Resale price method

The resale price method is a widely recognized approach within transfer pricing, a specialized area of international taxation. It helps multinational corporations (MNCs) and tax authorities determine an appropriate price for goods and services exchanged between related entities, known as controlled transactions. This method is particularly relevant when a manufacturing entity sells products to a related distribution company, which then resells them to independent customers. The objective of the resale price method is to ensure that the internal transaction price aligns with the arm's length principle, meaning it's the price that would have been agreed upon by unrelated parties in comparable circumstances.

History and Origin

The concept of determining fair prices for transactions between associated enterprises has been a cornerstone of international taxation for decades, evolving as global commerce became more complex. The arm's length principle, fundamental to transfer pricing, gained prominence to prevent the artificial shifting of profits across borders for tax advantages. International bodies like the Organisation for Economic Co-operation and Development (OECD) have played a significant role in developing and standardizing transfer pricing guidelines. The OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, first approved in 1995 and regularly updated, provide detailed guidance on various methods, including the resale price method. The 2022 edition, for example, consolidates earlier changes and clarifies the application of transactional profit methods.¹⁹, ²⁰, ²¹, ²², ²³ Similarly, the U.S. Internal Revenue Service (IRS) regulations, specifically 26 CFR 1.482-3, outline the resale price method as one of the acceptable approaches for transfers of tangible property, emphasizing its use for resellers who do not substantially alter the goods.¹⁶, ¹⁷, ¹⁸

Key Takeaways

• The resale price method is a transfer pricing method used to establish an arm's length price for goods sold between related entities.
• It is generally applied when a distributor or reseller purchases goods from an associated manufacturer and resells them to an independent third party.
• The method works by subtracting an appropriate gross profit margin from the external resale price to arrive at the arm's length purchase price for the distributor.
• Comparability is crucial, requiring analysis of functions performed, risks assumed, and assets employed by the controlled reseller compared to independent resellers.
• The goal is to prevent artificial shifting of profits and ensure each entity's taxable income reflects its economic contributions.

Formula and Calculation

The resale price method calculates the arm's length price by taking the external resale price of the product to an independent customer and subtracting an appropriate gross profit margin.

The formula is expressed as:

Where:

• ( P_C ) = Arm's length price in the controlled transaction (the price at which the manufacturing entity sells to the distribution entity).
• ( P_R ) = Applicable resale price to an uncontrolled, independent customer (the price at which the distribution entity sells to a third party).
• ( M_G ) = Appropriate gross margin (expressed as a percentage of total revenue from sales) earned by a comparable independent reseller in comparable uncontrolled transactions.

The Appropriate Gross Profit is calculated by multiplying the Applicable Resale Price by the Gross Profit Margin.¹⁵ This Appropriate Gross Profit is then subtracted from the Applicable Resale Price to determine the arm's length price for the controlled sale.

Interpreting the Resale Price Method

Interpreting the results of the resale price method involves assessing whether the calculated internal price aligns with market conditions. If the price determined using this method falls within an acceptable arm's length range, it suggests that the transaction between the multinational corporations is priced as if it were between independent parties. Conversely, if the price falls outside this range, it may indicate a potential for tax avoidance or profit shifting, prompting scrutiny from tax authorities. The method's reliability depends heavily on the accuracy and comparability of the chosen independent transactions. The degree of functional comparability between the controlled reseller and the uncontrolled comparables is paramount.¹³, ¹⁴

Hypothetical Example

Consider "Global Gadgets Inc.," a manufacturing entity in Country A, that produces smartwatches. Its subsidiary, "Global Gadgets Distributors," located in Country B, purchases these smartwatches and resells them to independent retailers in Country B.

1. Applicable Resale Price (( P_R )): Global Gadgets Distributors sells a smartwatch to an independent retailer for $200.
2. Comparable Gross Margin (( M_G )): Through a robust comparability analysis, financial data of independent distributors performing similar functions in Country B reveals an average gross profit margin of 25% for reselling comparable electronic goods.
3. Calculation: $$P_C = \$200 \times (1 - 0.25)$$ $$P_C = \$200 \times 0.75$$ $$P_C = \$150$$

Therefore, an arm's length price for Global Gadgets Inc. to sell the smartwatch to Global Gadgets Distributors would be $150. This price ensures that Global Gadgets Distributors earns a gross profit consistent with what an independent company performing similar functions would earn, after accounting for its cost of goods sold.

Practical Applications

The resale price method is widely applied in various scenarios involving the transfer of tangible goods where a reseller adds value primarily through distribution and marketing activities, rather than significant manufacturing or alteration. It is particularly suitable for transactions involving:

• Distributors and Resellers: Companies that buy finished goods from related parties and resell them without significant modification. This is its most common application.
• Wholesale and Retail: It can be used to set transfer prices for products moving through internal supply chain stages from manufacturing to wholesale or retail outlets within a multinational group.
• Routine Functions: It is generally preferred when the reseller performs relatively routine functions and does not own valuable intangible property related to the product, such as proprietary technology or brands, that would significantly impact profit.

This method helps multinational enterprises ensure compliance with international tax regulations and can be crucial during audits by tax authorities. For instance, significant tax disputes often arise from disagreements over transfer pricing, highlighting the importance of proper application of these methods. For example, Google has faced numerous tax disputes globally, with some involving allegations related to profit shifting and transfer pricing practices.⁸, ⁹, ¹⁰, ¹¹, ¹²

Limitations and Criticisms

While widely used, the resale price method has limitations. One primary challenge is finding truly comparable uncontrolled transactions. Differences in functions performed, risks assumed, contractual terms, and market conditions between the controlled transaction and potential comparables can significantly impact the reliability of the results. For instance, a reseller might take on unique market risks or invest in brand building, which could justify a different gross margin than a routine distributor.⁶, ⁷

Another criticism is its reduced applicability when the reseller adds substantial value to the product through further manufacturing, processing, or by developing valuable intangible assets. In such cases, the gross profit margin of a simple reseller may not adequately compensate for the value created by the more complex activities. Furthermore, obtaining accurate, publicly available financial data for genuinely comparable independent companies can be difficult, particularly in niche industries or developing economies, which often lack robust public data sources.¹, ², ³, ⁴, ⁵ This lack of data can compromise the method's reliability, making it susceptible to challenges during tax audits.

Resale Price Method vs. Cost Plus Method

The resale price method and the cost plus method are two of the core traditional transaction methods used in transfer pricing, both aiming to establish arm's length prices for tangible goods. The key distinction lies in which party's profit margin is primarily scrutinized and the direction of the transaction flow they are best suited for.

The resale price method starts from the price at which a reseller sells a product to an independent customer and works backward. It aims to determine the arm's length purchase price for the reseller by deducting an appropriate gross profit margin. This method is generally applied when a manufacturing or producing entity sells to an associated distribution or sales entity. The focus is on the gross margin of the reseller.

In contrast, the cost plus method starts from the manufacturer's or producer's costs. It determines the arm's length price by adding an appropriate gross profit markup to the cost of producing or supplying the goods in a controlled transaction. This method is typically used when a manufacturing or producing entity sells goods to a related sales or distribution entity, or for services provided, where the manufacturer's gross profit markup is the focus.

While both methods rely on comparable gross profit margins/markups, the resale price method is more appropriate for routine distribution functions, while the cost plus method is better suited for routine manufacturing or service provision.

FAQs

Q: When is the resale price method the most appropriate transfer pricing method?
A: The resale price method is generally considered most appropriate when a controlled entity purchases goods from an affiliated company and resells them to an independent third party without significantly altering the product. It is particularly useful for distributors or sales companies that primarily perform marketing and distribution functions.

Q: What kind of data is needed to apply the resale price method?
A: Applying the resale price method requires data on the resale price to independent customers and the gross profit margins of comparable independent distributors or resellers. This often involves searching commercial databases for financial information of companies performing similar business functions in the same or similar markets.

Q: Can the resale price method be used for services or intangible property?
A: No, the resale price method is specifically designed for transfers of tangible property. For services or intangible property, other transfer pricing methods like the comparable uncontrolled service price method, comparable uncontrolled transaction method, or profit split method are typically more appropriate.