Transfer Pricing Methods in a Nutshell
In a globalized economy, it is a common practice that entities forming part of a multinational enterprise (“MNE”) transact with each other. Such transactions between related parties are referred to as “controlled transactions”. The prices set in controlled transactions are called “transfer prices”. From a business perspective, it is important that each participant in a controlled transaction is adequately renumerated for the services or goods it provides. Transfer prices should reflect the contribution each entity makes to the overall value offered by the group.
Moreover, transfer prices impact the international tax footprint of the group. For that reason, tax authorities often review transfer pricing (TP) policies of the MNEs to prevent artificial profit shifting out of their respective jurisdictions. Under an internationally accepted standards, transfer prices should be set in line with the arm’s length principle. The OECD TP Guidelines indicate that transfer prices follow the arm’s length principle if they reflect the prices that would have been set between independent enterprises in comparable transactions, under comparable circumstances. In practice, the arm’s length prices are determined using transfer pricing methods. Below we outline internationally recognized TP methods.
Key Legal Issues
- To establish the arm’s length price, TP specialists apply transfer pricing methods.
- There are five main transfer pricing methods.
- Tax authorities may scrutinize the choice of the method, as well as the way it is being applied to the particular transaction.
- Malta introduced Transfer Pricing Regulations in November 2022.
Types of Transfer Pricing Methods
The OECD TP Guidelines outline five distinct transfer pricing methods. They are divided into two general categories: traditional transaction methods and transactional profit methods.
Traditional transaction methods make the comparison between the controlled and uncontrolled transaction(s) based on a direct comparison of prices, or gross margins. On the other hand, the transactional profit methods are generally based on an examination of net margins.
Traditional Transaction Methods
Traditional transaction methods comprise:
- the comparable uncontrolled price method – it compares the price of goods or services in a controlled transaction with prices applied in comparable transactions made between unrelated parties in comparable circumstances.
- the resale price method – it arrives at an arm’s length price by reducing the price at which a product purchased from an associated enterprise is resold to an independent enterprise by a resale price margin.
- the cost plus method – it uses as a starting point the costs incurred by the supplier of goods or services in a controlled transaction to which one adds a gross profit mark up.
These TP methods are explained in more detail in our article on Traditional transaction methods.
Transactional Profit Methods
Transactional profit methods include:
- the transactional net margin method – it examines an operating (net) profit that a taxpayer realizes from a controlled transaction divided by an appropriate metric, such as costs, sales, or assets.
- the transactional profit split method – it identifies and splits profits from a controlled transaction as would have been agreed between independent enterprises in comparable circumstances, depending on a relative contribution of each party.
These TP methods are outlined in more detail in our article on Transactional profit methods
The Choice of the TP Method
Under the OECD TP Guidelines, there is no hierarchy of transfer pricing methods. Nonetheless, traditional transaction methods are considered a most direct way of determining arm's length transfer prices. This is because they rely on comparable data from uncontrolled transactions with conditions that are highly similar to the transaction under review. These conditions include product, entity and market characteristics, contractual terms, assets employed in the transaction, functions and risks assumed by each party.
On the other hand, transactional profit methods do not have to look at comparable uncontrolled transactions involving identical or perhaps even broadly comparable products. Instead, they focus on the specific transactions between related parties. They may therefore rely more on internal data.
What This Means for You
In November 2022, Malta has introduced its first Transfer Pricing Regulations. Starting from year 2024, the Regulations impose transfer pricing documentation obligations on Malta resident companies engaging in intra-group transactions. It is expected that Malta tax authorities will ramp up their efforts in the fields of transfer pricing. Taxpayers involved in transactions with related entities should make sure that their transfer prices conform with the arm’s length principle. Transfer prices should be calculated using an appropriate TP method and ideally supported by comprehensive TP documentation.
How We Can Help
Our team of experienced advisors can help to identify, assess and mitigate potential transfer pricing risks in your business and to develop a sustainable, tax-efficient transfer pricing policy for the future. As a collaborating firm of Andersen, leading global Tax & Legal advisors, we offer the comfort of years of experience in this highly contentious area.
Get in touch with us to learn how we can help you to manage your transfer pricing risks so that your business remains in compliance with Malta TP laws whilst retaining its operational effectiveness.
