Transfer pricing methods: CUP, RPM, and CPM

The previous article introduced the arm’s length principle: even between related companies, prices should be set as if dealing with an independent third party. This article explains how the arm’s length price is actually determined, using the three traditional transaction methods.
 

What are transfer pricing methods?

Transfer pricing methods test whether an intercompany price is at the level that would have been agreed between independent third parties. In Korea, Article 8, Paragraph 1 of the Law for the Coordination of International Tax Affairs (LCITA) sets them out, and Items 1 to 3 cover the three known as the traditional transaction methods. The OECD Transfer Pricing Guidelines present the same methods. Each is illustrated below with a simple transfer pricing example.

Comparable Uncontrolled Price (CUP) method

The intercompany price is compared directly with the price in a similar transaction between independent parties. For example, if a parent sells the same component to its overseas subsidiary at KRW 100 and to an independent customer at KRW 120, the company checks whether the price difference of KRW 20 can be explained by reasonable factors.

The CUP method is the most intuitive but demanding to apply. Prices vary with product type and quality, volume, contract terms, timing, and market conditions, so you need independent transactions in which the conditions that affect price are sufficiently similar, and reasonably accurate adjustments must be possible for any material differences. Commodities such as crude oil, agricultural products, and minerals, which have open-market prices, are relatively easy to compare. For components with proprietary technology or branded products, comparable transactions are hard to find.

Resale Price method (RPM)

This method is used when a subsidiary buys products from a related company and resells them to a third party. The gross profit (profit before deducting selling and administrative expenses) that similar independent distributors typically earn is subtracted from the resale price to get the arm’s length purchase price. For example, if the subsidiary sells to consumers at KRW 150 and similar independent distributors earn a gross profit of 20% of the selling price (KRW 30), the arm’s length purchase price is KRW 150 − KRW 30 = KRW 120.

It is mainly used for distribution transactions in which products are resold without significant processing or alteration. Product comparability is generally less stringent than under the CUP method, but it is important that the functions performed and the risks assumed by the distributor are similar. Also, gross margin can differ depending on whether items such as freight are included in cost of goods sold or treated as selling and administrative expenses, so any difference in accounting treatment from the comparables must be adjusted for.

Cost Plus Method (CPM)

The profit that independent companies typically earn is added to the costs of the company that manufactures products or provides services. For example, if an overseas manufacturing subsidiary incurs a cost of KRW 100 and similar independent manufacturers add a 10% markup on cost, the arm’s length price is KRW 100 + (KRW 100 × 10%) = KRW 110. The 10% represents a gross profit markup on the relevant cost base, rather than a margin on the selling price.

It is mainly used for manufacturing and service transactions, and comparables should be checked for similar functions performed, assets used, and risks assumed. Differences in how costs are classified must also be adjusted for.
 

Which Method Should You Choose?

LCITA Article 8(1) requires the most reasonable method to be used, so there is no single answer for every transaction. Where the CUP method and another transfer pricing method can be applied with equal reliability, the CUP method is preferred because it compares transaction prices directly. In practice, however, sufficiently comparable transactions may be difficult to find, so other methods are also considered. Consider the nature of the transaction, the functions performed, assets used, and risks assumed by each party, and the reliability of the comparable data available. Then choose the most appropriate method and record the reasons and the basis of your comparability analysis in your transfer pricing report.
 

Conclusion

All three methods ask the same question: what would an independent third party have done? They check it through transaction prices or gross profit. Which method fits your intercompany transactions depends on the transactions themselves and the comparable data you can obtain.

Forvis Mazars provides transfer pricing services, including selecting the most appropriate transfer pricing method, benchmarking analysis, and preparing transfer pricing documentation. If you would like to check whether your intercompany prices are appropriate, please feel free to contact us.