Concepts of Arm’s Length Price in

Transfer Pricing
- Mihir Gupta
 Concepts of Arm’s Length Price

Before going on to the Arm’s Length Price, one should understand what is
Transfer Pricing? And why do we need it?

• Historically, MNCs conducted their operations through self-sufficient

subsidiaries. With increasing inter linkages in global manufacturing,
outsourcing and marketing, the MNCs look at possibilities of optimizing
their global profits.
• MNCs are free to charge whatever price they choose to with regard to
such transactions concerning the parent firm and their affiliate. The
transfer prices arbitrarily set to:
- Reduce taxes.
- Reduce tariffs
- Avoid exchange controls.
- Optimize global profits by reducing taxes and tariffs to the minimum or
nil levels.
• Therefore the transactions between MNEs arises questions of
quantification of taxation eligibility of each country on the same
transaction.
• For e.g.
An American Co. wants to sell the manufactured good in India at `200
having cost `100, thus the company has to pay 34% on the profit of `100
i.e. `34. But if it transfers the same good to India through Dubai (Tax
Heaven) the amount of profit in India will reduce and will lead to tax
evasion in India.
• So to overcome these types of evasions the Indian Government
introduced the Transfer Pricing Regulation with effect from April 1,
2002.
 Concepts of Arm’s Length Price

Now coming on to the ARM’S LENGTH PRICE.

Section 92(F) defines the Arm’s length price as the price applied (or proposed
to be applied) when two unrelated persons enter into a transaction in
uncontrolled conditions.

Uncontrolled conditions are Conditions which are not controlled or suppressed

or moulded for achievement of a pre-determined result are said to be
uncontrolled conditions.

Section 92 says any income any income arising from an international

transaction shall be computed having regards to arm’s length price.

Conditions to Constitute ARM’S LENGTH PRICE.

• The price should be applied or proposed to be applied in a transaction;

• The transaction is between unrelated persons; and

• The transaction is taking place in uncontrolled conditions.

Rules for Calculation ARM’S LENGTH PRICE

• In computing the income, allowance for any expense or interest shall
also be determined having regard to arm’s length price.

• Even where international transaction comprises of only an outgoing,

the allowance for such expenses or interest arising from the
international transaction shall also be determined having regard to the
arm’s length price,

• The provision would not be applicable in a case where the application

of arm’s length price results in a downward revision in the income
chargeable to tax in India.
 Concepts of Arm’s Length Price

Computation of ARM’S LENGTH PRICE

As per Section 92C, the arm’s length price shall be determined by any of the
method specified in this section, being the most appropriate method.

Methods

Price Based Methods • comparable uncontrolled price method;

• resale price method;
• cost plus method;

Profit Based Methods • profit split method

• transactional net margin method

Others • Any other method as prescribed by the board.

Comparable Uncontrolled Price (CUP)

• the price charged or paid for property transferred or services provided in

a comparable uncontrolled transaction, (i.e., a transaction between
enterprises other than associated enterprises whether resident or non-
resident) or a number of such transactions, is identified;
• such price is adjusted to account for differences, if any, between the
international transaction and the comparable uncontrolled transactions
or between the enterprises entering into such transactions, which could
materially affect the price in the open market;
• the adjusted price arrived at under above step is taken to be an arm’s
length price in respect of the property transferred or services provided
in the international transaction.

Resale Price Method (RPM)

• the price at which property purchased or services obtained by the

enterprise from an associated enterprise is resold or are provided to an
unrelated enterprise, is identified;
 Concepts of Arm’s Length Price

• such resale price is reduced by the amount of a 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;
• the price so arrived at is further reduced by the expenses incurred by the
enterprise in connection with the purchase of property or obtaining of
services;
• 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;
• the adjusted price arrived at under above step is taken to be an arm’s
length price in respect of the purchase of the property or obtaining of
the services by the enterprise from the associated enterprise.

Cost Plus Method (CPM)

• 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;
• 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;
• the normal gross profit mark-up referred to in above step is adjusted to
take into account the functional and other differences, if any, between
the international transaction and the comparable uncontrolled
transactions, or between the enterprises entering into such transactions,
which could materially affect such profit mark-up in the open market;
 Concepts of Arm’s Length Price

• the costs referred to in Step 1 are increased by the adjusted profit mark-
up arrived at under step 3 ;
• 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.

Profit Split Method (PSM)

• 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 be evaluated separately for
the purpose of determining the arm’s length price of any one
transaction.

Transactional Net Margin Method (TNMM)

• the net profit margin realised by the enterprise from an international

transaction entered into with an associated enterprise is computed in
relation to costs incurred or sales effected or assets employed or to be
employed by the enterprise or having regard to any other relevant base;
• 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 base;
• the net profit margin referred to in (above) 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;
• the net profit margin realised by the enterprise and referred to in
(above) is established to be the same as the net profit margin referred to
in (above);
• 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.
 Concepts of Arm’s Length Price

Concepts of Most Appropriate Method

• According to Section 92C(1), the arm’s length price shall be determined

having regard to the most appropriate method.
• The most appropriate method shall be the method which is best suited
to the facts and circumstances of each particular transaction, and which
provides the most reliable measure of an arm’s length price in relation
to an international transaction.

Factors to Determine the Most Appropriate Method

• the nature and class of the international transaction;

• the class or classes of associated enterprises entering into the

transaction and the functions performed by them taking into
consideration assets employed or risk assumed;

• the availability, coverage and reliability of data necessary for

application of the method;

• the degree of comparability existing between the international

transaction and the uncontrolled transaction and between the
enterprises entering into such transactions;

• the extent to which reliable and accurate adjustments can be made to

account for differences, if any, between the transactions being
compared and the enterprises entering into such transactions;

• the nature, extent and reliability of assumptions required to be made in

application of a method.
 Concepts of Arm’s Length Price

In India generally all the methods are accepted to arrive at the arm’s length
price, unlike other countries where specific prescribed method is suggested.

For e.g.

In Russia only CUP method is suggested to use. If only CUP does not give
reliable comparison then they can use PSM and RPM methods. And in an
extreme situation they can switch over other methods.

Generally Prescribed Method

More appropriate methods

• the comparable uncontrolled price method, or

• the resale price method or the
• cost plus method

Only in exceptional cases

• profit split method

• transactional net margin method
 Concepts of Arm’s Length Price

Determination of the ARM’S LENGTH PRICE where application of the MAM

results in more than one price.

As per rule 10CA in cases where the application any method results into more
than one price, the ARM’S LENGTH PRICE shall be computed as follow:

Before Amendment After Amendment

• While calculating the • A dataset shall be
ARM’S LENGTH PRICE, it constructed by placing the
was provided that where prices/data in an ascending
the most appropriate order.
• A minimum of six
method results in more
comparables would be
than one price, a price required in the dataset for
which differs from the applying the concept of
arithmetical mean by an range.
amount not exceeding 3% • An arm’s length range
and 1% in case of beginning from the 35th
manufacturing of such percentile of the dataset and
ending on the 65th percentile
mean may be taken to be
will be considered.
the arm’s length price at
the option of the assessee.

Use of Weighted Average

The price in respect of comparable uncontrolled transactions shall be

determined using the weighted average of the prices/data for:

1) the current year and preceding two financial years; or

 Concepts of Arm’s Length Price

2) two financial years immediately preceding the current year (but not
including the current year as the same may not have been available)

In accordance to the following:

• where the prices have been determined using RPM, the weighted
average of the prices shall be computed with weights being assigned to
the quantum of sales.
• where the prices have been determined using CPM, the weighted
average of the prices shall be computed with weights being assigned to
the quantum of cost.
• where the prices have been determined using TNMM, the weighted
average of the prices shall be computed with weights being assigned to
the quantum of cost incurred or sales effected or assets employed, or as
the case may be.

Exception:
• The concept of range will not be applicable in cases where the MAM is
selected to be the PSM or the ‘other method’.
• If the price at which the international transaction or SDT is undertaken is
outside the range, the ARM’S LENGTH PRICE of the transaction shall be
taken to be the median of the dataset.

Continued use of the Arithmetic Mean

In a case where dataset consist of less than six comparables, or the MAM
considered for determination of ARM’S LENGTH PRICE is Profit Split Method or
‘other method’, the ARM’S LENGTH PRICE will be determined based on the
arithmetic mean of all the prices /data included in the dataset. Further the
benefit of the three percent while adopting the arithmetic mean, continues to
be available.

Conclusion
These are the few concepts regarding the Arm’s Length Price in the Transfer
Pricing Regulations in India.
I thank to ICAI Ludhiana Branch for giving me this opportunity to present my
views on the topic,”Concepts of Arm’s Length Price in Transfer Pricing.”

Mihir Gupta
Vadodara
WRO0496964
Email: mihirgupta31@gmail.com Contact No: 9033978840/7405831507