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This term has been defined as a price, which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.
Computation of arm's-length price
The arm's-length price in relation to an international transaction is to be determined using the most appropriate method out of the specified methods, having regard to the nature or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as may be prescribed.
The five specified methods are:
Comparable Uncontrolled Price Method ('CUP')
A transfer pricing method that compares the price in an international transaction between associated enterprises to the price charged or paid in a comparable uncontrolled transaction. This method makes direct price comparisons between products / services sold to associated enterprises and unrelated parties. The price so determined is adjusted to account for differences, if any, between the international transaction and the uncontrolled transaction or between the enterprises entering into such transaction, which could materially affect the price in the open market.
Resale Price Method ('RPM')
This transfer pricing method is typically used in cases where the property or services are purchased by the taxpayer from the associated enterprise and are resold to an unrelated enterprise. The resale price so arrived at is further reduced by the amount of normal gross profit margin accruing to the taxpayer or to an unrelated enterprise from the purchase and resale of the same or similar property / services, in a comparable uncontrolled transaction. The price so arrived at is reduced by expenses incurred by the taxpayer in connection with the purchase of the property / services, to arrive at the inter-company purchase price of the product from an associated enterprise. The price may be further 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.
Cost Plus Method ('CPLM')
This transfer pricing method arrives at an arm's length price by using at the outset, the costs incurred by the taxpayer in producing property or in respect of services provided, to the associated enterprise. An appropriate gross profit mark-up to such costs arising from the provision of the same or similar property or services by the taxpayer or by unrelated enterprise, in a comparable uncontrolled transaction is added to such costs to arrive at the arm's length price. In arriving at the appropriate gross profit mark up due adjustments may be made to take into account functional or other differences between the international transaction and the comparable uncontrolled transactions which could materially affect such profit mark-up in the open market.
Profit Split Method ('PSM')
The PSM may mainly be used in case the transactions involve transfer of unique intangibles or in cases where there are multiple transactions amongst associated enterprises, which are so interrelated that they cannot be evaluated separately. This method combines the net profits of all associated enterprises from all such transactions. The relative contribution made by each such associated enterprise including the taxpayer to the earning of such profits, is then evaluated on the basis of the functions performed, assets utilized 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. The combined profits are then split amongst the enterprises in proportion to their relative contribution, which is then taken into account to arrive at an arm's length price. Further, the provisions also provide that the combined net profit may, in the first instance, be partially allocated to each enterprise to provide it with a basic return, with reference to market returns achieved for similar types of transactions by independent enterprises, and thereafter, the residual net profit remaining after such allocation may be split amongst the enterprises in proportion to their relative contribution.
Transactional Net Margin Method ('TNMM')
The TNMM compares the taxpayer's net profit margins, (computed in relation to costs incurred or sales effected or assets utilised by the taxpayer or having regard to any other relevant factor), realised from an international transaction entered into with an associated enterprise to the net profit margin realised by the taxpayer or by an unassociated enterprise from a comparable uncontrolled transaction having regard to the same factors. In arriving at the net profit margin from a comparable uncontrolled transaction, due adjustment may be made to take into account any differences between the international transaction and the comparable uncontrolled transactions, which could materially affect the amount of net profit margin in the open market; Though the provisions allow for use of any other Method as the Central Board of Direct Taxes may prescribe, no other method has been prescribed till date.