Transfer Pricing Methods ~ U-Tax Blog

Friday, January 10, 2014

Transfer Pricing Methods

Co-author Anton Babak
(junior associate of Lavrynovych
 and Partners Law Firm)
On September 1, 2013 the amendments to the Tax Code of Ukraine related to transfer pricing entered into force. The said amendments have particularly affected the methods of the computation of an arm’s length price, which thereafter started being referred to as the methods of the computation of a price in controlled transactions (hereinafter – «CTs»).

The list of methods remains unchanged. They are as follows:

- Method of comparable uncontrolled price;
- Resale price method;
- Cost plus method;
- Transaction net margin method;
- Transaction profit split method.

However, with the amendments to the Tax Code of Ukraine the rules for the application of each of the above-mentioned methods have been worded in a much greater detail. Furthermore, there have been introduced some new terms related to the application of the methods. These are such terms as gross margin of costs, net margin, net margin of expenses, etc.

Since September 1, 2013 the hierarchy of the said methods has been in operation. A taxpayer may apply any method, however if there is a possibility to employ the method of comparable uncontrolled price, this particular method must be applied. It is also possible to use several methods simultaneously (i.e. a combination of methods).

Next we shall give a brief consideration of each of the methods in accordance with the amendments.

Method of comparable uncontrolled price or «method No. 1» as it is often referred to by tax advisors, is based on the comparison of the prices of goods/services applied in a CT with a market range of prices for identical goods/services in comparable transactions. In order to determine the market range of prices, the information on the sales of identical (and in their absence – homogeneous) goods/services implemented by the taxpayer or other persons under comparable conditions is used.

It should be emphasized that before the entry into force of the amendments to the Tax Code of Ukraine, the comparison had been made with the prices of identical (homogeneous) goods/services and not with the market range of prices. Hence, one can note here a facilitation in that there is no need to ensure the accordance of the transfer price with a specific figure anymore, the taxpayer is just required to be within the range of prices.

Resale price method can be applied in one case only, namely when goods/services are purchased within a CT (for example, from related parties) and then are resold to unrelated parties. This method is used solely for the purpose of the determination of the arm’s length price of goods/services purchased within the scope of such a CT.

The method is based on the gross margin figure (a ratio of gross profit to net revenue), which is calculated relating to the purchase and resale of goods/services described above. The obtained gross margin figure is compared with the market range of gross margins (for the purpose of the determination of the latter, the gross margin figures of at least three comparable transactions with unrelated parties is taken into account).

«Cost plus» method is very similar to the resale price method, however, unlike the latter, it has a multi-purpose application (practically any transaction related to the sale of goods and services). The application of this method is not limited to transactions regarding the purchase of goods/services from a related party and their subsequent resale to unrelated parties, as is the case with the resale price method. Additionally, this method allows determining the arm’s length price not only in respect of the purchase (as the resale price method), but also in respect of the sale of goods/services in a CT.

Gross margin figure is also at the heart of this method, but now it is a gross margin of costs (defined as the ratio of the gross profit to the cost of sold goods/services). The same as in resale price method, the obtained gross margin of costs is compared to the market range of such gross margins.

Transaction net margin method is the third and the last method associated with the use of the profit margins. This method is the kind of «auxiliary» or «back-up» method, if compared to resale price method and «cost plus» method, and is used in case of absence or insufficiency of information for the application of the two latter methods. By its economic nature transaction net margin method is almost identical to the «cost plus» method with the difference that the latter uses the gross margin figures, whereas the former uses one of the net margin figures.

The application of methods based on gross margins (resale price method and the «cost plus» method) is preferable, since these methods allow making more reliable comparison of profitability ratios and thus may be viewed as those determining the arm’s length price more accurately. The basis for net margin ratios is operating profit, which, unlike gross profit lying at the root of gross margin ratios, takes into account administrative, marketing and other operating expenses. The indicated group of expenses can vary greatly for different economic entities and therefore can adversely affect the accuracy of the computation of the arm’s length price.

Transaction profit split method is the last method in the given list. The present method is directed at measuring the actual distribution of total profits between the parties to a CT and the further redistribution of such profits in a way similar to that done between unrelated parties on economically justified basis. The method involves the evaluation of the contribution made to the total profits according to the functions fulfilled by each party, the assets involved and economic (commercial) risks borne during the performance of a CT.

Finally, it is worth mentioning the adoption of the procedure for calculation and application of market ranges of prices and profit margins which form the basis of the application of transfer pricing methods. The procedure was approved by the Resolution of the Cabinet of Ministers of Ukraine No. 763 dated October 17, 2013.

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