Transfer Pricing Methods and

Selection of Most Appropriate

Method
Contents

Transfer Pricing – Quick background

Arm's Length Principle

Transfer Pricing Methods

Selection of Most Appropriate Method

 Transfer Pricing – a quick
background

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

• Transfer Pricing primarily requires any income arising from International

Transaction between two or more Associated Enterprises to be at
Arm’s Length Price and comparable to similar transaction between
unrelated enterprises.

• The term “international transaction” is widely defined to cover almost

all kinds of transactions.
 Arm's Length Principle

• Principles governing multinational transfer pricing:

— Arm's length principle
— Global formulary apportionment

• Arm's length principle most popular globally

• Arm's length principle requires the transaction between two associated

enterprises to be commercially at par with that of a similar transaction
between two independent enterprises entered in uncontrolled
conditions.

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

Comparability factors for application of
arm's length principle

Type of
Product

2 Functions Economic
4
Performed Conditions

Contractual
1 Risk Borne 5
Terms
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 material differences

Plays a critical role in selection/applicability of methods

Transfer Pricing Methods
Comparable
Uncontrolled Price

Traditional Resale Price

Methods Methods
Transfer Pricing

Cost Plus Methods

Methods

Transactional Net
Transactional Margin Method
Profit Methods
Profit Spilt Method
Other Methods
Comparable Uncontrolled Price (CUP) Method

Contents
Introduction and applicability

Types of CUP
Illustration
 Introduction and applicability

• Compares the price charged from the 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
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 or paid for property transferred or services provided in a
comparable uncontrolled transaction, or a number of such transactions, is
identified;
ii. Such price is adjusted to account for differences, if any, between the
international transaction and the comparable uncontrolled transactions or
between the enterprises entering 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
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 only when comparable uncontrolled transactions is available

in an comparable environment with adjustable differences.

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

• Demands highest degree of product comparability.

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 transaction can be used as CUP if one of the following
two conditions is 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; or
• reasonably accurate adjustments can be made to eliminate the
material effects of such differences.
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
 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
 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
Resale Price Method (RPM)

Contents
Introduction and applicability
Types of RPM
Application with illustration
Case studies & Judicial Precedents
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.
• 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.
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

• When CUP method is not applicable.

• Most useful in the case of traders & distributors

• Can easily be applied when no significant value addition is there

• Not applicable when Goods purchased from AE also sold to AE

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 gross margin in the
open market…
TP = RSP x (1‐GPM), where:
• TP = the Transfer Price of a product sold between a sales company and a
related company;
• RSP = the Resale Price at which a product is sold by a sales company to
unrelated customers; and
• GPM = the Gross Profit Margin that a specific sales company should earn,
defined as the ratio of gross profit to net sales, which the sales company
retains to cover its sales, general and administrative (SG&A) expenses, and still
make an appropriate profit

In case of no Material Differences.

 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 RPM can be applied by comparing the gross profit margin realized on goods procured from Co. Y
with the gross profit margin realized on goods procured from Co. A
 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
 Case Study &
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.

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

distribution.
• L'Oreal India adopted RPM to benchmark its

Outside India international transaction pertaining to purchase of

Purchase of
India finished goods finished goods for distribution in India.

L'Oreal India Customers

Sale of finished
goods
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.
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.
RPM – Key Judgment
The main grounds before the High Court and its verdict are as under:

There no distinguishing features were

Whether the Tribunal erred in holding that noted, the Tribunal did not err in holding
RPM was the most appropriate method for
determining ALP in respect of imports of
that RPM was the most appropriate
finished goods method for 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
that the substantial value addition made to the
goods has changed the degree of similarity in the sales effected to unrelated parties without any further
functions performed thereby making RPM non processing. The same view is also supported by
applicable in the instant case OECD guidelines and 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.
 Cost Plus Method

Contents
Introduction and applicability
Types of CPM
Application with illustration
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
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 or services by the enterprise, or by an unrelated enterprise, in a comparable
uncontrolled transaction, or a number of such transactions, 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;
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

• When CUP Method is not applicable.

Key Aspects in application

There must be a consistency in

cost base between controlled Concentrates on functional
and uncontrolled transactions, similarities. Risk profile must be
specially in the circumstances similar between controlled and
where costs have the effect on uncontrolled transactions.
the size of mark-up

Accounting inconsistencies
must be eliminated between
controlled and uncontrolled
transactions.
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 can be applied by comparing the gross profit margin realized on goods supplied to Co. Y with the
gross profit margin realized on goods supplied to Co. A
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 this case external CPM may be applied by comparing the gross markup realized by Co. P vis-a-vis the
gross markup realized by Co. X

manufacture and
Co. X Co. A
supply

Controlled Transaction

Co. P Co. Q
manufacture and
supply

Uncontrolled Transaction
Profit Split Method (PSM)
Contents

Introduction

Types of PSM

Strength and Weakness

Judicial precedents-global
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
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
Types of PSM

Residual Contribution
Analysis Analysis
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 non routine functions, risks and assets.
• This method is the most commonly used profit split method, particularly
popular in automotive, consumer electronics and financial services
industries.
PSM – Strengths and weakness

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

Transactional Net Margin Method
Contents

Introduction and applicability

Strength and Weakness

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

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 profit margin realized by the enterprise or by an unrelated enterprise from a comparable
uncontrolled transaction or a number of such transactions is computed having regard to the same
base.

iii. the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions
is adjusted to take into account the differences, if any, between the international transaction and the
comparable uncontrolled transactions, or between the enterprises entering into such transactions, which
could materially affect the amount of net profit margin in the open market.

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

v. the net profit margin thus established is then taken into account to arrive at an arm’s length price in
relation to the international transaction.
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
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 If two or more Comparable
product characteristics of the uncontrolled comparable Companies are selected, arithmetic
companies mean would 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
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.
Other Method
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
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

Selection of Most Appropriate
Method
 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
 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

Thank you