Pricing method affiliate transactions is an important foundation to help businesses comply Decree 132/2020/ND-CP and ensure the principle of independence (Arm's Length Principle) in tax management. Currently, there are 5 core methods recognized internationally and in Vietnam, including:
- Compare Independent Transaction Prices (CUP)
- Resale Price (RPM)
- Comparative Profit (TNMM)
- Profit Distribution Metric (PSM)
- Combined Price (CPM)
Choosing and applying each method correctly not only demonstrates expertise but also enhances transparency and reliability in the transaction records.
What is the transfer pricing?
Related party transactions (TRIs) are transactions that arise between two or more parties that have a common ownership, control or management relationship. In the context of international tax administration, transfer pricing has become a focus because it has the potential to be used to shift profits from high-tax countries to low-tax countries, eroding the national tax base.
The core objective of determining the price of related-party transactions is to ensure the Independence Principle (Arm's Length Principle). According to this principle, the transaction price between related parties must be equivalent to the transaction price between independent (non-related) parties under equivalent commercial and financial conditions. This is the basic foundation for all methods of determining the price of related-party transactions applied worldwide and in Vietnam.
Why is determining transfer pricing important?
The application of transfer pricing methods is not only a technical requirement but also a matter of strategic compliance, especially in today's highly regulated environment.
- Legal requirements: In Vietnam, the determination of transfer pricing must strictly comply with Decree 132/2020/ND-CP. This document details the methods for determining transfer pricing and the requirements for preparing documents. Compliance demonstrates high legality and credibility.
- Risk Management: Determining prices that are not based on the principle of independence will lead to great risks. Enterprises may face tax arrears, administrative fines, and be assessed as lacking transparency. Applying the correct methods of determining transfer pricing helps build trust with tax authorities.
Because of the strategic and legal importance of complying with the independence principle, mastering and correctly applying transfer pricing methods is a key factor in demonstrating the expertise and reliability of an enterprise. According to Decree 132/2020/ND-CP, the Vietnamese tax authorities prescribe 5 main transfer pricing methods, divided into two large groups.
In-depth analysis of 5 methods for determining transfer pricing
Decree 132/2020/ND-CP stipulates 5 main methods for determining transfer pricing, divided into two large groups. Specifically:
Group 1: Traditional transaction comparison method
This group focuses on directly comparing price factors or gross profit between related and independent transactions.
Comparable Uncontrolled Price (CUP) method
The method of comparing prices of independent transactions is to directly compare the selling price of a product or service in an affiliated transaction with the selling price of a similar product or service in an independent transaction. CUP is considered the most reliable method of determining the price of an affiliated transaction if it satisfies the conditions of comparability.
Requires a high degree of similarity in:
- Product or service characteristics (brand, quality, size).
- Contract terms (volume, payment terms).
- Market conditions (geography, time of transaction).
Advantage: High precision, directly reflects the principle of independence
Disadvantages:It can be difficult to find perfect comparative data, especially for niche or strongly branded products.
Resale Price Method (RPM)
The principle of the resale price method is to determine the purchase price of goods in an affiliated transaction by taking the resale price of the goods to an independent party and subtracting the standard Gross Margin rate. This rate is determined from the independent sales transactions of the company itself or of other independent companies.
Core formula:
GDLK purchase price = Resale price x (1 – standard gross profit margin |
For example: Company A (Vietnam) buys goods from parent company B (overseas) and resells them to independent customer C at a selling price of 100 USD/product with a standard gross profit margin of 20%.
The maximum price that company A can pay to B:
| Purchase price = 100 x (1 – 0.2) = 80 USD |
The price of 80 USD is the standard transfer price according to the independence principle, ensuring that Company A receives a gross profit of 20% equivalent to the market.
This is the most appropriate transfer pricing method for companies that act as distributors, mere traders, or companies that only perform simple sales and distribution functions, creating little added value or significant intangible assets.
Cost Plus Method (CPM)
The principle of the cost plus method is to determine the selling price of products or services in an associated transaction by adding a standard gross mark-up on cost to the associated party's production costs or service provision costs.
This method of determining transfer pricing is often applied to:
- Low-risk outsourcing companies
- Transactions providing internal support services.
Core formula:
Selling price = Affiliate cost x (1 + gross margin on standard cost) |
For example: Company M (a subcontractor manufacturer) produces products for parent company P with a total production cost of company M of 50 USD/product and a gross profit margin on standard cost of 8%.
The selling price that company M sells to P:
| Selling price = 50 x (1 + 0.08) = 54 USD |
Company M needs to sell the product at 54 USD to ensure a gross profit of 8% on cost, complying with the independence principle.
Finding the comparative gross profit margin in this method requires careful consideration of the cost components being calculated.
Group 2: Trading profit method
This group focuses on comparing the net profit achieved from related-party transactions with the net profit of comparable independent transactions.
Transactional Net Margin Method (TNMM)
The principle of the comparative profit method (TNMM) compares the Net Profit Indicators of the related party being analyzed (Tested Party) with the net profit margins of independent parties. This is the most commonly used method of determining the price of related party transactions worldwide and in Vietnam.
TNMM is less sensitive to small differences in function, assets, and risk than traditional methods such as CUP. More importantly, TNMM uses net profit data, which is easier to find and adjust than searching for perfect price or gross margin.
Common profit indicators:
- Net profit or revenue (ROS – Return on Sales).
- Net profit or total operating expenses (RPT or COS – Return on Total Cost or Operating Expenses).
- Net profit or assets (ROA – Return on Assets), often used for parties that use many assets.
Enterprises will adjust their related-party transaction prices to bring their net profit margins within the standard range of independent transactions.
Profit Split Method (PSM)
The profit allocation method (PSM) principle determines the total profit earned from related party transactions and then allocates this profit to related parties based on the relative contribution (e.g., marketing costs, intangible asset value, etc.) that each party contributes to the overall profit.
PSM is the most complex transfer pricing method, reserved for specific and complex transactions, such as:
- Transactions are highly integrated, making it difficult to assess the separate roles of each party.
- Where both parties jointly contribute valuable intangible assets and jointly bear significant risks.
The profit sharing method (PSM) closely reflects the actual profit sharing when the parties jointly create value.
Selection criteria and practical application process
The choice of a transfer pricing method is not a random choice but a rigorous analytical process.
The invariance principle is that the method of determining the price of related-party transactions chosen must be the method most appropriate to the nature of the transaction and have the most reliable comparative data to apply the independence principle. Enterprises must demonstrate the reasons why they cannot apply higher priority methods.
4 factors determining the appropriate transfer pricing method
The process of selecting an appropriate transfer pricing method is based on four core factors:
- Function, Asset and Risk Analysis (FAR Analysis): This is the foundation step. Analyze in detail the role, assets used (tangible, intangible) and risks borne by each related party. For example, a contract manufacturer (low risk) would be suitable for CPM or TNMM, while a company owning intangible assets (high risk) would need a higher profit margin.
- Reliability of Comparable Data: The ability to find data from independent transactions is key. If the comparable data for CUP is not similar enough, it makes sense to switch to TNMM (the less sensitive method).
- Nature of Transaction: The type of transaction determines the choice of transfer pricing method. For example, RPM is suitable for distribution, CPM for services, and PSM for joint ventures developing common intangible assets.
- Information Availability: Ability to collect detailed financial information (costs, operating expenses) of independent comparables.
Compliance with the above selection factors is mandatory, but even when the right transfer pricing method is chosen, businesses often make important technical mistakes in the application process, especially when processing comparative data.
Common mistakes and solutions
One of the most common mistakes when applying transfer pricing methods, especially TNMM, is to ignore material adjustments.
- Mistake: Applying TNMM but not adjusting for working capital differences. Working capital differences affect net profit, leading to unfair profit comparisons.
- Solution: Always make adjustments for material differences such as working capital (receivables, payables, inventories) and asset differences to improve the reliability of comparative data. Making these adjustments is a clear demonstration of expertise in applying the transfer pricing method.
To defend the adjusted argument and formalize compliance before the tax authorities, the role of the Transfer Pricing Document is irreplaceable.
The role of Affiliated Transaction Records
The transfer pricing documentation is indispensable evidence to demonstrate the correct application of the transfer pricing method. Including:
- Master File: Provides an overview of the multinational corporation.
- Local File: Detailed analysis of transactions, functions – assets – risks and application of transfer pricing methods of the unit in Vietnam.
- Country-by-Country Reporting (CbCR): Country-by-country reporting, applicable to large corporations, enhances global transparency.
Preparing a complete, accurate and timely set of related party transaction documents is a key factor in demonstrating compliance and high reliability to tax authorities.
Conclude
The correct application of the transfer pricing method is not only a tax compliance requirement but also a strategy to protect the interests and reputation of the enterprise in the long term. In the context of increasingly strict inspection by tax authorities, a systematic set of transfer pricing documents based on FAR analysis. Choosing the appropriate transfer pricing method and proving independence is the "shield" that helps enterprises reduce the risk of being taxed and affirm their transparent management capacity.
If businesses are still struggling to determine the method for determining transfer pricing, Please contact us immediately with MAN – Master Accountant Network for guidance and support.
Contact information MAN – Master Accountant Network
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Content production by: Mr. Le Hoang Tuyen – Founder and CEO of MAN – Master Accountant Network, CPA Vietnam with over 30 years of experience in accounting, auditing, and financial consulting.
Frequently asked questions about transfer pricing methods
What is the Arm's Length principle?
The Arm's Length Principle is the foundation of all transfer pricing methods. It requires that the terms and conditions of transactions between related parties be the same as those that independent parties would agree to under comparable circumstances.
Which method is most commonly used in Vietnam?
Although the comparable uncontrolled price (CUP) method is legally preferred, in practice, the most commonly used transfer pricing method in Vietnam is the TNMM. The reason is because of the flexibility of TNMM in accepting comparable data with a lower degree of similarity than CUP, and the ease of finding independent companies for comparing net profits.
Editorial Board: MAN – Master Accountant Network