Internship Project Report

Internship Project Report

on

Study of Concept of transfer pricing: prospects, challenges and the way forward
at

Nexdigm Pvt Ltd., Pune

By

Isha Joseph
B. Com
(2019-2022)

Submitted to

In partial fulfilment of the requirement for the award of Degree of

B. Com

Submitted Through

MIT-WPU School of Commerce, Pune.

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Internship Project Report

CERTIFICATE

This is to certify that Mr. /Ms. ISHA JOSEPH

of MIT-WPU SCHOOL OF COMMERCE has successfully completed the project work titled
Study of Concept of transfer pricing: prospects, challenges and the way forward
in partial fulfilment of requirement for the award of BCom. prescribed by the MIT World Peace
University, Pune, from 16/12/2021 to 1/04/2022.

This project is the record of authentic work carried out during the academic year 2022.

Prof. Shreeya Rajpurohit

Dr. Anjali Sane
Name of Project Guide HoS and Associate Dean – SoC

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Internship Project Report

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DECLARATION

I, Mr. / Ms. Isha Joseph hereby declare that this project is the record of authentic work carried

out by me during the academic year 2021-22. This project is plagiarism free and has not been

submitted to any other University or Institute towards the award of any degree.

Signature of the student

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Internship Project Report

ACKNOWLEDGEMENT

I would like to express my gratitude and appreciation to all those who have helped and contributed
towards the completion of the project. I excess my thanks and gratitude to Prof. Shreeya Rajpurohit for
the guidance and support throughout this project. I got to learn lot of things about Concepts related to
Transfer Pricing. Last but not the least I am Thankful to MIT- WPU for giving me opportunity to work on
this project.

I also express my deepest gratitude and special thanks to Mr. Ricky Ruparelia Manager of Nexdigm Pvt
Ltd., who despite being extraordinary busy with his duties, took time out to hear, guide and keep me on
the correct path and allowing me to carry out my project at their esteemed organization.

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Table of content

Sr. No. Particulars Page No.

1. Executive Summary 8
2. Introduction 9-16
3. Objectives of the study 17
4. Industry/sector Profile 18
5. Company Profile 19-21
6. Hypothesis 22
7. Data Analysis and Interpretation 23-45
8. Observation/Finding 46-49
9. Conclusion 50
10. Bibliography 51

List of Tables
Sr. No. Table No. Title Page No.
1 Table 1 Calculation of arm’s length Price 27
2 Table 2 Margin Computation 41
3 Table 3 Summary of margin 44
4 Table 4 Computation of range 45
5 Table 5 Summary of TP Method 50
6 Table 6 Summary of benchmarking process for various 52
methods used in transfer pricing

List of figures
Sr. No. Figure No. Title Page No.
1 Figure 1 Transfer Pricing 9
2 Figure 2 Company Logo 19
3 Figure 3 Internal CUP method 24
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4 Figure 4 External CUP 26
5 Figure 5 Explanation of cost-plus method through diagram 30
6 Figure 6 Cost Plus method 32
7 Figure 7 Example for profit split method 34
8 Figure 8 OP/OR Computation 43
9 Figure 9 Computation of OP/OR 47
10 Figure 10 Computation of weighted average OP/OR 47
11 Figure 11 Range Computation 48

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Executive Summary

Commercial transactions between the different parts of the multinational groups may not be subject to the
same market forces shaping relations between the two independent firms. One party transfers to another
goods or services, for a price. That price is known as "transfer price". This may be arbitrary and dictated,
with no relation to cost and added value, diverge from the market forces. Transfer price is, thus, a price
which represents the value of good; or services between independently operating units of an organisation.
But, the expression "transfer pricing" generally refers to prices of transactions between associated
enterprises which may take place under conditions differing from those taking place between independent
enterprises. It refers to the value attached to transfers of goods, services and technology between related
entities. It also refers to the value attached to transfers between unrelated parties which are controlled by a
common entity.

The title of the project is “Study of Concept of transfer pricing: prospects, challenges and the way
forward”. The main aim of the project is to understand the main objective of transfer pricing and the
compliances related to it.

The objectives of the project are as follows:

a. To understand transfer pricing compliances
b. To understand transfer pricing audit
c. To understand the preparation of transfer pricing documentation report
d. To understand Indian benchmarking
e. To understand global benchmarking
f. To understand the working of the tools of transfer pricing

In the era of globalization, when Multinational Enterprises (MNEs) have branches, divisions, subsidiaries
and offices operating across the globe; it is common for them to transact goods and services from one
jurisdiction to an associated enterprise in another tax jurisdiction.
This project helps to study that if there are associated enterprises across the border then how the dealing of
capital, investment and services are done so that both the units are benefitted.

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Introduction

There are a large number of Multi National Enterprises (MNE’s) and they are in a position to have presence
in multiple locations and do business activities virtually anywhere in the world. Apart from global trade
which the MNE’s anyway do, a significant volume of transfers of goods and services, capital (equity, debt
or other hybrid forms) and intangibles (intellectual property rights) take place within a MNE
group. These transfers within a group are called intra-group transactions and it is estimated that these intra-
group transactions may be in the region of about 60% of all international transactions. When
transactions take place between two unknown entities it is entirely driven by demand and supply forces in
the market but when such transactions are affected within the group entities i.e., associates, subsidiaries,
holding companies, JV’s or otherwise related parties, they are supposed to be driven by market forces which
in practice may or may not be there. Price mechanism is artificially decided by the parent company with a
view to derive maximum economic benefits and comparative tax advantage. This depends on differential
tax regulation and economies of scales of operations in different countries. So, it becomes pertinent that the
right price is fixed called as Transfer price for inter unit and intra unit transfers and cross border transactions
in buying or selling goods and services including tangible assets and intangibles too. Transaction arising
amongst related parties must comply with arms’ length pricing principles so that profits are correctly
reflected in countries where related parties to transaction exists.

Transfer pricing can be defined as the value which is attached to the goods or services transferred between
related parties. In other words, transfer pricing is the price that is paid for goods or services transferred from
one unit of an organization to its other units situated in different countries.
Some of the international transactions which are governed by the transfer pricing rules are Sale of finished
goods, purchase of raw material, purchase of fixed assets, sale or purchase of machinery etc., sale or
purchase of intangibles, reimbursement of expenses paid/received, IT enabled services, support services,
software development services, technical Service fees, management fees, royalty fees, corporate Guarantee
fees, loan received or paid etc.
Figure 1 Transfer Pricing

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Let’s try to understand the concept with a simple example. Suppose a company X purchases goods for $100
and sells to its associated company Y in another country for $200, who in turn sells the product in open
market for $400. Had X sold it directly, it would have made a profit of $300, but by routing it through Y,
it restricted it to $100. The transaction between X and Y is arranged and not governed by market forces.
The profit of $200 is thus shifted to country Y. The good is transferred on a price which is arbitrary or
dictated ($200) but not on the market price $400.

Terms related to Transfer Pricing

ASSOCIATED ENTERPRISES
Section 92A of the Income Tax Act, 1961 defines the term “Associated Enterprise” in two parts.
The first part says that “associated enterprise”, in relation to another enterprise, means an enterprise –
• which participates, directly or indirectly, or through one or more intermediaries, in the management
or control or capital of the other enterprise; or
• in respect of which one or more persons who participate, directly or indirectly, or through one or
more intermediaries, in its management or control or capital, are the same persons who participate,
directly or indirectly, or through one or more intermediaries, in the management or control or capital
of the other enterprise.
The second part states that two enterprises shall be deemed to be associated enterprises if, at any time during
the previous year,
• one enterprise holds, directly or indirectly, shares carrying not less than twenty-six per cent of the
voting power in the other enterprise; or
• any person or enterprise holds, directly or indirectly, shares carrying not less than twenty-six per
cent of the voting power in each of such enterprises; or

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• a loan advanced by one enterprise to the other enterprise constitutes not less than fifty-one per cent
of the book value of the total assets of the other enterprise; or
• one enterprise guarantees not less than ten per cent of the total borrowings of the other enterprise;
or
• more than half of the board of directors or members of the governing board, or one or more executive
directors or executive members of the governing board of one enterprise, are appointed by the other
enterprise; or
• more than half of the directors or members of the governing board, or one or more of the executive
directors or members of the governing board, of each of the two enterprises are appointed by the
same person or persons; or
• the manufacture or processing of goods or articles or business carried out by one enterprise is wholly
dependent on the use of know-how, patents, copyrights, trade-marks, licences, franchises or any
other business or
• commercial rights of similar nature, or any data, documentation, drawing or specification relating
to any patent, invention, model, design, secret formula or process, of which the other enterprise is
the owner or in respect of which the other enterprise has exclusive rights; or
• ninety per cent or more of the raw materials and consumables required for the manufacture or
processing of goods or articles carried out by one enterprise, are supplied by the other enterprise, or
by persons specified by the other enterprise, and the prices and other conditions relating to the
supply are influenced by such other enterprise; or
• the goods or articles manufactured or processed by one enterprise, are sold to the other enterprise
or to persons specified by the other enterprise, and the prices and other conditions relating thereto
are influenced by such other enterprise; or
• where one enterprise is controlled by an individual, the other enterprise is also controlled by such
individual or his relative or jointly by such individual and relative of such individual; or
• where one enterprise is controlled by a Hindu undivided family, the other enterprise is controlled
by a member of such Hindu undivided family or by a relative of a member of such Hindu undivided
family or jointly by such member and his relative; or
• where one enterprise is a firm, association of persons or body of individuals, the other enterprise
holds not less than ten per cent interest in such firm, association of persons or body of individuals;
or
• there exists between the two enterprises, any relationship of mutual interest, as may be prescribed.

INTERNATIONAL TRANSACTION
International Transaction means a transaction between two or more associated enterprises, either or both of
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whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property, or
provision of services, or lending or borrowing money, or any other transaction having a bearing on the
profits, income, losses or assets of such enterprises, and shall include a mutual agreement or arrangement
between two or more associated enterprises for the allocation or apportionment of, or any contribution to,
any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or
to be provided to any one or more of such enterprises.

ARM’S LENGTH PRICE

Arm’s length price means a price which is applied or proposed to be applied in a transaction between
persons other than associated enterprises, in uncontrolled transactions.

Special issues related to Transfer Pricing

I. Documentation requirements
Generally, a transfer pricing exercise involves various steps such as
• Gathering background information
• Industry analyses
• Comparatively little analyses (which includes functional analyses)
• Selection of the method for determining arm’s length pricing and
• Determination of arm’s length price
At every stage of the transfer pricing process, varying degrees of documentations are necessary. One
pressing concern regarding transfer pricing documentation is the risk of over burdening the taxpayer with
this disproportionately high cost in obtaining relevant documentations or in an exhaustive search for
comparable that may not exist. Ideally, the taxpayer should not be expected to provide more documentation
than is objectively required for a reasonable determination by the tax authorities whether or not the taxpayer
has compiled with the arm’s length principle. Cumbersome documentation demands may affect how a
country is viewed as an investment. destination and may have particularly discouraging efforts on small
and medium sized enterprises
Broadly the information or documents that the taxpayer need to provide can be classified as
i. Enterprises - related documents (for example the ownership shareholding pattern of the taxpayer,
the business profile of the MNE, industry profile etc)
ii Transaction - specific documentation (for example the details of each international transaction,
functional analyses of the taxpayers and associated enterprises, record of and controlled transactions for
each international transactions etc) and
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iii Computation - related documents (for example the nature of each international transaction and the
rational of selecting the method for each international transaction, actual computation of the arm’s length
price, factors and assumptions influencing the determination of the arm’s length price etc)
Furthermore, the domestic legislation of many countries requires contemporaneous documentation. The
Oxford dictionary defines the term contemporaneous as existing or occurring in the same period of time so
that such documentation cannot be created after the transaction is affected. Contemporaneous
documentation maintained in accordance with such obligation should have the characteristics of
completeness, accuracy and timeliness.

II. Intangibles
Intangible, (literally meaning assets that cannot be touched) are divided into two trade intangible and
marketing intangible - trade in tangible such as know-how related to the production of goods and the
provisions of services and typically developed through research and development marketing intangible
refers to intangibles such as a trade names trademarks and client list that aid in the commercial exploitation
of a product or services.
The arm’s length principal often becomes difficult to apply to intangible due to a lack of suitable
comparable for example in intellectual property tends to relate to the uniqueness of a product rather than
its similarities to other products. This difficulty in finding comparable is accentuated by the fact that dealing
with the intangible properties can also occur in many (often subtly different) ways such as by license
agreement involving payment of royalty, outright sale of the intangibles, compensation including in the
price of goods (that is selling and finished products including the know-how for further processing) or
package deals consisting of some combination of the above.
In cases where both parties’ own valuable intangibles, typically the profit split method is used. In cases
involving sub-licensing of intangibles by associate enterprises to third-party, Cost-plus Method can be used.
In case of a sale of an intangible, CUP may be used if there exist in an internal comparable.

III. Intra group services

An intra-group services, as the name suggests, is a service provided by one enterprise to another in the same
MNE group. For a service to be considered an intra-group service it must be similar to a service which an
independent enterprise in comparable circumstances would be willing to pay for in house or else perform
by itself. If not, the activity should not be considered as an intra-group service under the arm’s length
principle. The rational is that if specific group members do not need the activity and would not be willing
to pay for it if they were independent, the activities could not justify a payment. Furthermore, any incidental
benefits solely by being the member of an MNE group, without any specific services provided on perform,
should be ignored.

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An arm’s length price for intra group services may be determined directly or indirectly in the case of direct
charges the CUP method could be used if comparable services are provided in the open market. In the
absence of CUP, the cost-plus method could be appropriate to apply in such cases.
If a direct charge method is difficult to apply, the MNE may apply the charge indirectly via cost sharing or
in corporate in a service charge or not charging at all. Such methods could usually be accepted by the tax
authorities only if the charges are supported by four saleable benefit and if the method or based on sound
accounting and commercial principle and are capable of producing charges or allocations that are
commensurate with the reasonable expected benefits to the recipient.

IV. Cost contribution agreements

Cost contribution agreement CCA may be formulated among group companies to jointly develop, produce,
and obtain rights, assets or services. Each participant bears a share of the cost and in return is expected to
receive pro rata benefits from a developed property without further payment. Such arrangements tend to
involve research and development or services such as centralized management, advertising campaigns etc.
In a CCA there is not always a benefit that ultimately arises, only and expected one during the course of
the CCA. The interest of each participant should be agreed upon at the outset.
The contributions are required to be consistent with what I am independent enterprises could have
contributed under comparable circumstances, given such expected benefits. The CCA is not a transfer
pricing method, it is a contract. However, it may have transfer pricing consequences and therefore need to
comply with the arm’s length principle.

V. Use of secret compatibles

There is often concern expressed by enterprises over aspect of data collection by tax authorities and its
confidentiality. The fact is that tax authorities are privy to, as they need to be, very sensitive and highly
confidential information about taxpayers, such as relating to margins, profitability and business contacts
and contracts. Confidence in the tax system means that this information needs to be treated very carefully,
especially as if it may reveal sensitive business information about that tax payer’s profitability, business
strategies and so forth.
A secret comparable generally means the use of information or data about a taxpayer by the tax authorities
to form the basis of transfer pricing security of another taxpayer, who is often not given access to that
information - it may reveal confidential information about competitors operations for example caution may
be exercised in prescribing the use of secret comparable unless the tax authorities are able to (within limits
to confidentiality ) disclose the data and to the taxpayer so as to defend against an adjustment. The reason
for this question is that taxpayer may contain that use of such a secret information is against the basic

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principle of equity, as the taxpayer is required to benchmark his controlled transactions with comparable
not available to him, without the opportunity to question compatibility or argue that adjustments are needed.

Filing of FORM 3CEB

Form 3CEB under transfer pricing regulations is basically filled by the company with form 3CD under sec
92A TO 92F of the income tax act. These sections are basically related to Transfer Pricing, Form 3 CEB
filing is mandatory if the company is engaged in any of the international transaction with any associate
enterprise. In form 3CEB basically, you need to give a detail of all the international transactions and some
specified domestic transactions with associated enterprises. There are two preconditions of form 3CEB
filing under Transfer Pricing Regulation.

➢ Two or more associated enterprises enter into an international transaction

➢ Specified Domestic Transaction

Information required to file Form 3CEB

➢ Requires the taxpayer to provide general information about itself along with the aggregate value of
international transactions and SDT.
➢ Requires the taxpayer to provide the details of the international transactions entered into during the
Financial Year.
➢ Requires the taxpayer to provide the details of Specific Domestic Transactions entered into during
the FY.

Penalty for non-filing the Form 3-CEB

➢ On Failure to furnish report under Form 3CEB Minimum penalty of INR 100,000 may be imposed.
➢ While if you fail to furnish information or documents pertaining to international transactions or
specified domestic transactions under section 92D, a Penalty equivalent to 2% of the value of the
transaction may be imposed.
➢ If you fail to keep and maintain information and document, failure to report or furnish inaccurate
information- Penalty equivalent to 2% of the value of the transaction may be imposed.

Transfer Pricing Documentation

The purpose of transfer pricing documentation is to show that the company’s related-party transactions are
in accordance with the arm’s-length principle. Good transfer pricing documentation should clearly lay out

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how the functions, assets and risks are shared between related parties in each related-party transaction in
such a way that anyone can understand, whether or not they are familiar with the company.

Basically, a transfer pricing study report consists of the following:

➢ An executive summary of the parent company, Indian company and its subsidiaries. This describes
about the line of business the company is engaged in.
➢ FAR Analysis – Functional analysis, Asset analysis and risk analysis.
➢ Suitable method that can be used for computation of international transaction.
➢ Arm’s length price computation and analysis.
➢ Procedure of Benchmarking process.

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Objectives of the Study

The objectives of the study are as follows:

➢ To understand transfer pricing compliances
➢ To understand transfer pricing audit
➢ To understand the methods that are used for calculation of arm’s length prices
➢ To understand the preparation of transfer pricing documentation report
➢ To understand Indian benchmarking
➢ To understand global benchmarking
➢ To understand the working of the tools used in transfer pricing

Scope of the Project

▪ The project is based on the concepts of Transfer Pricing.

▪ The project also focuses on the methods of computing arm’s length price and the benchmarking
process.

Limitations of the Project

As the information provided by the client about the working of their company needs to be kept
confidential, so for the purpose of data analysis, the figures have been extracted anonymously.

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Industry/Sector Profile

The Business & Professional Services industry focuses on companies that provide services mainly to other
corporate entities or public bodies. It is a broad industry, spanning a number of sectors, including
Professional Services, Human Capital Services, Business Services and Infrastructure Services. Business
and Professional Service is a service provided by an organization or third party to enable the business
process of other organizations. These may include temporary workers, contract staff, and/or consulting
firms that use professionals as needed on projects outside their primary function within their own company.
The global professional services market reached a value of nearly $5,028.9 million in 2020, having
increased at a compound annual growth rate (CAGR) of 2.8% since 2015. The market is expected to grow
at a CAGR of 7.0% from 2020 to reach $7,063.9 million in 2025. The global professional services market
is expected to reach $9,371.1 million in 2030, at a CAGR of 5.8%.

Growth in the historic period resulted from globalization, technological developments, outsourcing back-
end operations to low-cost economies, rise in research and development, impact of e waste and strong
economic growth in emerging markets. Factors that negatively affected growth in the historic period were
outsourcing regulations, regulatory changes and shortage of skilled workforce.

Going forward, increasing investments in smart cities, financial reporting standards transition regulatory
reforms, increasing focus on customer satisfaction, growing legal technology, sustainable development and
global collaboration for environment protection. Factors that could hinder the growth of the professional
services market in the future include increasing penetration of DIY tools, rising costs, big data analytics,
in-house legal teams increasing pressure on traditional law firms and outbreak of coronavirus disease
(COVID-19).

The major competitors in the industry of business and professional services are:
➢ Deloitte Touché Tohmatsu Limited
➢ PricewaterhouseCoopers (PwC)
➢ Ernst & Young
➢ KPMG
➢ Accenture Plc

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Company Profile

Figure 2 Company Logo

Nexdigm is an employee-owned, privately held, independent global organization that helps companies
across geographies meet the needs of a dynamic business environment. It focuses on problem-solving,
supported by our multifunctional expertise enables us to provide customized solutions for our clients.
It provides integrated, digitally driven solutions encompassing Business and Professional Services that help
companies navigate challenges across all stages of their life-cycle. Through its direct operations in the USA,
Poland, UAE, and India, we serve a diverse range of clients, spanning multinationals, listed companies,
privately-owned companies, and family-owned businesses from over 50 countries.

VISION
The digital revolution has triggered a transition from an era where businesses were ‘built to last’, to where
businesses need to be ‘built to change’ to last. Nexdigm stems from the epiphany of the ‘now’ that is
constantly evolving. The vision flows from the knowledge of its leaders that the only thing that helps them
grow is their willingness to step up in time. The wisdom earned by accompanying clients on their varied
development curves, while constantly stretching up to all their business needs, has led SKP to bloom into
Nexdigm.

MISSION
Nexdigm represents a global readiness to serve the clients and lead them into the 'Next Paradigm' of
business. The new identity brings fresh energy to support organizations with specialized services across
industries.
The Nexdigm logo with intertwining lines represents the multi-functional capabilities across Business
Services and Professional Services, coming together to create an integrated solution for the clients.
The wave embodies the agility and flexibility that we employ, alongside world-class professional and
ethical standards. It imbibes our approach of partnership and collaboration while signifying the rapid pace
with which we are innovating and digitizing. Nexdigm resonates our plunge into a new paradigm of
business; it is our commitment to ‘Think Next.’

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SERVICES
Nexdigm is engaged in providing Business Services and Professional Services.

Business services comprises of:

➢ Business Process management

a. Finance & Accounting Management
b. Commercial Operations
c. Contract Management
d. Process Improvement
e. Shared Services

➢ Operations & Finance Transformation

a. Finance
b. Supply Chain
c. Intelligent Automation & Accelerated Analytics (ia3)

➢ Strategic Initiatives
a. Mergers, Acquisitions, Divestitures & Restructuring
b. Greenfield & Brownfield
c. Program Management/Business Consulting
d. Pre-Investment Advisory & Market Research

➢ Technology Advisory
a. Cyber Security & Data Privacy
b. Technology solutions
c. Cloud Migration

Professional Services comprises of:

➢ Entity Set-Up & Management

a. Business Establishment
b. Finance & Accounting
c. Payroll, Administration & HR Compliance

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d. Corporate & Tax Compliance
e. CFO Support & Finance Controller Services

➢ Taxation
a. Direct Tax & Indirect Tax
b. Transfer Pricing & International Tax
c. M&A Tax & Regulatory Services

➢ Assurance & Risk Advisory

a. Accounting Advisory
b. Internal Audit & Process Reviews
c. Technology Risk
d. Forensics

➢ Transaction Advisory
a. Transaction Support
b. Due Diligence & Valuations
c. Economic Analysis

Since its inception, Nexdigm has catered to numerous industries. Over time, it has developed a specialized
focus in Healthcare and Food Processing. Its solutions and services are customized, and it have domain
knowledge across most industries so they can cater to the clients' unique consulting and professional
requirements. The leaders use their experience and insights to illustrate industry trends and deliver
actionable solutions to our clients. They are often a source of thought leadership publications and
knowledge-sharing initiatives across the globe. The industries that Nexdigm have been worked for are
healthcare, food processing, manufacturing, banking & finance, IT & ITeS, energy and natural resources,
automobiles and real estate.

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Hypothesis

The hypothesis for the research project focuses on the effect of coordination on transfer prices of MNCs
with conflicting income tax and duty minimization incentives.

Hypothesis – 1
Hypothesis 1 throws light on the governmental coordination of income tax and customs enforcement. In
the presence of coordinated enforcement, any MNC using inconsistent prices is more likely to be
challenged. This result suggests that a coordinated enforcement regime has a deterrent effect on MNCs’
use of inconsistent prices and, that in the absence of this coordination, some MNCs may use inconsistent
prices more aggressively to minimize the sum of income taxes and duties.

Hypothesis – 2
Hypothesis 2 considers corporate coordination of the income tax and customs functions within the MNC.
In the presence of internal coordination, MNCs are more likely to recognize when conflicting incentives
exist and have information systems in place to set transfer prices that minimize the sum of income
taxes and duties. MNCs are more likely to myopically focus on income tax minimization, failing to
recognize that these prices will result in higher duties. Thus, our finding is consistent with more coordinated
firms altering their income tax transfer prices to minimize the sum of income taxes and duties.

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Data Analysis and Interpretation

This project consists of the study of different methods used for calculation of arm’s length price and the
benchmarking process.

TRANSFER PRICING METHODS

Arm’s length price means a price which is applied or proposed to be applied in a transaction between
persons other than associated enterprises, in an uncontrolled transaction.

The main ingredients of arm’s length price are:

1. The price should be applied or proposed to be applied in a transaction.

2. A transaction will be between two unrelated or persons; and
3. The transaction should be in uncontrolled conditions.

A very important aspect of transfer pricing is the process of determination of the arm’s length price. The
Central Board of Direct Taxes (CBDT), has prescribed 5 methods for determining the arm’s length price.
These are:

❖ Comparable Uncontrolled Price Method (CUP)

❖ Resale Price Method (RPM)
❖ Cost Plus Method (CPM)
❖ Profit Split Method (PSM)
❖ Transactional Net Margin Method (TNMM)

Comparable Uncontrolled Price Method (CUP)

Under this method;
i) Determined the price charged or paid for the property transferred or services provided in a comparable
uncontrolled transaction.
ii) Such price is adjusted to account for differences, if any, between the international transaction and
comparable uncontrolled controlled transactions or between the parties entering into such transactions,
which could materially affect the price in the open market.
iii) The adjusted price arrived at under ii) is taken to be Arm’s Length Price in respect of the property
transferred or services provided in international transaction.

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Typical transactions in respect of which the comparable uncontrolled price (CUP) method may be adopted
are:
(a) Transfer of standard goods;
(b) Provision of standardized services;
(c) Certain types of Intangibles;
(d) Interest on loans.
(e) Royalty payment
(f) Transaction dependent on publicly available market quotation i.e., commodity
exchange.
Figure 3 Internal CUP Method

In this case ICO 1 is an Indian company and it has sold certain unbranded Colombian coffee beans to its
associated enterprise ‘FCO’. In this transaction the sales price used here is the sales price relating to a
related party. When we are applying CUP method, in this case FCO is selling same unbranded Colombian
coffee beans to a non-associated enterprise in India. So, there is a selling price which is related to the related
party transaction and a selling price which is related to an unrelated party transaction. So, we can compare
these two selling prices provided that the goods sold is similar and the no. of units sold is similar. This is
known as Internal Comparable Uncontrolled Price Transaction. This is because the same entity is
buying and selling the goods.

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Figure 4 External CUP Method

In this case there is a transaction between two associated enterprises for the sale of unbranded Columbian
coffee beans and it is a controlled transaction because the two associated enterprise have a certain degree
of common control. These AE have not sold the same beans to any third party. So, internal CUP method is
not applicable. There is another transaction taking place where the non-associated enterprises 1 is selling
the same unbranded Colombian coffee beans to non-associated enterprise 2. This is known as External
Comparable Uncontrolled Price. This is because none of the original parties are involved in selling of the
beans to the third party.

Steps for calculation of arm’s length price using CUP Method

Step – 1: Identify the prices charged from or paid to, on transfer of goods or services in comparable
uncontrolled transaction/s.
Step – 2: Adjust the price so arrived at:
a. For functional difference between the international transaction or the Specified Domestic
Transaction (SDT) under review, and the comparable uncontrolled transactions
b. Between the enterprises entering into such transactions, which could materially affect the price in
the open market.
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Such adjusted price will be the arm’s length price.

Resale Price Method
Under this method,
i) The price at which property purchased or services obtained by the enterprise from an associated
enterprise are resold or are provided to an unrelated enterprise, is identified.
ii) Such resale price is reduced by the amount of normal gross profit margin accruing to the
enterprise or to an unrelated enterprise from the purchase and resale of the same or similar
property or from obtaining and providing the same or similar services in a comparable
uncontrolled transaction, or a number of such transactions;
iii) The price so arrived at is further reduced by the expenses incurred by the enterprise in
connection with the purchase of the property or obtaining the services.
iv) The price so arrived at is adjusted to take into account the functional and other differences
including differences in accounting practices, 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 gross profit margin in the open market;
v) The adjusted price arrived at iv) is taken to be arm’s length price in respect of the purchase of
property or obtaining of the services by the enterprise from the associated enterprise.

This method is applicable when property is purchased or services are obtained from associated enterprises
and the same are sold to unrelated enterprises. This is based on the price of a property or service purchased
or obtained from an associated enterprise and further resale of the same to unrelated enterprise.

Suppose a company Apple & Pear, based in Hong Kong, brews a very exclusive non-alcoholic beverage
called “the Mountain.” It sells this beverage to high-end nightclubs around Asia via associated distributors.
The market price for one can of “the Mountain” is USD 100. Apple & Pear does not sell the beverage to
independent distributors. Also, there is no company in Asia that brews a comparable beverage.

However, there are comparable distributors that sell “the Vulcano.” This is a competing alcoholic beverage
brewed by Gin & Juice, a company also based in Hong Kong. The market price for one bottle of “the
Vulcano” is USD 100. In addition, distributors report USD 5 gross margin per bottle sold with 2 USD on
custom duties.

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Apple & Pear wants to set the transfer price for the supply of “the Mountain” to the associated distributors.
There is no Internal Cup (no third-party transactions by Apple & Pear) or External Cup (no comparable
transactions). Therefore, the CUP method can’t be applied here (The CUP Method with example).

In our example, the distributors of “the Vulcano” are comparable to the distributors of “the Mountain.” The
result is that the gross margin and custom duties reported can be used as input for the Resale Price Method.

Table 1: Calculation of arm's length price

Particulars $
Market price of 1 bottle of the mountain at the distributor 100
(-) Gross margin associated distributor 5
(-) Custom duties associated distributor 2
Transfer Price 93

If the company Apple & pear uses resale price method for the calculation of arm’s length price then it
amounted to $93. This amount would be charged to its associated distributor.

The steps that are involved in the calculation of arm’s length price using the resale price method are as
follows:

a. Identification of transaction involving purchase of property or services which

constitutes an international transaction.
b. Identification of the price at which such property or services are resold or provided
to an unrelated party (resale price);
c. Working out the normal gross profit margin in a comparable uncontrolled
transaction. This is to be worked out both for internal comparable transaction as well as
external comparable transaction. Here it should be noted that for working out the
normal gross profit margin it is necessary to consider what an enterprise would earn
from purchase of the similar property or service from an unrelated party and the resale
of the same to another unrelated party.
d. Deduction of the normal gross profit so derived from the resale price.
e. Deduction of expenses incurred in connection with the purchase of goods;
f. Carrying out adjustment to the resultant amount for the material functional and
other differences between the uncontrolled transaction and the international
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transaction from the point of view of an open market;

Such adjusted price will be the arm’s length price.

Cost Plus Method

Figure 5 Explanation of cost-plus method through diagram

Rule 10B prescribes the manner in which CPM can be applied. The text reads as follows:
(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
or the specified domestic transaction and the comparable uncontrolled transactions, or
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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;”

This method is applicable where some semi-finished goods are sold between related parties or similar
situations or in respect of joint facility agreements, long term buy and supply arrangements of provisions
of services.

Suppose a company, Candy Casing (X) manufactures Iphone cases for associated enterprises. There are
many companies around that manufacture Iphone cases, including independent enterprise Ali Accessories
(B). B and X manufacture similar Iphone cases.

Now say that X is asked by associated enterprise Y to manufacture 100,000 Iphone cases. X wonders what
transfer price it should charge. This means that X should find the terms and conditions (here: the price) of
a comparable transaction. Under the Cost-Plus Method, X should then first compare its cost base with the
cost base of B when manufacturing 100,000 Iphone cases for a third-party client.

Provided that the cost base is comparable, the next step is to identify the mark-up on costs applied by B.
That mark-up should be added to the cost by X. The result is the arm’s length price.

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Figure 6 Cost Plus Method

The Applicability of Cost-Plus Method is as follows:

1) Where CUP or RPM method cannot be applied.
2) Inter group services
3) Contract manufacturers or joint facility agreements
4) Semi-finished goods sold
5) Long term buy and sell contracts
6) Rendering of research services

The application of the cost-plus method involves the following steps: -

a. Determination of the direct and indirect costs of production in respect of property transferred
or service provided to an Associated Enterprise.
b. Identification of one or more comparable uncontrolled transactions for same or comparable
and similar property or service.

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c. Determination of normal gross profit mark-up on costs in the comparable uncontrolled
transaction. Here it should be noted that the various components of costs of comparable
uncontrolled transaction should be the same as those of the international transaction.
d. Adjustment of gross profit mark-up so as to account for functional and other differences
including enterprise level differences between the international transaction and the
comparable uncontrolled transaction.
e. Adjustment of the cost of production in the international transaction which will give effect
to the adjusted gross profit mark-up.
f. Arrival of the arm’s length price based on steps (i) to (v)

Such adjusted price will be the arm’s length price.

Profit Split Method

Under this method;
i) The combined net profit of the associated enterprises arising from the international transaction
in which they are engaged, are 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 among the enterprises in proportion to their relative
contributions, as evaluated under ii);
iv) The profit thus apportioned to the assessee is taken into account to arrive at arm’s length price
in relation to the international transaction.

This method is applicable mainly in international transactions involving transfer of unique intangibles or
in multiple international transactions which are so interrelated that they cannot evaluated separately for the
purpose of determining the arm’s length price of any one transaction.

Typical transactions where the profit-split method may be used are transactions involving:

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(a) integrated services provided by more than one enterprise for e.g., in case of financial service sector,
where the activities performed by Indian company and foreign AEs in relation of a merger and acquisition
transaction are so interrelated that it may not possible to segregate them;
(b) transfer of unique intangibles, for e.g., two associated enterprises contribute their respective intangibles
to develop a new product or process and earn income from such product or process.

Figure 7 Example for profit split method

In the above example, we see two comparable joint ventures. Joint Venture I is owned by associated
enterprises Y and X. Opposite to that, Joint Venture II is owned by independent enterprises A and B.

Let’s say that we need to determine the transfer prices to be charged for the transactions related to Joint
Venture I.

For that, we can compare the terms and conditions of the controlled transactions by determining the division
of profits of comparable uncontrolled transactions. In this example, this means that we can compare Profit
Split I with Profit Split II.

There are two kinds of Profit Split Methods:

➢ Contribution profit split method;

➢ Residual profit split method.

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The contribution profit split method splits profit among associated enterprises according to the functions
performed and risks assumed. In addition, the assets are analysed which are contributed by each entity. In
particular, intangible assets.

The residual profit split method requires the identification of the routine profit for an entity as a first step.
Any remaining profit is then split based on each party’s contribution to the earning of the non-routine profit,
for example the ownership of intangibles.

Transactional Net Margin Method (TNMM)

Under this method;
i) The net profit margin realised by the enterprise from an international transaction entered into
with an associate 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 realised 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
basis;
iii) The net profit margin referred to in 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 realised by the enterprise and referred in i) is established to be the same
as the net profit margin referred in 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.

The TNMM requires establishing comparability level at a broad functional level. It requires comparison
between net margin derived from operation of the uncontrolled parties and net margin derived by an
associated enterprise on similar operation. Under this method, the net profit margin realised by an
associated enterprise from an international transaction is computed in relation to a particular factor such as
costs incurred, sales, assets utilized, etc. The net profit margin earned by an associate enterprise is compared
with net profit margin of uncontrolled transactions to arrive at arm’s length price.

Typical transactions where the transactional net margin method may be adopted are:
(a) provision of services;

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(b) distribution of finished products where resale price method cannot be applied;
(c) transfer of semi-finished goods where cost plus method cannot be applied;
(d) transactions involving intangibles where profit split method cannot be applied.

The UN TP manual offers the following guidance on the use of TNMM:

➢ TNMM is usually applied with respect to broad comparable functions rather than
controlled transactions.
➢ TNMM is mostly applied to the party performing routine manufacturing, distribution or
other functions that do not involve control over intangibles.
➢ TNMM may be more attractive if the data on gross margins are less reliable due to
accounting differences between the tested party and the comparable companies.

A very important point to be noted is that with respect to TNMM without further benchmarking analysis,
the method is not likely to stand out.
The further steps are:
➢ Selection of the tested party
➢ Period of Comparison
➢ Aggregation of Transactions
➢ Identification of Comparable entities
➢ Profit Level Indicators
➢ Adjustment Calculations

Selection of the tested party - Basis of selection of tested party is net profitability of controlled
transactions, reliable comparable data can be identified and has less complexity without its own intangibles
or unique assets and which performs the routine functions.

Period of Comparison - As per income tax act provision multiple years data can be used to eliminate
variations or difference in product life cycles, accounting years, economic conditions, market conditions
etc. Simple average or weighted average can used for multiple years data.

Aggregation of Transactions – Those transaction which cannot be evaluated on standalone basis can be
bundled with multiple transactions or those transaction which has closely linked products, similarity of
functions, assets, investments, intangible rights.

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Identification of Comparable entities - This can be internal or external comparables. In case of external
comparable, reliable database of Prowess and Capitaline Plus can be used or those data which are available
in public domain.

Profit Level Indicators - Gross profit less operating expenses Or PBT /PBIT/ PBDIT over Net sales,
Return on capital assets or capital employed, operating profit over operating cost.

Adjustment Calculations - Adjustment to comparable margin should be made to improve comparability.

It shall be based on commercial practices, economic principles or statistical analyses.

BENCHMARKING PROCESS
In the context of transfer pricing, Benchmarking is the process by which the arms’ length price is validated
on the basis of comparable financial information obtained from current and recognized databases with the
use of filters objectively. Benchmarking studies are the critical part of any transfer pricing documentation
file or policy and are mainly used to test the arm's length nature of the transactions with AE’s in preparing
a transfer pricing documentation file, set the mark-up attached to the transactions carried out between the
AE’s.

The following are the steps to be followed in carrying out the benchmarking process:

a) Determination of years to be covered

b) Analysis of taxpayer circumstances
c) Understanding of controlled transaction on the basis of FAR Analysis
d) Review of Internal Comparables, if any
e) Identifying sources for external comparables, wherever existing and possible
f) Selection of the most appropriate method and Profit Level Indicators
g) Identification of potential comparables after applying the filters
h) Determining the comparability adjustments required to be made
i) Interpretation of results and finally use of collected data and arrive at Arm’s Length Price (ALP)

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The Central Board of Direct Taxes (the CBDT) issued a Notification on October 19, 2015 (Notification)
that provided the rules for determining ALP in respect of all the related party transactions entered into on
or after April 1, 2014.

➢ Selection of comparables and use of multiple year data

a. The Notification provides that for the purpose of analysing the comparability of an
uncontrolled transaction with the related party transaction, the data pertaining to current year
in which the related party transaction has taken place should be considered.
b. However only in cases, where RPM, CPM or TNMM is selected as the most appropriate
method and the current year data is not available at the time of furnishing the return of
income, the data pertaining to the immediately preceding financial year (to the current year)
should be taken into consideration for analysing the comparability of an uncontrolled
transaction.
c. Consequently, if more than one price is determined (i.e., more than one comparable is
selected) by using any of the most appropriate method, the data values of the comparable set
shall be determined as follows:
d. In case of RPM, CPM and TNMM, where the current year data of comparable is available
and
e. if the comparable has also undertaken similar uncontrolled transaction/s in immediately
previous two financial years,
f. the most appropriate method shall be applied in similar manner to the preceding two
financial years also and the weighted average data values of the three years shall be
considered.
g. In case of RPM, CPM and TNMM, where the data for financial year preceding to the current
year is used and the comparable has also undertaken same or similar uncontrolled transaction
in the year immediately preceding year (to such financial year), then the weighted average
data value of these two years shall be considered.
h. Where CUP, PSM or Other method is applied, the data for only current year shall be used
to determine the data values of the comparable set.
i. The data values so determined for comparables shall be placed in an ascending order for
determining the ALP (dataset).

➢ Range of arm’s length price

The ALP shall be determined on the basis of data set so constructed as follows:

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Situation 1 –
a. In cases where CUP or RPM or CPM or TNMM is used; and
b. The data set used comprises of 6 or more comparables
The ALP shall be the prices falling within 35th to 65th percentile of the above dataset. Accordingly,
if the price at which the related party transaction is entered into by the taxpayer (transaction price)
falls within the range of 35th to 65th percentile, such transaction price shall be regarded as ALP.
However, if the transaction price does not fall within the range of 35th to 65th percentile, the median
of the dataset shall be regarded as ALP of the related party transaction.

Situation 2 -
a. In cases where PSM or Other Method is used; or
b. Where the number of comparables in the data set for CUP, RPM, CPM or TNMM is less
than 6 in numbers

The ALP shall be the arithmetic mean of all the values included in the data set. Additionally, the
variation of +/- 3% (as per the erstwhile law) shall be allowed in such cases for determining the
ALP.

➢ Determination of ALP at the time of assessment proceedings

The Notification provides that at the time of assessment proceedings, the comparables selection
may be modified in case of RPM, CPM and TNMM as follows:

a. if a comparable selected on the basis of preceding financial year data does not satisfy
comparability parameters based on the current year data (available at the time of assessment
proceedings), it shall be deleted; and
b. if any new comparable is available which satisfies the comparability parameters, it shall be
included in the comparable set for determining the arm’s length price.

➢ Determination of the Percentiles in Range

The range and the median to be used for determining the ALP is not just a simple 35% or 65% of
the data values in the data set. The Notification provides the methodology for determining these
range values as follows:

a. Count the number of entries in the data set and determine the 35% and 65% of such count.
The value placed in the data set at such 35% and 65% position is taken as 35th percentile

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and 65th percentile. For example, if the total number of comparables in the set are 7, then
the 35% of 7 is 2.45 and 65% is 4.55. So, the 35th percentile would be the value of
comparable at 3rd place in the data set and 65th percentile would be the value of comparable
placed at 5th position in the data set. Therefore, effectively the allowable range would be
the margin of 3rd and 5th comparable in this example.
b. The Notification further provides that if the 35% or 65% of the count of entries in the
comparable set is a whole value; for example, in a set comprising of 20 comparables, 35%
and 65% of the comparable set is 7 and 13. In such case, the 35th percentile would be the
arithmetic mean of the values of comparables at 7th and 8th position in the data set.
Similarly, the 65th percentile would be the arithmetic mean of the values of comparables at
13th and 14th position in the data set.

The above data represents the theoretical explanation of the benchmarking process. Now let’s understand
these steps using a practical example.

Suppose a foreign based company is engaged is manufacturing and distribution of heavy machines used in
mining and the machines which are used for fitting the spare parts in the automobile. The main aim of the
company is to produce products of the highest quality standards and offer these at the most competitive
price.

It has a subsidiary in India who purchases these machines from the parent company and sell them in the
Indian market and also provide after sales services.

Foreign Company

Indian Company purchases machine

from foreign company

Indian Company

Indian Company sells the purchased machine in the

Indian market and provides after sales services

Indian market

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Since the transaction that the Indian company majorly has with the foreign company is the purchase of the
machine, so the profit level indicator (PLI) for this case would Operating Profit/Operating Revenue
(OP/OR).

NOTE: The Net profit indicator or Profit Level Indicator (PLI) is the ratio of net profit to an appropriate
base (e.g., costs, sales, assets). The transactional net margin method relies on a comparison of an appropriate
net profit indicator for the controlled transaction with the same net profit indicator in comparable
uncontrolled transactions.

Computation of gross profit margin and operating margin with respect to revenue of the Indian company.

Table 2 Margin Computation

Particular 2021-22 2020-21 2019-20

A1 - OPERATING INCOME
Sales of Goods 170276923.00 100931477.00 244465216.00
Sale of Services
Commission Received 10157192.00 19463602.00 24476622.00
Installation & Maintenance 45265166.00 38447606.00 53740846.00
Total A1 225699281.00 158842685.00 322682684.00

A2 - OTHER OPERATING INCOME

Forex Gain 7045.00 -
Miscellaneous Income - 7103.00

TOTAL OPERATING INCOME (A1 + A2) 225706326.00 158849788.00 322682684.00

A3 - NON-OPERATING INCOME
Accrued Interest 3962340.00 4188680.00 -
Profit on sale of car - 980947.00 -
Stock written off 42541.00 - -
interest on Income Tax Refund 241381.00 - -

TOTAL NON-OPERATING INCOME (A3) 4246262.00 5169627.00

TOTAL INCOME AS PER P/L A = (A1 + A2

+ A3) 229952588.00 164019415.00 322682684.00

B -1 OPERATING EXPENSES
Cost of Material Consumed
Purchase of Stock in Trade 101842850.00 63779470.00 -
Dishwashing Machines - - 121007664.00
Accessories - - 7740958.00
Spare Parts - - 33060335.00
Changes in Inventories 5258563.00 (1704851.00) -
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Particular 2021-22 2020-21 2019-20
Dishwashing Machines - - (6051991.00)
Accessories - - (2325537.00)
Spare Parts - - (8646496.00)
Employee Benefit Expense 44746293.00 43156479.00 48864734.00
Depreciation and amortization expense 3429768.00 7062204.00 6584287.00
Other Expenses (Operating) 19559146.00 22124616.00 24804585.00
Foreign Exchange Loss - 3018584.00 -
Changes in Inventories - -
Miscellaneous Expenses 174846.00 327430.00 197268.00

TOTAL OPERATING EXPENSES (B1) 175011466.00 137763932.00 225235807.00

B - 2 NON-OPERATING EXPENSES
Provision for CSR Expenses 1395804.00 1118267.00
Loss on Assets written off - - 65254.00
TOTAL NON-OPERATING EXPENSES (B2) 1395804.00 1118267.00 65254.00

TOTAL EXPENSES AS PER P/L B = (B1 +

B2) 176407270.00 138882199.00 225301061.00

Profit Before Tax (A - B) 53545318.00 25137216.00 97381623.00

Profit Before Tax as per financials 53545318.00 25137216.00 97381623.00
Difference - - -

Operating Profit 50694860.00 21085856.00 97446877.00

Operating Profit as a % of Operating Cost 28.97% 15.31% 43.26%

Operating Profit as a % of Operating Revenue 22.46% 13.27% 30.20%

Gross Profits (Excluding Commission,

Installation & Maintenance) 63175510.00 38856858.00 -
GP / Sales 37.10% 38.50% -

Gross Profits (Including Commission,

Installation & Maintenance) 118597868.00 96768066.00 -
GP / Sales 52.55% 60.92% -

Figure 8 OP/OR Computation

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Chart Title
35

30

25

20

15

10

0
Yr 2021-22 Yr 2020-21 Yr 2019-20

Operating Profit/Operating Revenue

Table 3 Summary of margins

Operating Profit/Operating Revenue of the Indian Company

2021-22 2020-21 2019-20
22.46% 13.27% 30.20%

Let’s start with the process of benchmarking.

STEP 1: Selection of comparables

The comparables are to be selected by applying quantitative and qualitative filters on current year data (if
available) or immediately preceding financial year data.

➢ For the selection of the comparable companies our firm uses a tool known as Prowess. The first
step is to discuss the words that can be used for the search of comparable companies. These words
should be related to the functioning of the company. Since our Indian company is into selling of
machines to the Indian market, some relevant words would be trading, wholesaling, machines,
heavy machines, automobile, spare parts, fitting, mining, equipment, appliances etc.

➢ Using these words prowess will provide the comparable companies who are into this line of
business. Suppose from prowess we get around 3000 comparable companies.

➢ The next step would be to extract data relating to these comparable companies for the current year
and preceding 2 years i.e., 2021, 2020 and 2019.

➢ Then among the 3000 companies, the company whose adequate data is not available is rejected and
the companies left are taken forward for the qualitative analysis. Suppose the companies selected
for qualitative analysis is 1000.

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➢ The next step in this process is to extract the business description of these 1000 companies from the
internet using the reliable sites.

➢ After the extraction of the business description, we need to analyse each and every selected company
and reject the companies which have a totally different line of business than our Indian company
and we need to accept the companies which are in the similar line of business as that of our Indian
company.

➢ Suppose after rejecting and accepting the companies, we are left with 10 companies. These 10
companies would be further used for the computation of range.

STEP 2: Data to be used for ALP determination

Once the comparables are selected, the weighted average of the three years data or less (whichever is
available) would be used for determining the data values in comparable set for determining the ALP.
Further, multiple year data concept cannot be applied on CUP, PSM and Other method.

Since in this case the PLI that we are using is OP/OR, so we need the operating revenues and operating cost
from the prowess database of the selected 10 companies.

Please refer table to understand the computation of margins.

STEP 3: Applicability of range

If the comparables are 6 or more and the method used is CUP, Cost Plus Method (CPM), Resale Price
Method (RPM) or Transactional Net Margin Method (TNMM), the Arm’s Length Price (ALP) shall be
determined based on 35th to 65th percentile of the data values in the comparable set (as computed in the
Notification). However, if the comparables are less than 6 or the method used is PSM or Other Method, the
arithmetic mean shall be applied along with +/-3% variation for determining the ALP.

Please refer table to understand the computation of 35th and 65th percentile of the comparable companies.

Table 4 Computation of Range

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Figure 9 Computation of OP/OR

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OP/OR of comparable companies for FY 2021, 2020, 2019
12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
A B C D E F G H I J
-2.00%

-4.00%

-6.00%

-8.00%

FY 2021-22 FY 2020-21 FY 2019-20

Figure 10 Computation of weighted average OP/OR

Weighted Average OP/OR of comparable companies

8

0
A B C D E F G H I J
-1

-2

Weighted average OP/OR

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Figure 11 Range Computation

Range Computation
3.7

3.6

3.5

3.4

3.3

3.2

3.1

3
35th percentile Median 65th Percentile

Range

Importance of benchmarking in transfer pricing

➢ Mitigate transfer pricing risks with evidence that the determined arm’s length pricing is in good
faith;
➢ Minimize tax exposure through the benchmarking study and penalty through good cooperation in
the case that a tax adjustment is unavoidable;
➢ Effectively gauge company performance against comparable independent companies in a
comparable industry, and
➢ Establish appropriate transfer pricing for new business.

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Observation/Finding

Analysis of various Transfer Pricing methods used for the calculation of Arm’s Length Price.

Table 5: Summary of TP Methods

Sr No. Method Example of application

1. Comparable uncontrolled Price Method It looks at the terms and conditions of
(Internal/External)
transactions made between both related
and unrelated organizations to ensure
arm’s-length pricing across the board. If
the comparable transactions it has made
with third parties, then it is known as
internal CUP and if comparable
transactions that take place between third-
parties then it is known as external CUP.
2. Resale Price Method This method is applicable when property
is purchased or services are obtained from
associated enterprises and the same are
sold to unrelated enterprises. This is based
on the price of a property or service
purchased or obtained from an associated
enterprise and further resale of the same to
unrelated enterprise.

3. Cost Plus Method This method is applicable mainly in

international transactions involving
transfer of unique intangibles or in
multiple international transactions which
are so interrelated that they cannot
evaluated separately for the purpose of
determining the arm’s length price of any
one transaction.

4. Profit Split Method This method is applicable mainly in

international transactions involving
transfer of unique intangibles or in

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multiple international transactions which
are so interrelated that they cannot
evaluated separately for the purpose of
determining the arm’s length price of any
one transaction.
5. Transactional Net Margin Method It requires comparison between net
margin derived from operation of the
uncontrolled parties and net margin
derived by an associated enterprise on
similar operation. Under this method, the
net profit margin realised by an associated
enterprise from an international
transaction is computed in relation to a
particular factor such as costs incurred,
sales, assets utilized, etc. The net profit
margin earned by an associate enterprise
is compared with net profit margin of
uncontrolled transactions to arrive at
arm’s length price.

On the analysis of the various methods of transfer pricing prescribed for determination of ALP, three of the
five methods are directly or indirectly based on costs of the enterprise. This is explained as follows: -

a) Cost plus Method (CPM) is basically a mark- up over costs

b) Transactional Net Margin Method (TNMM) requires working out the net margin of the international
transactions. Now Net Margin is nothing but revenue minus costs, thus Net Margin is in reality a
function of costs.

c) Profit Split Method (PSM) requires working out either the combined profits of the associated
enterprises or the residual profits of the associate enterprises. In either case, costs enter the
calculation.

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As regards the Comparable Uncontrolled Price (CUP) method as well as the Resale Price Maintenance
(RPM), the costs of the enterprise which is being assessed continues to be in question. It is only when
comparison is made with external price, the non-cost factors require adjustment.

Findings of the practical example of benchmarking process

The purpose of a benchmarking study is to select comparable transactions for deriving arm’s length price
rationally based on the financial data of selected comparable. In other words, this requires identification of
comparable transactions that are used to assess whether the international transactions under review comply
with the arm’s length principle.

The following comparative table gives as a general guideline a brief summary of the Comparability
requirements, Benchmarking Approach and the Practical application with regard to the various methods of
determination of Arm’s Length Price: -

Table 6: Summary of benchmarking process for various methods used in transfer pricing

Method Comparability Benchmarking Practical Application

Requirements Approach
Comparable Very High Price Benchmarking Very difficult but most
Uncontrolled Price preferred, since it offers
(CUP) direct comparison
Resale Price High Gross Profit based Used mainly for
Maintenance Benchmarking Distributors
(RPM) and Service Providers
Cost Plus Method High Gross Profit based Used mainly for
(CPM) Benchmarking Manufacturers and
Service
Providers
Profit Split Method Medium Net Profit / Operating Used for Manufacturers,
(PSM) Profit / Cash Profit Distributors and Service
based Benchmarking Providers
Transactional Net Medium Net Profit / Operating Used for Manufacturers,
Margin Method Profit / Cash Profit Distributors and Service
(TNMM) based Benchmarking Providers

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The Operating Profit/Operating Revenue for the Indian company were calculated as follows:

➢ For FY 2021-22: 22.46%

➢ For FY 2020-21: 13.27%

➢ For FY 2019-20: 30.20%

On the basis of the margins calculated for the Indian company, it can be said that there has been a drastic
fall in the margin for the year 2020-21. The margins decreased by 56%. The reason for this can be that in
the year 2019-20 the negative amount relating to changes in inventory is Rs. 1,70,24,024 and for the year
2020-21 the negative amount relating to changes in inventory is Rs. 17,04,851 which is about 90% less
than the FY 2019-20. This difference can be because of the large amount of goods that has been
manufactured in the past year were sold in the current/present financial year.

After completing the process of benchmarking, it was observed that the 35th percentile calculated is 3.23%,
median is 3.49% and the 65th percentile is 3.65%. The OP/OR of the Indian company for the year 2021-22
is 22.46. This percentage (OP/OR = 22.46) is more than the arm’s length range of 3.23 – 3.65. in this case
the median calculated will be taken into consideration. The median is 3.65%.

Therefore, the arm’s length price is 3.65% and the necessary adjustments will need to be made.

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Conclusion

According to the example that we took to understand the process of benchmarking, the parent company and
the Indian company are the companies which are across border serving similar services to clients. These
companies are associated enterprises hence there are transfers of cash and services. The dealing between
associated companies and the dealing between individual companies differ a lot. Transfer pricing helps in
nullifying and eradicating wrong practice of internal transactions by the companies. Hence there is a need
of concept of transfer pricing, so that the transactions and the dealing are done in a lawful manner.

The suitability of different transfer pricing methods has been checked by comparing CUP method, Resale
price method, cost plus method, profit-split method and transactional net margin method.

In a scenario identifying, characterising, benchmarking, comparing and ultimately validating the Arms’
Length Price in an international transaction makes Transfer Pricing a subjective proposition, where no two
experts may always have the same view. Driven by conflicting considerations of the tax payer and the
revenue authorities, this becomes a very complex scenario, perhaps explaining the reasons for
significantly large volume of litigations on the subject.

A well-conducted benchmarking analysis is the backbone of TP documentation. It can provide strong

support for the company in justifying that its transfer price has been determined as per the arm’s length
principle and based on commercial drivers, and hence mitigate the risk of undesired TP adjustments by tax
authorities.

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