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Transfer pricing sits at the intersection of cost accounting, managerial decision-making, and tax compliance—making it a high-value topic that connects multiple course themes. You're being tested on your ability to understand how companies allocate costs and profits across divisions, why certain methods work better in specific situations, and what principles ensure transactions reflect economic reality. These concepts show up in questions about divisional performance evaluation, multinational operations, and ethical considerations in financial reporting.
Don't just memorize the five OECD-approved methods and call it a day. The real exam payoff comes from understanding when to apply each method, what makes transactions comparable, and how the arm's length principle serves as the conceptual backbone for everything else. Know what type of business situation calls for each approach—that's where FRQ points live.
Before diving into specific methods, you need to understand the principles that govern all transfer pricing decisions. These concepts aren't methods themselves but rather the analytical framework that determines which method applies and whether it's being applied correctly.
Compare: Functional Analysis vs. Comparability Analysis—both are analytical tools, but functional analysis looks inward at what each party does, while comparability analysis looks outward at market benchmarks. An FRQ might ask you to perform both before recommending a method.
These methods compare prices or gross margins directly and work best when reliable comparable transactions exist. They're called "traditional" because they were the first methods developed and remain preferred when good data is available.
Compare: Resale Price vs. Cost Plus—both use gross margins, but from opposite directions. Resale Price starts with the buyer's selling price and works backward; Cost Plus starts with the seller's costs and works forward. Choose based on which party is the "tested party" with more reliable data.
When direct price or gross margin comparisons fail, these methods examine net profit margins or profit splits. They're more flexible but require careful analysis because net margins are affected by many factors beyond transfer pricing.
Compare: TNMM vs. Profit Split—TNMM tests one party against external benchmarks, while Profit Split looks at both parties together. Use TNMM when one party performs routine functions; use Profit Split when both contribute unique value and no reliable one-sided analysis exists.
These mechanisms help companies manage transfer pricing risk before disputes arise. They're not pricing methods per se but rather administrative frameworks that provide certainty and reduce audit exposure.
Compare: APAs vs. Cost Sharing Arrangements—APAs provide certainty on how to price existing transactions, while cost sharing arrangements govern who pays for developing future assets. Both reduce disputes but address different planning needs.
| Concept | Best Examples |
|---|---|
| Direct price comparison | CUP Method |
| Gross margin analysis | Resale Price Method, Cost Plus Method |
| Net profit analysis | TNMM |
| Profit allocation | Profit Split Method |
| Foundational principles | Arm's Length Principle, Functional Analysis, Comparability Analysis |
| Prospective planning | APAs, Cost Sharing Arrangements |
| Distributor transactions | Resale Price Method, TNMM |
| Manufacturing/services | Cost Plus Method, TNMM |
A company's subsidiary manufactures components using proprietary technology and sells them to the parent for assembly. The parent then sells finished goods to independent retailers. Which transfer pricing method would you recommend for the intercompany component sale, and why?
Compare and contrast the Resale Price Method and Cost Plus Method. Under what circumstances would each be the most appropriate choice?
Why might a company prefer TNMM over CUP even when some comparable transactions exist? What trade-offs does this choice involve?
An FRQ describes two related parties jointly developing a new software platform, with each contributing unique intellectual property. Which method applies, and what information would you need to apply it correctly?
Explain how functional analysis and comparability analysis work together to support transfer pricing method selection. Which comes first, and why does the sequence matter?