You may have a reason for how you price a transaction between related entities. But would that reason hold up if a tax authority asked about it?
That matters even more when you have related entities operating across borders. The prices you set for goods, services, royalties, or financing affect where profits are reported, and tax authorities may have questions about how those prices were determined.
A clear transfer pricing strategy gives you a basis for setting those prices and supporting them when needed.
In this guide, we’ll cover the methods, documentation, and practical steps for building a defensible approach.
Why Multinational Businesses Need a Transfer Pricing Strategy
If your business has related entities in different countries, you may have goods, services, financing, or intellectual property moving between them. A transfer pricing strategy gives you a consistent basis for pricing those transactions and determining how to allocate profits across the entities involved.
A transfer pricing strategy also helps with some very practical issues:
- Audit risk: If the IRS or another tax authority questions an intercompany price, you already have the analysis and documentation showing how you arrived at it.
- Double taxation: A transfer pricing adjustment in one country can leave the same income taxed in another. A clear strategy can reduce the chances of getting into that situation.
- Regulatory compliance: A clear strategy helps you price related-party transactions consistently with the arm’s length principle and meet transfer pricing requirements across the jurisdictions where you operate.
- Performance evaluation: Consistent intercompany pricing helps you assess how individual entities are performing without differences in related-party transactions distorting their financial results.
The goal is to have a clear, supportable reason for why that price makes sense based on how the business actually operates.
Note: Your approach needs to follow the arm’s length principle, meaning related-party transactions should produce results consistent with what independent parties would agree to under comparable circumstances. In the U.S., Section 482 gives the IRS authority to adjust income and other tax items between controlled entities when necessary to clearly reflect income.
Core Elements of a Transfer Pricing Strategy
A transfer pricing strategy needs to explain how your intercompany pricing was developed, how it will be applied, and how you will keep it aligned with the business over time.
The main pieces usually include:
- A clear transfer pricing policy: Set out which intercompany transactions the policy covers, how they should be priced, and which entities are responsible for applying it.
- Functional and risk analysis: Determine each entity’s role in the transaction by examining its functions, assets, and risks. This helps establish how each entity should be compensated.
- The right method and comparable data: Choose a method that fits the transaction and supports the resulting price, markup, or margin with relevant market data where available. (More on this later.)
- Documentation: Keep the analysis behind the strategy, along with the supporting financial data and required transfer pricing files. Your documentation should also match what the business is actually reporting.
- Internal controls and monitoring: Once the policy is in place, you need a way to see whether it is being followed and whether actual margins are moving away from what the analysis supports.
- Cross-border consistency: Your approach should make sense in every jurisdiction involved. An approach that meets one tax authority’s requirements may not necessarily meet those of another.
- Regular review: Your transfer pricing policy may need to change as the business changes. If you add an entity, restructure operations, move functions between companies, or enter a new market, revisit the policy to make sure it still fits.
When these pieces are in place, you have a much clearer basis for setting your intercompany prices and supporting them if they’re questioned. From there, the next decision is which transfer pricing method best fits the transaction.
Transfer Pricing Methods That May Shape Your Strategy
Once you understand the transaction and what each entity contributes, you can determine how to test whether the pricing is at arm’s length. There are several accepted transfer pricing methods, and the right one depends on the transaction, the functions and risks of the entities involved, and the comparable data available.
Here is how the five commonly discussed methods work:
Comparable Uncontrolled Price (CUP) Method
The Comparable Uncontrolled Price (CUP) method compares the price in a related-party transaction with the price charged in a similar transaction between independent parties.
For example, if your company sells the same product to both a related distributor and an unrelated customer under similar terms, the unrelated sale may provide a useful reference for the intercompany price.
CUP can provide a direct comparison, but the transactions need to be genuinely comparable. Differences in volume, contract terms, geography, product features, or market conditions can affect the price and may require adjustments.
Resale Price Method
The resale price method is commonly considered when a related distributor buys a product and resells it to an independent customer without substantially changing it.
You start with the price charged to the independent customer and subtract an appropriate gross margin for the distributor. What remains provides a basis for the intercompany price.
This method tends to work best when the distributor performs relatively routine functions and reliable gross-margin data from comparable independent distributors is available.
Cost Plus Method
With the cost plus method, you start with the costs incurred by the related entity supplying goods or services and add an appropriate arm’s length markup.
Say your U.S. entity provides routine services to another company in the group. You would determine the relevant costs of providing those services and then apply a markup supported by comparable transactions or businesses.
The cost base needs particular attention. You should be clear about which direct and indirect costs are included and apply that treatment consistently.
Transactional Net Margin Method (TNMM)
The Transactional Net Margin Method (TNMM) looks at net profitability rather than directly comparing the price of a transaction. In U.S. transfer pricing rules, a similar approach is generally known as the Comparable Profits Method (CPM).
Typically, you focus on the entity with the simpler role in the transaction. You then compare its profitability, such as its operating margin or return on costs, with the profitability of similar independent businesses.
This approach can be useful when you cannot find a sufficiently comparable third-party transaction for a direct price comparison. The quality of the result still depends on choosing businesses that perform reasonably similar functions and using the right measure of profitability.
Profit Split Method
The profit split method looks at the combined profit from related-party transactions and divides it based on the contributions made by the entities involved.
The profit split method may be appropriate when both entities contribute unique, valuable assets, share significant risks, or operate so integrally that their contributions cannot be reliably evaluated separately.
For example, one entity may own valuable technology while another develops and improves that technology and brings the resulting product to market. In this case, both entities play a significant role in generating the profit.
How to Build a Transfer Pricing Strategy
The methods above give you different ways to price and evaluate intercompany transactions. Building a transfer pricing strategy means determining where those methods fit based on how your related entities actually operate.
Here’s what that process looks like:
Map Your Intercompany Transactions
Start by identifying the material transactions between your related entities, such as sales of goods, services, royalties, licensing arrangements, or intercompany financing.
For each one, note which entities are involved, what is being exchanged, how the price is currently set, and whether an intercompany agreement exists. The agreement should also match what is actually happening between the entities.
Understand Functional Analysis
Next, look at the functions performed, assets used, and risks assumed by each entity.
For example, knowing that one entity manufactures a product and another distributes it is only the starting point. You may also need to determine who manages inventory, makes key decisions, owns valuable intellectual property, or assumes market and credit risk.
Changes in these responsibilities can affect how an entity is compensated, so leadership and tax advisors need to consider whether the strategy still reflects how the business operates.
Choose a Transfer Pricing Method
With those facts in place, choose the method that best fits the transaction and the information available.
You might have a reliable third-party transaction that supports CUP, while a distribution or service arrangement may call for a different approach. You also don’t have to use one method across every intercompany transaction.
This is where advisor judgment becomes especially important. The method needs to reflect the transaction and be supported by reliable data, rather than simply produce a preferred result.
Benchmark with Comparable Data
Benchmarking gives you outside evidence to support the resulting price, markup, or margin.
Look for independent transactions or businesses operating under reasonably comparable circumstances. Depending on your method, you may be comparing prices, gross margins, markups, or net margins.
The result may be an arm’s-length range rather than one exact figure. Selecting appropriate comparables and documenting why they are relevant are key to supporting that range.
Set and Monitor the Policy
Once you have the method and benchmark, use them to set the pricing rules for your intercompany transactions, such as a specific price, markup, or target margin.
Then compare actual results with those targets during the year. If results move outside the expected range, leadership and tax advisors can determine what caused the difference and whether the pricing or broader strategy needs to change.
Why Transfer Pricing Strategies Fail in Practice
A transfer pricing strategy also depends on how consistently it is applied across the business. With multiple entities, jurisdictions, and teams involved, gaps can develop between the policy on paper and day-to-day practice.
Some of the most common issues are:
- No clear ownership: Transfer pricing often involves tax, finance, legal, and operational teams. If no one knows who is responsible for updating agreements, reviewing results, or providing documentation, important steps can be missed.
- Different entities apply the policy differently: A Japanese parent company and its U.S. subsidiary may interpret the same transfer pricing strategy differently when setting intercompany charges or applying markups. Without coordination, the two entities may price similar transactions differently.
- Documentation falls behind the business: Functions, risks, or intercompany arrangements can change without those changes making it into the transfer pricing documentation. That can leave you defending a position based on an outdated description of how the entities actually operate.
- Intercompany agreements no longer reflect the business: The way two entities work together can change while the agreement between them stays the same. That creates a gap between what the paperwork says and what is actually happening.
- Transfer pricing gets addressed too late: When it is treated mainly as a year-end or tax-return exercise, finance teams may discover issues after transactions have already been recorded and results are difficult to correct.
Support for Transfer Pricing Strategy, Documentation, and Risk
Transfer pricing can involve several parts of your business, from tax and finance to the teams managing intercompany transactions day-to-day.
For Japanese-owned U.S. companies, it also requires coordination between the U.S. subsidiary and the parent company in Japan. We at CDH bring bilingual expertise and experience working across both sides of that relationship to help keep the transfer pricing approach aligned across entities.
Depending on what you need, we can help with:
- Strategy and policy development: Our team reviews your intercompany transactions, functions, assets, and risks to determine an appropriate pricing approach.
- Benchmarking and documentation: We perform economic analyses, develop arm’s-length ranges, and prepare the documentation needed to support your position.
- Ongoing reviews: Through our advisory services, we can look at actual results during the year and help you address changes in the business or intercompany relationships.
- Audit and dispute support: We also respond to tax authority questions and support the methodology and documentation behind your transfer pricing position.
- Cross-border coordination: We work with your broader international tax team and, where needed, professionals through the Moore Global network in more than 100 countries.
If you’re unsure whether your current transfer pricing approach still fits your business, talk to our team about where the risks are and what may need to change.
Frequently Asked Questions (FAQs)
Here are a few common questions about transfer pricing strategies:
What Is the Difference Between a Transfer Pricing Policy and a Transfer Pricing Strategy?
A transfer pricing strategy is the broader approach you use to determine how intercompany transactions should be priced.
A transfer pricing policy puts that strategy into practice by setting the specific methods, prices, markups, margins, and procedures your entities will follow.
What Is the Arm’s Length Principle in Transfer Pricing?
The arm’s length principle means related entities should price transactions as independent parties would under comparable circumstances.
For example, if a company sells a product to independent distributors for $100 per unit, that price may provide a basis for pricing a comparable sale to its related subsidiary. A significantly different intercompany price needs support explaining why the difference is appropriate.
Who Needs a Transfer Pricing Strategy?
Multinational businesses with transactions between related entities should have a transfer pricing strategy. This may include companies with:
- Intercompany sales of goods
- Management or technical services
- Royalties and licensing arrangements
- Intercompany loans or financing
- Other cross-border charges between related entities
How Often Should the Transfer Pricing Strategy Be Reviewed?
Review your transfer pricing strategy at least annually to ensure the pricing, assumptions, and actual results still align.
At CDH, we also recommend quarterly reviews to monitor margins and business activity throughout the year. This can help you catch changes earlier and address potential transfer pricing issues before year-end.
Conclusion
A defensible transfer pricing strategy gives you a clear reason for how related entities are priced and the support to back that decision up. As your operations, markets, and intercompany relationships change, keeping the strategy current can also help you spot issues before they become harder to address.
If you need help developing or reviewing your approach, CDH brings transfer pricing and international tax expertise together with a broader understanding of your business. We can support policy development, benchmarking, documentation, and cross-border tax matters, with bilingual expertise for Japanese-owned U.S. subsidiaries and access to professionals in more than 100 countries.
If inconsistent pricing or documentation gaps are creating transfer pricing risk, contact us to get the right approach in place.
