Transfer Pricing — Tangible Property

(From “A Primer on Transfer Pricing” by Robert J. Misey, Jr., updated by Kimberlee S. Phelan)

Reminder of the example: NJCo manufactures and sells widgets in the U.S. Due to increased widget orders from Canadian customers, NJCo decides to form a Canadian distribution subsidiary (“CanSub”). Although CanSub does not have any manufacturing functions, CanSub employs its own administrative and sales staff while using NJCo’s unique distribution software to ensure that there are not any distribution problems. In an effort to make sure that CanSub is financially solvent, CanSub has payment terms to NJCo of six months and, if CanSub’s customers do not pay, CanSub enjoys the use of NJCo’s collection staff, which is comprised of former defensive linemen from Rutgers.

Tangible Property

The sale from NJCo to CanSub of widgets constitutes a sale of tangible property, which is the type of intercompany transaction tax professionals traditionally contemplated when reviewing transfer pricing. The arm’s length amount charged in intercompany transactions involving tangible property should be tested under one of the following methods: the comparable uncontrolled price method, the resale price method, the cost plus method, the profit split method, and the comparable profits method. [i]

The comparable uncontrolled price (“CUP”) method compares amounts charged in intercompany transactions with amounts charged in comparable third party transactions. [ii] If NJCo can find a comparable sale of its product to a third party, NJCo may try to apply the CUP method. For example, NJCo may try to compare sales to a major customer with sales to CanSub. However, the stringent comparability requirements regarding sales volume, geographic markets, currency exchange, and others may make the sales to the major customer uncomparable.

The resale price method (“RPM”) evaluates whether the amount charged in an intercompany transaction is at arm’s length by reference to the gross margin a comparable reseller would realize. [iii] For example, if CanSub can find comparable distributors of widgets in Canada, it may try to apply the RPM. However, the presence of different functions performed and risks assumed by the comparable distributors (i.e., a marketing function or sales functions), and the difficulty in obtaining the gross margin of these companies may affect the applicability of this method.

The cost plus method compares the gross margins on intercompany sales with gross margins on third party sales. [iv] For example, if NJCo receives a five- percent mark-up on its sales to CanSub and a five percent mark-up on sales to third parties, NJCo’s sales should be at arm’s length. However, as with the CUP method, the intercompany and third party sales may face a host of comparability problems.

The profit split methods allocate operating profits from intercompany transactions in proportion to the relative contributions of each party in creating the combined profits. [v] NJCo should review the functions performed, risks assumed, resources employed, and costs incurred to determine relative contributions. There are two types of profit split methods – the comparable profit split method and the residual profit split method. Although many foreign taxing authorities favor profit splits, profit splits are hard for the tax professional to apply because they involve the extremely difficult task of finding two unrelated companies that have functions, risks, and transactions comparable to NJCo and CanSub.

The comparable profits method (“CPM”) compares the profitability of the less complex party (“CanSub”) to that of comparable companies. [vi] As with profit splits, the CPM is based on profits rather than individual transactions. In applying the CPM, the analyst will choose a financial ratio for CanSub and determine if CanSub’s ratio is in the interquartile range for all comparable distributors. Two factors make the CPM easy to use: 1) comparability is based on functions performed and risks assumed, as opposed to comparability of product, and 2) financial information is easily derived from information that public companies disclose. Finally, although other countries have not shown enthusiasm for the CPM, the CPM is arguably similar to Canada’s Transaction Net Margin Method and is clearly the method of choice for the I.R.S.’ International Examiners.