Methods of determining ALP -Eric Mehta 1 August 2011
Concept of Transfer Pricing 1 August 2011 Page 2 Transfer Pricing
Concept of transfer pricing A price between unrelated parties is known as the arm s length price Transfer Pricing refers to pricing of international transactions between two associated enterprises (AEs) Due to special relationship between related parties, transfer price may be different than the price that would have been agreed between unrelated parties 1 August 2011 Page 3 Transfer Pricing
Arm s length price 1 August 2011 Page 4 Transfer Pricing
Arm s length price Price applied or proposed to be applied in atransaction between persons other than associatedenterprises,in uncontrolledconditions Determinationof arm s length pricesusing one of the Prescribedmethods Yes The price thus determined is the arm s length price Whether you arrive at a single price? No The arithmetic mean of such prices If the arithmetic mean is within +/-5% from the transfer price, transfer price considered to be at the arm s length 1 August 2011 Page 5 Transfer Pricing
Arm s length price The arm s length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, having regard to the nature/class of the transactions or class of associated enterprise or functions performed, namely Comparable uncontrolled price method Resale price method Cost plus method Profit split method Transactional net margin method Such other method as may be prescribed by the Board - None as of now (Section 92C) Choice of tested party 1 August 2011 Page 6 Transfer Pricing
Comparability All methods require comparables Transfer price is set/ defended using data from comparable companies Comparable company should be independent and similar to an associated enterprise. Following factors are generally used in judging comparability (Rule 10C(2)): nature of transactions undertaken (i.e. type of good, service etc.) company functions risks assumed contractual terms (i.e. similar credit terms) economic and market conditions 1 August 2011 Page 7 Transfer Pricing
Prescribed Methods 1 August 2011 Page 8 Transfer Pricing
Prescribed methods OECD Transfer Pricing Methods Traditional Transaction Methods TransactionalProfit Methods Comparable Uncontrolled Price Resale Price Method Cost Plus Method Profit Split Method Transactional Net Margin Method OECD 2010: Selection of most appropriate transfer pricing method to the circumstances of the case Earlier preference of traditional methods to transactional methods eliminated Indian rules prescribe no guidance requires use of most appropriate method 1 August 2011 Page 9 Transfer Pricing
Comparable Uncontrolled Price Method Considered the most appropriate method, for all transactions, if adequate information is available Compares the price charged in a controlled transaction with the price in an uncontrolled transaction Requires strict comparability in products, contractual terms, economic terms, etc Comparison under CUP requires Identification of price charged or paid in comparable uncontrolled situations Such price adjusted to account for differences if any between international transaction and uncontrolled transactions Adjusted price arrived above taken to be arm s length price 1 August 2011 Page 10 Transfer Pricing
Comparable Uncontrolled Price Method Internal CUP Related party - Manufacturer B Manufacturer A Non-related party External CUP Non-related party A Non-related party B 1 August 2011 Page 11 Transfer Pricing
Resale Price Method Compares the resale gross margin earned by associated enterprise with the resale gross margin earned by comparable independent distributors An arms length gross margin should be sufficient for a reseller to cover its operating expenses and make an appropriate operating profit (in light of its functions and risks) Preferred method for a distributor buying purely finished goods from a group company (if no CUP available) Group Manufacturer (France) $65 $100 Related Distributor (India) Unrelated Wholesalers 1 August 2011 Page 12 Transfer Pricing
Resale Price Method How does it work Identification of resale price by tested party Resale price reduced by normal gross profit with reference to uncontrolled transaction(s) Such price reduced by expenses incurred (customs duty etc.) in purchase of the product/ services. This price may be adjusted to account for functional and other differences if any Adjusted price arrived above taken to be arm s length price 1 August 2011 Page 13 Transfer Pricing
Resale Price Method Transaction: Import of goods from associated enterprises for resale to unrelated parties Actual resale price earned by XYZ India from sale of group company products to unrelated enterprises Less: Comparable gross profit margin Cost of Sales (A-B) Less: Expenses related to the purchase from group companies ALP for products procured from group companies during the year (C-D) A B C D E 1 August 2011 Page 14 Transfer Pricing
Cost Plus Method Compares the gross profit on costs the associated enterprise earns with the grossprofit on costs earned by comparableindependentcompanies Preferredmethod for: manufacturersupplyingsemi-finishedgoods companyproviding services Manufacturer A (Indian) Cost + 40% Related Manufacturer B (US) US Market 1 August 2011 Page 15 Transfer Pricing
Cost Plus Method How does it work Identification of direct and indirect costs of production incurred in tested party transactions Identification of normal gross profit with reference to uncontrolled transactions Normal gross profit adjusted to account for functional and other differences if any Adjusted gross profit added to total costs identified in step 1 Sum arrived above is taken to be arm s length price 1 August 2011 Page 16 Transfer Pricing
Cost Plus Method Transaction: Export of raw material and electronic components by XYZ India to associated enterprises Direct and Indirect cost of production incurred by XYZ India Add: Comparable gross profit margin ALP for products sold to AEs during the year (A+B) A B C 1 August 2011 Page 17 Transfer Pricing
Profit Split Method Calculates the combined operating profit resulting from a whole inter-company transaction based on the relative value of each associated enterprise's contribution to the operating profit The contribution made by each party is determined on the basis of a division of functions performed, valued, if possible using external comparable data Applicable for analyzing tangible, intangible or services issues 1 August 2011 Page 18 Transfer Pricing
Profit Split Method How does it work Determination of combined net profit of the associated enterprises arising out of international transaction Evaluation of relative contributions by each enterprise on the basis of functions performed, risks assumed and assets employed Splitting of combined net profit amongst enterprises in proportion to their relative contributions Profit thus apportioned to the tested party is used to arrive at the arm s length price 1 August 2011 Page 19 Transfer Pricing
Transaction Net Margin Method Examines net operating profit from transactions as a percentage of a certain base (can use different bases i.e.. costs, turnover, etc) in respect of similar parties Ideally, operating margin should be compared to operating margin earned by same enterprise on uncontrolled transaction Can compare to comparable transactions between independent parties Applicable for any type of transaction and often used to supplement analysis under other methods Most frequently used method in India, due to lack of availability of comparable uncontrolled prices and gross margin data required for application of the comparable uncontrolled price method/ cost plus method/ resale price method 1 August 2011 Page 20 Transfer Pricing
TNMM How does it work Computation of net profit as a percentage of a certain base realized from the international transaction. Computation of net profit realized by the tested party or an unrelated enterprise in a comparable uncontrolled transaction Net profit from uncontrolled transaction adjusted to account for differences if any The net profit thus established is taken into account to arrive at an arm s length price for the international transaction 1 August 2011 Page 21 Transfer Pricing
Economic adjustments Rule 10B provides for undertaking economic adjustments while determining the ALP using the prescribed methods Adjustments are changes made to the comparable companies financial data in order to make the comparable companies more similar to the tested party Voluntary adjustments Economic adjustments are made to account for differences between the tested party and the uncontrolled comparables that would materially affect the profits determined under the relevant profit level indicator Typically, adjustments are made to account for the following: Differences in working capital Differences in Contractual terms and conditions Capacity underutilization Risk differences 1 August 2011 Page 22 Transfer Pricing
Case Studies 1 August 2011 Page 23 Transfer Pricing
Case study 1 - Which Method applies X Inc USA Sale of chemicals 100kgs at Rs 90/kg X Ltd India 10kgs at Rs 100/kg Third parties in India Which method applies to this transaction? 1 August 2011 Page 24 Transfer Pricing
Case study 2 - Which Method applies X Inc USA Provision of software development services X Ltd India Compensation on basis of costs incurred Which method can be applied to this transaction? 1 August 2011 Page 25 Transfer Pricing
Case study 3 - Which Method applies X Inc USA Provision of software development services to X Inc and ABC Ltd India Compensation on basis of costs incurred X Ltd India ABC Limited India Which method can be applied to this transaction 1 August 2011 Page 26 Transfer Pricing
Case study 4 - Can CUP be applied? Licensing of formulations and technicals 3% of gross domestic sales and 5% of gross export sales of Product A XYZ UK XYZ Netherlands (Licensing of Technology) Licensing of technicals XYZ India 5% of net domestic sales and 8% of net export sales of Product A 1 August 2011 Page 27 Transfer Pricing
Case study 5 - Which Method applies 100kgs at Rs 90/kg X Inc USA X Ltd India 1000 kgs at Rs 80 /kg 100 kgs at Rs 90 /kg 90 kgs at Rs 100/kg Third parties in US XYZ Inc, USA (group company) Third parties in India Which method applies to this transaction? How would you defend TP for X Ltd India 1 August 2011 Page 28 Transfer Pricing
Case study 6 ABC Inc., USA Outside India India Import of software for resale ABC India (sole distributor) Royalty payments for distribution based on net sales Customer in India Which method can be applied to the transactions? Can royalty be disallowed to the extent of bad debts as it is based on net sales? 1 August 2011 Page 29 Transfer Pricing
Case Study 7 Outside India India ABC Inc., USA ABC India s business Sale of ABC India s Business to Indian customer Customer in India Which method can be applied to the transaction? 1 August 2011 Page 30 Transfer Pricing
Case study 8 - Can CUP be applied? XYZ UK XYZ India XYZ UK sells unique patented products to XYZ India Similar products are imported by third party Indian companies at lower rate There are minor variations in the products being compared in terms of purity, characteristics etc Can adjustments be made using CUP method? 1 August 2011 Page 31 Transfer Pricing
Case study 9 XYZ USA XYZ India Third parties in China XYZ India sells wipers to XYZ USA. Similar wipers are purchased by XYZ USA from third parties in China. CUP method applied by XYZ India. Transfer pricing officer disregarded CUP on basis that that conditions prevailing in the market are not similar How would you defend the case?? 1 August 2011 Page 32 Transfer Pricing
Case study 10 ABC Inc is a electronic component manufacturer based in Sweden and has a subsidiary in India ABC India ABC India is a manufacturer has the following transactions with its parent company: It sources components from ABC Inc to use in manufacture of CD players It imports CD players from ABC Inc for resale It receives technical know-how from ABC Inc and also uses the ABC brand name owned and developed by ABC Inc It avails a foreign currency loan from ABC Inc ABC India also sources components for its manufacturing function from unrelated entities ABC India purchases CD players from unrelated entities for resale purposes ABC India sells CD players to its group company in Thailand and also to unrelated entities 1 August 2011 Page 33 Transfer Pricing
Case study 10 ABC Inc (Sweden) Components and finished goods from unrelated entities Components & finished goods Brand name & technical know how ABC India Manufactured Finished goods Loan Indian Distributors ABC Thailand 1 August 2011 Page 34 Transfer Pricing
Case study 10 International Transactions Sourcing of components by ABC India from ABC Purchase of finished goods by ABC India from ABC for resale Export of manufactured (finished) goods by ABC India to ABC Thailand Payment of royalty to ABC for receipt of technical know-how and right to use the ABC brand name Availing of loan from ABC Payment of interest on loan by ABC India to ABC 1 August 2011 Page 35 Transfer Pricing
Purchase of components Price Analysis Comparison of price of similar components procured by ABC India from unrelated entities in economically similar jurisdictions and from ABC Comparison of price of similar components sold by ABC to ABC India and to unrelated parties in economically similar jurisdictions Comparison of price of similar components in transactions between two unrelated entities Margin based analysis Comparison of margins earned by ABC India from sale of finished goods using components procured from unrelated entities vis-à-vis those using components imported from ABC Comparison of margins earned by ABC India vis-à-vis margins earned by comparable manufacturers in India identified through external searches Comparison of margins earned by ABC from sale of components to ABC India vis-à-vis margins earned by ABC on sale of components to unrelated entities Comparison of margins earned by ABC vis-à-vis margins earned by comparable manufacturers in Sweden identified through external searches 1 August 2011 Page 36 Transfer Pricing
Import of finished goods for resale Price Analysis Comparison of price of finished goods purchased from unrelated entities in economically similar jurisdictions and from ABC Comparison of prices of finished goods sold by ABC to ABC India and to unrelated party (if any) in economically similar jurisdictions Comparison of prices of similar finished goods in transactions between two unrelated entities Margin based analysis Comparison of margins earned by ABC India from sale of finished goods procured from unrelated entities vis-à-vis those imported from ABC Comparison of margins earned by ABC from sale of finished goods to ABC India vis-àvis margins earned by comparable entities in Sweden engaged in uncontrolled transactions Comparison of margins earned by ABC India vis-à-vis margins earned by comparable distributors in India identified through external searches Comparison of margins earned by ABC vis-à-vis margins earned by comparable entities in Sweden identified through external searches 1 August 2011 Page 37 Transfer Pricing
Export of manufactured goods Price Analysis Comparison of prices of manufactured goods sold to ABC Thailand vis-à-vis those sold to unrelated entities in economically similar jurisdictions by ABC India Comparison of prices of manufactured goods procured by ABC Thailand from ABC India vis-à-vis those procured by ABC Thailand from an unrelated party (if any) in economically similar jurisdictions Comparison of prices of similar goods in transactions between two unrelated entities 1 August 2011 Page 38 Transfer Pricing
Export of manufactured goods Margin based analysis Comparison of margins earned by ABC India from export of manufactured goods to ABC Thailand vis-à-vis margins earned by sale of similar goods to unrelated parties Comparison of margins earned by ABC Thailand from resale of goods imported from ABC India vis-à-vis margins earned by ABC Thailand on resale of goods purchased from unrelated entities Comparison of margins earned by ABC India vis-à-vis margins earned by comparable entities in India identified through external searches Comparison of margins earned by ABC Thailand vis-à-vis margins earned by comparable entities in Thailand identified through external searches 1 August 2011 Page 39 Transfer Pricing
Payment of royalty Price Analysis Comparison of royalty payments made by ABC India for similar intangibles licensed from unrelated entities Comparison of royalty received by ABC from unrelated entities for licensing of similar intangibles Comparison of similar licensing arrangements between unrelated entities identified through an external search Margin based analysis Comparison of margins earned by ABC India at a company wide level with margins earned by similar manufacturers identified through external searches 1 August 2011 Page 40 Transfer Pricing
Availing of foreign currency loan Price Analysis Comparison of interest payments on similar loans availed by ABC India from unrelated entities Comparison of interest payments on similar loans given by ABC to unrelated entities Comparison of similar loan agreements between unrelated entities identified through external searches 1 August 2011 Page 41 Transfer Pricing
Case study - Key points Choice of tested party important Analysis of certain classes of transactions simpler Manufacturing Distribution Financial flows Analysis of transfer of intangibles more difficult Not an exact science detailed analysis of transactions and facts surrounding the transactions required to decide approach to transfer pricing 1 August 2011 Page 42 Transfer Pricing
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