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Transfer Pricing - Arm's Length Price Issues and Methods

Over the last two decades, the Government of India has significantly liberalized the economic policies which transformed India into the most favored nation for global investment.

Over the last two decades, the government of India has significantly liberalized the economic policies which transformed India into the most favored nation for global investment. The increasing economic activities between nations give rise to a new and complex issue of transfer pricing restricting inter-group companies from shifting the profit from high tax rate nations to low tax rate nations. The aim of Indian transfer pricing is the international transaction/specified domestic transactions between associated enterprises at Arm’s Length Price. The concept of Arm’s Length Price is to ensure that associated parties in the deal are acting independently without any pressure or duress from the other party.
With the advent of COVID-19 and subsequent lockdown, Indian subsidiaries of foreign companies may face lower profit margins which will have impact on arm length price of transaction between such associated enterprise. However, tax authorities might not accept such lower cost margin while computing Arm’s length price.
It therefore becomes pertinent for the associated enterprises to evaluate the best suited method of computing Arm’s Length Price on international transaction/ specified domestic transactions. In this article, emphasis is laid on the different methods of computing Arm’s length price in India and course of action for associated enterprise considering the effect of pandemic situation on their business.
As per Income Tax Act, 1961, Arm’s Length Price (ALP) is the price applied/ proposed to be applied when two unrelated persons enter into a transaction in uncontrolled conditions.


The methods mentioned below have been prescribed for the determination of ALP.

Comparable uncontrolled price (CUP) method

CUP is applied when price is charged for a product or service.
  1. Determine the price price chargeable for the property transferred or service that is provided in a ‘comparable uncontrolled transaction’.
  2. Such price is then adjusted to account for the practical difference between the international transaction and the comparable uncontrolled transaction that could materially affect the price in the open market.
  3. The adjusted price so arrived is the ALP.

Resale Price Method (RPM)

RPM is applicable when property is purchased or services are obtained from associated enterprises and the same are sold to unrelated enterprises.
  1. Decide the price at which the property purchased or service attained by the enterprise from an associated enterprise is re-sold or supplied to an unrelated enterprise.
  2. Such a resale price is reduced by normal gross profit margin accruing to the enterprise to the enterprise from the purchase and resale of similar goods in a comparable uncontrolled transaction (In case, there is no comparable uncontrolled transaction - consider the gross profit of an unrelated person from the purchase and resale of comparable goods)
  3. Decrease the expenses incurred by the enterprise in connection with the purchase of the property. 
  4. The price so obtained is adjusted to account for the functional difference in the international transaction which may perhaps materially affect the gross profit margin in the open market. 
  5. The adjusted price so arrived is the ALP.

Cost-plus Method (CPM)

This method is applicable where semi-finished goods are sold between related parties or similar situations or in respect of joint facility agreements, long term buy and supply arrangements of provision of service.
  1. Decide the direct and indirect costs of production with reference to property or service transferred to the associated enterprise.
  2. Determine normal gross profit from uncontrolled transactions. 
  3. Adjust normal gross profit for the functional and other differences observed in the international transaction. 
  4. Costs plus adjusted gross profit mark-up will be ALP.

Profit Split Method (PSM)

This method is applicable mainly in international transactions involving transfer of unique intangibles or in multiple international transactions which are so interrelated that they cannot evaluate separately.
  1. Decide the combined net profit of the related enterprise’s from the international transaction.
  2. Assess the contribution made by each party taking into consideration the functions, responsibility, assets utilized and external market data. 
  3. Divide the combined net profit in the ratio of the contribution as above determined. 
  4. Take the profit to arrive at ALP.

Transaction Net Margin Method (TNMM)

The TNMM requires establishing comparability level at a broad functional level. It requires comparison between net margin derived from operation of the uncontrolled parties and net margin derived by an associated enterprise on similar operation.
  1. Decide the net profit margin from the international transaction with an associated enterprise. 
  2. Net Profit Margin from the comparable uncontrolled transaction is computed. 
  3. Adjust the net profit of uncontrolled transactions for the difference between the transactions.
  4. Take the net profit margin so obtained to arrive at ALP.


Factually, the burden of proof w.r.t. arm’s length nature of transaction lies with the taxpayer. Therefore, each and every aspect of the transaction required detailed evaluation to apply the appropriate method in arriving at ALP. There is no particular method which is accorded as of greater or lesser precedence as also observed by Mumbai Appellate TRIBUNAL in the case of  Serdia Pharmaceuticals (India) (P.) Ltd. V. CIT (2011).
As mentioned, lower profit margins due to COVID will have an impact on arm length price of transaction between the associated enterprise. In this respect, below is gist of few germane judgments on transfer pricing on the subject of ALP.
It is constantly suggested that the companies should evaluate every aspect of the transaction in selecting the appropriate method for Arm’s length price and seek expertise assistance wherever required.

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