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Overview and Critique of Existing Transfer Pricing Methods In this Chapter, we provide an overview of the current transfer pricing regulations pertaining to intra-group transfers of tangible and intangible property, the performance of services, cost-sharing and global dealing. Our discussion consists of (a) a description of individual methodologies and the circumstances in which they are applied; (b) a review of the economic rationale for each methodology; (c) a critique of such rationale; and (d) an assessment of practical implications.
The U.S. and OECD transfer pricing regulations and guidelines sanction five transfer pricing methodologies:
1. The comparable profits method or “CPM” (referred to in the OECD Guidelines as the trans actional net margin method or “TNMM”);
2. The resale price method or “RPM”;
3. The cost plus method;
4. The comparable uncontrolled price (or “CUP”) method;
5. The profit split method.
Taxpayers are also permitted to establish fees for inter company services rendered to affiliates based on costs alone (without a profit element) under certain circumstances. Affiliated lenders may charge a published safe harbor floating loan rate (the “Applicable Federal Rate”), or, alternati vely, they may determine the prevailing market loan rate given the credit rating of the borrower and the loan terms.margin rate
The U.S. transfer pricing regime also encompasses intra-firm “cost-sharing” and “global dealing” as special cases, addressed in separate provisions. Cost-sharing regulations govern circumstances in which related companies jointly contribute to research and development activities, and are assigned specific, non-overlapping ownership rights in the research results. The term “global dealing operation” refers to
multinational financial intermediaries that buy and sell financial products, manage risk and execute transactions on behalf of customers. The proposed global dealing regulations do not formally encom
pass the global trading of physical commodities (as distinct from financi al products), although “the IRS solicits comments on whether these regulations should be extended to cover dealers in commodities . . .”
3.2 Resale Price and Cost Plus methods
Consider next the resale price and cost plus methods. Both are transactions-based methods that the OECD favors over the CPM/TNMM.
3.2.1 Circumstances when Resale Price and Cost Plus methods Apply
The resale price and cost plus methods (and, under the U.S. Temporary Regulations, the gross services margin method and the cost of services plus method) can be applied under the following fact patterns:
1. A single manufacturer sells similar products to both affiliated and unaffiliated distributors;
2. A single distributor sources similar products from both affiliated and unaffiliated suppliers;
3. A single services provider renders similar liaison or agency services (in the case of the gross servi
ces margin method) to both affiliated and unaffiliated companies, and, if relevant, utilizes the same intangible assets in doing so;
4. A single services provider renders similar services (other than liaison services in the case of the cost of services plus method) under the same contractual terms to both affiliated and unaffiliated companies and utilizes the same intangible assets, if any, in doing so;
5. Two or more manufacturers sell similar products, in one instance to affiliated distributors, and in the other instances, to unaffiliated distributors;
6. Two or more distributors source similar products, in one instance from affiliated suppliers and in the other instances, from unaffiliated suppliers; and
7. A group member performs routine manufacturing or distribution functions and licenses intellectual property from another group member.
Given one of the above fact patterns, one’s choice between the resale price and
cost plus methods depends principally on whether (a) one of the group members engages in internal arm’s length transactions, and (b) the affiliated manufacturer or the affiliated distributor is the least co
mplex entity (and therefore, the designated tested party). For example, under the first fact pattern, one would ordinarily apply the cost plus method, and under the second, the resale price method. As indicated above, the gross services margin method generally applies when the services at issue are intermediary in nature and the cost of services plus method applies when the tested party renders the same services to both affiliated and independent companies. Under the fifth and sixth fact patterns, one’s choice between the resale price and cost plus methods would be dictated by each group member’s ownership of intellectual property and the relative values thereof. Under the last fact pattern, the choice of methods depends on whether the licensee is a manufacturer or a distributor.
The U.S. regulations impose higher standards of comparability under the resale price and cost plus methods, as compared to the CPM: Products must be “of the same general type (e.g., consumer electronics),”11 and the parties being compared should perform similar functions, bear similar risks and operate under similar contractual terms. As previously noted, the OECD Guidelines do not differentiate between transfer pricing methods in establishing comparability criteria to the same degree as the U.S. regulations. Such criteria include the character of the property or service, the functions performed by the parties, contractual terms, economic circumstances and business strategies.
3.2.2 Description of Resale Price and Cost plus Methods
Briefly stated, under the resale price method, one compares the captive distributor’s gross margin on product sourced from affiliated companies with its gross margin on product sourced from unaffiliated companies. If the captive distributor does not source similar products from both affiliated and unaffiliated companies, one can compare its resale margin on products sourced from affiliated suppliers with the resale margins reported by unaffiliated distributors that source similar products from independent suppliers. An analogous comparison is made under the cost plus method and the cost of services plus method, except that the profit level indicator differs.
More particularly, under the cost plus and cost of services plus methods, the profit level indicator is equal to gross profits divided by cost of goods (or services) sold. 3.2.3 Underlying Economic Rationale
Less than one interpretation, the resale price method, applied to internal transactions, presupposes that individual distributors would pay similar purchase prices to their multiple s uppliers on an arm’s length basis and charge their unrelated customers similar selling prices. This set of assumptions, in turn, implies that (a) suppliers operate in the same competitive market or have no binding capacity c
onstraints and value the subject distributor’s business relatively highly, and (b) the distributor cannot (and is not forced to) differentiate among its customers in establishing its selling prices. If the resale price method depends on these assumptions for its validity, gross margin comparisons would only be valid if the products generating such margins are quite similar, not simply of the “same general type”. Similarly, the cost plus method, applied to internal transactions, may presuppose that individual manufacturers are unable to differentiate among customers in establishing their selling prices, and employ the same or similar technologies in producing product for different customers. Again, under this rationale, the products on which markups are being compared must be closely similar. Alternatively, the economic rationale for internal comparisons of resale margins or cost plus markups may simply be that individual distributors and manufacturers would necessarily earn a reasonably uniform gross margin or markup across transactions, consistent with the return that investors would require. As applied to external transactions, the only economic rationale for the resale price and cost plus methods would seem to be that market forces will equalize resale margins and gross markups across firms.
3.2.4 Critique of Economic Reasoning
As previously discussed, there is no reason to expect gross margins or gross markups to be equalize
d across firms, and, therefore, no good reason to compare an affiliated distributor’s (or manufacturer’s) resale mar gin (or gross markup) with the corresponding results reported by its unaffiliated counterparts. Therefore, as with the CPM, the resale price and cost plus methods, as applied to external transactions, are
not founded on valid economic principles.
Absent su ppliers’ manufacturing capacity constraints and the potential for price discrimination, comparisons of an individual distributor’s resale margins on product sourced from related and independent suppliers, respectively, makes a certain amount of sense. On a n arm’s length basis, the distributor would source exclusively from the lowest cost supplier if its suppliers’ selling prices differed, thus forcing them to charge the same price (or similar prices, in the case of similar products). Therefore, if the distributor cannot freely choose to price discriminate, and its customers do not insist on different prices (where “price” encompasses co-op advertising arrangements, volume discounts, etc.), it should earn similar resale margins across suppliers on an arm’s le ngth basis. Similarly, an individual manufacturer producing similar products for related and independent customers will generally use the same facilities (and, therefore, the same or similar manufacturing technologies and processes), absent dedicated production lines. If the manufacturer cannot freely ch
oose to price discriminate, and its customers would not insist on different prices at arm’s length, it should earn similar gross markups across customers on an arm’s length basis. Such internal comparisons do not depend on theoretical concepts of market equilibrium (although certain market structure assumptions are implicit), but rather, the profit-maximizing behavior of a single firm.
However, as a practical matter, the circumstances that permit such internal comparisons are relatively unlikely to arise. If we do not require internal arm’s length transactions to take place in the same geographic market as the parallel inter-company transactions, price discrimination will often be feasible. Most geographic markets are segmented to one degree or another one, and both demand and supply conditions in individual markets will likely differ. For obvious reasons, this possibility undermines the reliability of comparisons across geographic markets. Conversely, if we require the transactions being compared to take place in the same geographic market, the fact patterns permitting internal comparisons will rarely arise. Manufacturers are unlikely to sell to both affiliated and unaffiliated distributors in the same geographic market, because doing so would undermine the affiliated distributor. The same reasoning

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