Comparable Uncontrolled Price (CUP) Method

* The CUP method is ideal only if comparable products are available, or if reasonably accurate adjustments can be made to eliminate material product differences. Other methods will have to be considered if material product differences cannot be adjusted to give a reliable measure of an arm’s length price.

* The CUP method is the most direct way of ascertaining an arm’s length price. It involves the direct price comparison for the transaction of a similar product between independent parties.

* Comparability Analysis

* An uncontrolled transaction is comparable to a controlled transaction for purposes of the CUP method if one of the following conditions is met:

* None of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions could materially affect the price in the open market; or

* Reasonably accurate adjustments can be made to eliminate the material effects of such differences.

* An MNE using the CUP method to determine its transfer price must first identify all the differences between its product and that of the independent manufacturer. The MNE must then determine whether these differences have a material effect on the price, and adjust the price of products sold by the independent manufacturer to reflect these differences, to arrive at an arm’s length price. A comparability analysis under the CUP method should consider amongst others the following:

* Product characteristics such as physical features and quality. * If the product is in the form of services, the nature and extent of such services provided. * Whether the goods sold are compared at the same points in the production chain. * Product differentiation in the form of patented features such as trademarks, design, etc. * Volume of sales if it has an effect on price. * Timing of sale if it is affected by seasonal fluctuations or other changes in market conditions. * Whether costs of transport, packaging, marketing, advertising, and warranty are included in the deal. * Whether the products are sold in places where theeconomic conditions are the same.

Example 1

Taxpayer A, an MNE sells 70% of its product to an overseas associated company B, at a price of RM100 per unit. At the same time, the remaining
30% of that product is sold to a local independent enterprise C at RM150 per unit.

B

Transfer price 100

A

C

Arm’s length price The products sold to B and C are the same. The transaction between A and C may be considered as a comparable uncontrolled transaction. However, a functional analysis of B and C must first be carried out to determine any differences. If there are differences, adjustments must be made to account for these differences. Adjustments must also be made to account for different market conditions since B and C are located in different countries and for product quantity discounts since volume of sales to B and C are not the same. Assuming that reasonably accurate adjustments can be made to eliminate the material effects of these differences, then the CUP method may be applied using the unit price of RM150 as a comparable arm's length price.

Resale Price Method

* The resale price method is generally most appropriate where the final transaction is with an independent distributor. The usefulness of the method largely depends on how much added value or alteration the reseller has done on the product before it is resold, or the time lapse between purchase and onward sale. The method is more difficult to apply if the product has gone through a number of processes and the time lapse is too long (to the extent that market conditions might have changed) before it is resold or, when the reseller contributes substantially to the creation or maintenance of an intangible property that is attached to the product.

The starting point in the resale price method is the price at which a product that has been purchased from an associated enterprise is then resold to an independent enterprise. This price (the resale price) is then reduced by an appropriate gross margin (the resale price margin) representing an amount from which the reseller would seek to cover its selling and other operating expenses and in the light of functions performed (taking into account assets used and risks assumed), make an appropriate profit. An arm’s length price for the original transaction between associated enterprises is obtained after subtracting that gross margin, and adjusting for other costs associated with the purchase of the product (e.g. custom duties). A typical adjustment may be represented as follows:
Arm’s length price = Resale price – (Resale price x Resale price margin)
Where:
* Resale price margin = Sales price - Purchase price
Sales price
* Resale price margin must be comparable to margins earned by other independent enterprises performing similar functions, bearing similar risks and employing similar assets.

As shown in the formula, the focus is on the resale price margin. This margin should ideally be established from comparable transactions between the reseller (involved in the controlled transaction) and other independent parties. In the absence of such transactions, the resale price margin may be determined from sales by other resellers in the same market. The resale price margin is expected to vary according to the amount of value added by the reseller. Factors that may contribute to the value added depend on the level of activities performed by the reseller.

* Comparability Analysis

* An uncontrolled transaction is comparable to a controlled transaction for purposes of the resale price method if one of the following conditions is met: * None of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions could materially affect the resale price margin in the open market; or * Reasonably accurate adjustments can be made to eliminate the material effects of such differences.

* Factors which may influence the resale price margin and other considerations when performing a comparability analysis: * Functions or level of activities performed by the reseller and the risks undertaken e.g. whether the reseller is merely a forwarding agent or, a distributor who assumes full responsibility for marketing and advertising the product by risking its own resources in these activities; * Employment of similar assets in the controlled and uncontrolled transactions e.g. a developed distribution network; * Although broader product differences are allowed as compared to the CUP method, product similarities is still significant to some extent particularly when there is a high value or unique intangible attached to the product; * If the resale price margin used is that of an independent enterprise in a comparable transaction, differences in the way business is managed may have an impact on profitability; * The time lapse between original purchase and resale of the product as a longer time lapse may give rise to changes in the market, exchange rates, costs etc.; * Whether the reseller is given exclusive rights to resell the products; * Differences in accounting practices, where adjustments must be made to ensure that the components of costs in arriving at gross margins in the controlled and uncontrolled transactions are the same.

Example 2

Taxpayer B is a Malaysian subsidiary of multinational A, which is located overseas. B is a distributor of a high quality product manufactured by A. A also sells a similar product of a lower quality to an independent distributor D in Malaysia. The cost of product purchased from A by B is RM7.6 per unit. B resells the product to independent party C for RM8. Based on functional analysis, it was found that functions performed by B are similar to that of D. The gross profit ratio of D was found to be 10%.

Transfer price RM7.6 Arm’s length