
In this video, we will present the "Essential Notes" regarding the selection of transfer pricing methods in related-party transactions to ensure suitability and compliance with tax regulations. There are typically three methods:
- The first method is the method for comparing the transfer price and the arm's length price: This is the top priority method in selecting the evidential pricing method.
- The second method is the method for comparing profit margin: This method is widely and commonly used to demonstrate compliance during transfer pricing audits.
- The third method is the method for splitting or allocating the profits between related- parties: This method is the least commonly used among the three.
THE METHOD FOR COMPARING THE TRANSFER PRICE AND THE ARM'S LENGTH PRICE
"Why is the method for comparing the transfer price and the arm's length price considered the top priority method chosen?"
Answer:
The method for comparing the transfer price and the arm's length price is the fundamental and most precise approach. In other words, this is a direct method of proving by directly comparing the selling and purchasing prices of the related-party with those of independent parties.
We need to note that the selling and purchasing prices of the same goods must have similar characteristics, and the contractual terms must be the same. There are two reliable sources to consider for comparing independent prices: Internal company data and External market data.
The internal company data is considered a priority, meaning the selling prices offered by the company to independent parties are compared with the selling prices to related-parties for the same goods.
The external data source comes from comparing buying and selling prices through commodity exchanges or markets for similar goods and products among companies in the same industry.
The limitation of this method is the difficulty in finding exact comparables that meet the required conditions for comparison, and the comparables database may not always be readily available.
THE METHOD FOR COMPARING PROFIT MARGIN
“Why is the method of comparing profit margin the most widely used and popular method?"
Answer:
The method of comparing profit margin is the most widely used because it is easy to apply, prompt results, and minimal limitations. This method allows for accepting relative differences among the comparables.
The proof of the method of comparing profit margin is indirectly through the rate of return, that is, using the rate of return of companies similar in industry, size, geographical area, to compare with the rate of return of the company having related-party transactions.
“ Profit margin " is a critical indicator in business; therefore, this method is widely used to demonstrate the reasonableness of the price of related-party transactions.
Note, when choosing to apply the method of comparing profit margin, you need to consider reevaluating the nature of the transaction with the related-party in order to choose a suitable comparison of profit margin using one of the following three methods:
First, the method for comparing of gross profit to sales (resale price method).
Second, the method for comparing the ratio of gross profit to cost of goods sold (cost plus method).
Third, the method for comparing the net profit margin.
THE METHOD FOR SPLITTING OR ALLOCATING THE PROFITS BETWEEN RELATED-PARTIES
"Why is the method for splitting or allocating the profits between related-parties the least used method?"
Answer:
The method for splitting or allocating the profits is less commonly used due to its relatively low accuracy and the difficulty in collecting information across different countries.
The method for splitting or allocating the profits is only applicable when a taxpayer engages in a related transaction which is specific, integrated or closed in an enterprise group.
In other words, using the profits of all the enterprise group and then applying a suitable criterion to redistribute the profits among the related companies within the group. From then on, the recalibration of the profits of the subsidiaries engaged in related-party transactions.
The suitable criterion to redistribute the profits is the allocation ratio based on one or several factors such as revenue, expenses, fixed assets, or human resources of the related- parties engaged in transactions within the group.
