Methods for determining and verifying transfer prices

Transfer pricing is essential for both businesses and tax authorities, as it involves setting prices for transactions between related parties, where there may be a risk of under-reporting income in one of the jurisdictions. For this reason, it’s important to ensure these prices are correctly determined, and then properly verified. In this post, we outline the main methods and offer guidance on selecting the one best suited to the specifics of your transaction.

Which method to use for determining transfer prices?

First and foremost, it’s essential to clarify that taxpayers are not required to use any specific method to determine transfer prices. Transfer pricing regulations simply mandate that “related parties must establish transfer prices on terms comparable to those agreed upon by unrelated parties” (known as the “arm’s length principle”).

The method chosen should reflect the specifics of the transaction and the availability of reliable data to apply it effectively. Consequently, selecting the most appropriate method is crucial, ensuring it aligns closely with the nature of the transaction.

What are the transfer pricing verification methods?

As noted above, taxpayers are required to apply the arm’s length principle in controlled transactions. What does this verification entail? It involves comparing the price in a controlled transaction to the price used in comparable transactions between unrelated parties. This verification process is guided by the provisions of the Income Tax Act.

Polish law (along with international OECD guidelines) introduces five main methods for verifying transfer prices, divided into two categories:

a) Traditional transaction methods

1. Comparable uncontrolled price method (CUP),
2. Resale price method,
3. Cost plus method,

b) Transactional profit methods

1. Transactional net margin method (TNMM),
2. Transactional profit split method.

If none of these five standard methods is suitable, an alternative, known as the “sixth method”, may be used. This involves applying the method most appropriate to the circumstances, which may include valuation techniques, as we have discussed in our article on the sixth method.

1. Comparable uncontrolled price method (CUP)

This is the simplest and most direct method of price verification. It compares the price agreed upon in a controlled transaction (i.e. between related parties) with the price used by unrelated parties in comparable transactions.

2. Resale price method

The sale price to an unrelated party for goods or services previously purchased from a related party is reduced by the market resale margin. This determines the transfer price.

3. Cost plus method

In this method, the transfer price is calculated as the sum of the cost base and the profit markup. Costs include both direct and indirect costs associated with the purchase or production of the transaction’s subject matter.

4. Transactional net margin method (TNMM)

The TNMM examines the net profit margin realized from a controlled transaction. This margin is determined by deducting the costs incurred in executing the transaction from the revenue generated by the controlled transaction.

5. Transactional profit split method

It assesses the total profits or losses made by related parties in a specific controlled transaction. It then divides these by the proportion that independent parties would have expected to realize from entering into the transaction.

6. Sixth method

Standard methods are sometimes insufficient. In such cases, you can use an alternative, known as the “sixth method”, which may include valuation techniques.

These techniques are primarily employed when the market lacks comparable transactions. This situation often arises with unique intangible assets, such as patents or trademarks, or when valuing businesses.

However, please note that the use of these techniques may vary depending on local legal frameworks, data availability, or specific regulations.

Examples of methods used:

1. Comparable uncontrolled price method (CUP): Mainly used in transactions involving traded commodities or raw materials.
2. Resale price method: Ideal for transactions in which

1. a) one of the entities simply resells goods purchased from another related party, such as electronic equipment,
2. b) one of the entities makes only minor changes to the goods before reselling them.

1. Cost plus method: A common choice for contract manufacturing, where prices need to include production costs and a profit markup. It also works well for support services or the supply of semi-finished products.
2. Transactional net margin method (TNMM): A good choice for transactions where one of the entities performs less complex functions, carries fewer risks, and does not involve significant intangible assets. Examples include contract manufacturers, limited-risk distributors, and service transactions.
3. Transactional profit split method: Suitable for transactions involving intangible goods or services with a high added value, such as in the case of cooperation in research and development.

Summary

To ensure compliance and minimize tax risk, it is important to select both an appropriate method for determining transfer pricing and a method for verifying transfer pricing. It is important to note that these methods may vary.

When determining transfer prices, you should particularly consider:

– the nature of the transaction,

– the availability of reliable comparables,

– the specifics of local regulations.

Selecting the right method helps ensure your prices align with the arm’s length standard and simplifies the verification process. It also provides protection against potential disputes with tax authorities.

When choosing a verification method, make sure it directly aligns with the provisions of the Income Tax Act (CIT or PIT). There are several methods available, but it’s essential to choose the one that best reflects the market nature of your transaction.

Need support with transfer pricing determination or verification? Contact us to help you select the most suitable method and verify that your prices meet the arm’s length standard. Don’t wait for tax authorities to step in—ensure your business is fully compliant with both local and international regulations. Benefit from our 20 years of experience and expertise today.