Plain English
There is no single 'correct' formula for transfer pricing — instead there are five recognised tools, and the job is picking the one that best fits the facts. Three are traditional transaction methods that compare prices or margins directly (CUP, resale price, cost plus); two are transactional profit methods that compare net profit indicators or split combined profit (TNMM and profit split). Most real-world distribution and manufacturing arrangements end up using TNMM because reliable direct price comparables are hard to find; CUP is preferred when a truly comparable market price exists.
Technical definition
The five transfer pricing methods described in Chapter II of the OECD Transfer Pricing Guidelines: the Comparable Uncontrolled Price (CUP) method, the Resale Price Method, the Cost Plus Method (together the traditional transaction methods), and the Transactional Net Margin Method (TNMM) and the Transactional Profit Split Method (together the transactional profit methods), any of which may be selected as the most appropriate method for a given controlled transaction based on the strengths and weaknesses of each method, the nature of the transaction as determined by functional analysis, and the availability of reliable comparable data.
Why it matters
Method selection is the single decision most likely to be challenged in an audit — the wrong method, even applied perfectly, produces a defensible-looking answer to the wrong question.
How it works in practice
- 01Conduct a functional analysis to understand the transaction's economic substance.
- 02Assess data availability: is there a genuinely comparable uncontrolled price, or only broader margin comparables?
- 03Apply the most appropriate method rule: no fixed hierarchy, though traditional methods are preferred where equally reliable data exists.
- 04For one-sided transactions with a clear tested party, CUP, resale price, cost plus or TNMM are typically used.
- 05For genuinely integrated, two-sided transactions involving unique contributions from both parties, profit split is typically used.
Worked example
Choosing between cost plus and TNMM for a manufacturer
A contract manufacturer produces components for its parent under a toll manufacturing arrangement. No direct comparable uncontrolled price exists for the specific component, ruling out CUP. Comparable third-party toll manufacturers are identifiable, but reliable gross margin data (needed for cost plus) is not disclosed in public financial statements, while operating margin data is available. The analysis therefore selects TNMM with a full-cost mark-up profit level indicator, benchmarked against five comparable contract manufacturers earning 4-7% net cost plus, rather than cost plus in its strict gross-margin form.
Common mistakes
- Defaulting to TNMM automatically without properly considering whether CUP data exists.
- Applying profit split to a transaction where only one party makes unique, valuable contributions.
- Selecting a method based on which one produces the most favourable result rather than which is most reliable.
Audit red flags
- Method selection memos with no discussion of rejected alternative methods.
- Profit split applied without evidence that both parties make genuinely unique and valuable contributions.
- Internal CUPs available but not considered before external benchmarking was commissioned.
Documentation & data
Documents to hold
- A method selection memo discussing and ranking the methods considered.
- Evidence supporting rejection of methods not selected.
- The benchmarking or comparable analysis supporting the chosen method.
Data you need
- Internal comparable transaction data, if any exists.
- Access to a commercial database for external comparables.
- Segmented financials sufficient to compute the relevant profit level indicator.
Who owns this internally: Advisor or in-house economist selects and documents the method; in-house tax approves it as part of policy.
Jurisdiction notes
- OECD Guidelines jurisdictions
- Apply the most appropriate method rule without a strict hierarchy, though traditional methods are noted as generally preferable where equally reliable.
- United States
- Uses a formally named 'best method rule' under Section 482 regulations, conceptually similar but a distinct legal standard.
- Some emerging markets
- Historically imposed a stricter hierarchy favouring traditional transaction methods, though most have moved toward OECD-aligned flexibility.
Notes by role
Students & job seekers
Be ready to explain, with an example, why TNMM is used more often than CUP in practice despite CUP being conceptually the most direct method.
Advisors & consultants
Always document the methods rejected, not just the one chosen — auditors probe the rejection logic more than the selection logic.
Frequently asked
- Is there a required order in which to try the five methods?
- No fixed hierarchy exists under the OECD Guidelines; the taxpayer selects whichever method is most appropriate given the facts, though traditional transaction methods are favoured where data of equal reliability exists.
- Can more than one method be used for the same transaction?
- Yes, a secondary method is sometimes used to corroborate the primary method's result, particularly in complex or high-risk transactions.
Sources & status
- Primary source
OECD Transfer Pricing Guidelines, Chapter II
OECD, 2022
Reference material only, not advice on a specific fact pattern. Reviewed 2026-06-30.
Careers
How this shows up in the job
Method selection reasoning is the most consistently tested technical topic across transfer pricing job interviews at every seniority level.
Careers in transfer pricing