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A rebranding of the resale price method, cost plus method and berry ratio
Whenever a new version of the OECD Transfer Pricing Guidelines is released, we do a complete read-through with the team. And we discover new things every time we read them, because our perspective on things changes as we continue to gain experience in the field of transfer pricing.
Transfer pricing methods
In Chapter II, the OECD Transfer Pricing Guidelines elaborate on five transfer pricing methods, which can be used to establish whether the conditions of transactions between associated enterprises are consistent with the arm’s length principle. It describes two categories of transfer pricing methods named – somewhat confusingly – “traditional transaction methods” and “transactional profit methods”.
The traditional transaction methods consist of the comparable uncontrolled price (or CUP) method, the resale price (or RP) method and the cost plus (or CP) method. The transactional profit methods consist of the transactional net margin method (or TNMM) and the profit split (or PS) method.
You may be thinking: “What about the Berry ratio?”. We’ll get to that in a minute.
Inconsistency
There is a lot that can be said about the application of these transfer pricing methods, but in this article we want to zoom in on one interesting inconsistency.
The OECD combined methods that measure the net profit of a company to a certain base (such as costs, sales or assets) into a single transfer pricing method, being the TNMM. Yet, the OECD did not combine the methods that measure the gross profit of a company to a certain base (sales and costs), being the RP and CP methods.
These gross margin methods are discussed separately in the OECD Transfer Pricing Guidelines. Since these methods are very similar, the sections in Chapter II covering the RP method (Section C) and the CP method (section D) contain considerable duplication.
We promised to come back to the Berry ratio. Well, to add to the inconsistency, one gross margin method, i.e. the Berry ratio (or BR), is analysed as if it were a variation of the TNMM (paragraph 2.106 and onward). That doesn’t really make sense, does it?
TNMM
The TNMM is by far the number one transfer pricing method of choice in practice. When comparing net profit to costs it is often referred to as net cost plus (TNMM-NCP). When comparing net profit to sales it is generally referred to as operating margin or return on sales (TNMM-ROS). When comparing net profit to assets it is referred to as return on assets (TNMM-ROA).
Gross margin methods
Now, the TNMM-NCP and TNMM-ROS each have a gross margin sibling. The CP method compares gross margin to direct and indirect costs of production; the RP method compares gross margin to sales. One could argue that the BR (comparing gross margin to operating costs) is in fact TNMM-NCP’s brother and the CP method its cousin, but now we’re getting carried away.
Where the TNMM is the family’s favorite, the CP, RP and BR methods are the black sheep and rarely used in practice. The OECD Transfer Pricing Guidelines identify that differences in accounting rules and practices have a more significant impact on gross margin methods than on the TNMM. This argument is often used – perhaps even by default – to dismiss the gross margin methods and move on to the popular methods (TNMM, CUP or even PS).
Confusingly, in practice, people tend to refer to the “cost plus method” when they actually mean TNMM-NCP (net profit compared to costs). Reference is also incorrectly made to the “resale price method” or “resale minus method” where TNMM-ROS (net profit compared to sales) is meant.
Rebranding
With this blog we primarily want to urge the OECD to combine, in a next version of the OECD Transfer Pricing Guidelines, the analysis of the three gross margin methods (CP, RP and BR). We recommend renaming Section C of Chapter II from “Resale price method” to “Gross margin method”, which practitioners may then abbreviate as GMM.
While we’re at it, let’s rename Section B if Chapter II from “Transactional net margin method” to “Net margin method”, or “NMM”.
The available transfer pricing methods will then be reduced from five categories to four: CUP, GMM, NMM and PS.
Combining the gross margin methods will not only improve the structure of Chapter II of the OECD Transfer Pricing Guidelines, it would – in our view – also make the gross margin methods more accessible. At the least, it will reopen discussions among practitioners on the use of gross margin methods.
With such new structure of Chapter II, we hope the GMM will increase in popularity as, in fact, it may often be the most appropriate transfer pricing method. The availability of comparable gross margin data is often underestimated, especially in cases where internal comparables exist or in domestic comparable searches where consistency of cost classification – critical to the use of gross margin methods – can be reasonably assured.
When comparing gross profit to direct and indirect costs of production it may be referred to as gross cost plus method or GMM-CP; when comparing gross profit to operating costs it will continue to be referred to as Berry ratio or GMM-BR; and when comparing gross profit to sales it may be referred to as gross return on sales method or GMM-RP.
This article would not be complete with a final commercial remark. We are proud that Reptune’s Transfer Pricing Documentation solution facilitates the application of all transfer pricing methods. With this article we hope to increase the use of gross margin methods and the return on investment of this part of our transfer pricing documentation solution. 😊
