TRANSFER PRICING
IN SAUDI ARABIA

HOW IS TRANSFER PRICING SET?

The Organisation for Economic Co-operation and Development (“OECD”) transfer pricing rules state that the transfer price between group entities need to reflect the market price normally charged to a third party and negotiated upon the Arm’s Length Principle which is based on an analysis of the range of real market prices of a good or service in a country; therefore, allowing a single international standard for transfer pricing and tax computation, as well as ensure governments collect their share tax while providing multinational corporations with the advantage of avoiding double taxation. 

WHAT IS THE FORMULA OF TRANSFER PRICING?

The transfer pricing formula is:

Transfer Price = Outlay Cost + Opportunity Cost

Some companies calculate the minimum acceptable transfer price as equal to the variable cost, also referred to as the outlay cost or marginal cost. The marginal cost is identified as the total additional expense incurred from producing an additional unit of a good or service. 

However, as per the general economic transfer price rule, most companies calculate the minimum acceptable transfer price as equal to the outlay cost plus an opportunity cost.  The opportunity cost is the profit the division would make by selling the good or service in the marketplace as opposed to selling it to an internal division. 

WHAT ARE THE TRANSFER PRICING METHODS?

1. COMPARABLE UNCONTROLLED PRICE (CUP)

The Comparable Uncontrolled Price method compares the price charged for a good or service transferred in a controlled transaction with the price charged for the same good or service in a comparable transaction that is uncontrolled or between independent parties.

To determine whether the price charged by Division A for a good or a service sold to its associate Division B is at arm’s length, then the following information will be considered:

• Transaction A: The price charged for a good or service in a comparable uncontrolled transaction between Division A and an unrelated Party X.
• Transaction B: The price charged for a good or service in a comparable uncontrolled transaction between Unrelated Party X and Division B.
• Transaction C: The price charged for a good or service in a comparable uncontrolled transaction between Unrelated Party A and Unrelated Party B.

Where Transaction A and Transaction B are considered internal comparable transactions as it occurred between an internal tested party and an uncontrolled party; while Transaction C is described as an external comparable transaction where it occurred between two parties that are both unrelated to the group divisions.

To be considered a CUP, controlled transactions and uncontrolled transactions should meet high standards of comparability taking into consideration the following factors: characteristics of the good and service transferred, contractual terms, economic circumstances, and pursued business strategies.

Generally, a CUP is deemed as the most direct and reliable method of applying the arm’s length principle for transfer pricing for the following reasons:

• it is based on the open market price of tested transactions between related parties.
• it also takes into consideration the agreed price between two unrelated parties to the transaction, making it a two-sided analysis.
• it provides a direct comparison between internal comparable transactions and external comparable transactions.
• it is readily available to be used for transactions that involve tangible product.

On the other side, one of the shortcomings of this method is the unavailability of an external comparable market for the good or service being supplied.  

2.COST-PLUS METHOD (C+ METHOD)

In this method, the related manufacturing company is considered as the tested party in the transfer pricing analysis. The Cost-Plus method is a gross margin method as it derives its arm’s length amount from a gross profit mark-up added to the cost of goods sold incurred by the supplier of the good or service. 

Instead of comparing prices to test whether a transfer price is at arm’s length, the Cost-Plus method evaluates and compares whether the gross profit mark-up earned by the associated supplier is at arm’s length to the gross profit margin earned by suppliers of comparable products in transactions to unrelated parties. 

In the Cost-Plus Method, TP = COGS x (1 + cost plus mark- up), where:

• TP is the transfer price of a good or service sold by a supplier to a related party.
• COGS is the Cost of Goods Sold incurred by the supplier (including direct and indirect costs, excluding operating expenses).
• Cost plus mark-up is the gross profit mark-up or the ratio of gross profit to GOGS.

3. RESALE-MINUS METHOD

The Resale-Minus method evaluates the arm’s-length transfer price for a good or service based on the gross margin or the difference between the price at which the product is purchased and the price upon which it is sold to a third party. 

TP = Resale Price – Selling Price to 3rd party

The transfer price is based on the resale price adjusted by deducting the gross margin including additional costs associated with the purchase of the good or service. 

4. TRANSACTIONAL NET MARGIN (TNMM)

The Transactional Net Margin is the most used method for taxpayers recently in establishing the transfer price. 

It basically compares and tests the net profit margin earned in a controlled transaction with the net profit margin earned by the related party from a transaction with a third party or the net margin earned by a third party from a comparable transaction with another third party.

Relatively similar to the Cost-Plus and Resale Price method, yet the transactional net margin requires less product comparability, and involves the comparison of the net margin rather than the gross profit margin.

5. PROFIT-SPLIT METHOD (PSM)

The profit-split method starts with identifying the incurred profit from a related-party transaction and dividing that profit amongst the associated parties based on the relative value each party contributed towards that profit in terms of the function it performed, the risks it incurred and the assets it used in the transaction. Such that, the profit split between the associated parties would be in relative to what independent parties performing a similar function would anticipate in a comparable uncontrolled transaction. 

The advantages of the profit-split method:

• It is applicable in tangible and intangible property, trading activities, and financial services transaction.
• It is useful in cases where comparable transactions between unrelated parties are not available; or in cases where a transaction involves several related parties.
• It eliminates extreme result for one of the related parties, and instead, it analyses all parties involved in the controlled transaction.

The weakness of the profit-split method is relative to its actual application. For example, it may be difficult and costly to calculate the combined revenue and costs for all the related parties in the controlled transaction if the associates do not use the same accounting practices. 

WHAT ARE THE RISKS OF TRANSFER PRICING

Risks related to transfer pricing are both internal and external.

1. Disagreements within divisions of a group regarding the policies on pricing and transfer.
2. Divisions of the group might hold and assume different types of risks.
3. It could be difficult and costly to establish prices for intangible items and services. 
4. Tax Law compliant challenges.
5. The high-cost burden due to the time and labour required in establishing a proper accounting system to execute transfer prices and support it.