Transfer Pricing Methods for Arm’s Length Price | Know the 5 Types

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Transfer Pricing was introduced in India in 2001 and since then it has gone through numerous changes in respect to amendments for the purpose of strengthening the rule. Transfer Pricing is a policy framework which helps the government to enforce tax laws effectively and efficiently. This topic has been debated for many years, with amendments being made in order to strengthen the rule. In 2001, the rule was introduced in India and numerous amendments have been made since then.

The income tax law has put in place transfer pricing provisions to increase transparency in case of international transactions between associated enterprises. In order to avoid taxability, the price can be manipulated by certain taxpayers leading to losses to the exchequer. In such cases, transfer pricing methodologies are used to determine the arm’s length price of the transaction.

In the transfer pricing has to be determined based on the arm’s length principle. In Section 92F of the Companies Act it is defined that the arm’s-length price is projected to be applied to transactions between persons other than related Enterprises in uncontrolled conditions. There are various methods of transfer pricing specified for calculating the arm’s length price of any transaction. Let’s check them out!

Types of Transfer Pricing Methods

The following are the different types of transfer pricing methods applicable to the assessees:

  • Comparable Uncontrolled Price Method

Here, the arm’s length price is determined by comparing it with a comparable uncontrolled transaction. Adjustments are made in such prices to account for the differences between such international transactions and comparable uncontrolled transactions or differences between the enterprises conducting such transactions. Such an adjusted price will be considered an arm’s length price for the international transaction.

  • Resale Price Method

In this transfer pricing method, the price at which the goods or services received by the assessee from the associated enterprise is resold to an unrelated customer should be identified. Also known as a resale price, such price should be adjusted for normal gross profit margin, expenses associated with the purchase of property and functional and other differences. Such an adjusted price should be treated as an arm’s length price.

  • Cost Plus Method

Here, the direct as well as indirect costs of manufacturing or production incurred in respect of supplies made to the associated enterprises are determined. Normal gross profit markup is done to such costs as if the supplies were made to an unrelated enterprise. The gross profit markup should be adjusted for functional or other differences that could materially affect it. Such costs adjusted for profits shall be treated as arm’s length price.

  • Profit Split Method

This method of transfer pricing is used for one or more international transactions between two or more associated enterprises when the transactions are so inter-related that these transactions cannot be separately evaluated to determine the arm’s length price. Here, the combined net profits of all the associated enterprises are determined. Then the contribution of each associated enterprise is evaluated based on the assets employed, risks assumed and functions performed by these enterprises. The profits are allocated among these enterprises based on their relative contributions. In this way, the arm’s length price is determined for such international transactions.

  • Transactional Net Margin Method

In this method of transfer pricing, firstly the net profit margin from an international transaction conducted with its associated enterprise is determined considering the costs incurred, assets employed and sales effected. Secondly, the net profit margin for a comparable uncontrolled transaction with an unrelated enterprise is computed in a similar manner. This net profit margin is adjusted after taking into account the differences that materially affect the net profit margin. If both the net profit margins come out similar after the adjustment, then the same is used for determining the arm’s length price.

In a Nutshell

Following were the different methodologies of transfer pricing for computing the arm’s length price in case of international transactions between associated enterprises. Further, any other method can also be used if it considers the actual price charged and the price that would have been charged in case of uncontrolled transactions.

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