Transfer Pricing Systems:Methods &Selection(Part C)

a) Comparable Uncontrolled Price (CUP):- This method seeks to determine the ALP by comparing the controlled transaction with the uncontrolled transaction in relation to property transferred or services provided. This method is basically applied to concerns engaged in the manufacturing and selling of the product and hence to be applied to manufacturers.

Typical transactions in respect to which CUP may be adopted:-

1. Transfer of goods
2. Provision of services
3. Intangibles
4. Loans,provision of finance

The Comparable uncontrolled price method shall be determined in the following manner:-

1. Identify the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction
2. Such price is adjusted to account for differences,if any,between the international transaction and the uncontrolled transaction or between the enterprises entering into such transactions,which could materially affect the price in the open market
3. The price so adjusted is taken to be the arm’s length price in relation to the international transaction
4. The arm’s length price is compared with the price charged in the international transaction
5. If the price charged in the international transaction is lower than the arm’s length price or the price paid in the international transaction is higher than the arm’s length price then an adjustment is to be made to the price charged or paid in the international transaction by the amount of such variance

b) Resale Price Method:- This method evaluates whether the gross margin charged in the controlled transaction is at arms length by comparing with uncontrolled transactions. This method evaluates the process of functions performed rather than the products. The resale price is generally applied in the case where the reseller does not add any substantial value to the tangible property and no physical alteration in product is done. The Resale price method shall be determined from the following:-

1. Identify the international transaction of purchase of property or services
2. Identify the price at which such property or services are resold or provided to an unrelated party
3. Deduct the normal gross profit margin derived by the enterprise from the resale price of such property or services. The normal gross profit margin is that margin which the enterprise would earn from purchase of the similar product from an unrelated party and the resale of the same to another unrelated party.
4. Deduct also expenses incurred in connection with the purchase of goods from the price so arrived
5. Adjust the prices so computed for the differences between the uncontrolled transaction and the international transaction. These differences could be functional and other differences including differences in accounting practices. Further these differences should be such as would materially affect the amount of gross profit margin in the open market
6. The adjusted price arrived at is the arm’s length price for the property purchased or services obtained
7. Substitute the arm’s length price for the price charged in the international transaction and make adjustments to the income returned accordingly.

c) Cost Plus Method:- Under this method an appropriate mark-up would be added to the cost incurred by the supplier or service provider. The price that is arrived at after considering the mark-up method would be considered as Arms Length Price. This method probably is most useful where semi-finished goods are sold between related parties,where related parties have concluded joint facility agreements or long term buy-&-supply arrangements or where controlled transaction is the provision of services.

Typical transactions where cost plus method maybe adopted are:-

1. Provision of services
2. Joint facility arrangements
3. Transfer of semi-finished goods
4. Long term buying and selling arrangements.

The Cost Plus Method shall be determined from the following:

1. The direct and indirect cost of production incurred by the enterprise in respect of property transferred or services provided to an associated enterprise
2. 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 transaction,is determined
3. The normal gross profit mark-up referred to in the above sub-clause is adjusted to take into account the functional and other differences,if any,between the international transaction and the comparable uncontrolled transaction,or between the enterprises entering into such transactions,which could materially affect such profit mark-up in the open market
4. The costs referred to in the first sub-clause are increased by the adjusted profit mark-up arrived at under the third sub-clause
5. 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.

d) Profit Split Method:- A transactional profit method that identifies the combined profit to be split for the Associated Enterprises from a controlled transaction and then splits those profits between the AEs based upon an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arms length. This method is applicable only if it involves transfer of unique intangibles or multiple international transactions,which are so interrelated that they cannot be evaluated separately for the purpose of determining the arms length of any one transaction.

The following steps are to be taken under profit split method:-

1. The first step is to determine the total profit earned by the parties from a controlled transaction. The profit split method allocates the total integrated profits related to a controlled transaction,and not the total profits of the group as a whole. The profit to be split is generally the operating profit,before the deduction of interest and taxes. In some cases,it may be appropriate to split the gross profit.
2. The second step is to split the profit between the parties based on the relative value of their contributions to the non-arm’s length transactions,considering the functions performed,the assets used,and the risks assumed by each non-arm’s length party,in relation to what arm’s length parties would have received.

d) Transaction Net Margin Method:- This method primarily focuses on net margin released by the Associate Enterprise (foreign parties) in their controlled transaction with that of uncontrolled transaction. The net margin is not a derivative of a product alone,but derivative of various process viz;nature of the market,cost practice followed by the company,the presence of intangibles etc.

Typical kinds of transactions where the transactional net margin method may be used are:-

1. Provision of services
2. Distribution of finished products where resale price method cannot be adequately applied
3. Transfer of semi-finished goods.

The following steps are to be taken under Transaction Net Margin Method:-

1. Identify the net profit margin realized by the enterprise from an International transaction. The net profit margin may be computed in relation to costs incurred or sales effected or assets employed or any other relevant base
2. Net profit margin from a comparable uncontrolled transaction is identified
3. This net profit margin is adjusted to take into account the differences if any between the international transaction and the comparable uncontrolled transaction. The differences should be those that could materially affect the net profit margin in the open market
4. The adjusted net profit margin is taken into account to arrive at the arm’s length price in relation to the international transaction.

Methods Considered:-

Since the assessee enterprise is engaged in manufacturing and selling of the products,the methods Profit Split Method and Resale Price Method are not relevant for the assessee enterprise for the determination of ALP because:-

1. Resale price method as mentioned above is mainly concerned with the resale of the product without there being any addition of substantial value to the product nor there being any alteration in the product. Now,as the assessee enterprise is mainly engaged in the manufacturing business this method is of no relevance.
2. Profit Split Method is basically applicable where intangibles are involved or multiple international transactions are involved which are so interrelated that they cannot be evaluated separately for the purpose of determining the arms length of any one transaction. In our case as there are no intangibles involved and also that each transaction is separately identifiable,this method also holds no importance for us in determining the ALP.

Therefore,we are left with basically only three methods of pricing for the purpose of determination of ALP i.e.:-

1. Comparable Uncontrolled Price Method
2. Cost plus method
3. Transaction Net Margin Method,

Factors that should be taken into account for selecting the Most Appropriate Method of the above three:-

1. Nature and class of international transactions
2. Class or classes of associated enterprises and the functions performed by them taking into account the assets employed or to be employed and risks assumed by such enterprises
3. Availability,coverage and reliability of data. For instance,data relating to transactions entered into by the enterprise itself would be more reliable than the data relating to transactions entered into by third parties
4. The degree of comparability
5. The extent to which reliable and accurate adjustments can be made to account for the difference between the transactions.

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