Transfer Pricing

Method
In The Light Of Bangladesh Income Tax Ordinance -1984
Monday, May 22, 2017
Arm’s Length Price (ALP) (1)

Comparable
uncontrolled
price method

Resale price
Other Method
method

ALP
Methods

Transactional
Cost plus
net margin
method
method

Profit split
method

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Most Appropriate Method

Nature and
class of the
Reliable and international
accurate transaction Comparability
adjustments factors(i.e.
industry,
contractual terms)
Factors to be
considered

Sensitivity of
results in the
deficiency in data Quality of
and assumptions Reliability of relevant data
assumptions

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Selection of the most appropriate transfer pricing method

Methods Preferred for

Comparable • Where an independent enterprise buys or sells products that are identical or very similar to
Uncontrolled those sold in the controlled transaction.
Price Method • Where services are rendered that are identical or very similar to those rendered in the
controlled transaction.

Resale Price • A distributor buying purely finished goods from a group company (if no CUP available)
Method

Cost Plus • Semi finished goods sold between related parties

Method • Contract/toll manufacturing agreement
• Long term buy/supply arrangements
• Involving manufacture, assembly or production of tangible products or services that are
sold/provided to AEs

Profit Split • Involving transfer of unique intangibles or in multiple international transactions that cannot be
Method evaluated separately.

Transactional • Tangible property, intangible property or services.

Net Margin • TNMM is applied to the least complex of the related parties involved in the controlled
Method transaction.

As per Chapter 6. TRANSFER PRICING METHODS of UN Practical Manual on Transfer Pricing and
Chapter II: Transfer Pricing Methods of OECD Transfer Pricing Guidelines

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Methods – A Synopsis

Product Functional
Methods Approach Remarks
Comparability Comparability

Very difficult to apply as very

Prices are
CUP Very High Medium high degree of comparability
benchmarked
required
Difficult to apply as high
GPM (on sales)
RPM High Medium degree of comparability
benchmarked
required
Difficult to apply as high
GPM (on costs)
CPLM High High degree of comparability
benchmarked
required
Complex Method, sparingly
PSM Medium Very High Profit Margins
used

TNMM Medium Very High Net Profit Margins Most commonly used Method

Any other
Used in special circumstances
Method
Traditional Transaction Methods
Comparable Uncontrolled Price Method

The CUP Method evaluates the “price” charged in a controlled transaction with reference to the
“price” charged in internal or external comparable uncontrolled transactions.

When applying the CUP method, an uncontrolled transaction is considered comparable to a

controlled transaction if:

 There are no differences in the transactions being compared that would materially affect the
price; or
 Reasonably accurate adjustments can be performed to account for material differences
between the controlled and the uncontrolled transaction.

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Comparable Uncontrolled Price
Method
 Most Direct Method for testing ALP and the Parent Co.
Prices are Benchmarked

Transfer Price
 Requires strict comparability in products,
contractual terms, economic terms, etc. Outside
 Two types of CUPs available - Internal CUP & Bangladesh
External CUP Bangladesh
 Calls for adjustments to be made for Sub Co. Unrelated Co. X
differences which could materially affect the
price in the open market e.g.:
• Difference in volume/quality of product Unrelated Co. Y

• Difference in credit terms

External CUP
• Risks assumed Outside
Bangladesh
• Geographic market
 OECD - Priority to Internal CUP over External Bangladesh
CUP due to higher degree of comparability
Unrelated Co. Z
Traditional Transaction Methods
Comparable Uncontrolled Price (CUP)

Identify price charged or paid for uncontrolled transactions

If identified price differs from the international transaction, Calculate

differential amount.

Adjust the price of international transaction by differential amount.

Adjusted price is taken as arm’s length price

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Traditional Transaction Methods
Strengths and Weaknesses of the CUP

The strengths of the CUP method are:

 It is a two‐sided analysis as the price used reflects the agreed price between two
unrelated parties to the transaction;
 It avoids the issue of which the related parties involved in the controlled transaction should
be treated as the tested party for transfer pricing purposes;
 It involves a direct transactional comparison of a similar transaction between unrelated
parties
 It may be more readily used in instances such as, for example, transactions involving
commodity products.

The weaknesses of the CUP method are:

 The weakness of the CUP method lies in the difficulty of finding comparable uncontrolled
transactions in the light of the comparability standards that must be observed, particularly
with respect to the comparability of products, intellectual property or services

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Traditional Transaction Methods
Examples of CUP:
CUP example 1: Comparable Sales of Same Product

MCO, a manufacturer, sells the same product to both controlled and uncontrolled distributors. The circumstances
surrounding the controlled and uncontrolled transactions are substantially the same, except that the controlled sales
price is a delivered price and the uncontrolled sales are made free on board (f.o.b.) MCO’s factory (which means
the buyer takes responsibility for delivery costs of the goods for the remainder of their transit). Differences in the
contractual terms of transportation and insurance generally have a definite and reasonably ascertainable effect on
price, and adjustments are made to the results of the uncontrolled trans-action to account for such differences. No
other material difference has been identified between the controlled and uncontrolled transactions. As MCO is
engaged in both controlled and uncontrolled transactions, it is likely that all material differences between the two
transactions have been identified. In addition, the Comparable Uncontrolled Price Method is applied to an
uncontrolled comparable with no product differences, and there are only minor contractual differences that have a
definite and reasonably ascertainable effect on price. The results of this application of the Comparable Uncontrolled
Price Method will therefore provide the most direct and reliable measure of an arm’s length result.

CUP example 2: Effect of Trademark

The facts are the same as in Example 1 except that MCO affixes its value-able trademark to the property sold in the
controlled transactions but does not affix its trademark to the property sold in the uncontrolled transactions. Under
the facts of this case the effect on price of the trade-mark is material and cannot be reliably estimated. As there are
material product differences for which reliable adjustments cannot be made the Comparable Uncontrolled Price
Method is unlikely to provide a reliable measure of the arm’s length result.

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Traditional Transaction Methods
Examples of CUP:

CUP example 3: Minor Product Differences

The facts are the same as in Example 1 except that MCO, which manufactures business machines, makes minor
modifications to the physical properties of the machines to satisfy specific requirements of a customer in controlled
sales. MCO does not however make these modifications in uncontrolled sales. Only if the minor physical differences
in the product have a material effect on prices should adjustments be made to the results of the uncontrolled
transactions to account for these differences. These adjusted results may then be used as a measure of the arm’s
length result.

CUP example 4: Effect of Geographic Differences

FM, a specialty radio manufacturer, sells its radios to a controlled distributor, AM, within the western region of
Country A. FM sells its radios to uncontrolled distributors to serve other regions in Country A. The product sold in the
controlled and uncontrolled transactions is the same and all other circumstances surrounding the controlled and
uncontrolled transactions are substantially the same other than the geo-graphic differences. If the geographic
differences are unlikely to have a material effect on price, or they have definite and reasonably ascertain-able effects
for which adjustments are made, then the adjusted results of the uncontrolled sales may be used under the
Comparable Uncontrolled Price Method to establish an arm’s length price. If the effects of the geographic differences
would be material but cannot be reliably ascertained, then the reliability of the results will be diminished. However,
the Comparable Uncontrolled Price Method may still provide the most reliable measure of an arm’s length result.

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Traditional Transaction Methods
Resale Price Method

The RPM is applicable where the property or services purchased from the AEs and
are sold to unrelated enterprise without significant value addition – i.e. in cases of
resale of property or services.

Compares the resale gross margin earned by associated enterprise with the resale
gross margin earned by comparable independent distributors.

The resale price method focuses on the related sales company which performs
marketing and selling functions as the tested party in the transfer pricing analysis.
Resale Price Method
 Compares the resale gross margin
earned by associated enterprise with
Parent Co.
the resale gross margin earned by
comparable independent distributors
Transfer Price
 Preferred method for a distributor USD 75 Outside
buying purely finished goods from a Bangladesh
group company (if no CUP available)
 To be applied when a goods purchased Resale Price Bangladesh
or service obtained from an AE is resold USD 100
Sub Co. Unrelated Co. Y
to an unrelated enterprise.
 Under this method comparability is less
dependent on strict product
comparability and additional emphasis
is on similarity of functions performed &
risks assumed

Price paid by Sub Co. to AE is at arm’s length if the 25% resale margin earned by Sub
Co. is more than margins earned by similar distributors
Traditional Transaction Methods
Resale Price Method
Identify the price at which product or service is resold to an independent
enterprise

The price is reduced by comparable normal gross margin

Adjust the price by other costs associated with purchase of the product
(e.g. Custom Duty)

Adjust the price again by material differences between the international

transaction & comparable transaction

Arms length Price as per RPM

Traditional Transaction Methods
Strengths and Weaknesses of the RPM:

The strengths of the RPM are:

 The method is based on the resale price, a market price, and thus represents a demand
driven method; in situations where there is a weak relationship between the costs incurred
and the sales price of a product or services (e.g. when demand is inelastic), the resale
price may be more reliable;
 The method can be used without forcing distributors to inappropriately make profits. The
distributor earns an arm’s length gross profit margin, however, but could have operating
losses due, for example, to high selling expenses caused by business strategies such as a
market penetration strategy;

The weaknesses of the RPM are:

 It may be difficult to find comparable data on gross margins due to accounting

inconsistencies; and
 The method involves a one‐sided analysis, as its focus is on the related sales company as
the tested party in the transfer pricing analysis.

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Traditional Transaction Methods
Examples of RPM:

Subsidiary (S) purchase an asset from Parent (P). Subsidiary (S)’s total reported cost BDT 800
consisting BDT 600 property purchased from Parent (P) and BDT for other cost of goods sold
incurred to unrelated parties. Subsidiary (S)’s applicable resale price and reported gross profit
are as follows:

Applicable resale price......................................BDT 1,000

Cost of goods sold:

Cost of purchases from Parent (P)....................BDT 600
Costs incurred to unrelated parties....................BDT 200
Reported gross profit.........................................BDT 200 (25%)

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Traditional Transaction Methods
Examples of RPM:
Arm’s Given Price
Length
Associated Price? Associated Enterprises Independent
Enterprises 1 2 Enterprise

Given price =US$100

Resale price margin (25%) =US$ 25
Arm’s length price =US$ 75

It is assumed that the resale price is $100. This means that Associated Enterprise 2 resells the
bicycle to Independent Enterprise for $100. If we assume that an arm’s length gross profit
margin that Associated Enterprise 2 should earn is 25 per cent, Associated Enterprise 2 should
cover its SG&A expenses and make an appropriate profit with this 25 per cent gross margin.
The resulting transfer price between Associated Enterprise 1 and Associated Enterprise 2 (i.e.
the cost of goods sold of Associated Enterprise 2) is $75 (i.e. $100 x (1‐0.25).

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Traditional Transaction Methods
Examples of RPM:
RPM example 3:

SCO, a Country B corporation, is the distributor for FP, its foreign parent. There are no changes in the beginning
and ending inventory for the year under review. SCO’s total reported cost of goods sold is $800, consisting of $600
for property purchased from FP and $200 for other costs of goods sold incurred to unrelated parties. SCO’s
applicable resale price and reported gross profit are as follows:

Applicable resale price . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1 000

Cost of goods sold:
Cost of purchases from FP . . . . . . . . . . . . . . . . . . . . . . . .... $600
Costs incurred to unrelated parties . . . . . . . . . . . . . . . … …$200
Reported gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . …$200

The local taxing authority determines that the appropriate gross profit margin is 25 per cent. Therefore, SCO’s
appropriate gross profit is $250 (i.e. 25 per cent of the applicable resale price of $1000). As SCO is incur-ring costs
of sales to unrelated parties, an arm’s length price for property purchased from FP must be determined under a
two-step process. First, the appropriate gross profit ($250) is subtracted from the applicable resale price ($1000).
The resulting amount ($750) is then reduced by the costs of sales incurred to unrelated parties ($200). Therefore,
an arm’s length price for SCO’s cost of sales of FP’s product in this case equals $550 (i.e., $750 minus $200) and
not $600.

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Traditional Transaction Methods
Examples of RPM:
RPM example 4:

A controlled taxpayer sells property to another member of its controlled group which resells the property in uncontrolled sales.
It is for all practical purposes assumed that there are no changes in the beginning and ending inventory for the year under
review. Information regarding an uncontrolled comparable is sufficiently complete to conclude that it is likely that all material
differences between the controlled and uncontrolled transactions have been identified and adjusted for. If the applicable
resale price of the property involved in the controlled sale is $100 and the appropriate gross profit margin is 20 per cent, then
an arm’s length result of the controlled sale is a price of $80 ($100 - (0.2%×$100)).

RPM example 5:

FM, a foreign manufacturer, sells Product to UCO, its subsidiary in Country U, which in turn sells Product to its domestic
affiliate BCO. BCO sells Product to unrelated buyers. In this case, the applicable resale price is the price at which BCO sells
Product in uncontrolled transactions. The determination of the appropriate gross profit margin for the sale from UCO to BCO
will take into account the functions performed by UCO and BCO, as well as other relevant factors.

RPM example 6:

TCO, a Country T corporation, is the exclusive distributor of products for its foreign parent. To determine whether the gross
profit margin of 25 per cent earned by TCO is an arm’s length result, the local taxing authority considers applying the Resale
Price Method. There are several uncontrolled distributors that perform similar functions under similar circumstances in
uncontrolled transactions. However, the uncontrolled distributors treat certain costs such as discounts and insurance as cost
of goods sold, while TCO treats such costs as operating expenses. In such cases, accounting reclassifications must be made
to ensure consistent treatment of such material items. Inability to make such accounting reclassifications will decrease the
reliability of the results of the uncontrolled transactions.

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Traditional Transaction Methods
Examples of RPM:
RPM example 7:

WCO, a Country W corporation, manufactures Product Z, an unbranded product, and sells it to RCO, its wholly
owned foreign subsidiary. RCO acts as a distributor of Product Z in Country R, and sells it to uncontrolled parties
in that country. Uncontrolled Distributors A, B, C, D, and E distribute competing products of approximately similar
value in Country R. All such products are unbranded.

Relatively complete data is available regarding the functions performed and risks borne by the uncontrolled
distributors and the contractual terms under which they operate in the uncontrolled transactions. In addition, data
is available to ensure accounting consistency between all of the uncontrolled distributors and RCO. As the
available data is sufficiently complete and accurate to conclude that it is likely that all material differences between
the controlled and uncontrolled transactions have been identified; such differences have a definite and reasonably
ascertainable effect; and reliable adjustments are made to account for such differences, the results of each of the
uncontrolled distributors may be used to establish an arm’s length range.

RPM example 8:

The facts are the same as in Example 7, except that sufficient data is not available to determine whether any of
the uncontrolled distributors provide warranties or to determine the payment terms of the contracts. As differences
in these contractual terms could materially affect price or profits, the inability to determine whether these
differences exist between the controlled and uncontrolled transactions diminishes the reliability of the results of the
uncontrolled comparables. However, the reliability of the results may be enhanced by the application of a
statistical method when establishing an arm’s length range.
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Traditional Transaction Methods
Examples of RPM:

RPM example 9:

The facts are the same as in Example 7, except that Product Z is branded with a valuable trademark that is
owned by WCO. Companies A, B, and C distribute unbranded competing products, while Companies D and E
distribute products branded with other trademarks. Companies D and E do not own any rights in the trademarks
under which their products are sold. The value of the products that Companies A, B, and C sell are not similar to
the value of the products sold by S. The value of products sold by Companies D and E, however, is similar to
that of Product X.

Although close product similarity is not as important for a reliable application of the Resale Price Method as for
the Comparable Uncontrolled Price Method, significant differences in the value of the products involved in the
controlled and uncontrolled transactions may affect the reliability of the results. In addition, because in this case
it is difficult to determine the effect the trademark will have on price or profits, reliable adjustments for the
differences cannot be made. Because transactions involving Companies D and E have a higher level of
comparability than those involving Companies A, B, and C with Company S, only transactions involving
Companies D and E may be included in determining the arm’s length gross margin.

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Traditional Transaction Methods
Cost Plus Method (CPLM)

 Compares and identifies the mark up earned on direct and indirect costs incurred with that
of comparable independent companies.

 It involves comparison of the normal gross profit mark-up on costs earned by a service
provider or manufacturers to the gross profit mark-up earned by service providers or
manufacturers in uncontrolled conditions.

 In a controlled transaction involving tangible property the cost plus method focuses on the
related manufacturing company as the tested party in the transfer pricing analysis. The cost
plus method may also be used in the case of services rendered.

 The cost plus method is used to analyze transfer pricing issues involving tangible property
or services.
 Cost Plus Method
 Compares and identifies the mark up earned on
direct and indirect costs incurred with that of Parent Co.
comparable independent companies
 Preferred method in case Transfer Price
USD 125
• Semi finished goods sold between related Outside
parties Bangladesh
• Contract/toll manufacturing agreement Bangladesh
Sub Co.
• Long term buy/supply arrangements

USD 70
 To be applied in cases involving manufacture,

COGS
assembly or production of tangible products or
services that are sold/provided to AEs
 Comparability under this method is not as much
dependent on close physical similarity between Co. Y / AE Co. Z
the products.
 Larger emphasis on functional comparability

Price charged by Sub co to AE is at arm’s length if the 25% mark up on

cost is more than that of similar assemblers
Traditional Transaction Methods
Cost Plus Method (CPLM)

Cost base (direct & indirect cost) for the supply of property or the provision of services are determined.

A comparable profit mark-up (based on comparable accounting policies) is identified.

Appropriate adjustment is then made to the comparable profit mark-up taking account of
material differences between the international transactions and the comparable
uncontrolled transactions.

The adjusted profit mark-up is then added to the cost base.

The sum so arrived at is taken to be the arm’s length price of the property transferred or
services provided in the international transaction.
Traditional Transaction Methods
Strengths and Weaknesses of the CPLM:

The strengths of the CPLM are:

 This method is based on internal costs, the information on which is usually readily
available to the multinational enterprise.

The weaknesses of the CPLM are:

 There may be a weak link between the level of costs and the market price;

 The data on mark‐up gross margins may not be comparable due to accounting
inconsistencies and other factors;

 Accounting consistency is required between the controlled and uncontrolled transactions;

 The analysis focuses only on the related party manufacturer; and

 Since the method is based on actual costs, there may be no incentive for the controlled
manufacturer to control costs.

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Traditional Transaction Methods
Examples of CPLM:
Arm’s Length Price?
Associated Associated
Enterprises 1 Enterprises 2

Costs for Associated Enterprise 1 = BDT 500

Gross Profit Mark Up (50%) = BDT 250
Arm’s Length Price = BDT 750

It is assumed that Associated Enterprise 1, a bicycle manufacturer that manufactures bicycles under
contract for Associated Enterprise 2, earns a gross profit mark‐up of 15 per cent on its cost of goods
sold and classifies certain expenses (like warranty expenses) as operating expenses that are not
part of cost of goods sold. Four comparable independent manufacturers are identified which earn
gross profit mark‐ups between 10 to 15 per cent. However, these comparable companies account
for those particular (warranty) expenses as cost of goods sold. The unadjusted gross profit
mark‐ups of these comparables are thus not calculated on the same basis as the gross profit
mark‐up of Associated Enterprise 1. Unless reliable adjustments may be made to the calculation of
the gross profit mark‐ups of the uncontrolled transactions or, in the alternative, of Associated
Enterprise 1, for purposes of consistency, a net margin method may be more reliable.

26
Traditional Transaction Methods
Examples of CPLM:
CPM example 3:

LCO, a domestic manufacturer of computer components, sells its products to FS, its foreign distributor. UT1, UT2,
and UT3 are domestic computer component manufacturers that sell to uncontrolled foreign purchasers. Relatively
complete data is available regarding the functions performed and risks borne by UT1, UT2, and UT3, and the
contractual terms in the uncontrolled transactions. In addition, data is available to ensure accounting consistency
between all the uncontrolled manufacturers and LCO. As the available data is sufficiently complete to conclude that
it is likely that all material differences between the controlled and uncontrolled transactions have been identified,
the effect of the differences is definite and reasonably ascertainable, and reliable adjustments are made to account
for the differences, an arm’s length range can be established.

CPM example 4:

The facts are the same as in Example 3 except that LCO accounts for supervisory, general, and administrative
costs as operating expenses, which are not allocated to its sales to FS. The gross profit mark-ups of UT1, UT2,
and UT3, however, reflect supervisory, general, and administrative expenses because they are accounted for as
costs of goods sold. Accordingly, the gross profit mark-ups of UT1, UT2, and UT3 must be adjusted to provide
accounting consistency. If data is not sufficient to determine whether such accounting differences exist between
the controlled and uncontrolled transactions the reliability of the results will decrease.

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Traditional Transaction Methods
Examples of CPLM:
CPM example 5:

The facts are the same as in Example 3 above, except that under its contract with FS, LCO uses materials
consigned by FS. UT1, UT2, and UT3, on the other hand, purchase their own materials, and their gross profit mark-
ups are determined by including the costs of the materials. The fact that LCO does not carry an inventory risk by
purchasing its own materials, while the uncontrolled producers carry inventory, is a significant difference that may
require an adjustment if the difference has a material effect on the gross profit mark-ups of the uncontrolled
producers. Inability to reasonably ascertain the effect of the difference on the gross profit mark-ups will affect the
reliability of the results of UT1, UT2, and UT3.

CPM example 6:

FS, a foreign corporation, produces apparel for PCO, its parent corporation. FS purchases its materials from
unrelated suppliers and produces the apparel according to designs provided by PCO. The local taxing authority
identifies ten uncontrolled foreign apparel producers that operate in the same geographic market and are similar in
many respects to FS.

Relatively complete data is available regarding the functions performed and risks borne by the uncontrolled
producers. In addition, data is sufficiently detailed to permit adjustments for differences in accounting practices.
However, sufficient data is not available to determine whether it is likely that all material differences in contractual
terms have been identified. For example, it is not possible to determine which parties in the uncontrolled transactions
bear currency risks. As the differences in these contractual terms could materially affect price or profits, the inability
to determine whether differences exist between the controlled and uncontrolled transactions will diminish the
reliability of these results. Therefore, the reliability of the results of the uncontrolled transactions must be enhanced.

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Transaction Profit Methods
Transactional Net Margin Method (TNMM)

The TNMM examines the net profit margin relative to an appropriate base (e.g. costs, sales,
assets) that a taxpayer realizes from a controlled transaction (or transactions that are appropriate
to be aggregated).

The TNMM is used to analyze transfer pricing issues involving tangible property, intangible property
or services. It may be applied when one of the associated enterprises employs intangible assets,
the appropriate return to which cannot be determined directly

Net margins are less affected by transactional differences than price and less affected by
functional differences than gross margins. Product and functional comparability are thus less
critical in applying the TNMM;
Transactional Net Margin
Method
 Examines net operating profit from
transactions as a percentage of a certain
base (can use different bases i.e. costs,
turnover, etc) in respect of similar parties Parent A Unrelated Cos.
 Ideally, operating margin should be compared
to operating margin earned by same
Outside
enterprise on uncontrolled transaction –
Bangladesh
Internal TNMM
 Broad level of product comparability and
Bangladesh
high level of functional comparability Subsidiary B Unrelated Cos.

 Applicable for any type of transaction and Net margin 5% Net margin 3%
often used to supplement analysis under
other methods
 The application of the TNMM to a specific
tested party breaks down when factors other
than transfer prices have a material impact
upon profits
Transactional Net Margin
Method
 Grouping of transaction - Relevant controlled transactions require to be aggregated to test whether
the controlled transaction earn a reasonable margin as compared to uncontrolled transaction
 Selection of tested party - Least complex entity
 Selection of Profit Level Indicator such as Operating Margin, Return on Value added expenses,
Return on assets – Unaffected by transfer price
 Benchmarking exercise
• Entity with similar industry classification to the tested party – through search in local and
global databases
• Screen entities by applying appropriate quantitative filters
• Review financial and textual information available in the public database of the selected entities
– for qualitative filters
• Computation of ALP

Usually regarded as an indirect and one-sided method, but is most widely

adopted
Transaction Profit Methods
Transactional Net Margin Method (TNMM)

Net profit margin earned by the associated enterprise from the international transaction, is
computed having regard to an appropriate base such as costs, sales or assets.

Net profit margin earned by an independent enterprise from comparable uncontrolled

transaction is computed having regard to the same base.

Appropriate adjustment is then made to the net profit margin to take account of material
differences between international transactions and the comparable uncontrolled transactions.

The adjusted net profit margin is then applied to the base to arrive at the arm’s length price in
relation to the international transaction.
Traditional Transaction Methods
Strengths and Weaknesses of the TNMM:
The strengths of the TNMM are:

 Net margins are less affected by transactional differences than price and less affected by
functional differences than gross margins. Product and functional comparability are thus less
critical in applying the TNMM;
 Less complex functional analysis is needed, as TNMM is applied to only one of the related
parties involved;
 Because TNMM is applied to the less complex party, it can be used even though one of the
related parties holds intangible assets for which comparable returns cannot be determined;
 The TNMM is applicable to either side of the controlled transaction (i.e. to either the related
party manufacturer or the distributor); and
 The results resemble the results of a modified resale price / cost plus method of analysis.
The weaknesses of the TNMM are:

 Net margins are affected by factors (e.g. variability of operating expenses) that do not have
an effect, or have a less significant effect, on price or gross margins.
 Information challenges, including the unavailability of information on profits attributable to
uncontrolled transactions;

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Traditional Transaction Methods
Strengths and Weaknesses of the TNMM (continued)

 Net margins are affected by factors (e.g. variability of operating expenses) that do not have
an effect, or have a less significant effect, on price or gross margins.
 Information challenges, including the unavailability of information on profits attributable to
uncontrolled transactions;
 Measurement challenges: these may make it difficult to determine sales revenue, operating
expenses and assets relating only to the relevant controlled transactions or functions in
order to calculate the selected profit level indicator.
 TNMM is applied to only one of the related parties involved. The arm’s length net margin
found may thus result in an extreme result for the other related parties involved in the
controlled transaction (e.g. operating losses to one of the parties while the other party is
guaranteed a net profit).

34
Traditional Transaction Methods
Examples of TNMM:
TNMM example 1:

In applying the TNMM to the tested party distributor the resale price and the operating expenses of the related
party distributor are known, while the arm’s length net profit margin (i.e. net profit to sales ratio)13 is found on
the basis of a benchmarking analysis.

The cost of goods sold and the gross profit are the unknown variables. Assuming a resale price of $10,000,
operating expenses of $2,000 and an arm’s length net profit margin of 5%, using the TNMM the transfer price of
$7,500 is determined by working backwards using the available information. That is, a transfer price of $7,500
is required to ensure that the distributor earns a net profit margin of 5%.

Mechanism of TNMM applied on Related Party Distributor:

Initially Benchmarking
analysis
Resale price $10,000 $10,000
Cost of goods sold ? $7,500
Gross profit ? $2,500
Operating expenses $2,000 $2,000
Operating profit ? $500 (5% of resale price)

35
Traditional Transaction Methods
Examples of TNMM:

TNMM example 3: Transfer of Tangible Property Resulting in No Adjustment

FP is a publicly traded Country A corporation with a Country B subsidiary named BCO that is under audit for
its 2009 taxable year. FP manufactures a consumer product for worldwide distribution. BCO imports the
assembled product and distributes it within Country B at the wholesale level under the FP name.

FP does not allow uncontrolled taxpayers to distribute the product. Similar products are produced by other
companies but none of them is sold to uncontrolled taxpayers or to uncontrolled distributors.

Based on all the facts and circumstances, Country B’s taxing authority determines that the TNMM will
provide the most reliable measure of an arm’s length result. BCO is selected as the tested party because it
engages in activities that are less complex than those undertaken by FP.
There is data from a number of independent operators of wholesale distribution businesses. These potential
comparables are further narrowed to select companies in the same industry segment that perform similar
functions and bear similar risks to BCO. An analysis of the information available on these taxpayers shows
that the ratio of operating profit to sales is the most appropriate profit level indicator, and this ratio is relatively
stable where at least three years are included in the average. For the taxable years 2007 to 2009, BCO
shows the following results:

36
Traditional Transaction Methods
Examples of TNMM:
2007 2008 2009 Average
Sales $500,000 $560,000 $500,000 $520,000
COGS $393,000 $412,400 $400,000 $401,800
Operating expenses $80,000 $110,000 $4,600 $98,200
Operating profit $27,000 $37,600 (4,600) $20,000

After adjustments have been made to account for identified material differences between BCO and the
uncontrolled distributors, the average ratio of operating profit to sales is calculated for each of the uncontrolled
distributors. Applying each ratio to BCO would lead to the following comparable operating profit (COP) for
BCO:

The data is not sufficiently complete to conclude that it is likely that all material differences between BCO and
the uncontrolled distributors have been identified. The Country B taxing authority measures the arm’s length
range by the interquartile range of results, which consists of the results ranging from $19,760 to $34,840.
Although BCO’s operating income for 2009 shows a loss of $4,600, the tax authority determines that no
allocation should be made, because BCO’s average reported operating profit of $20,000 is within this range.

37
Traditional Transaction Methods
Examples of TNMM:
Uncontrolled Distributor OP/S (%) COP ($)
A 1.7 8,840
B 3.1 16,120
C 3.8 19,760
D 4.5 23,400
E 4.7 24,440
F 4.8 24,960
G 4.9 25,480
H 6.7 34,840
I 9.9 51,480
J 10.5 54,600
38
Transaction Profit Methods
Profit Split Method (PSA)

 Applied to multiple international transactions that cannot be evaluated separately.

 The profit split method is typically applied when both sides of the controlled
transaction contribute significant intangible property.

 The profit split method might be used in cases involving highly interrelated
transactions that cannot be analyzed on a separate basis.
Profit Split Method

 To be applied in cases involving transfer of

unique intangibles or in multiple international
transactions that cannot be evaluated
US Co A –
separately
Technology
 Calculates the combined operating profit intangibles
resulting from an inter-company transaction Outside
based on the relative value of each AEs Bangladesh
contribution to the operating profit
Bangladesh
 Evaluates allocation of combined profit/loss
in controlled integrated transactions Mfg. Co B

 The contribution made by each party is based

upon a functional analysis and valued, if
possible, using external comparable data Mkt Co C
Marketing
 The two methods discussed by OECD intangibles
Guidelines:
• Contribution PSM Analysis
• Residual PSM Analysis
Transaction Profit Methods
Profit Split Method(PSM)

The combined profit is identified arising from international transaction or

transactions and divisible among the associated enterprises.

The combined profit is then divided among the associated enterprises based
on relative contribution or basic return.

The profit thus allocated to the assessee is taken to be the arm’s length price.
Traditional Transaction Methods
Strengths and Weaknesses of the PSM:
The strengths of the PSM are:

 It is suitable for highly integrated operations for which a one sided method may not be
appropriate;
 It is suitable in cases where the traditional methods prove inappropriate due to a lack of
comparabletransactions;
 The method avoids an extreme result for one of the associated enterprises involved due to its
two‐sided approach (i.e. all parties to the controlled transaction are being analyzed); and
 This method is able (uniquely among commonly used transfer pricing methods) to deal with
returns to synergies between intangible assets or profits arising from economies of scale.

The weaknesses of the PSM are:

 The relative theoretical weakness of the second step.

 Its dependence on access to data from foreign affiliates.
 Certain measurement problems exist in applying the profit split method. It may be difficult to
calculate combined revenue and costs for all the associated enterprises taking part in the
controlled transactions due to, for example, differences in accounting practices. It may also be
hard to allocate costs and operating expenses between the controlled transactions and other
activities of the associated enterprises.

42
Traditional Transaction Methods
Examples of PSM (continued)
How to apply Residual Profit Split Method?

Particulars BD BDT
T
Combined Group Profits 200
Assign basic return to each entity
•Entity X 60
•Entity Y 40
•Entity Z 20 120
Residual profit 80
Contribution analysis (based on relative contribution of the
entities)
•Entity X 60
•Entity Y 20

Contribution Analysis – Element of subjectivity

43
Traditional Transaction Methods
Examples of PSM (continued)
Application of Residual Profit Split

 XYZ is a corporation that develops, manufactures and markets a line of products for use by the
police in Country A. XYZ’s research unit developed a bulletproof material for use in protective
clothing and headgear (Stelon). XYZ obtains patent protection for the chemical formula for Stelon.
Since its introduction, Stelon has captured a substantial share of the market for bulletproof
material.
 XYZ licensed its Asian subsidiary, XYZ-Asia, to manufacture and market Stelon in Asia. XYZ-Asia
is a well-established company that manufactures and markets XYZ products in Asia. XYZ-Asia
has a research unit that adapts XYZ products for the defence market, as well as a well-developed
marketing network that employs brand names that it has developed.
 XYZ-Asia’s research unit alters Stelon to adapt it to military specifications and develops a high-
intensity marketing campaign directed at the defence industry in several Asian countries.
Beginning with the 2009 taxable year, XYZ-Asia manufactures and sells Stelon in Asia through its
marketing network under one of its brand names.

44
Traditional Transaction Methods
Examples of PSM (continued)
Application of Residual Profit Split

 For the 2009 tax year XYZ has no direct expenses associated with the license of Stelon to XYZ-
Asia and incurs no expenses related to the marketing of Stelon in Asia. For the 2009 tax year
XYZ-Asia’s Stelon sales and pre-royalty expenses are $500 Million and $300 Million, respectively,
resulting in net pre-royalty profit of $200 Million related to the Stelon business. The operating
assets employed in XYZ-Asia’s Stelon business are $200 Million. Given the facts and
circumstances, Country A’s taxing authority determines that a residual profit split will provide the
most reliable measure of an arm’s length result. Based on an examination of a sample of Asian
companies performing functions similar to those of XYZ-Asia the district director determines that
an average market return on XYZ-Asia’s operating assets in the Stelon business is 10 per cent,
resulting in a market return of $20 Million (10% x $200 Million) for XYZ-Asia’s Stelon business,
and a residual profit of $180 Million.

 Since the first stage of the residual profit split allocated profits to XYZ-Asia’s contributions other
than those attributable to highly valuable intangible property, it is assumed that the residual profit
of $180 Million is attributable to the valuable intangibles related to Stelon, i.e. the Asian brand
name for Stelon and the Stelon formula (including XYZ-Asia’s modifications). To estimate the
relative values of these intangibles the taxing authority compares the ratios of the capitalized value
of expenditures as of 2009 on Stelon-related research and development and marketing over the
2009 sales related to such expenditures.
45
Traditional Transaction Methods
Examples of PSM (continued)
Application of Residual Profit Split
 As XYZ’s protective product research and development expenses support the worldwide protective
product sales of the XYZ group, it is necessary to allocate such expenses among the worldwide
business activities to which they relate. The taxing authority determines that it is reasonable to
allocate the value of these expenses based on worldwide protective product sales. Using
information on the average useful life of its investments in protective product research and develop-
ment, the taxing authority capitalizes and amortizes XYZ’s protective product research and
development expenses. This analysis indicates that the capitalized research and development
expenditures have a value of $0.20 per dollar of global protective product sales in the 2009 tax year.

 XYZ-Asia’s expenditures on Stelon research and development and marketing support only its sales
in Asia. Using information on the average useful life of XYZ-Asia’s investments in marketing and
research and development the taxing authority capitalizes and amortizes XYZ-Asia’s expenditures
and determines that they have a value in 2009 of $0.40 per dollar of XYZ-Asia’s Stelon sales.

 Thus, XYZ and XYZ-Asia together contributed $0.60 in capitalized intangible development
expenses for each dollar of XYZ-Asia’s protective product sales for 2009, of which XYZ contributed
a third (or $0.20 per dollar of sales). Accordingly, the taxing authority determines that an arm’s
length royalty for the Stelon license for the 2009 taxable year is $60 Million, i.e. one-third of XYZ-
Asia’s $180 Million in residual Stelon profit.

46
Thank you