1. Methods of determining ALP
3rd Intensive Study Course on Transfer Pricing
Methods of determining ALP
CA Vishwanath Kane
16 February 2013

2. Agenda Introduction Transfer Pricing Methods Overview
Applicability of Transfer Pricing Methods
Transfer Pricing Methods
A) Traditional Transaction Methods
i) Comparable Uncontrolled Price Method (CUP)
ii) Resale Price Method (RPM)
iii) Cost Plus Method
B) Transactional Profit Methods
i) Profit Split Method
ii) Transactional Net Margin Method (TNMM)
C) Residuary Method – Other Method
Summary of Transfer Pricing Methods

3. Introduction – Transfer Pricing
Transfer pricing provisions - To avoid shifting of profits to low tax Jurisdiction countries or tax heavens and India to get its share of tax
International Transactions with Associated Enterprise (AE) to be at Arms Length Price (ALP)
Computation of ALP using Most Appropriate Method (MAM)
Transfer Pricing methods are prescribed in Section 92C
Associated Enterprise
Corporate
Independent Enterprise
Price $A
Price $B
$A = $B
* The overarching premise is that, for the purpose of establishing profits for tax purposes, the price between associated enterprises (controlled transaction) should be same as would have been charged between independent enterprises (uncontrolled transaction)

4. Selection of TP methods Transfer Pricing Methods Overview
Traditional Transaction Methods
(Preferred methods)
Transactional Profit Methods
Residuary Method
Profit Split Method (PSM)
Transactional Net Margin Method
(TNMM)
Contribution
Analysis
Residual
Analysis
Any other method as provided in rule 10AB
The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.
Comparable
Uncontrolled Price (CUP)
Resale Price Method (RPM)
Cost Plus Method (CPM)

5. Selection of TP methods Transfer Pricing Methods Overview
No order of priority for selection of methods
Taxpayer has the option to choose the Most Appropriate Method
Methodologies prescribed are in line with OECD Guidelines
Rules 10B and 10AB describe the TP methods
Where more than one method can be applied the ALP shall be calculated on average mean of all such computations
The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

6. Selection of TP methods Applicability of Transfer Pricing Methods
The applicability of a transfer pricing method depends on the:
Comparability of controlled and uncontrolled transactions in terms of:
characteristics of property or services,
functions performed,
risks borne,
Contractual terms,
economic circumstances, and
business strategies
Data and information:
availability of information
reliability of assumptions,
sensitivity of deficits in data and assumptions
Purpose of its application, i.e. for planning, defending, documenting, reviewing or opposing transfer prices
The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

7. Traditional Transaction Methods

8. Controlled transaction Uncontrolled transaction
The CUP Method
What is CUP Method?
Compares the price charged in a controlled transaction to the price charged in a comparable uncontrolled transaction in comparable circumstances.
High degree of comparability of products and functions are required.
Differences are allowed if 1) they do not materially affect the price in the open market, 2) effect on price can be reliably measured & adjusted.
Compare Price $A & $B
Associated Enterprise
Corporate
Independent Enterprise
Price $A
Price $B
Controlled transaction
Uncontrolled transaction
Factors to Consider
Product similarity (similar type, quality, quantity, features, etc)
Seasonality (e.g., air conditioner, ski)
Same stage in supply chain (wholesales, retail, etc.)
Geographic market in which transaction takes place
Embedded intangibles
Contractual terms (e.g., warranty, discount policy, credit terms, shipping liability, etc.)
Other factors that might affect comparability 34

9. The CUP Method Continued…
Internal CUP
Related party
Manufacturer
Non-related party
Internal CUP application
Prices in any comparable dealing between the Company and an independent party; or
Prices in any comparable dealing between the associate enterprise who is a party to the transactions with the Company and an independent party.
Non-related party A
Non-related party B 34

10. The CUP Method Continued…
External CUP
Sale of Goods ‘Z’ to AE
INDCO
(India)
USCO
(USA)
Sale of Goods ‘Z’
Independent Company X
(China)
Company Y
(USA)
External CUP application
Prices in comparable dealings between two independent third parties
Permissible adjustments for comparability

11. The CUP Method Continued…
High degree of comparability required
Mostly used in Benchmarking of transactions like –
Sale / purchase of goods,
Interest rate,
Rate of Royalty and
Guarantee Fee Benchmarking
Preferred by Tax Authorities Globally
The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

12. The CUP Method Continued…
Since CUP method requires high degree of comparability, the adjustments proposed to be made to make the controlled and uncontrolled transactions comparable are :
Geographic market in which the transaction takes place
Quality of the Product or service
Volume
Foreign Currency Risk
Intangible property associated with the sale
Level of the market (i.e. wholesale, retail, etc.)
Contractual terms (e.g. Scope and terms of warranties provided, sales or purchase volume, credit terms, transport terms)
Date of transaction

13. The CUP Method Continued…
CUP has a number of problems:
insufficient market transparency for identifying comparable companies
difficult to accomplish necessary adjustment calculations which eliminate material differences
For some reasonably accurate adjustments can be made, but for products and markets its not feasible
some adjustment calculations even seem to be mutually contradictory
The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

14. The CUP Method – Case Law
Sl. No.
Case
Citation
Ruling 1.
Serdia Pharmaceuticals
(India) Private Limited vs. ACIT
445 SOT 391
(ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08)
The assessee, a pharmaceutical company, imported ‘Active Pharmaceutical Ingredient’ (‘API’s) from its foreign associated enterprises (‘AE’) and used them for manufacture of drugs. For transfer pricing purposes, the assessee adopted the ‘Transactional Net Margin Method’ (“TNMM”) as the most appropriate method and claimed that its transactions with the AE’s were at arms length on the basis that the assessee’s operating profit at 8.76% on net sales was higher than that of its comparable competitors. However, the TPO held that the assessee had purchased the APIs from the AE’s at prices that were higher than that paid for similar APIs by other companies in India. He rejected the contention of the assessee that the higher prices paid by the assessee were justified owing to their superior quality. The TPO held that the TNMM was not a “reliable” method and that the Comparable Uncontrolled Price (‘CUP’) was, on facts, the most appropriate method and computed the arms’ length price (‘ALP’) on that basis. On appeal, the CIT (A) upheld the stand of the TPO. On further appeal by the assessee, the Mumbai Tribunal dismissed the appeal of the assessee on the ground that for generic drugs, CUP is appropriate method despite quality differences.
The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

15. Resale Price Method (RPM)
What is Resale Price Method?
Based on the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise
The resale price is reduced by the resale price margin and this result can be regarded, after adjustment for other costs associated with the purchase of the product, as an arm’s length price of the original transfer of property between the associated enterprises. (OECD Guidelines, para 2.14)
Factors to Consider
Ordinarily used in cases involving the purchase and resale of tangible property
Reseller has not physically altered the product or added substantial value
Packaging, labeling or minor assembly are acceptable
Reseller does not apply intangible assets to add value
Functional/ accounting similarity is required 34

16. 1 2 3 Steps Resale Price Method Continued…
Determine the gross profit margin
earned in comparable uncontrolled
transactions 2
Subtract the appropriate gross
margin and expenses from the applicable resale price 3
The remainder will be the
arm’s length price with the
controlled entity 34

17. Whether the transaction is at arm’s length?
Resale Price Method Continued…
Particulars
Amount in INR
Sale price to uncontrolled entity
1,00,000
Cost of goods sold
85,000
Arms Length Gross Profit Margin – 15%
15,000
Arms Length Price
Purchase price from Associated Enterprise
92,000
Whether the transaction is at arm’s length? 34

18. Resale Price Method Continued…
Applicable in buy and sale transaction
Benchmarking of distributor adding no value to tangible goods but incurring heavy AMP costs
Maruti Suzuki India Limited (Delhi High Court ITR 210)
Tested party margin at Net Level V/s Gross Level 34

19. Resale Price Method Continued…
RPM has a number of problems:
identifying identical or similar functional and risk profiles;
facing differences in accounting practices, mainly with respect to costs of goods sold; and
eliminating influences from different economies of scale. 34

20. Resale Price Method – Case Law
Sl. No.
Case
Citation
Ruling 1.
ITO vs. L’Oreal India P. Ltd
ITA No. 5423/Mum/2009
The Tribunal upheld the use of Resale Price Method over TNMM where assessee bought products from AE and resold them without further processing;
ITAT agreed with the CIT(A)’s observation that there is no order of priority of methods to determine ALP. ITAT noted that OECD Guidelines stated that in case of distribution and marketing activities, when the goods are purchased from AEs which are sold to unrelated parties, RPM is the most appropriate method.
The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

21. Cost Plus Method What is Cost Plus Method?
Costs incurred by the supplier of property/service in a controlled transaction for property transferred or service provided to a related purchaser. An appropriate cost plus markup is added to this cost to make an appropriate profit in light of the functions performed & market condition. This result may be regarded as an arm’s length price of the original controlled transaction (OECD Guidelines, para 2.32)
Factors to Consider
Cost should include all costs associated with the process (manufacturing, provision of services) upto
manufacturing stage like raw materials, labour, electricity, factory rent, etc.
Product Comparability required is low
Mark up applied to the total cost is set or tested having regard to the third party comparable mark ups.
Profile of the parties involved
High degree of functional comparability
Assets employed
Accounting differences, etc. should be considered 34

22. 1 2 3 Steps Cost Plus Method Continued…
Compute the direct and indirect cost incurred in controlled transaction 2
Determine the normal gross profit margin earned in similar uncontrolled transaction 3
Apply the margin in step 2 on amount arrived at in step 1 after making the necessary adjustments, if any to arrive at the ALP 34

23. Cost Plus Method Continued…
Particulars
Independent Entities
Chinese subsidiary
(Amount in Rs.)
Direct Cost
100,000
300,000
Indirect Cost
50,000
150,000
Total Cost
450,000
Cost plus mark up (%) 8%
10%
Mark up
12,000
45,000
Details of Transactions:
Since the mark up earned by Indco from its Chinese subsidiary is higher than that of mark up earned from independent parties, the transaction with the Chinese subsidiary is at arm’s length 34

24. Cost Plus Method Continued…
Generally used to benchmarking of service providers and manufacturers
Issue of cost base in determination of cost plus mark-up in case of contract manufacturer and contract service provider
Pre checks before selecting CPM:
Ensure that inefficiencies do not result in higher profits as costs increase
Also must be taken into account that there is often no direct link between the amount of the costs incurred and the market price, i.e. arm’s length price
it requires extensive information about the cost base used in comparing the mark-ups
reasonable adjustments may not be possible when looking at external comparable companies. 34

25. Cost Plus Method – Case Law
Sl. No.
Case
Citation
Ruling 1.
L’Oreal India Pvt. Ltd., Mumbai vs Department Of Income Tax
ITA No. 6745/M/2008
The assessee company is a subsidiary of L'Oreal SA France engaged in the business of manufacturing and distribution of cosmetics and beauty products (contract manufacturing).
The TPO rejected CPM and adopted TNMM as the MAM and proposed an adjustment of Rs crores (approx) on its international transaction of purchase of raw materials. The CIT (A) order stated that “CPM is applied to test the price of goods that are manufactured and then sold or to measure the value of services performed by a service provider and is generally appropriate when the party being examined is not engaged in significant value adding activities”.
Accordingly, the Tribunal upheld the categorical finding of the CIT(A) that the Cost Plus Method adopted by the assessee is based on the functions performed and not on the basis of types of product manufactured, as normally the pricing methods get precedence over profit methods.
The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

26. TNMM – Case Law 1. Dishman Pharmaceuticals & Chemicals Ltd.
Sl. No.
Case
Citation
Ruling 1.
Dishman Pharmaceuticals & Chemicals Ltd.
ITA No.154 & 587/Ahd/2007 &
ITA No.2180 & 3213/Ahd/2007
The Tribunal held that given the facts of the case, use of internal CUP was not appropriate for benchmarking international transaction of exports to associated entities due to various differences. The Tribunal observed differences on account of (a) low volume, (b) sales within Indian market and (c) sales to different geographical location having incomparable economic and political risks.
Relying on OECD guidelines, the Tribunal also upheld the contention that TNMM is not the method of last resort and accordingly allowed TNMM applied by the assessee.
The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

27. Summary of Transfer Pricing Methods
Traditional Transaction Methods
CUP
- This method compares the transfer price directly with similar products sold in an independent uncontrolled situation
RPM
- When a buyer in an intercompany transaction in turn sells to an independent party, the RPM compares the gross profit margin with that achieved in a similar, uncontrolled transaction
OECD guideline and LCITA (Law for the Coordination of International Tax Affairs) which is Korean transfer pricing regulation state that traditional methods are preferred method. However, this may not be the case for other jurisdictions. For example, in the US, “best method rule” applies.
CPM
- For this method, the gross profit earned by the intercompany sale is compared with a similar independent transaction. This approach is typically used where goods are manufactured or assembled and then sold within the group. In this instance the goods compared do not have to be identical, but should perform similar functions.

28. Other Method
The other method evaluates the arm’s-length character of a controlled transaction by comparing the price charged in the controlled transaction to the price charged or would have been charged in a same or similar uncontrolled transaction in comparable circumstances.
Under this method, quotations, price list, data referred to in commercial negotiations, data points reflecting market trend and other evidences may be relied upon.
One needs to mention the reason for accepting/ rejecting the method based on the functional analysis. Also, reasons for considering Internal or External comparable companies are required to be mentioned. 34

29. Way forward…
Most Appropriate Method to be selected and applied based on facts and circumstances of the case (FAR, Data availability important)
Each year is a separate year - Different method can be used in each year - Principle of res-judicata not applicable
What happens if the TPO rejects the method applied by assessee in one year and in the next year the method selected by the TPO results in positive result 34

30. Thank you Vishwanath Kane vkane@deloitte.com Mobile No. 98190 43126
Landline No