Skip to main content
Avalara Help Center

Understanding Transfer Pricing Models

Avalara Transfer Pricing Reports focuses on three transfer pricing models – Cost-Plus, Low-Risk Distributor, Royalty. 

The tool generates US and OECD compliant transfer pricing reports that fall under these models. Each transfer pricing model includes specific intercompany transaction types. Refer to the different transactions and the fixed interquartile range.

If your company’s transfer pricing model structure is more complicated than the models mentioned below, or the arm’s length range of the covered transactions do not fit your situation, you may consult a transfer pricing expert.

Supply-chain model types

Model Type When to use Description
Cost-Plus Model When the subsidiary company is providing services to the parent company without selling anything to the consumers itself.

The Cost-Plus model is used for intercompany services. It is comprised of a Service provider and a Service Recipient.

Services provided by the subsidiary company are taxed, based on a percentage markup of the costs incurred by the parent company in running the subsidiary (salaries, rent, and so on). This markup is based on the industry standards for companies providing similar services, thereby, creating a legally safe arm's length markup.

Low-Risk Distributor Model When the subsidiary company is actively reselling goods or services to consumers.

The Low-Risk Distributor model is used for resale of goods (including software and SaaS). It is comprised of a Seller which sells its products to the other entity, the Reseller, for resale.

Sales made by the subsidiary company are taxed based on the markup percentage, which is based on a cost of goods set by the parent company. The intercompany price, the reseller’s cost of goods is a bottom-up plug number, after establishing an arm’s length operating profit margin (operating profit as a percentage of sales).

 

Royalty Model When a company owns an IP and licenses it to another company in the group for use in its business. Direct royalty rate for use of the technology or tradename or trademark. The benchmark is based on comparable agreements between unrelated parties, which create an arm's length royalty rate.

How do these models work?

Every intercompany transaction is comprised of two entities. One entity is the Service Provider or Reseller, while the other entity is the Service Recipient or Seller. Under these models, one entity is characterized as the principal and the other as the low-risk service provider or distributor. The intercompany price is determined by comparing the least complex entity’s (the low-risk service provider/distributor) operating profit margin derived from the intercompany transaction to the benchmark. If its operating profit falls within the benchmark's interquartile range, the intercompany transaction is considered at arm’s length.

How to determine the correct model for your organization structure?

Indicators that this is the right model for your intercompany transaction:

The service provider or reseller should be characterized as a low-risk service provider.

  • Bears limited risk in providing the service – bearing the risk, means that contractually it will pay for costs associated with the risk and it employs the personnel that can make decisions on the relevant risk. Similar to winning by points rather than a knock-out, the less risks the entity bears, the stronger the model is. Risks may include:
    • Inventory risk – for example if the reseller can return slow or dead inventory
    • Product/service liability risk – which entity will bear costs associated with recalls, product defects, damage for clients caused by using the product
    • Foreign exchange risk – if the revenues and costs are in different currencies. Does the service provider/reseller are compensated/purchase in their local currency?   
    • R&D risk – which entity bears the costs associated when more resources are required to complete the R&D. Also, the location of the senior R&D employees
    • Credit risk – Client’s bad debts. Which entity bears lost associated with clients’ bad debt.
  • No intangible assets are used in providing the service. 

How are these models applied?

The service provider is compensated for the services it provides, on a cost-plus basis, where the cost includes all direct and indirect costs (including cost of goods and operating cost, excluding interest and tax) associated with the provision of the service. Cost centers that exclusively provide a service to another member in the group, will allocate all the relevant expenses. Companies which are engaged other activities in addition to the intercompany transaction (for example, the headquarters entity, which provides management services to one of its subsidiaries) must identify and allocate the direct and indirect expenses associated with the intercompany transaction. Usually, a key allocation based on revenues is used to allocate the right amount of expenses.  

Glossary of terms used in this article

  • Principal company – with respect to the intercompany transaction, the party of the intercompany transaction which serves as the headquarters, owns most of the group’s intellectual properties and responsible for most of the group’s activities. In many cases, it’s the parent company.
  • Least complex entity – with respect to the intercompany transaction, the party of the intercompany transaction, which is responsible for less activities, owns fewer intellectual properties and employs fewer senior employees.  
  • Operating profit margin – the Earnings Before Interest and Tax (EBIT) as percentage of Net Sales.
  • Benchmark – the set of comparable companies’ operating profit margin
  • Interquartile range – the 25th and 75th percentile of benchmark’s results
  • Was this article helpful?