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)
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.
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
|
“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
|
“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.
“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.
“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)
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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