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    Published Tue, 21 Mar 2023 Income Tax

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    Transfer pricing refers to methods which determine the prices of transactions between associated enterprises which may take place under conditions differing from those taking place between independent enterprises. 

    It refers to the value attached to transfers of goods, services and technology between associated enterprises. An arrangement of transfer pricing is usually between related enterprises, such as holding and subsidiary companies. The arrangement specifies the transfer price for sale or purchase of goods between the holding and subsidiary companies.

    The Provisions of Transfer Pricing regulations in India have been introduced to ensure that income arising from an International Transaction or specified domestic transactions between Associated Enterprises shall be computed on Arm’s Length Price. Any cost or expense allocated or apportioned between two or more associated enterprises under a mutual agreement or arrangement shall also be at an Arm’s Length Price.

    Arm’s Length price

    The Arm’s Length Price (ALP) of a transaction between two associated enterprises is the price that would be paid if the transaction had taken place between two comparable independent and unrelated parties, where the consideration is only commercial.

    Computation of Arm’s length price:

    The following methods have been prescribed by Section 92C of the Act for the determination of the arm’s length price:

     • Comparable uncontrolled price (CUP) method

     • Resale price method (RPM)

     • Cost plus method (CPM)

     • Profit split method (PSM)

     • Transactional net margin method (TNMM)

     • Other Methods

    1. Comparable Uncontrolled Price (‘CUP’) method 

    CUP is a traditional and mostly preferred method for determining ALP where comparable data are available in commercial databases. It is the price of goods or services and conditions of a controlled transaction with those of an uncontrolled transaction. The CUP Method may also sometimes be used to determine the arm’s length royalty for the use of an intangible asset. CUPs may be based on either “internal” comparable transactions or on “external” comparable transactions.

    While determining the comparability of controlled and uncontrolled transactions, each material factor has to be taken into consideration. Hence, this method is not generally recommended unless the goods or services are highly comparable.

    The OECD Guidelines recommend the use of CUP under the following circumstances: 

    Where an AE sells the same product or services as is sold to independent third parties; None of the differences between the International Transaction/Specified Domestic Transaction and the comparable uncontrolled transaction, if any, could materially affect the pricing mechanism; and In case pricing mechanism is affected on account of differences in the nature of transactions as discussed above, reasonably accurate adjustments can be made to eliminate such differences.

    2. Resale Price Method or Resale Minus Method (‘RPM’) 

    This method takes into consideration, the price at which a product or service has been sold to unrelated parties which was initially bought or obtained from AEs. This price can be referred to as ‘resale price’. For application of RPM, the reselling of product or service should happen without adding any significant commercial value to the same. It means it will be more suitable in cases where only basic sales, marketing and distribution activities are undertaken.

    For the purpose of applicability of RPM, the resale price of the goods is reduced by the gross profit margin which is determined by comparing the gross profit margins in a comparable uncontrolled transaction. Further, costs which are associated with the purchase of such product like customs duty are deducted. 

    Example:    Given price                             = $500

                       Resale price margin (20%)      = $100

                       Arm’s length price                  = $400

    3. Cost Plus Method (‘CPM’) 

    The Cost Plus Method (‘CPM’) determines an arm’s-length price by adding an appropriate gross profit margin to an associated entity’s costs of producing goods or services. The first step is to determine the costs incurred by the supplier in a controlled transaction for products transferred to an associated purchaser. Secondly, an appropriate markup has to be added to the cost, to make an appropriate profit in light of the functions performed. After adding this (market-based) mark up to these costs, a price can be considered at arm’s length.

    Example: Cost of associated enterprise 1 =   $500 

                    Gross profit mark -up (50%)   =   $250

                    Arm’s length price                  =   $750

    4. Profit Split Method (‘PSM’) 

    The PSM is the transactional profit split method that focuses on highlighting how profits (and indeed losses) would have been divided within independent enterprises in comparable transactions. It starts by determining the profits from the controlled transactions that are to be split. The profits are then split between the associated enterprises according to how they would have been divided between independent enterprises in a comparable uncontrolled transaction. This method results in an appropriate arm’s length price of controlled transactions.

    There are two main approaches that can be taken for splitting profits. These are:

    1. Contribution analysis: The combined profits are divided based on the relative value of the functions performed by each of the related entities within the controlled transaction (considering assets used and risks assumed) or uncontrolled taxpayer’s percentage of the combined operating profit or loss is used to allocate the combined operating profit or loss of the relevant business activity

    2. Residual analysis: The combined profits are divided in two stages:

      1. Allocate income to routine contributions 

      2.  Allocate residual profit       

    5. Transactional Net Margin Method (‘TNMM’) 

    The TNMM is one of two transactional profit methods outlined by the OECD for determining transfer pricing. These types of methods assess the profits from particular controlled transactions. The TNMM involves assessing net profit against an “appropriate base”, such as sales or assets, that results from a controlled transaction. The OECD states that, in order to be accurate, the taxpayer should use the same net profit indicator that they would apply in comparable uncontrolled transactions. Taxpayer can use comparable data to find the net margin that would have been earned by independent enterprises in comparable transactions. The taxpayer also needs to carry out a functional analysis of the transactions to assess their comparability.

    If an adjustment is needed for a gross profit markup to be comparable, but the information on the relevant costs are not available, then taxpayers can use the net profit method and indicators to assess the transaction. This approach can be taken when the functions performed by comparable entities are slightly different.

    6. Other Method 

    CBDT has now prescribed the ‘other method’ retrospectively with effect from April 1, 2012 vide Rule 10AB. Rule 10AB shall apply to Assessment Year 2012-13 (i.e., FY 2011-12) and subsequent years. The new rule introduced in this respect deals with comparing actual price of uncontrolled transaction, which appears to be similar to the CUP Method. The rule introduces the concept of hypothetical third party transactions. It recommends use of price which would have been charged or paid in an uncontrolled transaction like quotations, price publications etc. In line with the OECD Guidelines, the other method provides for a relaxation on selection of five prescribed methods for determination of ALP.

    The most appropriate method referred shall be applied for the determination of arm’s length price, in the manner as may be prescribed. Provided that where more than one price may be determined by the most appropriate method, the Arm’s Length Price shall be taken to be the arithmetic mean of such prices, or, at the option of the assessee, a price which may vary from the arithmetical mean by an amount not exceeding 5% of such arithmetical mean.

    Advance Pricing Agreements   Transfer Pricing   International Taxation   Arms length price