Transfer Pricing Methods:
Calculating Arm's Lenth Principle
A deal between two interrelated or enterprise associates parties. That is behavior as if they were not related, so that there is no query of a disagreement of attention. In simple way we can describe this as “a deal between two unconnected or associate parties”.
OECD introduce the transfer pricing guidelines for multinational enterprises and tax administrations in 1995. OECD guidelines are appreciated globally. In the transfer pricing system, the transfer pricing has to be resolute on the basis of the arm’s length principle so price determined is the Arm’s Length Price (ALP). According to the ALP there are two type of transfer pricing method
- Traditional Transaction Method
- Transactional profit method or Non Transactional Method
Traditional transaction method:
These methods highlight each transaction particularly relatively in view of the overall profit shape of connected entities at the ALP. OECD Guidelines submit to the next methods as transactional method
- Comparable Uncontrolled Price method (CUP)
- Resale Price Method (RPM)
- Cost Plus Method (CP method or C+)
Comparable Uncontrolled Prices method (CUP):
In this method, price charged in an uncontrolled deal between comparable entities is recognized and evaluate with the verified entity price to determine the Arm’s Length Principle.
The CUP method offer the finest evidence of ALP. A arm’s length price may arise where:
- Tax payer or another member of the associate group sells the product, in comparable sizes and in the comparable terms to ALP in similar promote markets (internal comparable).
- An ALP party sells the similar product, in similar size of quantity and in the comparable conditions to other arm’s length party in similar markets (an external comparable).
- The taxpayer of the entities buys the similar quantities, in comparable quantities and in the similar terms from the associate parties in the comparable markets (internal comparable).
- An ALP party buys the particular goods, in comparable quantities and in the similar terms from the other arm’s length associate party in similar markets (external comparable).
Cost Plus Method (CPM):
In this method, the total price of intangible incurred by the tested parties in transferring products and services to Associated Enterprises is measured and the sum of gross profit spot used by similar enterprises in comparable transactions with self-determining associated enterprises is determined. The sum of gross spot arrived at is used to take into account functional and other variation to determine ALP. The extra similarities in the functions, risks and property, the extra likely it is that the cost plus method will create an suitable estimation of an arm's length result.
In common, for reason of apply a cost-based method, costs are divided into three categories:
- Direct costs:- raw materials;
- Indirect costs:- repair and maintenance which may be allot among several goods.
- Operating expenses:- selling, general, and organizational expenses.
The cost plus method uses limits calculated after direct and indirect costs of goods. Correctly shaping cost under the cost plus method is important. Cost is typically calculated in agreement with accounting values that are usually accepted for that exacting industry in the region where the products are produced.
The cost base of the deal of the associated parties to which a mark-up is to be applied be calculated in the same way and returns comparable functions, risks, and properties as the cost base of the similar transactions. Where cost is not exactly resolute in the same way, both the mark-up and the transfer will be used.
Resale Price Method (RPM):
RPM method is related to CPM. This method is used where the vendor adds similarly little value to goods owned from associate enterprises. Here, Arm’s Length Price is determined by reducing the relevant gross profit mark-up from the sale price charged to free entity.
The resale price method starts with the resale price to arm's length entities (of a goods buy from an non-arm's length entities ), minimized by a similar gross margin. This similar gross margin is resolute by reference to either:
- The resale price margin earned by a associate of the group in similar uncontrolled transactions (internal comparable); or
- The resale price margin earned by an arm's length enterprise in similar uncontrolled transactions (external comparable).
Beneath this method, the arm's length price of products obtain by a taxpayer in a non-arm's length deal is resolute by reducing the price understand on the resale of the products by the taxpayer to an arm's length entities, by an suitable gross margin. This gross margin, the resale margin, should allow the vendor to:
- Recover its operating costs; and
- Earn an arm's length profit support on the factors achieve, properties used, and the risks understood.
Transactional Profit Methods:
: In transactional profit methods, related parties profit statistics are measured and adjusted relevantly to their share. These are:
Profit Split Method (PSM):
This method is used when associate enterprise transactions are included that it becomes very hard to conduct a transfer pricing analysis on a transactional base. The priority function to do is combined net profit acquiring to connected entities from a transaction is decide. After that combined net profit is allotted in between connected entities with mention to market income gained by free enterprises in comparable transactions.
In this Profit Split Method (PSM):
- First move is to decide the sum of profit gained by the associate parties from a controlled transaction. The Profit Split Method (PSM) allots the total incorporated profits connected to a controlled transaction, not the total profits of the associate group as a complete. The profit to be split is usually the operating profit, before the reduce of interest and taxes. In some satiations, it may be suitable to split the gross profit.
- Second move is to split the profit among the associate parties base on the comparative price of their assistance to the non-arm's length dealings, allowing for the functions assumed, the properties used, and the risks understood by each non-arm's length associate parties, in connection to what arm's length parties would have taken.
Profit Split Method (PSM) applied where:
- The functioning of two or more non-arm's length associate parties are extremely included, making it hard to assess their dealings on an entity basis; and
- 4. The continuation of valuable and sole intangibles makes it hard to set up the proper stage of comparability with uncontrolled dealings to relate a one-sided method.
Due to the difficulty of international operations, one group of the global group is rarely allowed to the total return attributable to the important properties, such as intangibles.
Transactional Net Margin Method (TNMM):
Generally accepted in cases of transfer of semi-completed products, distribution of completed goods and transactions linking the condition of services.
In this method:
- Relatively the net profit margin of a entities take position from a non-arm's length deal with the net profit margins understand by arm's length associate parties from comparable transactions; and
- Observe the net profit margin relation to suitable base such as price, sales or properties.
This vary from the cost plus and resale price methods that balance gross profit margins. though, the TNMM need a stage of similarity to that necessary for the request of the cost plus and resale price methods. Where the applicable information exists at the gross margin stage, associate enterprises should apply the cost plus or resale price method.
Most Appropriate Methods:
Cost plus method (CPM): this method is generally used where semi finished products are transferred.
Comparable Uncontrolled Prices Method (CUP): ): this not favorable as no public database is accessible concerning prices apply by autonomous enterprises in import of comparable products.
Resale Price Method (RPM):): In this method the vendor adds comparatively small or no value to goods taken from associate enterprises. In the current case in this method may be taken as the very important method as similar data of comparable deals by independent entities is available.
Profit Split Method (PSM): PSM method is used when associate enterprises are so combined that it turns into difficult to make transfer pricing analysis on transactional methods basis.
Transactional Net Margin Method (TNMM): In this method generally apply in the case of transfer of partially completed products, distribution of completed goods and where RPM cannot be sufficiently applied. In general RPM more suitably applied in this case, TNMM is also not right.