Transfer Pricing Methods

and
their applications
Anurag Sharma
Joint Commissioner of Income Tax (TP)
Bhaskar Goswami
Addl. Commissioner of Income Tax (APA)

Introduction

Basic principles of transfer pricing

Transfer Pricing methods
Principles and limitations
Application of the methods

Transfer Pricing Basic Principles

Transfer Pricing is a mechanism developed by

tax jurisdictions to ensure that they get a just

share of the global taxes paid by MNE groups
It is often seen that MNE groups would like to
shift profits to a low tax jurisdiction.
With the passage of time, the motives for tax
shifting has changed/evolved.

Basic principles
Transfer

pricing regulations apply to

international transactions that are entered
into by associated enterprises.
Transfer pricing compares the transfer
prices that are exchanged between AEs
with an arms length price.
The basis of all transfer pricing audits is
comparability.

Changes made by Finance Act, 2012

Explanation added to Sec. 92B to provide an inclusive definition of

the expression international transaction. [w.r.e.f 01.04.2002] This

includes
(a) the purchase, sale, transfer, lease or use of tangible property
including building, transportation vehicle, machinery, equipment,
tools, plant, furniture, commodity or any other article, product or
thing;
(b) the purchase, sale, transfer, lease or use of intangible property,
including the transfer of ownership or the provision of use of rights
regarding land use, copyrights, patents, trademarks, licences,
franchises, customer list, marketing channel, brand, commercial
secret, know-how, industrial property right, exterior design or
practical and new design or any other business or commercial rights
of similar nature;
(c) capital financing, including any type of long-term or short-term
borrowing, lending or guarantee, purchase or sale of marketable
securities or any type of advance, payments or deferred payment or
receivable or any other debt arising during the course of business;

Finance Act, 2012

(d) provision of services, including provision of
market
research,
market
development,
marketing
management,
administration,
technical service, repairs, design, consultation,
agency, scientific research, legal or accounting
service;
(e) a transaction of business restructuring or reorganisation, entered into by an enterprise with
an associated enterprise, irrespective of the
fact that it has bearing on the profit, income,
losses or assets of such enterprises at the time
of the transaction or at any future date;

Finance Act, 2012

The explanation also provides an inclusive definition of the

expression intangible property. [w.r.e.f. 01.04.2002]

Amendment to subsection (2) to Sec. 92-in sub-section (2),
for the words international transaction, the words
international
transaction
or
specified
domestic
transaction shall be substituted; [w.e.f. 01.04.2013]
Subsection (2A) to Sec. 92 inserted which reads-(2A) Any
allowance for an expenditure or interest or allocation of
any cost or expense or any income in relation to the
specified domestic transaction shall be computed having
regard to the arms length price.;
The expression specified domestic transaction has been
defined by newly inserted Sec. 92BA [w.e.f. 01.04.2013]

Transfer Pricing Methods

Method

Usage

Comparable uncontrolled
method (CUP)

price Used mainly in respect of transfer

of goods, provision of services,
intangibles, loans, provision of
finance.

Resale-price method (RPM)

Used mainly in case of distribution

of finished goods or other goods
involving no or little value
addition

Cost plus method (CPM)

Used mainly in respect of

provision of services, joint facility
arrangements, transfer of semi
finished goods, long-term buying
and selling arrangements

TP methods..
Profit-split method (PSM)

Transactional
net
method (TNMM)

Used mainly in report of

transactions
involving
integrated services provided by
more than one enterprise,
transfer of unique intangibles,
multiple
inter-related
transactions, which cannot be
separately evaluated
margin Used in respect of transactions
for
provision
of
services,
distribution of finished products
where resale price method
cannot be adequately applied,

Any other method as prescribed The choice has been left to the
by the CBDT
TPO to adopt any method that
he thinks fit.

Comparable Uncontrolled Price (CUP)

CUP method compares the price charged in a

controlled transaction with that charged in a

comparable uncontrolled transaction.
If

comparable uncontrolled transactions are

available, this method is considered most direct
and reliable method

Comparison of prices charged in one transaction

with those charged in another transaction is the

most direct approach.
Differences in prices can be traced directly to

differences
in
arrangements.

commercial

and

financial

CUP Method - Types of comparables

Internal Comparable

B, AE
$ 65

Oil

$ 55

C, non AE

External Comparable
$ 65
A

B, AE

Oil
X

$ 55

C, non AE

CUP- Limitations
Requires strict similarity between products

and services

Difficulty in finding uncontrolled transaction

comparable so that no differences have a
material effect on price

Making reasonably accurate adjustments is a

subjective exercise for issues of quality,
contract terms, geographical location, level of
market, intangibles etc.

CUP Case study

The taxpayer is a manufacturer and distributor of

motorcycles.
Among various international transactions that
the taxpayer has entered into, there is an import
of spare parts and components from its AE,
amounting to
Rs. 81 Crores.
The taxpayer has used TNMM to benchmark this
transaction by aggregating its sale transaction.
Based on this analysis, the taxpayer has
concluded that its transaction related to
purchase of spares and components from its AE
is at arms length.

CUP- Case study.

The TPO found that the taxpayer was purchasing the

same kinds of spares and components from the

domestic market at cheaper rates.
The TPO noticed that the volume of imports was very
small as compared to the domestic purchase. Hence,
any mis-pricing would not be detected if we looked at
the aggregate profits. Hence, TNMM would not the
appropriate method.
The TPO adjusted the prices of spares imported for the
costs related to Custom Duty/Excise Duty and Overseas
Freight.
With this comparison, it was found that the taxpayers
has paid a higher price to the AE as compared to the
price paid to domestic suppliers.

IMPORTED (-) INDIGENOUS

RATES
Material
PART CODE

(IMPORTED)
CHAIN, CAM
ROLLER CAM
CHAIN TENS
ROLLAR COMP
CAM CHAIN
SEAL VALVE
STEM
GASKET
ASSY.CYL.HEAD.
RING SET
PISTON.STD.
RING SET
PISTON(0.25)
RING SET
PISTON(0.50)
RING SET
PISTON(0.50)
RING SET
PISTON(0.75)
SPROCKET
TIMING
SPROCKET CAM
CHAIN CAM
TOTAL DIFF

Qty Imp

2005-2006
Value Dif
38,21,330

rate Dif

14401178003

1,76,620

21.64

14502086000

13,000

9,899

14610086013

69,500

13,77,079

19.81

12209GB4681

3,26,426

22,03,556

6.75

12250GF6000

29,134

18,46,123

63.37

13011GN5961

3,013

1,37,809

45.74

13012GN5961

2,809

1,29,051

45.94

13013GN5961

1,443

66,066

45.78

13013KCC306

1,161

76,833

66.18

13014GN5961
14311-KN69300C
14321-KEH9000C
14401-KEH9000C

760

34,757

45.73

8,000

4,44,586

55.57

8,000

4,19,198

52.40

8,000

(2,04,195)

(25.52)

0.76

CUP Case study

The TPO concluded that the taxpayer has

been unable to demonstrate

That the types of goods imported were not

available in India. In fact, such goods have

actually been purchased here.
That there is a justifiable reason for
purchasing goods from Japan where the cost
of manufacture is supposedly higher.
Based on these findings an adjustment of

Rs.1.54 Crores was made in the case.

Resale Price Method (RPM)

RPM tests arms length character of a transfer

price in a controlled transaction by reference

to the gross profit margin realized in a
comparable uncontrolled transaction

RPM compares a distributors / resellers

gross margin on controlled transactions with
the gross margins of comparable independent
firms.

RPM.
Trading

/ marketing activities, including

activities of pure resellers

Purchase from AEs for resale to unrelated

parties without substantial value addition
by the reseller

Generally used in cases involving the

purchase and sale of tangible property

RPM.Limitations
Relevance of functional similarity for the purpose

of determining appropriate comparables

Presentation of financial statements of Indian

companies
- break up of direct and indirect costs
- adjustment for accounting differences
- absence of segmental information

Difficult to apply in following cases -

- transaction involving rendering of services

- substantial value addition made by the reseller

RPM Case study

The taxpayer is an importer and reseller of

insulin.
The taxpayer has used TNMM
appropriate method.
The net margin of the taxpayer
the average net margin of
comparables.
Based on this comparison, the
concluded that its transactions
length

as the most
is 5% against
7% of the
taxpayer has
are at arms

RPM- Case study

The facts of the case are
The taxpayer is a pure reseller.
It does not add any value to the goods that it
re-sells.
The taxpayer had stated in the TP report that
Resale Price Method (RPM) would be the most
appropriate method.
The taxpayer has used TNMM as the method
on the ground that reliable data is not
available for use of RPM

RPM - Case study.

Given the facts, the TPO determined that
RPM would be the most appropriate method.
There was sufficient and reliable data
available in the public domain that would
enable the use of RPM.
The taxpayer was itself able to provide
financial data that could be used in work out
gross margins of the comparables

RPM Case study

RPM Case study

The conclusions that the TPO arrived at were
The taxpayer had obviously used TNMM as the
method due disguise the fact that the gross level
margins demonstrated was at great variance with
that of comparables.
There was no dispute about the cost base that
was to be used for calculation of the gross
margin.
RPM was used as the most appropriate method .
After
benchmarking the taxpayer against
appropriate comparables it resulted in an
adjustment of
Rs. 13.95 Crores

Cost Plus Method (CPM)

CPM

tests the arms length character of a

transfer price in a controlled transaction by
reference to the gross profit mark up realized in
a comparable uncontrolled transaction.

CPM measures the value of functions performed

Gross profit markup provides

Compensation for performance
manufacturing /
assembly, as well as

of

- Return on capital invested and risk assumed

by the manufacturer

CPM Applicability

Transfer of semi-finished goods

Inter - unit transfers within an organization

Provision of services

Contract Manufacturing - particularly for

highly specialized and customized products
where
the
costs
of
productions
are
unpredictable e.g. turnkey projects

Requires lesser product / service similarity as

compared to the CUP method

RPM/CPM Issues of ascertaining costs

Direct

Cost: materials, supplies, salaries,

travel expenses for employees performing
services

Indirect
Costs: Utilities, occupancy,
overhead expenses
Excluded Costs
Interest expense not incurred for the benefit of

AE
Share holding related expenses
Compliance cost to Government
regulations

policies

Transactional Net Margin Method

(TNMM)
In TNMM the taxpayer attempts to establish

the arms length nature of its international

transactions
By looking at the Profits it has attained from

transactions with the AE

And comparing these profits with the profits
attained by parties operating in an uncontrolled
environment
Having similar transactions

These NET MARGINS can be calculated as

Returns /Profits
on
Sales or revenue

Costs incurred

Assets utilized
Concept of Profit Level

TNMMApplication
Provision of various complex services
Distribution of finished products where RPM

cannot be applied
Transfer of semi-finished goods

TNMM Case study

The facts of the case are
The taxpayer is a manufacturer of catalytic
converters.
It imports semi-finished goods from its AE.
The taxpayer has chosen CUP as the most
appropriate method.
It has compared sales made by the AE to
unrelated parties and concluded that its
international transactions are at arms length

TNMM - Case study

The facts that emerged during the audit were
The CUP data used by the taxpayer was flawed
as the exports by the AE were of products in a
different stage of completion and to countries
other than India.
Most of the production process was completed
by the AE before the goods reached India.
Could the AE pass on a loss to the taxpayer?The taxpayer was incurring a loss at the net
level

TNMM- Case study

The determination of the TPO was

The use of CUP by the taxpayer was
misplaced.
The use of CUP did not reflect the reality of
the net level loss incurred by the taxpayer.
The AE was not entitled to pass on a loss to
the taxpayer.

TNMM Case study

The TPO further determined that
TNMM would be the most appropriate method.
After benchmarking the taxpayer against a
suitable set of comparables, the arms length
margin was worked out to be 5.05% against the
margin of (-) 5.76% returned by the taxpayer.
This resulted in an adjustment of Rs.2.04 Crores

Profit Split Method (PSM)

Profit Split Method (PSM) may be

applicable for
International

Transactions
involving
transfer of unique intangibles.
Multiple
International
Transactions
which are so interrelated that ALP of
any one of transaction cannot be
evaluated separately

How is it done
Combined net profit of the associated enterprises

arising
from
the
international
transactionis
determined.
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.
Combined net profit is then split amongst the
enterprises in proportion to their relative contributions.
Profit thus apportioned to the assessee is taken into
account to arrive at an arm's length price in relation to
the international transaction.

A case study
Taxpayer (XIPL) is a 100 percent subsidiary of X

Japan. XIPL markets a comprehensive range of

digital
imaging
products
that
include
photocopies, fax-machines, printers, scanners,
digital cameras and multi media projectors.
Major International Transactions reported by XIPL
are Import of finished Goods for resale and
Provision of software development services &
Reimbursement of advertisement expenses and
price support.
Goods sold by XIPL carry X brand. X Japan is the
legal owner of the brand.
XIPL is found to be incurring a very high level of
Advertisement and Marketing Promotion (AMP)
expenditure.

AMP An international
transaction
Taxpayer has not reported any international transaction

related to AMP expenditure.

Section 92B that defines international transaction to
include the purchase, sale, transfer, lease or use of
intangible property, including the transfer of
ownership or the provision of use of rights regarding
land use, copyrights, patents, trademarks, licences,
franchises, customer list, marketing channel, brand,
commercial secret, know-how, industrial property right,
exterior design or practical and new design or any
other business or commercial rights of similar nature
[Inserted by the Finance Act, 2012 w.r.e.f 01.04.2002]
Sec. 92B defines intangible property to include
marketing related intangible assets, such as,
trademarks, trade names, brand names, logos.
[Inserted by the Finance Act, 2012 w.r.e.f 01.04.2002]

TPOs findings

By incurring an elevated level of AMP expenditure,

taxpayer is promoting the brand that belongs to the

AE.
Against the reimbursement of Rs. 48,06,63,749
taxpayer has incurred an AMP expense of
Rs.
93,32,44,900.
AMP/Sales ratio of taxpayer is 8.05% and of the
comparables is 1.03%.
AMP/Sales ratio X Japan (at consolidated level) is
2.49%.
Taxpayer is therefore creating a marketing intangible
in favour of the AE is India.
This is an unreported international transaction that
needs to be benchmarked. TPO decides that PSM is
the Most Appropriate Method.

Taxpayers contentions
AMP is not an international transaction.
AMP expense is required to boost sales.
It has complete ownership over the AMP expenditure.
Shares a principal to principal relationship with the AE.
Composition of AMP expenditure
Advertisement campaigns Rs.35 Crores
Retail branding, printing and related activities - Rs.22.3

Crores
Awareness of local products through promoters deployment
across India and PR agency cost - Rs.4.2 Crores
Events, meets and product launches - Rs.13.3 Crores
Local exhibitions and participations - Rs.2.1 Crores
Promotional offers, freebies - Rs.10.8 Crores
Sales conferences - Rs.1.7 Crores
Sponsorship - Rs.2.5 Crores

Methodology of applying PSM

Based on the decision in Rolls Royce Plc

Vs. DDIT [TIOL-408- ITAT-DELHI]

Affirmed by Honble High Court of Delhi
Profits of X group at the consolidated
level
attributed to the following
significant activities
Manufacturing - 50%
Research and development - 15%
Advertisement, marketing and promotion

(AMP) - 35%
Taxpayer sought application of decision in

the case of Rolls Royce Singapore.

Calculation of ALP
A. Net Sales: 3,669,533 Million Yen.
B. Net Profit attributable to marketing & advertising

activity = 35% of Operating Profit

= 35% of 385,181 Million Yen. Based on above
exchange rate of 0.553 (
www.oanda.com/currency/historical-rates/) the
attribution of profits required from the AE, is computed,
this amounts to Rs.74,551,589,000
C. AMP expenditure of AE: 91,403 Million Yen
(Rs.50,545,859,000)
D. AMP expenditure incurred by the taxpayer =
Rs.933,244,900
E. AMP Taxpayer/AMP of X Group *100 :
(933,244,900/50,545,859,000)*100= 1.8%
F. Attribution of profits to AMP expenses = 1.8%
of Rs. 74,551,589,000/ = Rs. 1,341,928,602/-

The methodology of a TP
audit

FAR Analysis
Functions performed
Assets utilized
Risks assumed

The methodology
Comparability

is the
benchmarking process.

foundation

of

good

A good comparability analysis will ensure

The correct choice of method
The correct choice of comparables
Assess the need for comparability adjustments

The search process that will identify comparables

must be based on a scientific and rational basis that

will cover the FAR analysis and the economic
substance of the international transactions being
benchmarked

Comparability adjustments
Adjustments have to be made to Profit

Margins of comparables
These adjustments are made to account for
the
Differences that could materially affect price in

open market
Differences in
Differences in
Differences in
Differences in

contractual terms
depreciation methods
market conditions
applicable cost base

Comparability adjustment Case study

The facts of the case are
The taxpayer is manufacturer and trader of
cosmetic products.
The manufacturing and trading segments are
separately identified business segments.
(in Form 3CEB)
In the trading segment, the taxpayer is
purchasing goods in the domestic market and
exporting them to the AE.

Comparability adjustment case

study..
The other relevant facts were
The taxpayer has used TNMM as the method
The taxpayer claims that the only expense
that is relevant to the trading segment is cost
of goods sold.
All other expenses, including personnel
expenses, depreciation etc., are all allocated
to the manufacturing segment.

Comparability adjustment Case

study
The other observations of the TPO were
While the taxpayer has identified cost of goods
sold to be the only relevant expense in the
trading segment, that is not the case with the
comparables.
In the case of the comparables, the taxpayer had
included all expenses to arrive at the net margin.
The average OP/TC of the comparables had been
arrived 6.66% while the margin of the taxpayer
in the trading segment is calculated to 10.37%

Profit & Loss

Account
Operating
Income
Other income
Export
incentives
Total income
Excise duty
Cost
of
materials
consumed
Cost of traded
goods sold
Personnel
expenses
Manufacturing
&
other
expenses
Depreciation

Manufacturing

Trading

419,889,270

79,872,909

Other domestic Total

as
per
transactions
P&L Account
90,138,117
589,900,296

362,830

21,390,209
-

21,390,209
362,830

420,252,100
18,182,450
268,819,925

79,872,909
-

111,528,326
-

611,653,335
18,182,450
268,819,925

72,370,149

82,316,372

154,686,521

3,245,505

21,226,307

31,543,103

11,522,597

72,370,149

82,316,372

505,980,903

7,502,760

29,211,954

105,672,432

21,226,307
31,543,103

11,522597

Less:
218,197
adjustment on
account
of
depreciation
Total operating 351,076,185
expenses
Operating
69,175,915
profit

Comparability adjustment..Case study..

As per Rule 10 B(3)
An uncontrolled transaction shall be comparable
to an international transaction if
(i) none of the differences, if any, between the
transactions being compared, or between the
enterprises entering into such transactions are
likely to materially affect the price or cost
charged or paid in, or the profit arising from,
such transactions in the open market; or
(ii)reasonably accurate adjustments can be
made to eliminate the material effects of such
differences.

Comparability adjustment..Case study..

Findings of the TPO
If the comparables that have been chosen by
the taxpayer must be used, their margins
must be adjusted as per the scheme of Rule
10B(3)
The expenses that have been excluded while
calculating the tested party margin must also
be excluded while calculating the margin of
the comparables.
Accordingly, the relevant expenses in the
case of the comparables will be limited to
cost of goods sold

Particulars

X Limited

Y Private Limited

Sales
Industrial sales

INR in Crores
0.08

Income from non-financial 103.12

services
Operating Income
103.2

10.14

Cost of Goods Sold (COGS)

61.2

9.11

Total operating expenses

61.2

9.11

Operating profit

42

1.03

OP/TC

68.62

11.30

10.14

Comparability adjustment..Case
study..
The TPO calculated arms length price of the
international transaction related to sale of
traded goods based on the following principles
The method remains TNMM
The comparables have been adjusted as per
Rule 10B(3)
The average margin of the comparables was
calculated to be 39.96% as against 10.37% of
the taxpayer.
This resulted in an adjustment of Rs.2.14 Crores.

Issues raised in TP audits so far

1. Selection of appropriate comparables
2. Comparability adjustments
3. Valuation of intangibles and their
4.
5.
6.
7.
8.
9.

ownership
Accounting issues
Change of tested party
Change of PLI / Change of Method
Cost allocation/ Contribution
Reimbursement of expenditure
Use of diagnostic ratios

Thank You !!!!