Resale Price Method (RPM) in Transfer Pricing: Analysis 

1. Introduction to RPM:

-RPM as a Traditional Transaction Method: The Resale Price Method (RPM) stands as one of the traditional transaction methods employed to ensure adherence to the arm’s length principle. This principle ensures that transactions between associated enterprises are conducted on fair terms, reflecting what would be agreed upon by unrelated entities. In the context of transfer pricing analysis, RPM places a spotlight on the related sales company, primarily engaged in marketing and selling functions. 

-Analyzing the Resale Price Method: The core focus of the Resale Price Method is to evaluate the price at which a related sales company (in this case, Associated Enterprise 2) sells a product to an unrelated customer (resale price). This analysis aims to establish an arm’s length gross margin, representing the portion retained by the sales company to cover Sales, General, and Administrative (SG&A) expenses while still generating a reasonable profit. The determination of an appropriate profit level is based on the functions performed, assets utilized, and risks assumed by the sales company. 

Resale Price Method:

Associated Enterprise 1————————>   Asscoiated Enterprise 2——————-> Independent Enterprise

Arm’s Length Price  ?  Resale Price

Resale Price =   100

Reasle Price Margin =    25%

Arm’s Length Price  =    75

-Key Components of RPM: 

• Functional Analysis: 
• The Resale Price Method requires a thorough examination of the functions, assets, and risks assumed by the related sales company. This ensures that the profit level is commensurate with its contributions. 
• Gross Margin Consideration: 
• Instead of directly determining arm’s length prices (as with the Comparable Uncontrolled Price Method), RPM concentrates on arm’s length gross profits. This approach makes it less reliant on precise transactional (product) comparability. 
• Intragroup Transactions: 
• The arm’s length price for intragroup transactions between the sales company (Associated Enterprise 2) and a related entity (Associated Enterprise 1) is determined by considering the remaining portion of the product’s price after accounting for the arm’s length gross margin. 

-Implementation of RPM: 

• Data Analysis: 
• Detailed data on resale prices, cost structures, and financial performance of the related sales company is crucial for implementing RPM. 
• Comparable Analysis: 
• Identification of comparable transactions involving unrelated entities serves as a benchmark for assessing the arm’s length nature of resale prices. 
• Profit Adjustment: 
• Adjustments are made to ensure that the retained gross margin aligns with what unrelated parties would typically agree upon, accounting for the specific functions, assets, and risks of the sales company. 
• Documentation: 
• Thorough documentation of the analysis, assumptions, and adjustments is essential for compliance and transparency, providing a robust defense in the event of scrutiny by tax authorities 

 -Consequently, the Resale Price Method (RPM) focuses on the sales company, often the one doing the marketing and selling. Here’s how the transfer price (the price for selling products within a company group) is figured out using this method: 

Transfer Price (TP) = Resale Price (RSP) x (1 – Gross Profit Margin (GPM)) 

• TP: This is the Transfer Price, meaning the price for selling a product within a company group. 
• RSP: Resale Price is the price at which the sales company sells a product to customers outside the company group. 
• GPM: Gross Profit Margin is the profit that the sales company should make on the sale. It’s calculated by taking the gross profit (sales minus the cost of making the product) and dividing it by the net sales. 

-Alternative Approaches: 

There are different ways to figure out a fair price. For instance, if a company acts as a sales agent without owning the goods, you can use the commission they earn (a percentage of the price the goods are sold for outside the company) as a comparable gross profit margin. Always consider the functions, assets, and risks of the reselling company when determining the resale price margin 

2. Understanding Arm’s Length Gross Profit Margin in Resale Price Method (RPM):

-Gross Profit Margin in RPM: The Resale Price Method (RPM) focuses on a financial metric called the gross profit margin. This margin is derived by subtracting the cost of goods sold from net sales. In simpler terms, it looks at how much money is made from selling a product after accounting for the cost of producing or acquiring it. This is especially straightforward when the reseller doesn’t significantly enhance the value of the product. 

• Net Sales: This is the revenue a sales company generates by selling products to customers outside the company group. 
• Cost of Goods Sold: This includes the cost of purchasing the goods sold plus certain extra non-operating costs. When determining the gross margin for products bought from a related company, the cost of goods sold will involve the transfer price paid to that related party, often a manufacturer. 

-Importance of Accounting Consistency: Consistency in accounting practices is crucial in applying the RPM. For meaningful comparisons, the gross profit margins must be consistent between controlled (related parties) and uncontrolled (unrelated parties) transactions. If there are differences in accounting principles or practices, the comparability of gross profit margins may be compromised. 

• Example Differences: 
• Reporting of certain costs (like discounts, transportation costs, insurance, and costs of warranty function) as operating expenses or cost of goods sold might vary between comparable distributors and the related sales company. 
• Discrepancies in inventory valuation methods can also impact gross margins. 

-Ensuring Apples-to-Apples Comparison: To avoid comparing “apples with oranges,” adjustments may be necessary. These adjustments ensure that the analysis considers similar elements, making it an “apples-to-apples” comparison. This step is vital to maintaining the integrity of the RPM analysis. 

3. Transactional Comparison Versus Functional Comparison in Transfer Pricing:

-Introduction: Determining the arm’s length price or margin can be approached through either a functional comparison or a transactional comparison. These methods play a crucial role in evaluating the fairness of transactions, especially in scenarios involving sales companies dealing with various products, such as different types of bicycles. 

-Two Approaches to Determine Arm’s Length Gross Profit Margin: 

Transactional Comparison: 

• This approach involves analyzing each transaction the tested party (e.g., Associated Enterprise 2) engages in, specifically looking at comparable products. For instance, it might explore the gross profit margin earned by Associated Enterprise 2 when reselling bicycles purchased from an independent manufacturer. Even if the transaction involves different types of bicycles, similarities in cost structures (Costs of Goods Sold – COGS) may render gross margin comparisons reliable. 

Functional Comparison: 

• In contrast, the functional comparison approach focuses on examining the gross profit margins earned by independent companies in comparable uncontrolled transactions. Here, the emphasis is on finding companies with similar functions, asset usage, and risk assumption as the tested party (Associated Enterprise 2). This could involve comparing distributors of products like wheelbarrows and carts. 

-Practical Considerations: 

• Transactional comparisons often achieve broader product and accounting consistency compared to functional comparisons. In practice, it may not always be necessary to conduct a resale price analysis for each individual product line distributed by a sales company under the Resale Price Method. Instead, the method can be applied to determine the overall gross margin a sales company should earn across its complete range of aggregated products. 

Key Takeaways: 

• Transactional Comparison: Focuses on comparing individual transactions involving similar products. 
• Functional Comparison: Concentrates on finding comparable companies with similar functions, assets, and risks. 
• Practical Application: Transactional comparisons are often more practically achievable for maintaining consistency in product and accounting measures. 

4 Ensuring Comparability in the Application of the Resale Price Method:

-Criteria for Comparability: An uncontrolled transaction is deemed comparable to a controlled transaction under the Resale Price Method (RPM) if: 

• No Material Differences: There are no substantial differences between the transactions that significantly affect the gross margin. This includes aspects like contractual terms and freight terms. 
• Adjustments Feasibility: If there are differences, adjustments can be reasonably and accurately made to eliminate their impact. 

-Emphasis on Functional Comparability: The RPM is typically applied on a functional basis rather than a transactional one. Functional comparability, focusing on the similarity in functions performed, becomes more crucial than product comparability. This is because product differences are likely to have less impact on profit margins compared to prices. 

-Product Similarity Importance: While some product differences may be acceptable under the Resale Price Method, the nature of the products involved in controlled and uncontrolled transactions should still be broadly similar. Significant differences may indicate variations in functions performed, assets used, or risks assumed, potentially affecting arm’s length gross margins. 

-Compensation Consistency: For a distribution company, the compensation should generally be the same regardless of whether it sells washing machines or dryers. This is because the functions, risks, and assets involved are similar for both activities. However, distributors dealing with markedly different products cannot be directly compared. While the price of individual products may differ, the compensation for similar functions should remain consistent. 

Considerations for Reliable Transfer Pricing: 

• Product Line Analysis: It is not always necessary to conduct a resale price analysis for each product line separately. Instead, the Resale Price Method can be applied more broadly, considering the gross margin a sales company should earn across its full range of broadly similar products. 
• Greater Product Similarity: While product comparability is less critical under the Resale Price Method, having greater similarity among products within a product line can lead to more reliable transfer pricing results. 

-Dependence on Functional Comparability: As the gross profit margin compensates a sales company for marketing and selling functions, the Resale Price Method relies heavily on comparability in functions, risks, and assets. It specifically emphasizes functional comparability, expecting a similar level of compensation for similar functions, assets, and risks across different activities. Material differences affecting gross margins in controlled and uncontrolled transactions necessitate adjustments typically applied to the gross profit margins of uncontrolled transactions. Operating expenses related to functions, assets, and risks should be considered, as these differences often manifest in varying operating expenses. 

-Key Considerations in Functional Comparability: Several considerations impact the determination of functional comparability under the Resale Price Method: 

• Effect of Factors on Gross Margins: Unlike the Comparable Uncontrolled Price (CUP) Method, the Resale Price Method’s reliability can be influenced by factors with less impact on product prices but more on the costs of performing functions. Examples include cost structures, business experience, and management efficiency. 
• Resale Price Margin in Value Addition: Attention is required when the reseller significantly adds value to the product, especially in creating or maintaining related intangibles (e.g., trademarks) or further processing goods before resale. 
• Impact of Reseller Activities: The level of activities performed by the reseller, such as acting as a sales agent or a buy-sell distributor, affects the resale price margin. A buy-sell distributor typically commands a higher compensation. 
• Commercial Activities and Unique Assets: Resellers engaged in significant commercial activities or utilizing valuable and unique assets (e.g., marketing intangibles) may earn a higher gross profit margin. 
• Exclusive Reselling Rights: Consideration should be given to whether the reseller has exclusive rights to resell the goods, as this can affect the resale price margin. 
• Accounting Practices: Differences in accounting practices between the reseller and comparable companies should be analyzed, and adjustments made to enhance comparability. 
• Product Value Differences: The analysis should account for differences in product value, influenced by factors like a valuable trademark. 

-Market Considerations: Recognition that returns to similar functions may vary in different markets is crucial. Generally, reliability is enhanced when the reseller and comparable companies operate in the same market, acknowledging the market-specific dynamics influencing returns to functions. 

5. Strengths and Weaknesses of the Resale Price Method:

-Strengths: 

Market-Driven Basis: 

• The Resale Price Method is based on the resale price, a market-driven metric, making it demand-driven. This is particularly advantageous in situations where the relationship between costs and sales price is weak, such as when demand is inelastic. 

Avoidance of Forced Profits: 

• Distributors are not compelled to inappropriately generate profits. Instead, they earn an arm’s length gross profit margin. In certain circumstances, distributors may experience operating losses due to commercial factors, such as high selling expenses from strategic decisions like a market penetration strategy. In contrast to methods like the Transactional Net Margin Method, which usually result in an arm’s length range of positive operating profits, the Resale Price Method does not mandate positive operating profits for the tested party. 

-Weaknesses: 

Challenges in Finding Comparable Data: 

• Difficulty may arise in locating comparable data on gross margins, often due to accounting inconsistencies among companies. 

One-Sided Analysis: 

• The Resale Price Method conducts a one-sided analysis, primarily focusing on the related sales company as the tested party. This concentration on the distributor may lead to extreme results for the related supplier. For instance, the supplier might incur a loss even if the distributor is profitable, based on the determined arm’s length gross profit margin and transfer price derived from benchmarking analysis. This asymmetry could be a limitation in certain scenarios. 

6. When to Use the Resale Price Method:

-Applicability Criteria: 

In a Fully-Fledged Manufacturer Scenario: 

• The Resale Price Method is suitable for intragroup transactions involving a “fully-fledged” manufacturer that possesses valuable patents or other intangibles. This is particularly relevant when compared to scenarios involving limited risk or contract manufacturers. 

Key Conditions: 

• The CUP Method is not applicable. 
• The sales companies involved do not own or contribute to valuable intangibles. 
• Reliable comparisons can be made based on the Cost of Goods Sold (COGS). 

-Example Scenario: 

• Consider a situation depicted in Figure 4.D.2, where Associated Enterprise 1 owns valuable patents for manufacturing bicycles and has a valuable trade name. Associated Enterprise 2 purchases and resells the bicycles to unrelated dealers locally. The Resale Price Method is chosen in this case if the CUP Method is not applicable. The Cost Plus Method is not preferred because: 

• The fully-fledged manufacturer (Associated Enterprise 1) owns unique and valuable intangibles, conducts R&D activities, and operates more complex operations than the sales company (Associated Enterprise 2). 
• Results from the Cost Plus Method are less reliable compared to the Resale Price Method. 
• Identifying comparable manufacturers with similar intangibles for the Cost Plus Method is challenging or nearly impossible. 

-Methodology: 

• The Resale Price Method establishes the transfer price by referring to the resale or gross margins (gross profit/net sales) earned by third-party resellers. This comparison is made against the gross margin earned by Associated Enterprise 2 on bicycles acquired from related parties. 

-Additional Application: 

• The Resale Price Method can also be applied in a commissionaire/commission agent structure involving a principal and related commissionaires/commission agent. In such cases, the method determines an arm’s length commission to be earned by the commissionaires/commission agents. 

 7.Case Examples of the Resale Price Method: 

-Example 1: 

Scenario Overview: 

• A controlled taxpayer sells property to another member within its group. 
• The second member resells the property to an unrelated customer. 
• No significant changes in beginning and ending inventory during the reviewed year. 
• Information on an uncontrolled comparable is comprehensive, allowing for the identification and reliable adjustment of material differences between controlled and uncontrolled transactions. 

Calculation Steps: 

• Applicable Resale Price: The resale price of the property involved in the controlled sale is $100. 
• Comparable Uncontrolled Transaction: In an uncontrolled comparable transaction, the reseller earns a gross profit margin of 20%. 

Arm’s Length Price Calculation: 

• The arm’s length result for the controlled sale is calculated as follows: 

• Arm’s Length Price = Applicable Resale Price – (Gross Profit Margin × Applicable Resale Price) 
• Arm’s Length Price = $100 – (0.20 × $100) 
• Arm’s Length Price = $80 

 Interpretation: 

• In this example, an arm’s length result for the controlled sale, based on the Resale Price Method, is determined to be $80. This implies that, considering the gross profit margin earned in an uncontrolled comparable transaction, the controlled sale price should be adjusted to achieve an arm’s length outcome. 

 -Example 2: 

Scenario Overview: 

• SCO, a corporation in Country B, acts as the distributor for FP, its foreign parent company. 
• No significant changes in beginning and ending inventory for the reviewed year. 
• SCO’s total reported cost of goods sold is $800, comprising $600 for property purchased from FP and $200 for other costs incurred with unrelated parties. 
• Local taxing authority determines the appropriate gross profit margin as 25%, referencing an independent reseller in a comparable uncontrolled transaction. 

Calculation Steps: 

• Applicable Resale Price: $1,000 
• Reported Gross Profit: $200 
• Appropriate Gross Profit Margin: 25% of the applicable resale price ($1,000) = $250. 

Determining Arm’s Length Price: 

• Step 1: Subtract Appropriate Gross Profit ($250) from Applicable Resale Price ($1,000) 

• Result: $1,000 – $250 = $750 

• Step 2: Reduce the above amount by Costs of Sales Incurred to Unrelated Parties ($200) 

• Arm’s Length Price for Purchases from FP = $750 – $200 = $550 

Interpretation: 

• In this example, the local taxing authority establishes an appropriate gross profit margin of 25% by referring to an independent reseller in a comparable uncontrolled transaction. 
• The arm’s length price for SCO’s purchases from FP, determined through a two-step process considering the applicable resale price, gross profit, and costs incurred to unrelated parties, is $550, not $600 as initially reported. This adjustment aligns the transaction with an arm’s length outcome. 

 -Example 3: 

Scenario Overview: 

• TCO, a corporation in Country T, serves as the exclusive distributor for products from its foreign parent. 
• Local taxing authority aims to determine if TCO’s gross profit margin of 25% aligns with an arm’s length result using the Resale Price Method. 
• Multiple uncontrolled distributors, undertaking similar functions in comparable uncontrolled transactions, are available for comparison. 

Considerations: 

• Cost Treatment Discrepancy: 

• Uncontrolled distributors treat certain costs (e.g., discounts and insurance) as cost of goods sold. 
• TCO treats these costs as operating expenses. 

Challenges and Adjustments: 

• Accounting Reclassifications: 

• To ensure a consistent comparison, accounting reclassifications must be made to align the treatment of material items like discounts and insurance across controlled and uncontrolled transactions. 

Impact on Method Reliability: 

• Inability to Reclassify: 

• If accounting reclassifications cannot be successfully made, the reliability of applying the Resale Price Method based on uncontrolled transaction results may decrease. 
• Consistent treatment of material items is crucial for reliable and meaningful comparisons. 

Interpretation: 

• This example highlights the importance of accounting consistency in applying the Resale Price Method. 
• In cases where uncontrolled distributors and the tested party (TCO) treat certain costs differently, efforts should be made to make necessary accounting reclassifications for accurate and comparable results. 
• Failure to achieve consistent treatment may impact the reliability of the Resale Price Method, emphasizing the need for careful consideration of accounting practices in transfer pricing analysis. 

 -Example 4: 

Scenario Overview: 

• WCO, a corporation in Country W, is the manufacturer of Product Z, an unbranded product. 
• RCO, a wholly-owned foreign subsidiary, acts as the distributor of Product Z in Country R and sells it to unrelated parties. 
• Uncontrolled Distributors A, B, C, D, and E operate in Country R, distributing competing unbranded products of similar value. 
• Detailed data on functions, assets, risks, and contractual terms are available for both controlled (RCO) and uncontrolled distributors. 

Conditions: 

• Data Completeness: 

• Sufficiently complete and accurate data available for functions, assets, risks, and contractual terms for both controlled and uncontrolled distributors. 

• Accounting Consistency: 

• Data ensure accounting consistency between RCO and uncontrolled distributors. 

Analysis and Adjustment: 

• Identifying Differences: 

• Through comprehensive data analysis, all material differences between controlled and uncontrolled transactions are identified. 

• Reliable Adjustments: 

• Reliable adjustments are made to account for identified differences, ensuring meaningful and accurate comparisons. 

Method Application: 

• Establishing Resale Price Margins: 

• Results from each uncontrolled distributor (A, B, C, D, E) are used to establish a range of arm’s length resale price margins. 
• These margins serve as benchmarks to apply to transactions involving RCO. 

Interpretation: 

• This example illustrates the successful application of the Resale Price Method in a scenario involving the distribution of unbranded products. 
• Through detailed data analysis and reliable adjustments for identified differences, the results from uncontrolled distributors are used to establish an arm’s length range of resale price margins. 
• The availability of comprehensive and accurate data is crucial for ensuring the reliability and effectiveness of the Resale Price Method in transfer pricing analysis. 

 -Example 5: 

Scenario Overview: 

• Continuing from Example 4, WCO manufactures Product Z, and RCO is the distributor in Country R. 
• Uncontrolled Distributors A, B, C, D, and E operate in Country R, distributing competing unbranded products. 
• In this scenario, data regarding warranties provided by uncontrolled distributors and payment terms are not sufficiently available. 

Conditions: 

• Data Insufficiency: 

• Insufficient data on warranties provided by uncontrolled distributors. 
• Lack of information on payment terms in contracts with uncontrolled distributors. 

Challenges: 

• Material Contractual Differences: 

• Inability to determine if uncontrolled distributors provide warranties or discern payment terms. 
• Potential material effects on price or profits due to these undetermined contractual differences. 

Mitigation Strategy: 

• Statistical Method Application: 

• Acknowledging the limitations in data completeness, a statistical method is applied to enhance the reliability of results. 
• The statistical approach aims to compensate for the lack of specific information on warranties and payment terms. 

Method Application: 

• Enhanced Arm’s Length Range: 

• Despite data insufficiency, a statistical method is employed to establish an enhanced arm’s length range. 
• This statistical range incorporates broader parameters, considering potential variations in contractual terms. 

Interpretation: 

• This example highlights the impact of insufficient data on specific contractual terms, potentially affecting the reliability of uncontrolled comparable. 
• The application of a statistical method becomes crucial in situations where specific contractual details are unavailable. 
• While statistical methods provide a broader perspective, they should be employed judiciously, considering the nature of the data and the potential impact of undetermined factors on transfer pricing results. 

 -Example 6: 

Scenario Overview: 

• Building upon the previous examples, WCO manufactures Product Z, and RCO distributes it in Country R. 
• Uncontrolled Distributors A, B, C, D, and E operate in Country R, but with different branding scenarios. 
• Companies A, B, and C distribute unbranded products, while Companies D and E distribute products branded with trademarks. 

Conditions: 

• Trademark Ownership: 

• Product Z is branded with a valuable trademark owned by WCO. 
• Companies A, B, and C distribute unbranded products. 
• Companies D and E distribute products branded with other trademarks but do not own any trademark rights. 

Challenges: 

• Product Value and Trademark Influence: 

• Products of Companies A, B, and C differ significantly in value from Product Z. 
• Products of Companies D and E are similar in value to Product Z but bear different trademarks. 
• Difficulty in determining the precise effect of the trademark on price or profits. 

Adjustment Challenges: 

• Because of the unique branding scenario, reliable adjustments for differences in value and trademark influence are difficult to ascertain. 

Resolution Approach: 

• Selective Inclusion of Comparable Transactions: 

• Due to challenges in determining the trademark’s impact, only transactions involving Companies D and E, with similar product values and trademarked products, are considered for establishing the arm’s length gross margin. 
• Transactions involving Companies A, B, and C, which differ significantly in product value and lack a comparable trademark scenario, are excluded from the analysis with Company S. 

Interpretation: 

• This example underscores the importance of considering not only product value but also branding scenarios in the application of the Resale Price Method. 
• The inherent difficulty in quantifying the impact of trademarks on pricing or profits emphasizes the need for a selective and nuanced approach to include only transactions with higher comparability levels in establishing an arm’s length gross margin. 

Conclusion:

This comprehensive exploration provides a deep understanding of the Resale Price Method, offering insights into its components, application, and real-world scenarios. As a valuable tool in transfer pricing, RPM’s strengths, weaknesses, and considerations equip businesses for effective implementation and compliance.