This article has been written by Rohan Patel, from Symbiosis Law School, NOIDA.
The guest speaker
Ashutosh Mohan Rastogi, Founding Partner at Amicus (Law Firm) and Tax Counsel/ Advisor with more than 15 years of experience in Transfer Pricing and International Taxation, holding a LL.B. degree from Delhi University and a LL.M. degree from New York University School of Law in Tax & Corporate Law.
Abhyuday Agarwal is an alumnus of the National University of Judicial Sciences, Kolkata. Presently, the COO and co-founder of LawSikho and the co-founder of iPleaders. His previous work experience includes being a part of Trilegal, Mumbai.
Transfer pricing methods
- Transaction Based Method: They focus on specific related party transactions and they try to measure the outcome associated with that specific transaction.
a). Comparable Uncontrolled Pricing (CUP) Method: The focus is on the price for that transaction.
b). Resale Price Method (RPM): The focus is on the gross profit resale transaction.
c). Cost Price Method(CPM): The focus is on the gross profit from the manufacturing or the services transaction.
- Profit Based Method: We start testing profitability at the company level. It applies where there is a joint development of intangibles.
a). Profit Split Method (PSM): It is applied where we need to determine how to split the super nulling profits. It is very rarely used and it involves a very high subjectivity and therefore it is also known as the method of last resort.
Evolution of transfer pricing methods
Introduced in 2001, and further Finance Act and in 2012 another method was introduced. Initially, there was a narrow band which was plus minus 5% and later it was reduced to plus minus 3%.
In 2014, Range concept and multiple year data were introduced and in 2017, OFCD came-up with guidelines on comparability and it revised its transfer pricing guidelines.
Economic underlying the transfer pricing methods
The common sense in the application of this Transfer Pricing Method and the basic concept of profit and pricing is based on the roots of the definition and the economics of the transfer pricing methods. The objective of transfer pricing methods is that the price is below the arm’s length price or above the arm’s length price and we directly gauge the transfer price. The purpose of transfer pricing is not just about profits, which is a common mindset among the people but transfer price is about ensuring the right transfer price and the net profit & gross profit are the indirect consequence of the transfer price. In this transaction, the CUP method is the most direct method.
Analysis of different methods
Comparable Uncontrolled Method (CUP)
This is one of various kinds of methods which are used in calculating the transfer pricing. This method is generally used where the nature of the product dealt by the enterprise is the same and also there should be similarity in the credit terms, risk and geographical markets.
The CUP method can be of two kinds:
a). Internal: In the internal method of CUP the buyer entity is the subsidiary of the selling entity and the selling also sells the product some other external entity in the same geographical market as of its subsidiary entity.
b). External: When two unrelated entities do business of sale and purchase it is known as external CUP.
In the external CUP method sometimes the parameters are not satisfied but in the internal CUP method, the chances of success are very high. Even the court had held that internal CUP method to be preferred over external CUP.
In the common practice, CUP is the best method but you need to ensure from the agreement available for the transaction that the nature of service, contractual terms, geographical market, and time period, all these factors have been seen. The impact of all these factors may vary from case to case.
For example: in some cases, the time period may be one month to three month or four months where the price is not significant as the price may be relevant for the entire year and if it can be proved you can take the data as valid CUP data.
In the success of CUP method the court has really played a very important role as the court have really played a very important role as the court have been very pragmatic in approach while analyzing CUP data and they are not outrightly rejecting CUP data for vague reasons.
Resale Price Method
In this method, the evaluation is done by testing the gross profit margin of the reseller. In this method, we search for unrelated supplies and COGS and we see that it ranges from the permissible unit as per Indian transfer pricing regulation i.e. 7.5% to 8.24%.
Transactional Net Margin Method (TNMM)
In TNMM the concept of net margin is being used and the concept of operating profit is slightly different from the concept of operating profit in the case of profit before tax concept in financial statements.
The income & expense activity of an organisation can be differentiated into two segments and the one is routine activity and the other one is non-routine activity. The routine activity comprises the activities like depreciation, purchase of raw material, rent, etc. and the non-routine activities are like sales of business units, sales of fixed assets, etc. From this the operating income can be obtained and it can be used to further calculate the operating profit.
Another aspect to be focused on while calculating the operating income is that you should bifurcate the firm’s activity into core-activity and non-core activity. Once the operating profit is obtained then you can move forward with the Transactional Net Margin Method.
In TNMM, the two major questions to be considered is what is the profit measure to be considered and what is the base to be considered.
Case Ex: A co. Is a reseller in India and it is a value added reseller. Exporter P sells to A co. And A co. Further sells it to customers. Now the major question here is what method should be applied here? In this scenario, A is doing more function just then reselling therefore here in this case it is very important to calculate the net-profit because net profit will need to knock-off the extra charges which A co. is incurring for value creation to obtain the transfer pricing.
In such a scenario TNMM is more relevant and not RPM.
a). Sony India Pvt. Ltd.: In this case, the tribunal held that reimbursement of advertisement expenses be included for the purpose of determining operating margin and the notice pay and penalty received from staff members would not constitute operating profit.
b). Asahi Glass Ltd.: In this case, the tribunal held that the extraordinary items cost pertaining to loss due to floods be included for the purpose of determining operating margin and also additional compensation which has been taken as an item of operating revenue, then the costs incurred in bearing such risks have to be considered as operating cost.
c). Saggezza India (P) Ltd.: In this case, the tribunal held that the employee cost and consultancy charges were non-operating costs, it being not related to the project executed and billed in the assessment year under consideration.
d). St. Jude Medical India (P) Ltd.: In this case, the tribunal held that where the assessee had received an income in a suit relating to patent infringement, would fall under the category of “other income” and not operating revenue for the purpose of transfer pricing study.
e). TNT India (P) Ltd.: In this case, the tribunal held that for arriving at net margin of operating income, only operating income and operating expenses for relevant business activity of assessee are to be taken in consideration.
f). Marubeni India (P) Ltd.: In this case, the tribunal held that interest income cannot be included as operating profit for transfer pricing analysis using TNMM.
Transactional Net Margin Method (TNMM) Application Process
The process of using TNMM starts with the collection of data. The data needed for TNMM is available on public domain. When TNMM is applied on operating cost, one thing which is to be considered is that in transfer pricing parallence people get confused between Cost Plus Method & TNMM method. When the operating profit is calculated as a function of total cost than the correct technical term in transfer pricing is TNMM. In TNMM the total cost is considered as base rather than sales.
Challenges in Transactional Net Margin Method
It doesn’t have as accuracy as the CUP method because in TNMM the calculation is not just of the goods sold but also of the overheads. It also exposed the company wide profitability to transfer pricing adjustment. As the overheads are completely market determined, the net margins are affected by the factors that have nothing to do with price setting.
The one more method which is allowed under the Indian Transfer Pricing Regulations is “other methods”. It is generally used when discounted cash flow approaches for valuing intangibles or while you are doing allocation of common cost or sometimes even for the issue of shares or reimbursement. When the available five methods cannot be used then you can use any logical method under the head of “other method.”
From CUP method to Profit Split Method and further the other methods, the one major change which we can analyze is the accuracy. Accuracy diminishes from CUO method to other method because the role of third party factors come into play.
Commonly used methods for intercompany transactions
a). Royalty: For Royalty, the most common method used is CUP method.
b). Management fees: For this, the commonly used method is CUP method and when you have to do the allocation of the common cost for management fees then another method is to be used.
c). Interest on Loan: For the transaction of Interest on loan the method which is considered the most sensible is CUP method.
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