Which transfer pricing method suits the diamond industry, given the difficulty in accessing reliable data?

QUESTION POSTED BY: Student
PROGRAMME: Postgraduate Diploma in International Taxation
TOPIC: Transfer PricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... Extended (WEEKS 28, 29 & 30)
LECTURER: Okkie Kellerman

FULL QUESTION

In your opinion, which transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... method will be the best to apply in to the the diamond industry, based on the fact that it’s not easy to get information on the same?

ADDITIONAL WRITTEN ANSWER

Applying transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... methods in the diamond industry can be particularly challenging due to its unique characteristics, such as high-value transactions, limited comparables, and vertically integrated operations. Given these challenges, the Resale Price Method (RPM) and Transactional Net Margin Method (TNMM)The Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to... are often considered more practical for this industry compared to other methods. Here’s an analysis of their application and why they might be appropriate:

1. Resale Price Method (RPM)

Why it fits:

Focus on resale margins: RPM evaluates the arm’s length nature of a transaction by examining the gross profit margin on resale, which can often be more accessible than direct cost or pricing data in the diamond trade.
Applicability to distributors: For diamond wholesalers or retailers who purchase diamonds from related entities and resell them to third parties, this method can be applied using data from comparable distributors.
Challenges:
- Limited comparable gross profit margins in the diamond industry due to market opacity.
- Significant variations in diamond quality, grade, and cut may distort comparability.

2. Transactional Net Margin Method (TNMM)The Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to...

Why it fits:

Reliance on net profit margins: TNMMThe Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to... uses net margins instead of gross margins, making it less sensitive to differences in product characteristics, which is advantageous for the diamond industry.
Flexibility: This method works well in scenarios where detailed transaction-level comparables are unavailable, as it allows the use of broader financial data for similar industries or companies.
Focus on functions and risks: Since the diamond industry often involves multiple functions (e.g., mining, cutting, polishing, and retail), TNMMThe Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to... allows analysis at the functional level.
Challenges:
- Difficulty in finding suitable external comparables for profitability margins in niche sectors like diamond mining or trading.
- Risk of distorted results if comparables operate in significantly different markets.

3. Profit Split Method (PSMThe Profit-Split Method (PSM) is a critical tool in transfer pricing, used to allocate profits or losses among associated enterprises participating in controlled transactions. This method is particularly relevant when transactions involve integrated operations or unique and valuable intangibles that make comparable uncontrolled prices challenging to establish. The PSM ensures compliance with the arm's length principle, requiring that profits are...)

Situational use:

For vertically integrated operations: Many diamond companies are involved in the entire value chain, from mining to retail. PSMThe Profit-Split Method (PSM) is a critical tool in transfer pricing, used to allocate profits or losses among associated enterprises participating in controlled transactions. This method is particularly relevant when transactions involve integrated operations or unique and valuable intangibles that make comparable uncontrolled prices challenging to establish. The PSM ensures compliance with the arm's length principle, requiring that profits are... is effective when multiple related parties contribute significantly to value creation, and profits must be allocated based on contributions.
Applicability: If the value drivers in a transaction are unique (e.g., access to diamond mines or proprietary cutting techniques), this method allows allocation based on internal factors.
Challenges:
- Complex to implement due to the subjective nature of profit allocation.
- Requires detailed financial data from all related entities, which can be difficult to gather in the diamond industry.

4. Comparable Uncontrolled Price MethodThe Comparable Uncontrolled Price (CUP) Method is a transfer pricing approach that assesses whether the price charged in an intercompany transaction between related entities is consistent with the arm’s length principle. The arm’s length principle, a fundamental concept in transfer pricing, requires that the conditions of a transaction between associated enterprises be equivalent to those which would have been agreed... (CUPThe Comparable Uncontrolled Price (CUP) Method is a transfer pricing approach that assesses whether the price charged in an intercompany transaction between related entities is consistent with the arm’s length principle. The arm’s length principle, a fundamental concept in transfer pricing, requires that the conditions of a transaction between associated enterprises be equivalent to those which would have been agreed...)

Limited use:

Why it struggles: Diamonds are unique, and no two stones are identical in quality, size, and characteristics, making it difficult to find truly comparable uncontrolled transactions.
When it works: CUPThe Comparable Uncontrolled Price (CUP) Method is a transfer pricing approach that assesses whether the price charged in an intercompany transaction between related entities is consistent with the arm’s length principle. The arm’s length principle, a fundamental concept in transfer pricing, requires that the conditions of a transaction between associated enterprises be equivalent to those which would have been agreed... may be useful in highly standardized transactions, such as bulk trading of industrial diamonds or rough diamonds with consistent grades.

Best Approach

Given the difficulty in obtaining precise data in the diamond industry, TNMMThe Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to... is often the most practical and widely used method. It provides a balanced approach by focusing on overall profitability, which is more accessible through broader financial comparables. However, if the company operates at multiple stages of the value chain, a hybrid approach involving TNMMThe Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to... for routine functions and PSMThe Profit-Split Method (PSM) is a critical tool in transfer pricing, used to allocate profits or losses among associated enterprises participating in controlled transactions. This method is particularly relevant when transactions involve integrated operations or unique and valuable intangibles that make comparable uncontrolled prices challenging to establish. The PSM ensures compliance with the arm's length principle, requiring that profits are... for unique contributions may yield the most defensible results.

VIDEO SCRIPT

The diamond industry does present unique challenges when it comes to applying transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... methods.

These challenges stem from the high value of transactions, the limited availability of comparables, and the vertical integration often seen in the industry.

Given these complexities, selecting the right transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... method requires careful consideration of the specific circumstances and the type of data that is realistically available.

Let’s begin with the Resale Price Method.

This method is particularly useful when analyzing transactions involving distributors who purchase diamonds from related entities and resell them to third parties.

RPM focuses on the gross profit margin earned on resale, making it a good fit for the wholesale and retail segments of the diamond trade.

One advantage of RPM is that gross margin data is often more accessible than direct pricing information, which is notoriously opaque in the diamond market.

However, the unique characteristics of diamonds—such as variations in quality, grade, and cut—can make it difficult to find comparable transactions, which limits the application of this method.

Another commonly used method in the diamond industry is the Transactional Net Margin MethodThe Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to..., or TNMMThe Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to....

TNMMThe Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to... analyzes net profit margins rather than gross margins, which makes it less sensitive to differences in product characteristics. This flexibility is particularly advantageous in the diamond trade, where comparables for specific transactions are hard to come by.

Instead, TNMMThe Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to... allows us to rely on broader financial data from companies engaged in similar activities, such as diamond mining, cutting, or trading. Moreover, it aligns well with the functional and risk profile of entities in the diamond supply chain.

Despite its strengths, TNMMThe Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to... has its own challenges. Identifying suitable comparables that operate under similar economic conditions can be difficult, especially given the niche nature of the diamond sector.

The Profit Split Method, or PSMThe Profit-Split Method (PSM) is a critical tool in transfer pricing, used to allocate profits or losses among associated enterprises participating in controlled transactions. This method is particularly relevant when transactions involve integrated operations or unique and valuable intangibles that make comparable uncontrolled prices challenging to establish. The PSM ensures compliance with the arm's length principle, requiring that profits are..., might be a better fit in situations involving vertically integrated operations.

Many diamond companies are involved in the entire value chain, from mining to retail. PSMThe Profit-Split Method (PSM) is a critical tool in transfer pricing, used to allocate profits or losses among associated enterprises participating in controlled transactions. This method is particularly relevant when transactions involve integrated operations or unique and valuable intangibles that make comparable uncontrolled prices challenging to establish. The PSM ensures compliance with the arm's length principle, requiring that profits are... is particularly effective in such cases because it allows profits to be allocated based on each entity’s contributions to value creation.

For example, a company with exclusive access to diamond mines or proprietary polishing techniques may warrant a larger share of the profits.

However, PSMThe Profit-Split Method (PSM) is a critical tool in transfer pricing, used to allocate profits or losses among associated enterprises participating in controlled transactions. This method is particularly relevant when transactions involve integrated operations or unique and valuable intangibles that make comparable uncontrolled prices challenging to establish. The PSM ensures compliance with the arm's length principle, requiring that profits are... can be complex to implement, as it requires detailed financial data from all related entities, and the allocation of profits can often be subjective.

The Comparable Uncontrolled Price MethodThe Comparable Uncontrolled Price (CUP) Method is a transfer pricing approach that assesses whether the price charged in an intercompany transaction between related entities is consistent with the arm’s length principle. The arm’s length principle, a fundamental concept in transfer pricing, requires that the conditions of a transaction between associated enterprises be equivalent to those which would have been agreed..., or CUPThe Comparable Uncontrolled Price (CUP) Method is a transfer pricing approach that assesses whether the price charged in an intercompany transaction between related entities is consistent with the arm’s length principle. The arm’s length principle, a fundamental concept in transfer pricing, requires that the conditions of a transaction between associated enterprises be equivalent to those which would have been agreed..., is often considered the gold standard in transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... because it compares prices directly.

However, in the diamond industry, CUPThe Comparable Uncontrolled Price (CUP) Method is a transfer pricing approach that assesses whether the price charged in an intercompany transaction between related entities is consistent with the arm’s length principle. The arm’s length principle, a fundamental concept in transfer pricing, requires that the conditions of a transaction between associated enterprises be equivalent to those which would have been agreed... is of limited use. Diamonds are unique, and no two stones are identical in quality or size.

This makes finding true comparables for uncontrolled transactions difficult.

That said, CUPThe Comparable Uncontrolled Price (CUP) Method is a transfer pricing approach that assesses whether the price charged in an intercompany transaction between related entities is consistent with the arm’s length principle. The arm’s length principle, a fundamental concept in transfer pricing, requires that the conditions of a transaction between associated enterprises be equivalent to those which would have been agreed... can be applied in situations involving highly standardized transactions, such as the bulk trading of industrial-grade diamonds or rough diamonds with consistent grades.

Now, considering the practical realities of the diamond industry, the Transactional Net Margin MethodThe Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to... often emerges as the most practical and widely used approach.

Its focus on overall profitability, rather than specific transaction details, makes it more flexible and defensible in audits.

That said, in cases where a company operates across multiple stages of the value chain, a hybrid approach might be warranted.

For instance, TNMMThe Transactional Net Margin Method (TNMM) is one of the five primary transfer pricing methods recognised under the OECD Transfer Pricing Guidelines. TNMM is applied to evaluate whether the conditions of a controlled transaction between associated enterprises are at arm’s length. Unlike traditional transaction methods, which directly compare prices or gross margins, TNMM compares the net profit margin relative to... can be applied to routine functions, while PSMThe Profit-Split Method (PSM) is a critical tool in transfer pricing, used to allocate profits or losses among associated enterprises participating in controlled transactions. This method is particularly relevant when transactions involve integrated operations or unique and valuable intangibles that make comparable uncontrolled prices challenging to establish. The PSM ensures compliance with the arm's length principle, requiring that profits are... can address unique contributions, ensuring that profits are allocated appropriately across the group.

In summary, while each transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... method has its strengths and limitations, the choice ultimately depends on the availability of data and the specific functional profile of the entities involved. Understanding these nuances is critical to ensuring that the chosen method aligns with both the arm’s length principleThe Arm’s Length Principle (ALP) is a cornerstone concept in international taxation and transfer pricing. It requires that transactions between related parties, such as subsidiaries or affiliates within a multinational enterprise (MNE), mirror those that would occur between independent entities under similar circumstances. This principle ensures that each entity within an MNE is compensated fairly and transparently, based on the... and the unique characteristics of the diamond trade.