Transfer Pricing Methods are various methods which are used for determination of the Arm’s Length Price (“ALP”) in relation to an international transaction. They include various methods like the Comparable Uncontrolled Price Method (‘CUP’), Resale Price Method (‘RPM’), Cost Plus Method (‘CPM’), Profit Split Method (‘PSM’) and the Transactional Net Margin Method (‘TNMM’).
Each of these method can be applied to a particular set of transaction, based on their nature and facts.
As per Section 92C of the Income Tax Act, 1961, ALP shall be determined by any of the following methods :
- Transfer Pricing Methods – TRADITIONAL TRANSACTION METHOD –
- Comparable Uncontrolled Price Method (‘CUP’)
- Resale Price Method (‘RPM’)
- Cost Plus Method (‘CPM’)
- Transfer Pricing Methods – TRANSACTIONAL PROFIT METHODS –
- Profit Split Method (‘PSM’)
- Transactional Net Margin Method (‘TNMM’)
- Transfer Pricing Methods – ANY OTHER METHOD PRESCRIBED BY THE CENTRAL BOARD OF DIRECT TAXES – Rule 10AB
Other Method , can be considered as a 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 – COMPARABLE UNCONTROLLED PRICE (“CUP”) METHOD
WHEN CAN CUP METHOD BE APPLIED
Comparable UNCONTROLLED PRICE, as the name suggests, compares the price in the transaction which is being evaluated for arm’s length, with the price charged /received between two unrelated parties for similar goods or services.
This can take place under two cases, i.e, where the transaction is between : –
- the company and unrelated third party (Internal CUP) . In such cases, the concerned company buys, or sells similar goods or services in comparable transactions with unrelated enterprises; or
- Two unrelated parties (External CUP) . In such cases, two Unrelated enterprises buy or sell similar goods or services, as is being done between the AE.
STEPS INVOLVED IN CUP METHOD – Assume examining transactions of X Ltd. for transfer pricing purpose
STEP 1 : – identifying prices of comparable uncontrolled transaction/s
Identify prices charged from or paid to, on transfer of goods or services
in comparable uncontrolled transaction/s by X Ltd. Such transaction could be entered into by X Ltd. itself or between two unrelated enterprise.
STEP 2 : – Adjustments to uncontrolled Price
The price arrived at Step 1 should be adjusted for the following : –
- If there are any functional differences between the international transaction or the Specified Domestic Transaction (SDT) under review, and the comparable uncontrolled transactions , adjustment should be made for such functional differences . Functional differences could be for the following : –
- a) Quality of product or service,
- b) Contractual terms,
- c) Credit terms (one entity allows a credit of 1 month and other allows credit of 6 months),
- d) Transport terms – Free on Board, Cost, Insurance and Freight
- e) Market level (wholesale, retail etc.));
- If there are any differences between the enterprises entering into such transactions, such as size of the entity (if one entity is market leader and other is a small startup in same segment), operating environment, which could materially affect the price in the open market, the price should be adjusted for such differences.
Such adjusted price will be the arm’s length price.
TRANSFER PRICING METHODS – RESALE PRICE METHOD (“RPM”)
In the case of, resale price method, there are three parties to a transaction : –
- Non-resident related enterprise – AE1
- Resident importer and reseller – AE2
- Resident Buyer – Non – AE1
Under the resale price method, when a resident importer and reseller (AE2), and a related enterprise (AE1), enter into a transaction, and the purchaser or service recipient in that transaction (AE2) , resells the product/ provides services to an unrelated enterprise (Non – AE1), the ALP has to be calculated by deducting a “normal profit of the purchaser/recipient of services” from that resale price . The price so arrived at is deemed to be the arm’s length price applicable to the transaction between the related parties.
RPM compares the gross margins (i.e. gross profit over sales) earned in transactions between related and unrelated parties for determination of Arm’s length price.
NOTE : –
- RPM is generally used in case where the tested party (AE2) purchases products or acquire services from related parties and sells the same to independent parties without adding substantial value to the product or services. For example in case of distribution function.
STEP 1 : –
Identify the Resale Price, i.e, the price at which property or services are resold or provided to an unrelated party
STEP 2 : –
Reduce Normal gross (not net) profit margin, which are derived BY THE ENTERPRISE from the resale price of such property or services in comparable uncontrolled transactions (internal comparable). (Normal Net profit margin should not be considered as we need to reduce only gross profit margin)
STEP 3 : –
Reduce any expenses incurred by the enterprise in connection with the purchase of goods /property, or obtaining of services (For example, if customs duty borne by purchaser, the same should be reduced in Step 3).
STEP 4 : –
- Impact of Functional and other differences, (including accounting practices) between international transaction (or SDT) and the comparable uncontrolled transactions,
- Impact of differences, between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market (Adjustments affecting only net profit margin should not be considered).
TRANSFER PRICING METHODS – COST PLUS METHOD (“CPM”)
Under Cost plus method, the arm’ s length price is determined by adding appropriate gross profit margin , also known as the cost plus mark up, (considering the function performed, return on capital and risk assumed by an entity) to the AE’s cost of producing goods/ providing services.
This method is most suitable in cases, where a manufacturer sells tangible goods to both related and unrelated parties.
As per the Organisation for Economic Co-operation and Development (OECD), Cost Plus Method is applicable when,
- Semi-finished goods are sold between Associated Enterprises,
- There are long term supply and purchase agreements between Associated Enterprises,
- Provision of services between Associated Enterprises,
- Agreements relating to contract manufacturing, between Associated Enterprises.
STEPS INVOLVED IN COST PLUS METHOD
STEP 1 : – Direct and indirect costs of production
Determine the direct and indirect costs of production in a tested party transaction.
STEP 2 : – Determine normal gross profit mark-up to such costs
Determine the amount of a normal gross profit mark-up to such costs, arising from the transfer or provision of the same or similar goods or services : –
- by the enterprise itself, (i.e., transfer of similar goods or services by the enterprise – Internal comparable), or
- by an unrelated enterprise to another unrelated enterprise (i.e., transfer of similar goods or services between unrelated parties) – External comparable,
in a comparable uncontrolled transaction, or a number of such transactions.
STEP 3 : –
The normal gross profit mark-up determined above shall be adjusted to account for the functional and other differences.
STEP 4 : –
The costs referred to in Step 1, shall be increased by the adjusted profit mark-up calculated in Step 3 leads to arm’s length price.
TRANSFER PRICING METHODS – PROFIT BASED METHODS
When traditional methods of determining arm’s length price, are not found to be appropriate given the facts of the case, the profit based methods can be used to determine the arm’s length price.
Profit-based methods examine the profits, that arise from particular transactions among Associated Enterprises, against profits derived by other independent enterprise, who may be involved in same or similar transaction.
The two profit-based transfer pricing methods, recognised by the TP legislation, are : –
- Profit Split method (“PSM”) ;
- Transactional net margin method (“TNMM”).
TRANSFER PRICING METHODS – PROFIT SPLIT METHOD (“PSM”)
In case of a transaction between two related Enterprises, both the enterprise maybe earning certain profits or losses. Under the profit split method, the total operating profit earned by the parties involved in the transaction is first ascertained. There after it is splitted, amongst the parties, based on the respective contributions.
PSM evaluates, if, the profits or loss, allocated to a particular entity, out of combined operating profit,of controlled transaction, is at arm’s length, considering their individual contribution in the overall profit or loss.
STEPS INVOLVED IN PSM
STEP 1 : – DETERMINE COMBINED NET PROFIT
Determine combined net profit of the AEs, arising from the controlled international transaction.
STEP 2 : –
Evaluate the relative contribution made by each AE, to the earning of such combined net profit.
STEP 3 : –
The combined net profit is then splitted amongst the enterprises in proportion to their relative contributions.
STEP 4 : –
The profit so apportioned to the tested party, is considered to arrive at an arm’s length price of the international transaction.