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Arm’s length principle for Transfer Pricing

Determination of arm’s length price

6.1 The income arising from an international transaction is required to be computed having regard to the arm’s length price. Section 92F(ii) defines arm’s length price as ‘a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.’
Thus, the definition provides that a price at which independent enterprises deal with each other (which is ordinarily determined by market forces), should be reckoned as the arm’s length price.
The provisions relating to determination of arm’s length price are contained in section 92C which provides as follows:
“(1) 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 transactions or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe, namely:—

    (a)   comparable uncontrolled price method
    (b)   resale price method
    (c)   cost plus method
    (d)   profit split method
    (e)   transactional net margin method
     (f)   such other method as may be prescribed by the Board

(2) The most appropriate method referred to in sub-section (1) shall be applied, for determination of arm’s length price in the manner as may be prescribed:
Provided that where more than one price may be determined by the most appropriate method, the arm’s length price shall be taken to be the arithmetical mean of such prices.”
Paraphrasing, the provisions of section 92C(1) and (2) stipulate the following:
§           The arm’s length price shall be determined by the most appropriate method which shall be one out of the methods specified.
§           The most appropriate method shall be ascertained having regard to the nature or class of transactions or class of associated persons, etc.
§           The most appropriate method shall be applied in the manner prescribed by the Board for determination of arm’s length price.
§           If more than one price is determined by the most appropriate method, the arm’s length price shall be taken to be the arithmetical mean of such prices.

Selection of a stipulated method alone is permitted

6.2 The section provides that the arm’s length price shall be determined by applying a method specified in it. In this connection, the OECD Guidelines provide as follows:
“No one method is suitable in every possible situation and the applicability of any particular method need not be disproved. Tax administrators should hesitate from making minor or marginal adjustments. Moreover, MNE groups retain the freedom to apply methods not described in this Report to establish prices provided those prices satisfy the arm’s length principle in accordance with these Guidelines. However, a taxpayer should maintain and be prepared to provide documentation regarding how its transfer prices were established.” (para 1.68)
Thus, the Guidelines permit application of method not specified in them.
Selection of only one method is permitted
6.3 The section stipulates selection of one method which is the most appropriate method. In this connection, the OECD Guidelines provide as follows:
“While in some cases the choice of a method may not be straightforward and more than one method may be initially considered, generally it will be possible to select one method that is apt to provide the best estimation of an arm’s length price. However, for difficult cases, where no one approach is conclusive, a flexible approach would allow the evidence of various methods to be used in conjunction. In such cases, an attempt should be made to reach a conclusion consistent with the arm’s length principle that is satisfactory from a practical viewpoint to all the parties involved, taking into account the facts and circumstances of the case, the mix of evidence available, and the relative reliability of the various methods under considerations.” (para 1.69)
Use of arm’s length range is not permitted
6.4 The section provides that the arm’s length price shall be the arithmetic mean of the prices determined. Thus, it does not permit the use of an arm’s length range of prices. In this connection, the OECD Guidelines provide as follows:
“In some cases it will be possible to apply the arm’s length principle to arrive at a single figure (e.g., price or margin) that is the most reliable to establish whether the conditions of a transaction are arm’s length. However, because transfer pricing is not an exact science, there will also be many occasions when the application of the most appropriate method or methods produces a range of figures all of which are relatively equally reliable. In these cases, differences in the figures that comprise the range may be caused by the fact that in general the application of the arm’s length principle only produces an approximation of conditions that would have been established between independent enterprises. It is also possible that the different points in a range represent the fact that the independent enterprises engaged in comparable transactions under comparable circumstances may not establish exactly the same price for the transaction. However, in some cases, not all comparable transactions explained will have a relatively equal degree of comparability.” (para 1.45)
“A range of figures may also result when more than one method is applied to evaluate a controlled transaction.” (para 1.46)
Thus, the Guidelines permit adoption of a range of figures as arm’s length price.
v  Methods for determination of arm’s length price

6.5 The methods for determination of arm’s length price are explained in the subsequent paragraphs:

6.5-1 Comparable uncontrolled price method (CUP) - The OECD Guidelines define CUP method as ‘a transfer pricing method that compares the price 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.’
A CUP may be determined mainly in any one of the following two ways:
§           if the enterprise sells (or buys) the same product under same circumstances to [or from] an unrelated third party, that price can be used as a CUP.
§           if a transaction is undertaken either by the company with a third party or by two unrelated parties and there are some differences in the product traded, or in the circumstances of the transaction, and adjustments can be made to the price to take account of these differences, then the adjusted price can be used as a CUP.
As per Article 2.7 of the said Guidelines an uncontrolled transaction is comparable for purposes of the CUP method if one of the two conditions are met:
§           none of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions could materially affect the price in the open market.
§           reasonably accurate adjustments can be made to eliminate the material effects of such differences.
In applying the CUP method, all the facts and circumstances that are likely to affect the price must be considered. The market location, the volume of transactions, the risks involved, the warranty and payment terms, the market conditions, etc., may have an implication on the price of the product. Adjustments are made to the uncontrolled price to negate the effect of the differences in facts and circumstances, to arrive at the CUP.
EXAMPLES
  (A)  USCO, a US company, sells computer monitors to its Indian subsidiary (ICO) for resale. USCO also sells computer monitors to other computer resellers (say, CMI) in India on identical terms. In case USCO sells the monitors to CMI for Rs. 10,000, the CUP price for the computer monitors being sold by USCO to ICO would also be Rs. 10,000.
  (B)  Suppose, in the aforesaid illustration, the terms are different for warranty:
          The warranty in case of sale of monitors by ICO is handled by ICO. However, for sale of monitors by CMI, USCO is responsible for the warranty for 3 months. Suppose, USCO and ICO offer extended warranty at a standard rate of Rs. 1,000 per annum. In such a case, if USCO sells the monitors to CMI for Rs. 10,000, the arm’s length price for the computer monitors being sold by USCO to ICO would be:

Rs.
Third party sale price
10,000
Less : Value of 3 months warranty [Rs. 1,000/12 × 3]
250
CUP
9,750
6.5-2 Resale price method (RPM) - The OECD Guidelines define RPM as follows:
“A transfer pricing method based on the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise. The resale price is reduced by the resale price margin. What is left after subtracting the resale price margin can be regarded, after adjustment for other costs associated with the purchase of the product (e.g., custom duties), as an arm’s length price of the original transfer of property between the associated enterprises.”
For the above purposes, the OECD’s Guidelines define Resale Price Margin as
“a margin representing the amount out of which a reseller would seek to cover its selling and other operating expenses and, in the light of the functions performed (taking into account assets used and risks assumed), make an appropriate profit.”
The Guidelines further provide that “the resale price margin of the reseller in the controlled transaction may be determined by reference to the resale price margin that the same reseller earns on items purchased and sold in comparable uncontrolled transactions. Also, the resale price margin earned by an independent enterprise in comparable uncontrolled transactions may serve as a guide.” (para 2.15 of the Guidelines)
The resale price method is ordinarily used when the reseller has not added substantial value by either physically altering the property or using its intangible property before resale.
EXAMPLE
ICO is a distributor of software developed by its parent company in the US. The end customer price (or retail price) of the software is Rs. 5,000. Assuming comparable independent distributors in India earn margins of 10%, the arm’s length transfer price would be as follows:

Rs.
Final Retail Price in India
5,000
Less : Margin earned by comparable distributors
500
Transfer Price using RPM
4,500
6.5-3 Cost Plus method - The OECD Guidelines define cost plus method as follows:
“A transfer pricing method using the costs incurred by the supplier of property (or services) in a controlled transaction. An appropriate cost plus mark up is added to this cost, to make an appropriate profit in light of the functions performed (taking into account assets used and risks assumed) and the market conditions. What is arrived at after adding the cost plus mark up to the above costs may be regarded as an arm’s length price of the original controlled transaction.”
For this purpose, the OECD’s Guidelines define cost plus mark up as
“A mark up that is measured by reference to margins computed after the direct and indirect costs incurred by a supplier of property or services in a transaction.”
The Guidelines further provide that
§           the cost plus mark up of the supplier in the controlled transaction should ideally be established by reference to the cost plus mark up that the same supplier earns in comparable uncontrolled transaction. In addition, the cost plus mark up that would have been earned in comparable transactions by an independent enterprise may serve as a guide. (para 2.33 of the Guidelines)
§           an uncontrolled transaction is comparable to a controlled transaction (that is, it is a comparable uncontrolled transaction) for purposes of the cost plus method if one of the two conditions is met:
  (a)   none of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions materially affect the cost plus mark up in the open market; or
  (b)   reasonably accurate adjustments can be made to eliminate the material effects of such differences. (para 2.34 of the OECD Guidelines)
EXAMPLE
ICO, an Indian company is a wholly owned subsidiary of USCO, a US car manufacturer. ICO has an assembly plant. It supplies no capital, automotive knowledge and takes no risk. Based on an analysis of the financial statements of comparable companies, it is determined that similar assembly businesses earn 20% on costs. Applying this margin to the costs of ICO, one can arrive at the arm’s length transfer price. Assuming that ICO’s cost is Rs. 100, the transfer price under cost plus method would then be Rs. 120.
6.5-4 Profit split method (PSM) - The OECD Guidelines define PSM as follows:
“A transactional profit method that identifies the combined profit to be split for the associated enterprises from a controlled transaction (or controlled transactions that is appropriate to aggregate) and then splits those profits between the associated enterprises based upon an economically valid basis that approximates the division of profit that would have been anticipated and reflected in an agreement made at arm’s length.”
EXAMPLE
Assumptions
A, is a US intangible holding company that provides patents to a related manufacturing company B, in India. B, sells its entire production to a related marketing company C. There are no significant marketing intangibles (trade marks, etc.).
Methodology
In order to determine the arm’s length price for royalty to be paid by B in respect of patents provided by A, the following methodology will have to be adopted:
  (a)  A set of companies that are comparable to B are found.
  (b)  On the basis of the profits of such companies, the optimum profits that should be earned by B are determined.
   (c)  Thereafter, a set of marketing companies that are comparable to C are identified.
  (d)  On the basis of profits of comparable companies, the optimum profits for C are determined.
  (e)  The entire actual profits of the group that is, profits of A, B and C are then aggregated.
   (f)  From such aggregate profits, the optimum profits attributable to activities of Company B and Company C as determined in (b) & (d) above are deducted.
  (g)  The balance profits give the value of intangibles held by A and would indicate the optimum level of royalty to be paid by B.
6.5-5 Transactional Net Margin Method (TNMM) - The Guidelines define TNMM as:
“A transactional profit method that examines the net profit margin relative to an appropriate base (e.g., costs, sales, assets) that a taxpayer realises from a controlled transaction (or transactions that it is appropriate to aggregate).”
The Guidelines further provide that the net margin of the taxpayer from the controlled transaction (or transactions that are appropriate to aggregate) should ideally be established by reference to the net margin that the same taxpayer earns in comparable uncontrolled transactions. Where this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise may serve as a guide. A functional analysis of the associated enterprise and, in the latter case, the independent enterprise is required to determine whether the transactions are comparable and what adjustments may be necessary to obtain reliable results. (para 3.26 of OECD Guidelines)
Choice of appropriate transfer pricing method
6.6-1 For tangible property - The Guidelines provide that where it is possible to locate comparable uncontrolled transactions, the CUP method is the most direct and reliable way to apply the arm’s length principle. Consequently, in such cases the CUP method is preferable over all other methods. (para 2.7 of OECD Guidelines)
6.6-2 Services - The method to be used to determine arm’s length transfer pricing for intra-group services should be determined according to the prescribed guidelines. Often, the application of these guidelines will lead to use of the CUP or cost plus method for pricing intra-group services. A CUP method is likely to be used where there is a comparable service provided between independent enterprises in the recipient’s market, or by the associated enterprise providing the services to an independent enterprise in comparable circumstances. For example, this might be the case where accounting, auditing, legal, or computer services are being provided. A cost plus method would likely to be appropriate in the absence of a CUP where the nature of the activities involved, assets used, and risks assumed are comparable to those undertaken by independent enterprises. (para 7.31 of OECD Guidelines)
6.6-3 For intangible property - In establishing arm’s length pricing in the case of a sale or licence of intangible property, it is possible to use the CUP method where the same owner has transferred or licensed comparable intangible property under comparable circumstances to independent enterprises. If the aforesaid enterprise sub-licenses the property to third parties, it may also be possible to use some form of resale price method to analyse the terms of the controlled transaction. (para 6.23 of OECD Guidelines)
In the sale of goods incorporating intangible property, it may also be possible to use the CUP or resale price method. (para 6.24 of OECD Guidelines)
In cases involving highly valuable intangible property, it may be difficult to find comparable uncontrolled transactions. It, therefore may be difficult to apply the traditional transaction methods and the transactional net margin method, particularly where both parties to the transaction own valuable intangible property or unique assets used in the transaction that distinguish the transaction from those of potential competitors. In such cases the profit split method may be relevant although there may be practical problems in its application. (para 6.26 of OECD Guidelines)
Definition in section 92F(ii)
6.7 Irrespective of which method is ascertained/identified as the most appropriate method, while applying the said method for determination of the arm’s length price, the definition of arm’s length price under section 92F(ii) should always be kept in mind. Hence, the cardinal principle which can never be lost sight of is, that the objective is to determine ‘a price which is applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.’ Hence, whatever be the method being applied, the effort/objective/attempt should be to arrive at a price which independent enterprises in uncontrolled conditions would have transacted at.

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