Arm’s Length Pricing

The concept of Arm’s length derives its meaning from the independent relation shared between independent parties. Unlike business transactions between related parties, the transactions between unrelated parties are done at an open market price and accordingly, Arm’s Length Price (‘ALP’) demonstrates the price that should have been charged between related parties had those parties were not related to each other.  

Under Indian Transfer Pricing regulations, the entire transfer Pricing Mechanism is based on computation of income arising out of cross-border transactions having regard to the arm’s length price. The definition of ALP as defined under Organisation for Economic Co-operation and Development (‘OECD’) Transfer Pricing Guidelines means a price, at which transactions between persons other than associated enterprises are carried out in uncontrolled circumstances.

In general, the Indian Transfer Pricing Regulations provide exhaustive definitions of terms Associated Enterprise (‘AE’) and International Transactions on which the transfer pricing procedure is based. In other words, for the purpose of computing Arm’s length price, it is pertinent to understand the concept of AE and International transactions.

The term Associated Enterprises has been defined under the Income Tax Act, 1961 under section 92A(1). The concept of Deemed Associated Enterprises has been defined under section 92A(2) of the Act. Further, certain parties are defined as AE under Indian Domestic Transfer Pricing provisions.

Under Income Tax Act, 1961 Section 92F define Arm’s Length Price is the price applied (or proposed to be applied) when two unrelated persons enter into a transaction in uncontrolled conditions. Unrelated Persons;

Section 92A, the persons said to be unrelated if they are not associated or deemed to be associated enterprise.

Uncontrolled Conditions; are that conditions which are not controlled or suppressed or moulded for achievement of a predetermined results.

1. Comparable Uncontrolled Price Method(CUP) Under this method;

i) Determined the price charged or paid for the property transferred or services provided in a comparable uncontrolled transaction.

ii) Such price is adjusted to account for differences, if any, between the International transaction and comparable uncontrolled controlled transactions or between the parties entering into such transactions, which could materially affect the price in the open market.

iii) The adjusted price arrived at under ii) is taken to be Arm’s Length Price in respect of the property transferred or services provided in international transaction.

2. Resale Price Method Under this method

i) The price at which property purchased or services obtained by the enterprise from an associated enterprise are resold or are provided to an unrelated enterprise, is identified.

ii) Such resale price is reduced by the amount of 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;

iii) The price so arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase of the property or obtaining the services.

iv) 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;

v) The adjusted price arrived at iv) is taken to be arm’s length price in respect of the purchase of property or obtaining of the services by the enterprise from the associated enterprise.

Cost Plus Method Rule 10B prescribes the manner in which CPM can be applied. The text reads as follows:

(i) 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;

(ii) 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;

(iii) The normal gross profit mark-up referred to in sub clause (ii) Is adjusted to take into account the functional and other differences, if any, between the international transaction or the specified domestic 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;

(iv) The costs referred to in sub-clause (i) Are increased by the adjusted profit mark-up arrived at under sub-clause (iii);

(v) 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;”

Transactional Net Margin Method (TNMM)

Under this method;

i) The net profit margin realised by the enterprise from an international transaction entered into with an associate 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;

ii) 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 basis;

iii) The net profit margin referred to in ii) 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;

iv) The net profit margin realised by the enterprise and referred in i) is established to be the same as the net profit margin referred in iii);

v) 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.

Profit Split Method Under this method;

i) The combined net profit of the associated enterprises arising from the international transaction in which they are engaged, are determined;

ii) The relative contribution made by each of the associated enterprises to the earning of such combined net profit, is then evaluated on the basis of the functions performed, assets employed or to be employed and risks assumed by each enterprise and on the basis of reliable external market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances.

iii) The combined net profit is then split among the enterprises in proportion to their relative contributions, as evaluated under ii);

iv) The profit thus apportioned to the assessee is taken into account to arrive at arm’s length price in relation to the international transaction.