The Internal Revenue Service has adopted specific regulations to govern how related businesses should determine pricing and allocate profits among related businesses. This is of particular interest to US businesses that are controlled by non-US taxpayers either directly or through related non-US businesses and which sell goods sourced by the non-US taxpayers into the US market through a controlled US entity.
Don’t assume that just because one pricing method is listed that means it can be the basis for your pricing structure. Some people read the regulations too literally, normally jumping to method 6, and want to base their pricing on some other convoluted methodology because it gives them the best answer to minimizing their US tax liability. In fact the regulations specify that each pricing scheme and resulting allocation of profits must use the “best method” available to determine the pricing of goods exchanged between controlled entities. In practical application, you will likely want to apply the methods in the order they are listed below, only considering the next method in the list if for some reason the lower numbered pricing structures will not work with your situation.
Summary of pricing methods:
- CUP-Comparable Uncontrolled Price-What do you charge another un-related entity in an arm’s-length transaction?
- The resale price method– Similar to CUP method in that it looks to see if the pricing results in a comparable gross profit margin on the part of the US business to what would be achieved in a comparable arm’s length transaction.
- The cost plus method-Looks at pricing from the view of the non-US selling entity to see if it is achieving a comparable markup or gross profit as would be achieved from selling to an unrelated entity in an arm’s-length transaction.
- The comparable profits method-Also measures profits, but from the viewpoint of are the gross profits achieved comparable to unrelated third parties who engage in similar selling activities under similar circumstances with un-related third parties.
- The profit split method-Basically this method looks to determine if the allocation of combined profit or loss between the two related entities is reasonable relative to the value of each entity’s contribution to achieving that profit.
- Unspecified methods-The catchall if none of the above methods is appropriate or there are other factors that must be taken into consideration to arrive at a reasonable price level for the related entities.
For more details-Download the text of the regulations and discussion of transfer pricing methods.