Methods of Transfer Pricing for Calculating the Arm’s Length Price

Transfer pricing provisions apply to taxpayers undertaking international transactions. When the entities are related to each other, then the chances of manipulation of transactions increases to shift the profits from the lower taxation state to the higher taxation state. Therefore, when the provisions become applicable, then in order to calculate the profits of the taxpayers, certain methods have been prescribed under the transfer pricing regime to arrive at the arm’s length price and calculate the profits accordingly. What are the methods to calculate arm’s length price and how profits are calculated using these methods? Let’s find out!

Methods of Transfer Pricing

Following are the methods of transfer pricing for calculating the arm’s length price:

Comparable Uncontrolled Price Method: Under this method, the transaction in relation to the provision of goods or services in any comparable uncontrolled transaction should be identified. The difference between the international transaction and the comparable uncontrolled transaction should be accounted for that materially affects the price in the open market. The adjusted price should be considered as the arm’s length price for the international transaction being undertaken.

Resale Price Method: In this method, the price at which the property being purchased or the services obtained from the associated enterprises are being resold should be identified. Then the adjustments in relation to the normal gross profit margin, expenses incurred in relation to the purchase of property or provision of services as well as functional differences, including those in accounting practices should be adjusted. The adjusted price derived after the above adjustments shall be considered as the arm’s length price.

Cost Plus Method: In this method of transfer pricing, the direct, as well as indirect costs of production incurred with respect to the property being transferred or the services being provided, should be determined. Further, a normal gross profit markup as applicable to the transfer of similar property or provision of similar service or by an unrelated enterprise in the comparable uncontrolled transaction should be added to the above costs. The adjusted price should be considered as an arm’s length price.

Profit Split Method: This method is primarily applicable in international transactions that involve the transfer of unique intangibles or when there are multiple international transactions that are so interrelated that they cannot be separately evaluated. Therefore, under this method, the combined net profits of the associated enterprises shall be determined. The relative contribution of each associated enterprise to the net profit is evaluated and then the combined net profit is split amongst the enterprise.

Transactional Net Margin Method: Under this method, the net profit margin that is being realized by each enterprise from the international transaction with an associated enterprise shall be computed. Then, the net profit margin realized in a comparable uncontrolled transaction by the enterprise or by an unrelated enterprise shall be determined. This net profit margin should be adjusted for the differences that materially affect the margin. If both the net profit margins are similar, then it should be considered that the arm’s length price has been arrived at.

Following were the methods to calculate the arm’s length price under the transfer pricing. Further, the CBDT has the power to prescribe any other method as well. For any assistance in relation to the transfer pricing applicability and compliances, feel free to contact the ASC Group.