Arm’s Length Principle – Transfer Pricing

Why Arm’s length price?

  • The cornerstone of the Transfer Pricing Provision is determining an Arm’s Length Price (‘ALP’) of a transaction between Associated Enterprises.  
  • This course will provide you the methods to be adopted for determining the ALP and factors which needs to be considered in order to identify comparable uncontrolled transactions.
  • ALP 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.

Prescribed Methods

  • Section 92C provides that the arm’s length price in relation to an international transaction shall be determined by any of the following 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. The prescribed methods are
Prescribed Methods
  • Out of the above Most Appropriate Method (‘MAM’) shall be applied for determining the ALP.
  • There is no necessity to apply the methods sequentially to check if it is the most appropriate method.
  • However, as a good practice, it is best to evaluate all the methods for suitability and then arrive at the Most Appropriate Method.
  • Rule 10B(1) provides for determining of ALP.
  • The Rule explains how ALP under the 6 methods has to be determined.

CUP Method

  • Under this method the price charged or paid for any item under any comparable uncontrolled transaction or transactions should be identifiable
  • Adjustment to account for differences 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
  • The adjusted price will be considered as ALP
  • The requirement of product or services similarity is highest. Further, the quality, quantity, time of the transaction along with the geographical location in which the goods are transacted also play an important role in determining if the prices are comparable.
  • This often makes it very difficult in using this method as Most Appropriate Method.
Cup Method

Internal CUP is always preferable over external CUP since the reliability of data and similarity of product etc. can be easily verified.

Illustration

  • Avian Ltd sells 10,000 units of product A to its AE in Singapore at USD 20 per unit. It also sells the similar units with slight modification to unrelated party C for USD 18 per unit. For the AE, Avian uses a special casing which is not used for the unrelated party. The cost of the casing per unit is estimated to be USD 1.75 per unit
Illustration

Question

Par India Ltd sold 1 million protective guards to Mars International (UK), which is a group company. The arm’s length price of protective guards can be ascertained under CUP method, where

  1. Par India sells similar protective guards to Kars International (Swiss) which is another group company
  2. Par India sells 100 similar protective guards to an unrelated Indian company
  3. Par India sells similar protective guards to Ritz (Singapore) which is not an AE
  4. Par India sells different type of protective guards to Mike (UK) which not an AE but differentiation of product is very extensive.

Answer c.

Internal CUP can be applied if the entity carries out similar comparable transaction in terms of product/ service type, geographical location, volume etc with an unrelated party. Since this meets all the criteria it can be used as an Internal CUP for determining ALP.

Question

Genesys India Ltd has purchased 1 lakh kits of raw material from Genesys Australia, its parent company. The sale of similar type, quality and volume between two unrelated third parties would be regarded as

  1. Internal CUP
  2. External CUP
  3. None of the above

Answer b.

The sale of similar type, quality and volume between two unrelated third parties would be regarded as external CUP since the Genesys is not part of the transaction

Question

Prime India purchased 1000 components from Prime USA for $10 each. Prime India purchased 1200 components from an unrelated party for $9 each. However, the components purchased from Prime USA has an additional part, the cost of which can be attributed to $1.25 per component. What is the ALP?

  1. ALP is $10.25
  2. ALP is $9
  3. ALP is $10

Answer c.

The comparable price would be $9 before adjustment. Since the additional component cost is $1.25, the same has to be added to the identified price i.e. $ 9+$1.25, which makes it $10.25. If the ALP is taken as $10.25 instead of the transaction price of $10, then it would reduce the profit or increase the loss as the case may be. Accordingly, Arm’s length principle would not apply and transaction price would not be altered. Accordingly, the ALP id $20.

RPM

  • This method is applicable when an item obtained by the enterprise from an AE is resold or provided to an unrelated enterprise
  • Following adjustments can be made to such resale price
  • Normal gross profit margin
  • Expenses incurred in connection with obtaining the item
  • Other functional differences which could materially affect the gross profit margin in the open market
  • Here again the requirement of product similarity is very high since it requires gross profit comparison. Non-availability of gross profit details of comparable companies makes this method difficult to use.

Example

  • G Ltd imports its artificial turf from its New Zealand AE and sells them in Indian market. The price it paid to the AE is USD 10,000. The exchange rate is 1USD – Rs 65 The other direct expenses incurred in connection with the sales are Rs 50,000. G Ltd sold the goods to Indian retailers for Rs 800,000. The average profit made by competitive entities is 6% on sales. Find the ALP?
Rpm

Question

RPM can be used in the which of the following circumstances?

  1. AmanCo India imports pens from its parent company and resells the same without any value addition to the retailers in India
  2. Ans: Correct. RPM can be used since an item obtained by the enterprise from an AE is resold or provided to an unrelated enterprise
  3. Amax India exports laptops to its subsidiary in Philippines which resells them after configuration it to its retailers
  4. Ans: Incorrect. RPM can be used when an item obtained by the enterprise from an AE is resold or provided to an unrelated enterprise. In this case Amax India exports laptops to its subsidiary in Philippines which in turn resells after configuration. Accordingly, RPM cannot be used.
  5. AmanCo India imports some parts of camera from its parent company in KDK form and it assembles the same with indigenous components and sells it to the retailers in India
  6. Ans: Incorrect. RPM can be used when an item obtained by the enterprise from an AE is resold or provided to an unrelated enterprise. In this case AmanCo India imports only parts of camera and the other components it purchases locally so RPM cannot be used.

CPM

  • This method is applicable where the goods produced are sold to AEs or services rendered to AEs.
  • Under this method, the direct and indirect costs of production incurred by the enterprise for the item should be determined.
  • The amount of normal gross profit mark-up to such costs arising from the same or similar uncontrolled transaction. This gross profit margin can be adjusted to take into account any functional or other material differences in the open market
  • Here again the product / service similarity is very high.
  • Since this method is dependent on cost structure which is specific to the industry and type of product and services, obtaining comparables may be difficult.

Illustration:

  • A India Ltd sells all the manufactured garments to B US Inc. The purchases are made locally and A India Ltd incurs other costs which amounts to Rs 10,00,000.
  • Companies operating in similar industry make a margin of 12% on cost. A India Ltd invoices B USA Inc for Rs 10,75,000. Find ALP

Solution

Cpm

PSM

  • Primarily applied 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 ALP of one transaction.
  • In this method, combined net profit of the AEs arising from the international transactions are determined.
  • The relative contribution of each AE to earning of such combined net profit is then evaluated on the basis of Functions performed, Assets employed, Risks assumed (‘FAR analysis’) by each enterprise.
  • This evaluation is done based on reliable market data which can indicate how such contribution would be evaluated by unrelated enterprises performing similar functions.
  • The combined net profit is then split amongst the AEs in proportion to their relative contribution.
  • Sometimes the net profit is split into basic profit and super profit (residual profit) so as to ensure that the enterprise receive basic return appropriate to the type of international transaction.

Illustration

  • AB Inc USA entered into a contract for constructing a metrorail project in India for which its subsidiaries in Japan and India worked together.
  •  The entire contract price was US$ 200 million dollars.
  • The project earned a profit of Rs US$50 million of which routine contribution is $20 million whereas the relative efforts put by the group companies are 40%, 30% and 30% respectively.
  • Non-routine profits are split among group companies on the basis of ownership of non-routine intangibles i.e 20%, 30% and 50%.
  • Compute ALP of the related party in US, Japan and India.

Solution:

Psm

Question

PSM is typically applicable in which of the following circumstances

  1. In international transactions that are so interrelated that they cannot be evaluated separately to determine Arm’s length price of any one transaction.
  2. When there is a tri-patriate agreement between AEs
  3. It is a residual method and is applicable in the event that no other method is applicable.

Answer a.

PSM is typically applicable in international transactions that are so interrelated that they cannot be evaluated separately to determine Arm’s length price of any one transaction

Question

Operating profits are distributed to the AEs usually in the following manner.

  1. Basic profit and residual profit
  2. Gross profit and net profit
  3. As a percentage of revenue

Answer a.

Sometimes the net profit is split into basic profit and super profit (residual profit) so as to ensure that the enterprise receive basic return appropriate to the type of international transaction

 

TNMM

  • In this method, the net margin realized by the enterprise from an international transaction with an AE is computed having regard to cost incurred or sales effected or assets employed or having to any other relevant base. It is referred to as Profit Level Indicator (‘PLI’).
  • The net margin realized by the enterprise from uncontrolled transaction or by an unrelated enterprise for a similar transaction is computed using the same PLI.
  • Profit margin is adjusted to take into account differences which could materially affect the net profit margin in the open market.
  • This method requires functional similarity rather than product or service similarity and accordingly widely used.

Illustration

  • KPO Ltd renders services to its parent company in UK and other group companies.
  • They also provide services to other unrelated parties but those services are not comparable to the services rendered to the AE.
  • Similar companies earn a margin on cost @ 17.5% The details of KPO Ltd is as under: Find ALP
Tnmm

Solution:

Tnmm 1

Question

TNMM is widely used as Most appropriate method because

  1. This method focuses on margins earned by the enterprise rather than transaction price of similar transaction
  2. It is the easy to apply this method as data on net margins of comparable companies are easily available.
  3. TNMM requires functional similarity rather than product or service similarity when compared with other methods
  4. All of the above.

Answer d.

TNMM focuses on margins earned by the enterprise rather than transaction price of similar transaction and data on net margins of comparable companies are easily available. TNMM requires functional similarity rather than product or service similarity when compared with other methods.

Any other method

  • Any method which takes into account the price which has been charged or paid or would have been charged or paid for same or similar uncontrolled transactions under similar circumstances considering all facts.
  • This method is also widely used as it is often difficult to obtain comparable uncontrolled entities performing similar transactions.

Example

  • Let us say a company Seafair India Ltd is engaged in building a seaport with the technology support of its parent company Seafair UK Plc. The project is envisaged to be completed in 5 years, till which time there would be no revenue. In the meantime, Seafair would pay technical fee to the parent company. How to benchmark the transaction in the absence of margin and similar uncontrolled companies?
  • In situations like this where the company does not earn revenue, we have to look into other ways by which this can be benchmarked. Some of the examples are
  • Floating a tender to obtain quote from unrelated parties for performing similar services and that quote can be used for benchmarking the transaction under ‘Under other method’
  • Often companies undertaking projects involving a substantial construction period, take loans from consortium of banks. These banks often evaluate and approve expenditure beyond a certain threshold. If the technical fee falls within such expenditure, the approval can be used to benchmark the transaction.

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