 Hello and welcome to this session. This is Professor Farhad and this session would look at US transfer pricing rules, sale of tangible property, part two. In the first session we looked at comparable uncontrolled price method and resale price method. In this method we would look at the three other methods that we did not cover which are the cost plus comparable profit and the profit split method. This topic is covered in international accounting as well as on the ACCA exam. As always I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1500 plus accounting, auditing, finance and tax lectures. These are the courses that I cover including CPA questions. On my website I do have additional resources such as PowerPoint slides, notes, multiple choice questions, 2000 plus CPA questions and many quasi-CPA simulations. The prerequisite for this topic is in the description if you need so and basically we're going to be looking for is the sale of tangible property based on the treasury regulation that requires the use of one of the five specified methods to determine an arm length price and a sale of tangible property. What is a tangible property? Either inventory or fixed asset between related parties. The five methods are comparable uncontrolled price method and resale method. Those two methods we already covered in the prior session. You can look in the description. In this session we look at the cost plus method, comparable profit methods and the profit split method starting with the cost plus method. First of all when do we use the cost plus method when there is no comparable uncontrolled sales but basically what we cannot find something comparable to what we are doing and the related buyer does more than simply distribute the goods it purchases. So basically it's not like the the resale price where we sell something and the person that the party that we sold it to simply resell it. Here we sell something to another party then they use it under manufacturing process. So the cost plus method adds an appropriate gross profit using a comparable uncontrolled transaction and you're saying you just said we can we use it when there is no comparable uncontrolled sales well we have to kind of find out what will be the closest thing to add the profit and we'll look at an example to the cost of producing a product to establish an arm length transaction. So this method normally uses in cases involving manufacturing why because you sell items that goes into a bigger product then that item they might go into you know another product as well. So that's why it's in manufacturing assembly same thing you'll sell an item that goes into another item like you sell a radio the radio goes into the car or you sell batteries the batteries are assembled into the car or other production of goods that are sold to related party. So here the physical similarity between the product transfer is not important in determining a comparability under this method as it is under the comparable uncontrolled price method. So it doesn't have to be the same item as long as it's comparable enough we can live with it. Okay so what factors will determine can we can we factor when we are looking at the cost plus method factors that could be considered relevant is the complexity of the manufacturing or assembly process so we can look at similar manufacturing or assembly process. Manufacturing production and engineering process how did they make the product engineering wise how did they buy it how do they control inventory and how do they test it so we could look at these factors to determine whether we have a comparability. And the best way to illustrate this is to just take a look at an example assume that P company which is the parent company has a subsidiary in Taiwan that acquires material to locally to produce electronic components so the Taiwanese subsidiary is a producer in the component the component costs four dollars per unit to produce in Taiwan and it's sold only to P company so notice there is no they're not selling it to third part there is no comparable uncontrolled price okay because the job because the Taiwanese subsidiaries that does not sell the component to other unrelated the comparable uncontrollable uncontrollable price method is not applicable here okay parent company combines the electronic component important from Taiwan with other part to assemble electronic switches so simply put they will send us one item and this item goes into a bigger item so we're not really reselling it we're not really reselling because we don't simply resell it the resale price method is also out okay so now what we have to do P must look at a comparable transaction between unrelated parties in Taiwan to determine whether the cost plus method can be used now we have to look at if there's any similar companies to what we're doing that they sell their product in Taiwan so let's assume um comparable company in Taiwan manufacture similar electronic component from its inventory of material and sell them to unrelated party at an average gross profit markup of 25 percent well good now we have something to work with if it's four dollars add 25 percent markup we have five dollars now in this case the application of the cost plus method result in a transfer price of five of five dollars which is four dollars times 25 cent which is 25 percent which is a dollar plus four equal to five dollars so we just solve the problem the second method we're going to be looking at is comparable profit method okay the comparable profit method is based on the assumption that similarly situated taxpayer will tend to earn similar return over a given period so simply put if you are in it and if you are if if two companies are in the same tax in the similar tax situation they should be making the same profit okay so under this method you just have to look at one or two parties in the related transaction is chosen for examination so basically you have to see okay the the treasury will have to see okay let me take a look at your situation because they're going to be similar to your subsidiary or similar to your sister company because you guys are situated in the in the same tax or similar tax jurisdiction okay so how what we do in arm length price is determined by referring to an objective measure of problem of profitability earned by uncontrolled taxpayer on comparable uncontrolled sales so basically we look at something similar to yours okay so profit indicator that might be considered will be will be the ratio of operating income to operating asset simply put taken operating income divided by operating asset to find a ratio ratio remember ratio is a percentage the ratio of gross profit to operating expenses we can take gross profit divided by operating expenses or the ratio of operating profit to sales or we can take operating profit divided by sales to find a percentage and see that percentage of comparable profit is acceptable okay if the transfer price results in ratios for the party being examined that are in line with those ratios for similar businesses then the transfer price will not be challenged so simply put they would look at your business and they would look at your profit based on a certain ratio one of these ratios and if those ratios are comparable to other businesses then then your transfer price is acceptable or fair okay so let's take a look at an example and she is a u.s. manufacturers distribute its product in a foreign country through its foreign sales subsidiary i'm sorry vid vidco assume that the that the that the subsidiary has a sales of a million dollar and operating expenses of 200 000 so let's start let's let's build the income quasi income statement here so we have sales of a million and operating expenses of 200 000 okay let's see what else do we have over the past several years comparable distributor to the to the foreign subsidiaries have earned operating profit equal to five percent so simply put what we're saying the profit of similar companies should be five percent of sales the profit is 50 000 so we have sales of a million operating expenses of 200 000 well guess what what's left is cost of goods sold cost of goods sold under those circumstances must be 750 000 okay so under this comparable method a transfer price the transfer transfer price that provide vid vid company and earning an operating an operating profit equal to five percent of sales will be considered an arm land and we already find out that cost of sales should be 750 based on these ratios well so a million will give you 50 50 000 of profit to achieve this profit so 1 million minus 200 000 minus the profit of 50 cost of goods sold must be 750 so if we transfer to them 750 if we use 750 as the transfer price then it's acceptable this is the amount that gloss code would be allowed to charge as a transfer price for its sales 750 000 so this what this example demonstrate is the ratio of operating profit to sales so we looked at the profit which was 50 000 and we looked at sales which was a million this is the five percent profit so this is what we used we use the operating profit to sales okay the treasury regulation also specifically mentioned the use of the ratio of operating profit to asset so we could use some sort of operating profit to operating asset look at similar companies and the ratio of gross profit to operating expenses you could also take the gross profit divided by operating expenses to see if that's an acceptable indicator in applying this method okay the profit split the profit split method is the last method here we assume that the buyer and the seller are one economic entity one economic unit the total profit earned by the economic unit from the sales to uncontrolled parties is allocated to members of the economic unit based on the relative contribution into the profit so after we after we computed our total profit for the company sales let's just let's make it sales minus cost of goods cost of goods sold cost of goods sold equal to profit this is the profit for sorry my pen is acting up let me just do this one more time so if we have profit let's start from the beginning sales minus cost of goods sold equal to the profit and for the sake of simplicity for the sake of simplicity what's going to happen is we're going to be using the relative value of each party's contribution let's assume we contributed 50 50 50 to this profit 50 50 to this profit so what's going to happen is this the profit will have to be split 50 50 and how do we split the profit 50 50 we basically adjust the cost the transfer price between the two parties where the profit is split 50 50 50 between those two parties now if one party contributed more and the profit should be 80 and my profit should be 20 the other party should be because it should be 20 percent then guess what then the 80 percent will have a higher they would receive a higher i'm sorry they would receive a higher transfer price okay so the relative value of each party's contribution and earning is based on the functions performed the risks assumed and the resource employed in the business activity that generated the profit what i meant to say if they contributed more they should absorb more profit that's what i that's what i was trying to say if they if they contributed more if they're assuming more risk then they're taken then they should take more profit actually cost will be lower not higher the transfer price will be lower i misspoke if you have any questions about this topic please let me know as always i would like to remind you and by the way before i proceed there are two versions of this method i'm not going to cover them just it's too much details i'm sure if that's what you do for a living you know it or if it's in your textbook you would know it as well as always i would like to remind you to connect with me and please visit my website for additional lectures i strongly suggest if you're studying for your cpa exam to subscribe it's an investment in your career good luck and study hard