- The comparable uncontrolled price method.
- The resale price method.
- The cost-plus method.
- The transactional net margin method
- The transactional profit split method.
- Other method if above methods do not give arm’s length price.
A) Comparable Uncontrolled Price Method (CUP Method)
- CUP Method should be applied when we can find data of price of a comparable uncontrolled transaction between Unrelated Parties.
- Begin with the Price charged or paid for Goods/ Services provided in a Comparable Uncontrolled Transaction between Unrelated Parties.
- Make Adjustments for differences between the Transaction &Comparable Uncontrolled Transactions.
- Adjusted Price is equal to the Arm’s Length Price provided in Controlled Transaction between Related Parties
B) Resale Price Method (RPM)
- RPM is based on the price at which a product that is purchased from a Related Party is resold to an Unrelated Party (Independent Third Party Customers).
- RPM should be applied for Distributors who purchase goods from Related Parties and sell those goods – to Unrelated Parties – either without further processing, or without incorporating those goods into a more complicated product by way of assembly or manufacture.
- Calculation would involve following Procedure;
- Identify the transaction of purchase of goods/services from a Related Party.
- Identify the price (resale price) at which such goods/services are resold to an Unrelated Party by the Taxpayer.
- Identify the normal gross profit margin in a comparable uncontrolled transaction. The normal gross profit margin is that margin which an independent enterprise would earn from resale of similar product – similar product purchased from an unrelated party and resold to another unrelated party.
- Deduct the normal gross profit from the resale price realized by the Taxpayer.
- Deduct direct expenses incurred by the Taxpayer (Distributor) in connection with the purchase of goods from a Related Party
- Adjust the functional and other differences including differences in accounting practices.
- The price finally arrived at is the arm’s length price of the purchase of goods from a Related Party.
- CUP method is a two sided method (wherein the said method can be applied using details / data of either of the transacting parties), RPM is a one sided method wherein only the margins earned by one of the transacting party i.e., the distributor, can be analyzed / evaluated.
C) Cost Plus Method (CPM)
- CPM can be the Most Reliable Method for Manufacturers who supply products & Service Providers who provide services, to Related Parties and Connected Persons.
- CPM can also be used where facilities or costs are shared among the Group Members under a Cost Sharing Arrangement (CSA).
Calculation would involve following Procedure;
- Determine the direct and indirect cost of production in respect of goods/ service provided to a related party.
- Identify one or more comparable uncontrolled transactions where similar property is transferred or similar service is provided.
- Determine normal gross profit mark-up on costs in the comparable uncontrolled transaction. Such costs should be computed according to the same accounting norms. In other words, the components of costs of comparable uncontrolled transaction should be the same as those of controlled transaction between related parties.
- Adjust the gross profit mark-up to account for functional and other differences between the controlled transaction and the comparable uncontrolled transaction. Such adjustments should also be made for enterprise level differences.
- The direct and indirect cost of production in the controlled transaction is increased by such adjusted gross profit mark-up.
- The resultant figure is the arm’s length price.
D) Transactional Net Margin Method (TNMM)
- Typical transactions where TNMM is used are transactions involving:
- Purchase and Sale of products from and to Related Parties
- Receipt of services and Provision of Services from and to Related Parties
- Distribution of finished products where RPM cannot be applied
- Transfer of semi-finished goods where CPM cannot be applied
- Under TNMM, we select a Tested Party – either the Taxpayer or its Related Party – whose Net Operating Profit Margin earned from Controlled Transaction is compared with –
- the net operating profit margin earned by the Tested Party itself from Comparable Uncontrolled Transactions (Internal TNMM), or
- the net operating profit margin earned by an Independent Party engaged in a Comparable Uncontrolled Transaction (External TNMM).
E) Transactional Profit Split Method (PSM)
The PSM identifies the profits to be split from the Controlled Transactions between Related Parties and then splits those profits between the Related Parties on an economically valid basis that approximates the division of profits that would have been agreed between Independent Enterprises in comparable circumstances.
PSM is likely to be the /Most Reliable Method in following transactions –
- Unique and valuable contributions by each of the Related Parties participating in the transaction
- Transactions involving Unique and Valuable Intangibles
- Highly Integrated Business Operations
- Shared Assumption of Economically Significant Risks or Separate Assumption of Closely Related Risks
There are following two types of approaches for splitting profits among Related Parties under PSM –
a) Contribution Analysis
Under a contribution analysis, the relevant profits, which are the total profits from the controlled transactions under examination, are divided between the AEs in order to arrive at a reasonable approximation of the division that Independent Enterprises would have achieved from engaging in comparable transactions.
b) Residual Analysis
Where out of the contributions made by the AEs some contributions (like manufacturing, distribution, services, etc.) can be reliably valued applying a one-sided method (such as TNMM) and benchmarked using comparable, while others cannot, the application of a residual analysis may be appropriate.
F) Other Methods:
The sixth method allows the use of ‘any method’ which takes into account (i) the price which has been charged or paid or (ii) would have been charged or paid for the same or similar uncontrolled transactions, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts.
- Third party quotations/ invoices;
- Valuation reports;
- Tender/Bid documents;
- Documents relating to the negotiations;
- Standard rate cards;
G) Which Methods to Use:
- CUP method may be used in case of loans, service fee, transfer of tangibles, sale and purchase of goods/ commodities, etc.;
- RPM is most useful in case of marketing operations of finished products, especially in case of distributors not performing significant value addition to the product;
- CPM is normally used where raw materials or semi-finished goods are sold; where joint facility agreements or long-term buy-and-supply arrangements, or the provision of services are involved;
- PSM is normally used in cases where the transactions involve provision of integrated services by more than one enterprise. For example – One enterprise holds technology and the other enterprise holds the distribution network and both are the key intangibles for the overall success of the Group; freight forwarders and supply chain specialists.
- Transactional net margin method could be used in case of manufacturing operations, sale of raw materials or semi-finished goods where CPM is not the most appropriate method, and marketing operations of finished products where RPM is not the most appropriate method.
- Other method may be used in case of royalties, commodities, transfer of intangibles and shares, etc.
- Other Adjustments:
- Working Capital & Capacity Adjustments needed to be Accounted for when using TNMM Method.
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