What is Transfer Pricing - What you need to know!

The overall principle behind transfer pricing legislation is that the price at which transactions between connected parties are effected should be the same as the price which would be negotiated between independent parties acting at arm’s length.

TP rules are designed to prevent groups structuring intra-group transactions so as to artificially increase the level of profits realised in low-tax jurisdictions or to understate the level of profits realised in high-tax jurisdictions.

So what does this actually mean?

Think of it this way, imagine if Company A manufactures solar panels and is based in Ireland. The group, also have a company in France that is used as a sales and distribution company for the French market.

If it costs €500 to make the solar panels and they can be sold for €1,000, then the group will make €500 profit (ignoring any ancillary costs).

Where TP Rules didn’t exist

Ireland’s CIT rate is 12.5% while France’s rate is 28%+. Therefore, if Transfer Pricing rules didn’t exist, multinationals such as this one could manipulate where they pay tax by shifting profits. So, ignoring transfer pricing, the following could occur:

- Company A in Ireland sells solar panel to Company B in France for €990 Taxable Profit = €490 [990 sale – 550 cost]

- Company B sells to customer in France for €1,000 Taxable Profit = €10 [1,000 sale – 990 cost]

Total Profit = €500

Looking at the above, Company A charged as much profit as it could to retain substantial profits in Ireland where the tax rate is lower. When the French company sells the product, it paid €990 for it, and sold it for €1,000 thereby only realising €10 profit that is available to tax at the higher rate. This is called profit shifting.

The above example would result in the following tax being paid:

- Ireland CIT Return - €490 x 12.5% = €61.25

- France CIT Return - €10 x 28% = €2.80

- Total Tax Bill for the group = €64.05

Where TP Rules exist

If TP rules required the Irish entity to charge its connected company ‘cost +40%’, then the Irish company would sell the product to the French connected company for €700 (500+30%). Thereby realising a €200 profit in Ireland and subsequently a €300 profit in France. The tax calculation would therefore look like:

- Ireland CIT Return - €200 x 12.5% = €25

- France CIT Return - €300 x 28% = €84

- Total Tax Bill for the group = €109

Key Observations

If you notice from the above, the multinational is paying 70% more tax than in scenario 1. What is also noted is that the company is now paying 30 times more tax in France! I think you can now understand why there is so much debate in this area and why at times it can be a contentious area of discussion. Remember the above example when reading the rules below.

What is the appropriate transfer pricing method?

Broadly, there are five methods which may be used to set an appropriate transfer price. All of these methods seek to replicate the conditions of an independent transaction. Selecting a transfer pricing method always aims at finding the most appropriate method for the particular transaction and that no one method is suitable for every possible situation. The selected method will depend on the nature of the transaction and the available comparable transactions.

1. Comparable Uncontrolled Price (“CUP”)

This is the most straight-forward method of transfer pricing as it simply relies on the price at which the entity in question sells its goods and services to unrelated parties. The price charged on the sale to the independent customer is assumed to be at a commercial level.

Problems arise where the entity does not sell the goods/services to unrelated customers so that the price must be based on what competitors charge for the particular good/service. This information can be difficult to obtain.

Sometimes adjustments may be required to the CUP to reflect differences in the related party transaction and a third party transaction. For example, if a Company A intended to sell 1 million laptops to its related entity Company B and sought to use a comparable transaction where Company X sold 1,000 extremely similar laptops to an unrelated party, an adjustment would likely be required to the price charged by Company A to Company B to reflect the size of the order (ie Company B would expect a discount on the per unit price).

The CUP method is problematic where there is no independent market for the particular good or service, i.e. it is a component used in the production of an item which is then sold to third parties.

2. Resale price method

Under this method the price that the buyer sells the product or service to a third party is reduced by an appropriate gross margin for the intra-group buyer to arrive at the price which the intra-group should pay for the goods.

This method is appropriate for marketing or distribution operations. The price ensures that the reseller is compensated for costs incurred and earns a profit for the functions performed, any assets employed and risks borne.

The resale price method will only be appropriate where the functions undertaken by the reseller are not materially different to the functions undertaken by the reseller under the comparable third party transaction.

The resale price margin tends to be easier to determine when the reseller does not add substantially to the value of the product.


Company A sells laptops through independent distributors in four countries. The distributors market the product and earn a 5% margin.

Company A decides to set up a subsidiary in Singapore. This is Company A’s first time to sell into an Asian market and it hopes that, if it is successful, it will begin to sell in more countries in the region. The Singapore subsidiary is not permitted to sell any other products and must also provide technical support to Singapore customers who buy the laptops.

Even if all other elements of the contract are similar to the contracts entered into with the four independent parties, the 5% margin will not be an arm’s length remuneration for the Singapore subsidiary. It should be entitled to earn a higher margin by reference to the restriction imposed on its ability to sell other products and the additional technical support it will provide.

In this case, it may be difficult to adjust the price paid to the independent distributors to reflect the additional functionality undertaken by the Singapore subsidiary and it may be the case that different comparables will be required.

3. Cost plus

Applying this method, the arm’s length price is determined as a mark-up on costs (direct and indirect) incurred in providing the good or service.

This method is often used for manufacturers and intra-group services where, as noted above, there may not be an independent market for the particular good or service as it is used in the production of other goods which are then sold to third parties.

Appropriate profit margin should be determined based on the particular functions performed by the Vendor Company in providing the good or service.

The cost plus method is usually only appropriate where the entity charging the cost-plus price carries out limited functions and assumes limited risks.


Company A has a subsidiary in the UK. The UK subsidiary is engaged by Company A to carry out R&D. Company A directs the R&D and assumes all of the risks related to the R&D. Once the R&D is completed Company A will own any IP that has been developed.

It is likely that in this scenario that the UK subsidiary would be remunerated on a cost plus basis. The level of increment above the costs incurred might reflect how innovative and complex the research was.

4. Transactional Net Margin Method (“TNNM”)

If the methods described above cannot be reliably used, the TNNM is often used.

This method requires the identification of a net profit indicator (eg return on assets, return on sales, profit in excess of costs). It operates similarly to the RSPM and CPM, except that while those methods reference gross profits, the TNMM typically references net profits. Information regarding the net profit margins of third parties is more likely to be available in financial statements and that is one of the reasons why the TNMM is frequently used. The selected net profit indicator should be appropriate to the transaction and the functions carried on by the parties.

Once the net profit indicator is identified, the base to which the indicator is applied should be identified. Sales or distribution operating expenses might be an appropriate base for distribution activities. Full costs or operating expenses might be an appropriate base for a service or manufacturing activity. Operating assets might be an appropriate base for capital-intensive activities such as manufacturing.

Application of the TNMM requires selection of the ‘tested party’, ie, which of the parties to the transaction should the price be determined by reference to. The tested party should always be the entity that carries on the more routine functions (ie that is the party that should earn the price determined by reference to costs or sales). The other party should be the entrepreneur in the transaction, the entity that assumes the risks and earns the ‘residual’ profit or losses.

The OECD TPG note that the TNMM is unlikely to be reliable if both parties to a transaction make unique and valuable contributions.

5. Transactional Profit Split Method (TPSM)

This TPSM is usually appropriate where it is difficult to identify what party to a transaction should be the tested party as both parties are making unique and valuable contributions, or where their contributions are highly integrated and cannot reliably be valued in isolation from one another, or where they share in the risk of the transaction and accordingly should be permitted to share in the profits (or losses) of a transaction.

Under the TPSM the profit earned on a transaction is split between the connected parties based on the profit which would be expected to be realised by independent businesses in the same situation.

There are two possible approaches to splitting the profits:

–A contribution analysis involves splitting the profit by reference to the relative value of the contribution made by each party to the transaction. The value of the relative contributions of the parties should be supported by data from transactions between third parties.

–A residual profit split involves a two-step approach, first if any of the parties to the transaction undertakes any routine (non-complex) functions, the remuneration of those elements is first determined using one of the methods described above. Once routine functions are remunerated the remaining profit (the ‘residual’) is split between the parties. Typically, the allocation of the residual profit among the parties will be based on the relative value of the non-routine contributions of the parties in the same way as in the application of the contribution analysis outlined above.


Company A is the parent company of a global group operating in the pharmaceutical sector. Company A owns a patent for a new pharmaceutical formulation. Company A designed the clinical trials and performed the research and development functions during the early stages of the development of the product, leading to the granting of the patent.

Company A enters into a contract with Company S, a subsidiary of Company A, according to which Company A licenses the patent rights relating to the potential pharmaceutical product to Company S. In accordance with the contract, Company S conducts the subsequent development of the product and performs important enhancement functions. Company S obtains the authorisation from the relevant regulatory body. The development of the product is successful and it is sold in various markets around the world.

The contributions made by both Company A and Company S are unique and valuable to the development of the pharmaceutical product.

Under these circumstances, the TPSM is likely to be the most appropriate method for determining the compensation for the patent rights licensed by Company A to Company S.

If Company S undertook no further development or enhancement of the product and manufactured and distributed the product in accordance with Company A’s instructions, the TPSM may not be the most appropriate method as it should be possible to find reliable comparable for Company S’s relatively routine functions.


Transfer Pricing is an extremely important area in international tax and it is a key focus for multinationals across the world. Whether you are a tax professional, a student of tax or indeed someone who just interested in tax, having a knowledge of transfer pricing will help you understand the discussions that are currently taking place on international taxation around the world.

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