Methods of computing Arm's Length Price

I dealt with the basic concept of transfer pricing in an earlier post. As promised (to myself), I will now deal with the methods of computing arm’s length price (ALP).

ALP, crudely, is the fair market value at which transactions take place in the open market. Section 92C names the methods and Rule 10B elaborates on their application. There are primarily 5 methods of ALP computation:

1. Comparable Uncontrolled Transaction Method - CUP Method

2. Cost Plus Method - CPM

3. Resale Price Method - RPM

4. Profit Split Method - PSM

5. Transactional Net Margin Method - TNMM

The most complicated of these (and probably the most popular) is TNMM, I think. PSM has hardly ever been used in Indian cases. CUP is the simplest and most preferred one.

In this post however, I have discussed only the first three methods. I shall discuss PSM and TNMM in the next post.

CUP METHOD:

Under CUP method, the transacting enterprise has to:

• Identify the price paid for goods or services provided in a (or a number of) comparable uncontrolled transaction(s).
• Adjust such price to account for differences, which could materially affect it in the open market, between:
• Transaction with AE and comparable uncontrolled transaction, or
• The enterprises entering into such transaction

Sale price in uncontrolled transaction: 100

Add (in proportion to better quality goods sold to AE): 25

ALP = 125

In the above scenario, the transaction between the TE and Unrelated Enterprise 2 would be an ‘internal comparable.’ The transaction between the two unrelated enterprises would be an ‘external comparable.’ This is true for all methods of ALP computation; transactions of the TE with third parties would be termed as internal comparables. It is to be noted that internal comparables are preferred over external comparables, since they provide a greater degree of comparability.

CUP Method is generally preferred in all situations, where suitable uncontrolled transactions are available. The uncontrolled transactions can be considered comparable in terms of the goods sold, services rendered, prices charged, qualitative and quantitative comparability, etc.

COST PLUS METHOD:

Under CPM, the transacting enterprise has to:

• Determine the costs of production (direct and indirect)
• Determine the normal gross profit mark-up on such costs, incurred by an unrelated enterprise
• Adjust this mark-up to account for functional or other differences that could materially affect it in the open market
• Add the adjusted profit mark-up to the costs of production.

ALP = 150 + 10 + 2 = 162

CPM is most suitable for:

• Sale of semi-finished goods
• Provision of services
• Long-term buy and supply arrangements

RESALE PRICE METHOD:

Under RPM, the transacting enterprise has to:

• Identify price at which goods / services obtained from AE are re-sold to unrelated enterprise
• Reduce such price by:
• normal GP margin accruing to assessee / unrelated enterprise from similar uncontrolled transaction
• expenses incurred by assessee for obtaining goods / services
• Adjust the price on account of functional differences that could materially affect it in the open market

Price of sale: 120

Less: 15 (normal GP margin)

          10 (freight charges)

Add:    5 (packaging expenses)

ALP = 100

RPM  is most suitable for:

• Chain of distribution of goods through an intermediate company
• Marketing operations