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Arm's length price is popularly known as ALP is the internationally accepted transfer pricing standard which must be applied for tax purposes by Multinational enterprises and tax administration. Even Indian Transfer Pricing Regulation recognizes determination of pricing between associated enterprises on an arm's length basis. It is basically the price at which a person would to another if the two persons were not connected or related to each other.
The term "arm's length price" is defined to mean a price applied in uncontrolled conditions. In other words it refers to the market value of a particular transaction ignoring the impact on pricing due to existence of special relationship between associated enterprises. The term "enterprise" is widely defined to include any person carrying out commercial activities of various types specified in the relevant section.
ADOPTION OF ALP:
Arm's length principle would avoid the creation of tax advantages or disadvantages that would otherwise distort the relative competitive position of either type of entity. By separating tax considerations from economic decisions the arm's length principle promotes the growth of international trade and investment.
Difficulty In Applying Arm's Length Principle
MNE groups are dealing in the integrated production of highly specialized goods, in unique intangibles , and/or in the provision of specialized services.
Associated Enterprises may engage in transactions that independent enterprises would not undertake. Example: sale or license of intangibles.
Arms length Principle may result in an administrative burden for both the tax administrations for evaluating significant numbers and types of cross-border transactions. Far placed geographical locations and confidentiality etc. may cause difficulty in obtaining comparable data.
FACTORS DETERMINING COMPARABILITY ON THE BASIS OF TYPE OF TRANSACTIONS.
Type of Transaction
Factors/Characteristics to be compared
Transfer of tangible property
The physical features of the property , like its quality and reliability.
The availability of the product, Volume of supply etc.
Provision of services
The nature and extent of the services
The form of transactions (eg. licensing or sales).
The type of property ( eg. patent , trademark , etc. )
The degree and duration of protection and,
The anticipated benefits from the use of the property.
Best Method Rule of Transfer Pricing
The best method rule is intended to avoid the rigidity of the priority of methods that formerly had been required. The rule guides taxpayers and the IRS as to which method is most appropriate in a particular case. The temporary regulations no longer provided for an ordering rule to select the method that provides for an arm's-length result. Rather, in choosing a method, the arm's-length result must be determined under the method which provides "the most accurate measure of an arm's-length result."
The best method rule appears to be somewhat subjective and, because of its technical nature, may require special expertise. Certainly, the rule does not appear to eliminate the potential for controversy between the IRS and taxpayers. The rule will likely require taxpayers to expend more energy developing intercompany transfer prices and reviewing data.
Multiple Methods of Transfer Pricing
The temporary regulations encouraged the taxpayer to use more than one transfer pricing method. When two or more methods produce inconsistent results, the best method rule should be applied to determine which method produces the most accurate measure. Presumably, if the results are consistent, it may not be necessary to invoke the best method rule.
If the best method rule does not clearly indicate the most accurate method, consistency between results should be considered as an additional factor. Using this approach, the taxpayer should ascertain whether any of the methods, or separate applications of a method, yields a result consistent with any other method.
Comparable Uncontrolled Price Method
The use of the CUP method precludes an additional allocation of related product development costs or overhead unless such charges are also made to arm's length parties. This prevents the double deduction of those costs-once as an element of the transfer price and once as an allocation.
The CUP method provides the best evidence of an arm's length price. A CUP may arise where:
the taxpayer or another member of the group sells the particular product, in similar quantities and under similar terms to arm's length parties in similar markets
the taxpayer or another member of the group buys the particular product, in similar quantities and under similar terms from arm's length parties in similar markets (an internal comparable); or
Where differences exist between controlled and uncontrolled transactions, it may be difficult to determine the adjustments necessary to eliminate the effect on transfer prices. However, the difficulties that arise in making adjustments should not routinely preclude the potential application of the CUP method. Therefore, taxpayers should make reasonable efforts to adjust for differences.
Resale price method of Transfer Pricing
The resale price method begins with the resale price to arm's length parties, reduced by a comparable gross margin. This comparable gross margin is determined by reference to either:
the resale price margin earned by a member of the group in comparable uncontrolled transactions (internal comparable); or
the resale price margin earned by an arm's length enterprise in comparable uncontrolled transactions (external comparable).
Under this method, the arm's length price of goods acquired by a taxpayer in a non-arm's length transaction is determined by reducing the price realized on the resale of the goods by the taxpayer to an arm's length party, by an appropriate gross margin. This gross margin, the resale margin, should allow the seller to:
recover its operating costs; and
earn an arm's length profit based on the functions performed, assets used, and the risks assumed.
Where the transactions are not comparable in all ways and the differences have a material effect on price, the taxpayer must make adjustments to eliminate the effect of those differences. The more comparable the functions, risks and assets, the more likely that the resale price method will produce an appropriate estimate of an arm's length result.
An exclusive right to resell goods will usually be reflected in the resale margin.
The resale price method is most appropriate in a situation where the seller adds relatively little value to the goods. The greater the value-added to the goods by the functions performed by the seller, the more difficult it will be to determine an appropriate resale margin. This is especially true in a situation where the seller contributes to the creation or maintenance of an intangible property, such as a marketing intangible, in its activities.
Example: The resale price method begins with the price at which a product that has been purchased from an Associate Enterprise is resold to an independent enterprise. For example, company ABC has sold a product to an associated company XYZ at Rs. 1000. The company B has resold the same to an unrelated Party A at a price of Rs. 2000. In order to arrive at arm's length price between A and B the price charged by XYZ to A would be scrutinized. If reasonable profits in hands of XYZ are presumed at Rs. 600, arm's length price between ABC and XYZ will be Rs.1400(2000-600). There may be further adjustments due to customs duty, etc.
Cost plus method of Transfer Pricing
In Cost Plus Method, first the cost incurred by the supplier of property (mainly service) is determined. An appropriate cost plus mark-up is then added to the cost, to arrive at an appropriate profit in the light of the functions performed and market conditions. The resultant figure is the arm's length price. So essentially, CPM involves comparability of gross margins earned by suppliers in uncontrolled transactions..
In general, for purposes of applying a cost-based method, costs are divided into three categories:
(A) direct costs such as raw materials;
(B) indirect costs such as repair and maintenance which may be allocated among several products; and
(C) operating expenses such as selling, general, and administrative expenses.
The cost plus method uses margins calculated after direct and indirect costs of production.. For purposes of calculating the cost base for the net margin methods, operating expenses usually exclude interest expense and taxes.
Transactional Profit Methods of Transfer Pricing
Traditional transaction methods are used when the information available on comparable transactions is not detailed enough to allow for adjustments necessary to achieve comparability in the application of a traditional transaction method, taxpayers may have to consider transactional profit methods.
However, the transactional profit methods should not be applied simply because of the difficulties in obtaining or adjusting information on comparable transactions, for purposes of applying the traditional transaction methods..
The OECD Guidelines endorse the use of two transactional profit methods:
the profit split method; and
transactional net margin method (TNMM).
The key difference between the profit split method and the TNMM is that the profit split method is applied to all members involved in the controlled transaction, whereas the TNMM is applied to only one member.
a. Profit split method of Transfer Pricing
This method is applicable where transactions are so inter-related that they cannot be evaluated separately for the purpose of determining arm's length price of any one transaction. The profit-split method first identifies the profit to be split for the associated enterprises. Then the profit so determined is split between the associated enterprises on the basis of functions performed, assets employed or to be employed and risks assumed by each enterprise. Such contribution is valued to the extent possible by any available reliable external data.
b. Transactional net margin method (TNMM) of Transfer Pricing
In case of this method, 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 in the enterprise or having regard to any other relevant base. Such net margin then, may be compared with comparable uncontrolled transaction, which the tax-payer has entered into with unrelated enterprise (internal comparison). If this is not possible, net margin that would have been earned in comparable transactions by an independent enterprise may be compared (external comparison). Thus, TNMM operates in a manner similar to cost plus and resale price methods.