Arm’s Length Price – Meaning and Determination

Arm’s Length Price- Meaning and Determination

In commercial parlance, an arm’s length price is the price at which independent enterprises deal with each other, where the conditions of their commercial and financial relations ordinarily are determined by market forces. Section 92F(ii) of the Act, however, defines the arm’s length price as a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.
The steps involved in the determination of the arm’s length price can be summarised as follows:

(i) identification of the “international transaction” or specified domestic transaction;
(ii) identification of an “uncontrolled transaction” – Rule 10A (a);
(iii) identification and comparison of specific characteristics embodied in international transactions or specified domestic transactions and uncontrolled transactions – Rule 10B (2);
(iv) finding out whether uncontrolled transactions and international transactions or specified domestic transactions can be compared by reconciling/resolving differences, if any – Rule 10B (3);
(v) ascertaining the most appropriate method by applying the tests laid down – Rule 10C;
(vi) determination of the arm’s length price by applying the method chosen – Rule 10B (1).

Section 92C(1) stipulates that the arm’s length price is to be determined by adopting any one of the following methods, being the most appropriate method:
• Comparable Uncontrolled Price method (CUP method)
• Resale Price Method (RPM)
• Cost Plus Method (CPM)
• Profit Split Method (PSM)
• Transactional Net Margin Method (TNMM)
• Other Method (OM) as prescribed by the Board and provided in Rule10AB

Comparable uncontrolled transactions

Rule 10B (2), lays down the criteria for comparability between international transactions and uncontrolled transactions. This process is not quantitative but qualitative and involves exercise of judgment. The criteria listed in Rule 10B(2) are:
• distinctive nature of the property transferred or services provided;
• functions performed taking into account the assets employed or to be employed;
• risks assumed by the respective parties;
• contractual terms of the transaction;
• market conditions.

Rule 10A (a) defines an “uncontrolled transaction” to mean “a transaction between enterprises other than associated enterprises, whether resident or non-resident”. When an uncontrolled transaction has been entered into, it could be said that it has been contracted under “uncontrolled conditions”.
An uncontrolled transaction can be between:
• a resident and a non-resident; or
• a resident and a resident; or
• a non-resident and a non-resident.

FAR Analysis

Analysis of functions performed
Under this process, first a functional analysis of the transaction is carried out to identify the roles performed by each party thereto. Only the material or important functions are considered, while insignificant or irrelevant functions are ignored. What is important to consider is not the number of functions performed but their criticality.

Analysis of assets employed
Transactions that are proposed to be compared should be analysed for the assets employed.

Analysis of risks assumed
Transactions that are proposed to be compared should be analysed for the risk-content.

Comparable Uncontrolled Price Method (CUP Method)

Rule 10B(1)(a) – Comparable uncontrolled price method, by which,-

(i) the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions, is identified;
(ii) such price is adjusted to account for 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 price in the open market;
(iii) the adjusted price arrived at under sub-clause (ii) is taken to be an arm’s length price in respect of the property transferred or services provided in the international transaction.

Typical transactions in respect of which the comparable uncontrolled price method may be adopted are:

(a) Transfer of goods;
(b) Provision of services;
(c) Intangibles;
(d) Interest on loans.

Resale Price Method (RPM)

Rule 10B(1)(b) resale price method, by which,-

(i) The price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or are provided to an unrelated enterprise, is identified;
(ii) such resale price is reduced by the amount of a 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 property or obtaining of 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 under sub-clause (iv) is taken to be an arm’s length price in respect of the purchase of the property or obtaining of the services by the enterprise from the associated enterprise.

Typical transactions where the resale price method may be adopted are distribution of goods involving little or no value addition.

 Cost Plus Method (CPM)

Rule 10B(1)(c) cost plus method, by which,-

(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 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.
Typical transactions where the cost plus method may be adopted are:
(a) provision of services;
(b) joint facility arrangements;
(c) transfer of semi finished goods;
(d) long term buying and selling arrangements.

Profit Split Method (PSM)

Rule 10B(1)(d) profit split method, which may be applicable mainly in international transactions involving transfer of unique intangibles or in multiple international transactions which are so interrelated that they cannot be evaluated separately for the purpose of determining the arm’s length price of any one transaction, by which-

(i) the combined net profit of the associated enterprises arising from the international transaction in which they are engaged, is 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 function 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 amongst the enterprises in proportion to their relative contributions, as evaluated under sub-clause (II);
(iv) the profit thus apportioned to the assessee is taken into account to arrive at an arm’s length price in relation to the international transaction:

Provided that the combined net profit referred to in sub-clause (i) may, in the first instance, be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of international transaction in which it is engaged, 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 in the manner specified under sub-clauses (ii) and (iii), and in such a case the aggregate of the net profit allocated to the enterprise in the first instance together with the residual net profit apportioned to that enterprise on the basis of its relative contribution shall be taken to be the net profit arising to that enterprise from the international transaction.

Typical transactions where the profit-split method may be used are transactions involving:
(a) integrated services provided by more than one enterprise for e.g., in case of financial service sector, where the activities performed by Indian company and foreign AEs in relation of a merger and acquisition transaction are so interrelated that it may not possible to segregate them;

(b) transfer of unique intangibles, for e.g. two associated enterprises contribute their respective intangibles to develop a new product or process and earn income from such product or process.

Transactional Net Margin Method (TNMM)

Rule 10B(1)(e) transactional net margin method, by which,-

(i) 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 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 base;
(iii) the net profit margin referred to in sub-section (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 to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (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.

Typical transactions where the transactional net margin method may be adopted are:
(a) provision of services;
(b) distribution of finished products where resale price method cannot be applied;
(c) transfer of semi finished goods where cost plus method cannot be applied;
(d) transactions involving intangibles where profit split method cannot be applied.

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