5 Transfer Pricing Method
Transfer pricing is the accounting method which company uses to charge service or goods that sell from one division to another in the same company. It allows the company to charge for the goods or services that transfer between subsidiaries or divisions. As the buyer and seller under the same control of one company or group company, so the price can be increased or decreased to manage the profit of both.
The top management will change the price to minimize both buyer and seller’s profit to save tax. They can decrease the seller’s profit by charge a low price to another related party. The profit is transferred from one party to another but it still remains in the same group company.
5 Transfer Pricing Method
Comparable Uncontrolled Price Method
Comparable uncontrolled price method is the method by which we compare the price of goods or services to the market price. The market price is the price that is not under the control of the buyer and seller under the same parent. It is the price which determines by the unrelated parties.
The price decides by both seller and buyer in the same entity/group is not reliable as they are the related party. Top management can use a price strategy to transfer profit between the party. So we have compared with the price in the market which the agreed price between buyer and seller who are not related. This price is more reasonable and reflects the real goods or service value.
This method is the most reliable one as it shows the difference between market price and purchase price. However, there are some problems with is this method, as the goods or services do not exist in the market. So we cannot benchmark the transfer price and market price. Some goods and services are not available in the market. The subsidiary may transfer the work in progress product to another subsidiary. This kind of product will not be found on the market.
The Resale Price Method
This is the method that analyzes the resale price of the purchased products from the related party. The profit margin should be aligned with the other products currently selling. It does not make scenes to purchase and sell at lose or slightly profit. A huge profit margin is also a problem as it is too good to be true, the cost may be too low.
The resale price to the unrelated party is a very fair price. And the profit margin should be similar between one product to another in the same entity. So we can compare the profit margin of all products to check if the cost of purchase from the related party is fair or not.
However, it will be hard if the related party purchase the service which just a part of production cost or the goods is only a small part of the finished product. It is almost impossible to compare the gross profit to identify the arm’s length transaction.
The Cost Plus Method
The cost-plus method analyzes the marked-up profit over the cost of the entity. Similar to the resale price method, but it focuses on the markup profit of the product. It analyzes whether the marked-up cost makes by the buyer is arm’s length or not.
The mark-up percentage of the product should be similar between one product to another. The same product should have the same markup between the related and unrelated parties.
The Comparable Profits Method
The comparable profit method takes a look at the profit margin earned from the controllable transaction and compares it with the uncontrollable transaction. A controllable transaction is a transaction between the related party. Uncontrollable transactions happen between unrelated parties.
The Profit Split Method
This method will take a look at the profit of both related parties, the buyer and seller. And compare with a profit of uncontrollable transaction with the unrelated party. It is the overall method look on a strategic level when there are many transactions happen during the accounting period. This method needs to access both buyer and seller’s financial statement when both of them make many controllable transactions. The profit of both parties should be similar to the other parties making the same transaction. The profit should be fairly divided between the two. If any party taking a huge unfair profit from another party, it means the price is fair. The transactions are arm’s length.
