Transfer Pricing Methods Explained in Simple Language

Transfer Pricing Methods Explained in Simple Language

Let’s now understand Transfer Pricing Methods

“Arm’s length price” is defined in section 92F(ii) to mean price which is applied or proposed to be applied in a transaction between persons other than associated enterprises in uncontrolled conditions.

Section 92C deals with the method for determining arm’s length price and the factors which are to be considered for applicability or non-applicability of a particular method to a given situation. The factors as well as methods incorporated in this section are not exhaustive and the CBDT may prescribe further factors and methods.

It provides that the arm’s length price in relation to an international transaction shall be determined by any of the following transfer pricing methods, being the most appropriate method, having regard to the nature of transaction or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe, namely –

  • Comparable Uncontrolled Price method(CUP);

  • Cost Plus Method(CPM);

  • Resale Price Method(RPM);

  • Profit Split Method(PSM);

  • Transactional Net Margin Method(TNMM);

  • Such other transfer pricing methods as may be prescribed by the Board.

Section 92C(2) provides that the most appropriate method out of the above transfer pricing methods has to be applied for determination of arm’s length price, in the prescribed manner.

Rule 10AB of Transfer Pricing Methods:

Accordingly, the Board has prescribed that the other method for determination of arm’s length price in relation to an international transaction shall be any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts.

Transfer Pricing Methods:

1.Comparable uncontrolled price method(CUP):

A comparable uncontrolled price is the price agreed between unconnected parties for the transaction of goods or services under similar circumstances.

Steps to compute ALP based on CUP is as follows:

  1. Identification of price charged or paid for property transferred or services provided under any comparable uncontrolled transaction(s).

  1. Such price is adjusted to account for differences, if any, between the international transaction and comparable uncontrolled transactions or between the enterprises entering into such transactions which could materially affect the price in the open market can be made.

  1. Adjusted price arrived above taken to be as arm’s length price in respect of the property transferred or services provided in the international transaction.

Meaning of “Uncontrolled transaction”:

Uncontrolled transaction means a transaction between enterprises other than associated enterprises, whether resident or non-resident.

Note:

The comparable uncontrolled price method requires a high degree of comparability of products, services and functions and such comparability can be improved by carrying out necessary reasonable adjustments, in respect of differences arising on account of various factors such as quality of the product or service, contractual terms, credit terms, transport terms, level of the market (i.e. wholesale, retail, etc.), geographic market in which the transaction takes place, etc.

2.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 gross profit margin should reflect the functions performed by an entity and should include a return for capital used and risks assumed by the entity.

Steps to compute ALP based on CPM is as follows:

  1. Identification of direct and indirect costs of production incurred by the enterprise in respect of property transferred or services provided to an associated enterprise.

  1. Determination of amount of normal gross profit mark-up to such costs arising from the transfer or provision of the same or similar property or services by the enterprise or by an unrelated enterprise in comparable uncontrolled transaction or transactions.

  1. The normal gross profit mark-up determined above is adjusted to account for functional and other differences, if any, which could materially affect such profit mark-up in the open market.

  1. Adjusted gross profit mark-up added to total costs identified in (i) above.

  1. Sum arrived above is taken to be arm’s length price in relation to the supply of property or provision of services by the enterprise.

Note:

This method probably is most useful where semi-finished goods are sold between related parties, where related parties have concluded joint facility agreements or long-term buy-and-supply arrangements, or where the controlled transaction is the provision of services.

3. Resale price method(RPM):

The resale price method (RPM) is a method which compares the gross margins (i.e. gross profit over sales) earned in transactions between related and unrelated parties for the determination of the ALP. The RPM requires high level of functional comparability and is mainly applicable where the controlled party is a distributor.

The RPM evaluates whether the amount charged in a controlled transaction is at arm’s length by reference to the gross margin realised in comparable uncontrolled transactions.

Steps to compute ALP based on RPM is as follows:

  1. Identification of resale price by tested party i.e., the price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or provided to an unrelated enterprise.

  1. Resale price is reduced by normal gross profit margin with reference to uncontrolled transaction(s).

  1. Such price reduced by expenses incurred (customs duty etc.) in connection with purchase of the product/ services.

  1. This price may be adjusted to account for functional and other differences, if any, including differences in accounting practices which could materially affect the gross profit margin in the open market.

  1. Adjusted price arrived above taken to be as arm’s length price

Note:

RPM is generally used to test transactions involving distribution function, i.e. when the tested party purchases products/ acquires services from related party and resells the same to independent parties. The use of RPM is appropriate where the reseller does not add substantially to the value of the product/ services. Where the transactions are not comparable in all ways and the differences have a material effect on price, one has to make adjustments to eliminate the effect of those differences. For this purpose, consideration of operating expenses associated with functions performed and risks assumed may be necessary, because differences in functions performed are often reflected in operating expenses.

4.Profit split method(PSM):

This is a method which may be applicable mainly in international transactions involving transfer of unique intangibles or in multiple international transactions which are so inter-related that they cannot be evaluated separately for the purpose of determining the arm’s length price of any one transaction.

The Profit Split Method (PSM) evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is at arm’s length with reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss. The combined operating profit or loss must be derived from the most prominently identifiable business activity of the controlled taxpayers for which data is available that includes the controlled transactions (relevant business activity).

Steps to compute ALP based on PSM is as follows:

  1. Determination of combined net profit of the associated enterprises arising out of international transaction in which they are engaged.

  1. Evaluation of relative contributions by each enterprise to the earning of such combined net profit on the basis of functions performed, risks assumed and assets employed by each enterprise. This evaluation is to be made on the basis of reliable external market data which can indicate how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances.

  1. Splitting of combined net profit amongst the enterprises in proportion to their relative contributions, as evaluated above.

  1. Profit thus apportioned to the assessee is taken into account to arrive at the arm’s length price in relation to the international transaction.

Note:

Allocation of profits must be made in accordance with one of the following allocation methods:

  • Comparable profit split – Under this transfer pricing methods, 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.

  • Residual profit split – Following the two-step process:

  1. Allocate income to routine contributions

  1. Allocate residual profit

5.Transactional net margin method(TNMM):

Under the Transactional net margin method (TNMM), an arm’s-length price is determined by comparing the net profit margin in relation to an appropriate base (example costs, sales, assets) of the tested party with the net profit margin in relation to the same base, of an uncontrolled party engaged in comparable transactions.

Steps to compute ALP based on TNMM is as follows:

  1. Computation of net profit margin realized by the enterprise from the international transaction with an AE having regard to costs incurred or sales effected or assets employed or having regard to any other relevant base.

  1. Computation of net profit margin realized by the enterprise or an unrelated enterprise in a comparable uncontrolled transaction by applying the same base as above.

  1. Net profit margin realized from uncontrolled transaction is adjusted to account for differences, if any, which could materially affect the net profit margin in the open market.

  1. The net profit margin realized by the enterprise referred in (i) above is established to be the same as net profit margin referred in (iii) above.

  1. The net profit margin thus established is taken into account to arrive at an arm’s length price for the international transaction.

6. Other Transfer Pricing Methods:

The Other method allows the use of ‘any method’ which takes into account

  1. the price which has been charged or paid or

  1. would have been charged or paid for the same or similar uncontrolled transactions with or between non-associated enterprises, under similar circumstances.

The various data which may possibly be used for comparability purposes under this method could be third party quotations, valuation reports, tender/Bid documents, documents relating to the negotiations, standard rate cards, commercial & economic business models; etc.

Want to know about Range Concept in Transfer Pricing with Examples,Click Here. 

I hope you now understood “Transfer Pricing Methods“.

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