Transfer Pricing Methods and

Selection of Most Appropriate

Method
Agenda

Transfer Pricing – Quick background

Arm's Length Principle

Overview of Methods

Selection Most Appropriate Method

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Transfer Pricing –
a quick background

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 Background

• Transfer Pricing in India introduced with effect from April 1, 2001.

• Any international transaction undertaken between associated enterprises would be subject to transfer
pricing regulations

• The term “international transaction” is widely defined to cover almost all kinds of transactions Domestic

• TP applicable if aggregate value of specified domestic transactions ("SDT")

exceeds INR 5 crores

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 Background

• Principles governing multinational transfer pricing:

―Arm's length principle
―Global formulary apportionment

• Arm's length principle most popular globally

• Arm's length principle requires

commercially at par with that ofthea similar
transaction betweenbetween
transaction two associated enterprisesenterprises
two independent to be

entered in uncontrolled conditions.

• Transfer pricing methods are mechanism to determine arm's length price

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Background

Comparability factors for application of arm's length principle

3

Type of
Product

2 Functions Accounting 4
Performed Practices

Contractual
1 Risk Borne Terms 5

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Background

Comparability Rule

To be comparable means


none of the differences (if any) could materially affect the condition being examined
in the methodology (e.g. price or margin), or

 that reasonably accurate adjustments can be made to eliminate effect of any such
differences

Plays a critical role in selection/applicability of methods

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Overview of TP Methods

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Transfer Pricing Methods

Comparable Uncontrolled Price

Resale Price Method

Cost Plus Method

Transactional Net Margin Method

Other Method

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 Comparable Uncontrolled Price (CUP) Method
Contents

Introduction and applicability

Types of CUP

Illustration

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 Introduction and applicability

• compares the price charged from the a property transferred/service provided in a controlled
transaction with the price charged in the comparable uncontrolled transaction

adjustments are required for material differences between the controlled and
• uncontrolled transactions which have the potential to affect price in the open market,

most direct method and preferred by tax authorities globally

•
CUP can be exact or constructed. constructed CUP tends to arrive at the arm's length price
of a controlled transactions after several adjustments. Quality of constructed CUP relies
•
on the quality of adjustments

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 Indian TP regulations on CUP

• Indian regulations provide for selection of most appropriate method

• Various factors need to be considered to determine most appropriate method Indian

• regulations do not provide any preference to any particular method CUP still preferred

• over any other method due to direct comparability

Rule 10B(1)(a):-

i.The price charged

transaction, or paid
or a number of for
suchproperty transferred
transactions, or services provided in a comparable uncontrolled
is identified;

ii.Such price is adjusted to account

comparable for differences,
uncontrolled if any,orbetween
transactions betweenthe
theinternational transaction
enterprises entering and the
into such transactions, which
could materially affect the price in the open market.

iii.The adjusted price arrived at under sub-clause (ii) is taken to be an arm‟s length price (“ALP”) in respect of
the property transferred or services provided in the international transaction

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 Applicability of CUP

• As per the Transfer Pricing Guidelines issued by the ICAI, typical transaction in which CUP method may be
adopted are:
•Transfer of Goods
•Provision of Services
•Intangibles
•Interest on loans

•
Applicable
environmentonly
withwhen controllable
adjustable uncontrolled transactions is available in an comparable
differences.

• Difficulty in adjusting the material differences does not prohibit the use of CUP.

• Demands highest degree of product comparability.

• A valid CUP must correspond to the actual price charged in a controllable uncontrolled transaction in similar
economic circumstances,

Any Other Method introduced provides for the use of catalogues, quotations and other indirect evidences
•

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 OECD Guidelines on CUP

• As per the Organization for Economic Co-operation and development (“OECD”) guidelines, it is a TP method which:
•compares the price charged for property or services transferred in a controlled transaction to the
price charged for property or services transferred in a comparable uncontrolled transaction in
comparable circumstances.

CUP method is the most direct and reliable way to apply the arm's length principle.
•
Comparable uncontrolled(iftransaction
•none of the differences can the
any) between be used as CUP being
transactions if one compared
of the following two conditions
or between the is met:
•
enterprises undertaking those transactions could materially affect the price in the open market; or
•reasonably accurate adjustments can be made to eliminate the material effects of such
differences.

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Comparability Factors

Factors to be considered while

selecting comparable
uncontrolled transaction
• Type of Product •Market

levels

• Geographical Market •

Period of Transaction •

Contractual terms

• Economic Conditions •

product similarity

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 Types of CUP

Internal CUP
Co. Y

Co. X Sells

Co. A

Co. X & Co. Y are associated enterprise (AE) and Co. A is an unrelated party. X sells a common product to
both AE as well as to the non related party.

In this case internal CUP can be applied by comparing the price charged from Co. Y with the price charged from Co.
A. However any contractual difference between the two sale contracts must be adjusted

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 Types of CUP

External CUP

Co. X Sells Co. Y

Controlled Transaction

Co. P Sells Co. Q

Uncontrolled Transaction

Co. X is engaged in sale of a particular product to its AE, i.e. Co. Y. An unrelated entity, co. P sells the identical
product to Co. Q.

In this case external CUP can be applied by comparing the price charged by Co. X with price charged by Co. P. However
adjustments must be made with regard to any differences in volume, geography contractual terms

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 Resale Price Method (RPM)
Contents

Introduction and applicability Types

of RPM

Application with illustration Case

studies

Judicial Precedents

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 Introduction

• The resale price method is most appropriate in a situation where the seller adds relatively little value to the
goods.
• The greater the value-added to the goods by the functions performed by the seller, the more
difficult it will be to determine an appropriate resale margin.

• This is especially true in a situation where the seller contributes to the creation or maintenance
of an intangible property, such as a marketing intangible, in its activities.

• While resale price method may require less product comparability, it is a fact that closer
comparability of products will produce better results.

• The factors to be considered in this method are level of costs, value addition at each stage, time-
frame of resale, computation of gross margin, etc.

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 Applicability of RPM

• Property purchased or services obtained from a related party and resold to an independent party

No major value addition to goods purchased or services obtained from associated

enterprises
•

No intangible assets is applied to add value to the goods resold

•
Most useful in the case of traders & distributors
•
Can easily be applied when no significant value addition is there
•
N ot applicable when Goods purchased from AE also sold to AE
•

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 Indian TP regulations on RPM

Rule 10B(1)(b) :-
• The price at which property purchased or services obtained from an AE is resold or provided to
an unrelated enterprise is identified.

• Such resale price is reduced by the amount of a normal gross profit margin…,

• in a comparable uncontrolled transaction

• The price so arrived is further reduced by the expenses incurred by the enterprise in
connection with the purchase…

• The price so arrived at is adjusted to take into account the functional and other differences,
including differences in accounting practices, if any, which could materially affect the amount of
gr
oss margin in the open market…

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 RPM – Possible Adjustment

• Inventory Level

• Contractual Terms

• Accounting Practices

• Sales, Marketing, Advertising Programs, and Services The

• Level of the Market

• Foreign Currency Risks

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 Illustration - Internal RPM

Internal RPM may be applied when the same reseller is engaged in trading of similar goods in both controlled and
uncontrolled circumstances.

Co. Y

Sells Co. X Sells Co. B

Co. A

In the illustration above Co. X resells the similar goods procured from a related party (Co. Y) and an
unrelated party (Co. A) to an unrelated party (Co. B).

Internal
with the RPM
gross can bemargin
profit appliedrealized
by comparing theprocured
on goods gross profit
frommargin
Co. Arealized on goods procured from Co. Y

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 Illustration - External RPM

External RPM may be applied when an independent party is engaged in trading of similar goods as traded
by tested party in uncontrolled circumstances.

Co. Y Sells Co. X Sells Co. Y

Controlled Transaction

In the illustration company X resells the goods procured from related party, Co. Y while company P is reselling the
similar goods procured from Co. Q, an unrelated party.

In this case external RPM may be applied by comparing the gross margins realized by Co. P vis-a-vis the gross
margins realized by Co. X

Co. Q Sells Co. P Sells Co. R

Uncontrolled Transaction

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Case Study

Facts:-
•Product
Development ABC Group
•Quality Control
•Marketing
Distribution •Distribution •Manufacture
garments and sale of readymade
ABC Group •Customer Billing
Customers
Companies •Overall group
management •Its subsidiaries also produce
readymade garmentsand sellABC
under of brands,

brands. licensed brands, private labels, and store

Export of readymade

Third Party
garments

ABC India
Vendors
•Joint
partiesVenture of ABC US and Indian third

•Manufacturing and Exporting garments to

ABC Group Companies
•Raw Material
Procurement
•Manufacturing
Indian •ABC
co's. India exports primarily to ABC Group
ABC India •Quality Control
Suppliers Procures •Marketing
Raw Materials •Packaging
•Export •It has net level losses

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 Case Study

1. Manufacturing and Exports of readymade

International Transactions garments

ABC India :- Routine manufacturer operating

independently
Economic Characterization
ABC US :-risk
(Principle ABC US acts
bearing as a distributor.
entity, carrying business
activities involving sales and marketing of
garments)

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Case Study

Most Appropriate Method

Internal Resale Price Method

Approach

ABC US as a tested party

Comparison of the
US earns from Gross Profit margin
following of ABC
transactions:

•ABC US and ABC India

•ABC US and third parties in Asia

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Case Study

Internal RPM

Customer

ABC US

GP margin GP margin from

from ABC third party
India

ABC
Third party
India Vendors

GP margin from India <= GP margin from third party = ALP

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 Judicial Precedent

ITO vs. L’Oreal India P. Ltd

(5423/Mum/2009) Facts of the case

•L'Oreal India is engaged in the business of manufacture

and distribution of cosmetics and beauty products.

•L'Oreal India had two business (i) manufacture and (ii)

AE distribution.

•L'Oreal India adopted RPM to benchmark its international

transaction pertaining to purchase of finished goods for

Outside India Purchase of distribution in India.

India finished goods

L'Oreal India Customers

Sale
goodsof finished

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 RPM – Key Judgment

TPO's Contention

•The TPO rejected the RPM adopted by L'Oreal India, on the grounds that L'Oreal India's pricing policy is not
at arm‟s length since it is consistently incurring losses.

•He proposed an adjustment by applying TNMM

•The TPO also observed that the comparable's gross margins cannot be relied upon because of product
differences, and that the FAR comparison of L'Oreal India vis-à-vis comparable companies is sufficient only

for application of TNMM and not RPM.

CIT's Contentions
•The CIT(A) deleted the entire addition made by the TPO and considered taxpayer‟s contentions

•Reliance was placed on the OECD guidelines and guidance note issued by ICAI.

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 RPM – Key Judgment

ITAT Judgment

•The Tribunal agreed with the CIT(A) that there is no order of priority of methods to determine ALP.
• The Tribunal observed that RPM, being one of the standard methods, is the most appropriate method for
distributing and marketing activities when the goods are purchased from AEs and resold to unrelated parties. The Tribunal
• also noted that this view was supported by OECD guidelines.

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 RPM – Key Judgment

The main grounds before the High Court and its verdict are as under:

There no distinguishing features were noted,

Whether the Tribunal erred in holding that RPM the Tribunal did not err in holding that RPM
was the most appropriate method for
determining ALP in respect of imports of
was the most appropriate method for
finished goods determining ALP in respect of imports of
finished goods.

The High Court observed that the Tribunal, in its

order, has noted that RPM can be adopted in case of
distribution or marketing activities when the goods
Whether the Tribunal erred in not appreciating
are purchased from associated entities and there are sales
that the substantial value addition made to the goods has
changed the degree of similarity in the functions effected to unrelated parties without any further processing.
performed thereby making RPM non applicable in the The same view is also supported by OECD guidelines and
instant case accordingly, the Tribunal did not err in holding that RPM is
the most appropriate method for the international
transactions in respect
of import of finished goods.

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 Cost Plus Method
Contents

Introduction and applicability Types

of CPM

Application with illustration Case

studies

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 Cost Plus Method

• CPM is applicable in the case of manufacturers or service providers engaged in supply of a property or
provision of services to its related party

•
CPM compares the gross profit mark-up on the costs incurred by the tested party in the supply
of property or provision of services to the related party with the gross profits realized on supply
of similar property or provision of similar services by the tested party/comparable entities in
uncontrolled transactions

• Under CPM Arm's Length Price ("ALP") is computed as:

ALP = Direct and indirect cost of production in respect of property transferred or

service provided
(+) Gross profit mark-up earned in comparable uncontrolled transaction
(+) / (-) Adjustments for differences which would materially affect the gross profit
margins in open market

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Indian TP regulations on CPM

Rule 10B(1)(c)
i.the direct and indirect costs of production incurred by the enterprise in respect of
property transferred or services provided to an associated enterprise, are determined;

ii.the amount of a normal gross profit mark-up to such costs (computed according to the
same accounting norms) arising from the transfer or provision of the same or similar
property
uncontrolled transaction, or services
or a number of suchbytransactions,
the enterprise, or by an unrelated enterprise, in a comparable
is determined

iii.the normal gross profit mark-up referred to in sub-clause (ii) is adjusted to take into
account the functional and other differences, if any, between the international
transaction and the comparable uncontrolled transactions, or between the enterprises
entering into such transactions, which could materially affect such profit mark-up in the
open market;
iv.the costs referred to in sub-clause (i) are increased by the adjusted profit mark-up
arrived at under sub-clause (iii);;

v.the sum so arrived at is taken to be an arm's length price in relation to the supply of the
property or provision of services by the enterprise;

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Applicability of CPM

• Supply of a property or provision of services to a related party

• Most useful in the case of transfer of semi finished goods, where long term arrangements
have been entered between related parties, provision of services

• Not applicable in the case of receipt of a property or receipt of services from related party

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Key Aspects in application

There must be a consistency in cost base between

controlled and uncontrolled transactions, specially
in the
circumstances where costs have the effect on the
size of mark-up

As the term direct and indirect costs of

production are not defined anywhere, it may be Accounting inconsistencies must be
difficult to determine the costs especially for eliminated between controlled and
the comparable uncontrolled transactions uncontrolled transactions.

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Key Aspects in application

concentrates on functional similarities. Risk profile

must be similar between controlled and
uncontrolled transactions. Internal comparables
more reliable

Fewer
productadjustments
differences required onLess
than CUP. account of by
vitiated
indirect expenses

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Key Aspects in application

• Appropriate adjustments required to eliminate material differences Some

• illustrative adjustments:

―Inventory levels and turnover rates;

―Sales, marketing and advertising programs;

―level of market

―Accounting practices

―contractual terms

―tangible and intangible assets

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Types of CPM – Internal CPM

Internal CPM may be applied when the same reseller is engaged in trading of similar goods in both controlled and
uncontrolled circumstances.

Co. A

Co. X manufactures Sells

Co. Y

In the illustration above Co. X manufactures a certain commodity and supplies the same both to the related party (Co. Y)
and unrelated party (Co. A)

Internal CPM
gross profit can berealized
margin appliedon
bygoods
comparing the to
supplied gross
Co. profit
A margin realized on goods supplied to Co. Y with the

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Types of CPM – External CPM

External CPM may be applied when an independent party is engaged in manufacture and supply of similar
products as supplied by tested party in uncontrolled circumstances.

In the illustration company X is supplying the goods to related party, Co. Y while company P is supplying the goods to
Co. Q, an unrelated party.

In thismarkup
gross case external CPM
realized mayXbe applied by comparing the gross markup realized by Co. P vis-a-vis the
by Co.

manufacture and
Co. X Co. A
supply

Controlled Transaction

Co. P Co. Q
manufacture and
supply

Uncontrolled Transaction
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 Profit Split Method (PSM)
Contents

Introduction

Types of PSM

Strength and Weakness Judicial

precedents-global

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Introduction

• PSM determines arm‟s length profit based on combined profits derived by related parties

PSM is relevant
• –where different related parties are doing typical activity in value chain and
external

–comparable with similar FAR is difficult to apply

Sharing of non-routine assets or entrepreneurial risks
•

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Indian TP regulations on PSM

Rule 10B(1)(d)

i.the combined net profit of the associated enterprises arising from the
international transaction in which they are engaged, is determined;

ii.the relative contribution made by each of the associated enterprises to the

earning of such combined net profit, is then evaluated on the basis of the
functions performed, assets employed or to be employed and risks assumed by
each enterprise and on the basis of reliable external market data which
indicates how such contribution would be evaluated by unrelated enterprises
performing comparable functions in similar circumstances;

iii.the combined net profit is then split amongst the enterprises in proportion to
their relative contributions, as evaluated under sub-clause (ii);

iv.the profit thus apportioned to the assessee is taken into account to arrive at
an arm‟s length price in relation to the international transaction

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Types of PSM

Residual Contribution
Analysis Analysis

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Types of PSM

Residual Profit Split Method

• The residual profit, i.e., portion of the profit attributable to the entrepreneurial, non-routine or residual functions is
split based on the profit split principles.
• There is a characterization of functions, risks and assets to routine and non-routine, wherein the routine
functions are considered to be relatively simple and for which the comparable market data is easily

available.
• The profit is attributed to the routine functions and the arm‟s length character is first applied to this part of the profit.

The residual profit, if attributable to the non-routine / entrepreneurial functions is split on the basis as
• considered appropriate depending on the character of the profit

• A common issue with this method is that there is often a very thin line between routine and nonroutine
functions, risks and assets.
• This method is the most commonly used profit split method, particularly popular in automotive, consumer
electronics and financial services industries.

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PSM – Strengths and weakness

Strengths Weakness
• Offers solutions for integrated operations • Difficulty in application Necessitating
not offered by one-sided methods
• application of similar
accounting policies and standards
Helps share profits for unique
• intangibles contributed
• Allocation of costs
Less dependant on comparables • Reluctance of tax authorities to accept
•
Less likely to leave any party to the
• transaction with extreme profitability as Voluminous data
both parties are evaluated •

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Judicial precedents-global

GSK settles largest tax dispute in history for $3.1bn

US - marketing Profit UK - developer and

subsidiaries allocation manufacturer

How much of the product's value should be attributed to each jurisdiction?

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 Transactional Net Margin Method
Contents

Introduction and applicability

Strength and Weakness

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Introduction

• Generally the default method for use in the absence sufficient info for other methods

• Comparison at operating margin level

• Comparison at transactional level, where possible

• Test the simplest party

• Broad level of similarity of FAR

• Selection of the right comparables and PLI are critical factors Most

• preferred and practical method

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Indian TP regulations TNMM

Rule 10B(1)(e)
i the net profit margin realized by the enterprise from an international transaction entered into with an associated
. enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the
enterprise or having regard to any other relevant base

ii the net profittransaction

margin realized by the of
enterprise or by an unrelated enterprise from ato
comparable
. uncontrolled or a number such transactions is computed having regard the same
base.
iii
the net profittomargin
is adjusted referred
take into to in
account thesub-clause (ii) ifarising
differences, in comparable
any, between uncontrolled
the international transactions
transaction and the
.
comparable uncontrolled
could materially affect thetransactions,
amount of netorprofit
between the enterprises
margin in the open entering
market. into such transactions, which

iv. the net profit

the same as themargin realized
net profit byreferred
margin the enterprise and referred
to in sub-clause (iii) to in sub-clause (i) is established to be

v. the net profit

relation to themargin thus established
international transaction.is then taken into account to arrive at an arm’s length price in

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Applicability - TNMM

• No specific guidance is provided on when this method is reliable except rule 10C(2)
• However typical transactions in respect of which the Transactional Net Margin method may be
adopted are:


Transfer of goods

Provision of services

Purchase of goods
•
Factors of Comparability to be considered while selecting TNMM

Functions Performed (taking into account assets used and risks assumed)

Contractual terms

Conditions prevailing in the markets, location, laws in force etc.

Business Strategies

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Applicability - TNMM

How it is applied?
Nature of International Transactions

FAR Analysis

Characterization of entities, selection of tested party, selection

of Most Appropriate Method, functional and product If two or more Comparable Companies
characteristics of the uncontrolled comparable are selected, arithmetic mean would
companies establish the arm’s length price.

Economic Analysis and arriving at net margin of CC

Adjustment of the above net margin for transaction level /

company level differences on the basis of FAR analysis

Adjusted net margin is used for Benchmarking International

Transactions

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TNMM – Strength and Weakness

Strengths

•Net profit indicators are less affected by transactional differences than is the case with
price, as used in the CUP method.

•Net profit indicators are also more tolerant to some functional differences between the
controlled and uncontrolled transactions than gross profit margins.

Weaknesses
•Information on uncontrolled transactions may not be available at the time of the
controlled transactions.

•Difficulties in determining an appropriate corresponding adjustment when applying the

transactional net margin method.

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 Other Method

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Other Method

• 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

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The Methods - Snapshot

Turnover
Comparable Uncontrolled Price
(Cost of sales)

Gross profit
Resale Price Method Cost Plus Method
(administration, Marketing,
Selling and Distribution
expenses)

Operating profit TNM Method Profit Split Method

Price charged / paid or proposed

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Selection of Most Appropriate
Method

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 Most Appropriate Method

• „Most appropriate method‟ is method best suited to facts and circumstances,

providing most reliable measure of ALP

• „Most appropriate method‟ to be selected having regard to the following factors:

- Nature and class of international transaction
- Functions performed, assets utilized, risks assumed
- Availability and reliability of data
- Degree of comparability between controlled and uncontrolled
transactions
- Possibility to make reliable and accurate adjustments
- Nature, extent and reliability of assumptions required

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 Choice of Transfer Pricing Method: Economic
determinants

CUP method Product Functional Intangible

Similarity Similarity presence
Resale Price Cost Plus

Traditional methods

Profit based methods

TNMM

Residual Profit Split

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