Article 34 – Case Scenarios
- Comparable uncontrolled Price Method.
Illustration 1: The controlled transaction in this figure involves the transfer of computers between Associated Enterprise 1, a computer manufacturer in Country 1, and Associated Enterprise 2, a
computer importer in Country 2, which purchases, imports and resells the computers to unrelated computer dealers in Country 2. Associated Enterprise 1 is the parent company of Associated Enterprise 2.
In applying the CUP Method to determine whether the price charged for Computers transferred in this controlled transaction is at arm’s length, the following information is assumed to be available for consideration: ¾ The price charged for Computers transferred in a comparable uncontrolled transaction between Associated Enterprise 1 and Unrelated Party C (i.e. transaction #1); ¾ The price charged for Computers transferred in a comparable uncontrolled transaction between Associated Enterprise 2 and Unrelated Party A (i.e. transaction #2); and ¾ The price paid for Computers transferred in a comparable uncontrolled transaction between Unrelated Party A and Unrelated Party B (i.e. transaction #3).
Comparable uncontrolled transactions, such as transaction #1 or #2, which involve a transaction between the tested party and an uncontrolled party, are referred to as internal comparables. Comparable uncontrolled transactions such as transaction #3, which involves a transaction between two parties neither of which is an associated enterprise, are called external comparables. The application of the CUP Method involves a detailed transactional comparison whereby the controlled and uncontrolled transactions are compared.
Illustration 2
Ghai Ltd. is the Indian parent company holding group of various multinational companies
having diversified business portfolio. Its group companies are spread across Country A. One of its subsidiaries Cad Ltd. (Country A) is engaged in the business of manufacturing and trading of compute$ Ghai Ltd purchased a computer from Cad Ltd for $ 15,000 which included warranty for 3 months. The identical computer was purchased by Ghai Ltd by paying $ 14,000 from unrelated party with 1 year of warranty. Fair value of warranty is $ 700 for one year. However, Cad Ltd provided
credit of 4 months to Ghai Ltd. Arm’s length interest rate is 9% p.a. Net profit before tax of
Ghai Ltd. is ` 25,00,000. Assume 1 $ = ` 70.
=Ghai Ltd, the Indian company and Cad Ltd., Country A are associated enterprises, since Cad Ltd. is the subsidiary of Ghai Ltd.
As Ghai Ltd. purchased similar product from an unrelated entity at $14,000, the
transactions between Ghai Ltd. and such unrelated party can be considered as
comparable uncontrolled transactions for the purpose of determining the arm’s length
price of the transactions between Ghai Ltd. and Cad Ltd. Comparable Uncontrolled Price (CUP) method of determination of arm’s length price (ALP) would be applicable in this case.
However, such figure needs to be adjusted by the functional adjustments:
| Particulars | Nos. | Price ($) |
| Purchase of computer from unrelated party | 14000 | |
| Less: Difference in warranty ($700*9/12) Cad Ltd offered warranty only for 3 months while unrelated party offeredwarranty for 1 year. Therefore, 9 months’ cost of warranty has to be adjusted | 525 | |
| Add: Adjustment for credit extended ($14000*9%*4/12) Cad Ltd has provided credit for 4 months whereas unrelated party has not provided such credit. Therefore, adjustment for the cost of such credit has to be carried out to arrive at arm’s length price. | 420 | |
| Arm’s length price | 13895 | |
| Purchase of computer from related party | 15000 | |
| Transfer pricing adjustment | 1105 | |
Illustration 3:
A Ltd. purchases 10,000 MT metal from B Ltd. its subsidiary @INR 30,000 /MT. Also purchase from C Ltd. 2,500 MT @ INR 40,000/MT. A Ltd. received a discount of INR 500 /MT as a quantity discount from B Ltd. The transaction with B Ltd. is at FOB (Free on board) whereas with C Ltd. is at CIF (Cost, Insurance, and Freight). The cost of freight and Insurance is INR 1,000. Compute Arm Length Price.
Solution: Computation of Arm Length Price:
(Amount in Rs)
| Price Charged by C Ltd. | 40,000 |
| Less: Quantity Discount | 500 |
| Less: Cost of freight and Insurance | 1,000 |
| Arm Length Price | 38,000 |
Illustration 4: AE1 sold 1,000 bicycles to AE 2, at FOB price (Free on Board) of Rs 3,000 per bicycle.
AE 1 sold 10,000 bicycles to Non-AE at CIF price (Cost, Insurance and Freight) of Rs 6,000 per bicycle.
AE2 would bear the cost of insurance and freight of Rs 500 per bicycle.
Sales were made to Non-AE at credit facility of three months whereas the sales to AE 2 have always been on cash basis.
The cost of credit may be taken as 1% per month. Compute Arm Length Price.
Solution: Computation of Arm Length Price:
(Amount in Rs)
| Price Charged from Non AE | 6,000 |
| Less: Cost of freight and Insurance | 500 |
| Less: Three months credit to Non-AE ($ 6,000 * 3%) | 180 |
| Arm Length Price | 5,320 |
Illustration 5: Purchase from X Ltd. is for 10,000 MT at a price of $20,000 per MT.
Purchase from P Ltd. is for 2,500 MT at a price of $35,000 per MT
Quantity discount of $750 per MT is offered by X Ltd
Alloy mix (per MT) for purchase from X Ltd. is: 0.5 kg Gold and 1 kg Silver. The alloy mix (per MT) for purchase from P Ltd. is: 1 kg Gold and 1 kg Silver. Cost of the Gold is $2,000 per kg.
Calculate Arm Length Price.
Solution: Computation of Arm Length Price:
(Amount in Rs)
| Price Charged by P Ltd. | 35,000 |
| Less: Quantity Discount | 750 |
| Less Alloy Mix – Gold content (0.5kg*2000) | 1,000 |
| Arm Length Price | 33,250 |
Illustration-6:
ABC Ltd., an Indian company engaged in manufacturing business supplies the manufactured product to XYZ Ltd., an US based company (Holding company of ABC Ltd.) @300 USD per unit. Insurance and Freight amounts to $2000 per unit bear by ABC Ltd. on supply to XYZ Ltd. It also supplies the same to EFG Ltd, an unrelated entity @28,000$ per unit. On these facts, how is the assessment of ABC Ltd. is going to be affected? (Assume 1 USD= $75)
Solution: ABC Ltd., the Indian entity is an Associate enterprises of XYZ Ltd., the US based entity since ABS Ltd. is a Subsidiary of XYZ Ltd. ABC Ltd. supplies the goods to XYZ Ltd. for resale in US. The price charged from XYZ Ltd., for a similar product transferred in comparable Uncontrolled transaction is Identifiable.
Therefore, Comparable Uncontrolled Price (CUP) Method for determining arm length price can be applied.
Statement showing computation of Arm’s Length Price (per unit)
| Particulars | Amount(USD) | Amount($) |
| Sale price charged by ABC Ltd. to EFG Ltd. | – | 28,000.00 |
| Add: Cost of Freight and Insurance not charged to EFG Ltd. | 2,000.00 | |
| Arm’s Length Price | 30,000.00 | |
| Less: Price charged to XYZ Ltd | 300.00 | 22,500.00 |
| Difference per Unit | 7,500.00 |
ABC Ltd. charged $ 7,500 per unit in short, which is required to be added in the Total Taxable Income of ABC Ltd.
Illustration-7:
U Ltd., an UK based entity supplies 1,00 bicycles to I Ltd., an Indian subsidiary of U Ltd. at $7,50,000. It also sales 2,50 bicycles to O Ltd., an outsider entity at $16,50,000 gets a discount of 2% for purchasing in bulk quantity. U Ltd. is also required to modify its bicycle before supplying it to I Ltd. which amounts to $250 per unit. On these facts, how is the assessment of I Ltd. is going to be affected.
Solution:
I Ltd. purchases bicycles from U Ltd., an associates entity after some modifications which excess cost to $5,000 per unit to I ltd. The price charged by U Ltd., for a similar product transferred in Comparable Uncontrolled environment is identifiable.
The price charged from O ltd. subject to some special discount provided because of bulk purchase needs to be consider while calculating Arm’s length price.
Statement showing calculation of Arm’s Length Price
| Particulars | Amount | Amount(per unit) |
| Sale price charged by U ltd. to O Ltd. | 1,650,000.00 | 6,600.00 |
| Add: Additional modification charges not paid by O Ltd. | 250.00 | |
| Add: Quantity discount provided for bulk purchase @2% | 132.00 | |
| Arm’s Length Price | 6,982.00 | |
| Less: Price charged to I Ltd. | 750,000.00 | 7,500.00 |
| Difference per Unit | (518.00) |
Therefore, Addition required to be made in the computation of Total income is $51,800 ($518 per unit for 100 units)
Illustration 8:
Indian company M(Ltd) holds 30% of Equity shares in Foreign Co (S Ltd). Indian Company sold 12000 Units @3000 per Unit whereas it sold 1500Units @5000 per unit to P(LTD) Outsider
Additional Information
- Sale to S Ltd on FOB & Sale to P Ltd on CIF & Cost of Insurance & freight is 300 per unit.
- Since order from S Ltd is more in qty so M Ltd provide discount of 150 per unit.
- M Ltd provide warranty to S Ltd & not provide to P Ltd Cost of Same is 100 per unit.
Calculate Arm Length Price?
Ans Price charged in Uncontrolled transaction 5000 Rs
Less Insurance & Freight (300)Rs
Less Discount (150)Rs
Add warranty 100 Rs
Arm Length Price 4650
Illustration 9:
Sony, Japan and Y Ltd., Indian Co. are AEs. Y manufactures mobile phones and sells to Sony, Japan. • Y also sells to L.G. Korea • Details of price • FOB Sales to Sony 1,20,000 phones = $2,000 per phone • CIF Sales to LG 20,000 = $3,200 per phone • Other Details • Sony pays freight and insurance = $300 per phone • LG = 1 year Warranty. • No warranty to Sony (Such warranty costs = $350 per phone) • Quantity Discount to Sony $50 per phone
Sol Sales to LG = Uncontrolled Unrelated Transaction
Comparable Uncontrolled Price = $3,200
Less: Adjustments
Freight and Insurance 300 • Warranty Costs 350 • Quantity Discount 50
ALP of sales to Sony $2,500
- Difference $ 500
Quantity sold to Sony 1,20,000 x 500 = $60,00,000 Increase in Sales • The income of Y should be increased by $60,00,000 in the assessment.
Illustration 10:
A Ltd. (India) Refining and sale of copper metal Purchase of crude metals from X Ltd. (US) (AE) & from P Ltd.(Australia) (Non AE)
Purchase from X Ltd. is for 10,000 MT at a price of $30,000 per MT. • Purchase from P Ltd. is for 2,500 MT at a price of $40,000 per MT. • Quantity discount of $500 per MT is offered by X Ltd. • Credit period allowed by X Ltd. is one month. Cost of the credit is 1.25% p.m. • Transaction with X Ltd. is at FOB whereas with P Ltd. is CIF. Freight & Insurance cost is $1,000. • Alloy mix (per MT) for purchase from X Ltd. is: 0.5 kg Gold and 1 kg Silver. The alloy mix (per MT) for purchase from P Ltd. is : 1 kg Gold and 1 kg Silver. Cost of the Gold is $2,000 per kg.
Sol Computation of ALP:
| Particulars | Price per MT (Comparable uncontrolled transaction (with P co.) |
| Price (Per MT) | 40,000 |
| Adjustments: Less: Quantity discount | (500) |
| Less: Alloy Mix – Gold content (0.5*2,000) | (1000) |
| Less: Freight & insurance cost | (1000) |
| Add: Interest for the differential credit period (40,000*1.25%) | 500 |
| Arm’s Length Price | 38000 |
Illustration 11
ABC Ltd. is a foreign subsidiary company of XYZ Ltd. XYZ Ltd. sells refrigerators to ABC Ltd. at a price of $ 10,000 each for sale to its dealers in Singapore. In other States, XYZ Ltd. is directly selling to their dealers at $ 12,000 with a warranty of one year ($ 500 for each fridge). ABC Ltd. does not offer such warranty. Quantity sold to ABC Ltd. is 8000 units and to dealers of XYZ Ltd. is 3000 units. Discuss the method to be applied to arrive at the arm’s length price and compute the ALP. How is the assessment of XYZ Ltd. going to be affected?
Sol ABC Ltd. and XYZ Ltd. are associated enterprise as ABC Ltd is subsidiary of XYZ Ltd. Comparable product (fridge) is sold to dealers (Uncontrolled transactions). Hence in given circumstances Comparable Uncontrolled Price (CUP) Method for determining arm’s length price can be applied
| Particulars | Amount |
| Sale price charged to Dealers of XYZ Ltd. | 12,000 |
| Less cost of warranty included in price | (500) |
| Arm’s length price | 11,500 |
| Actual price paid by ABC Ltd. to XYZ Ltd. | 10,000 |
| Difference per unit | 1500 |
| Addition required to be made in the computations of the total Income of XYZ Ltd. (1500 x 8000 units) 12,00,000 |
Addition required to be made in the computations of the total Income of XYZ Ltd. (1500 x 8000 units) 12,00,0000
Illustration 12: Internal CUP Method
ABC Ltd. is a Fashion House and it provides licensing rights to a third party to use the Brand Name and Logo for $ 10 Lakhs. Company also has a policy of providing a concession of 5% on account of 40% and above advance payment. Third party makes 50% advance payment. ABC Ltd. has provided licensing rights to its European Subsidiary for $ 6 Lakhs and its Subsidiary makes 30% advance payment. Calculate Arm Length Price.
Will your answer be any different if the Subsidiary makes 45% advance payment?
Solution:
Situation 1:
| Particulars | Amount |
| Sale Price for Third Party | 1000000 |
| Less: Concession of 5% | – |
| Arm Length Price | 1000000 |
| Sale Price for Subsidiary | 600000 |
| Difference (Income to be raised for ABC Ltd.) | 400000 |
(Note: Benefit of Concession will not be provided to Subsidiary as it is not meeting the criteria of 40% advance payment)
Situation 2: Yes, the answer would be different as in this case Benefit of Concession will be provided to Subsidiary as it is meeting the advance payment criteria.
| Particulars | Amount |
| Sale Price for Third Party | 1000000 |
| Less: Concession of 5% | 50000 |
| Arm Length Price | 950000 |
| Sale Price for Subsidiary | 600000 |
| Difference (Income to be raised for ABC Ltd.) | 350000 |
Illustration 13: Internal CUP Method
Pathan Fabrics exports goods (Silk Fabric with additional Embroidery) to third party for $ 1000/m (Inclusive of Embroidery Cost). Additional Embroidery costs $100/m. He exported a consignment of 10000 metres to third party. A similar consignment of same quantity but with no additional Embroidery was also exported to its relative concern in Canada for $ 80 lakhs. Calculate Arm Length Price.
Solution:
| Particulars | Amount |
| Sale Price for Third Party | 10000000 |
| Less: Embroidery Cost | 1000000 |
| Arm Length Price | 9000000 |
| Sale Price for Subsidiary | 8000000 |
| Difference (Income to be raised for Pathan Fabrics) | 1000000 |
Illustration 14: External CUP Method
XYZ Ltd. wants to sell a Product A to its foreign Subsidiary for $200/Set. The consignment comprises of 60 sets. Government is providing Subsidy on such goods amounting to $20 per Set Another similar Company EPF Ltd. sells each Set for $ 190 after considering Industry discount of 10% for bulk orders of 100 Sets or more. Compute Arm Length at which XYZ Ltd. should sell its product to its Subsidiary.
Solution:
| Particulars | Amount |
| Sale Price for Third Party for each set | 190 |
| Add: Discount | 10 |
| Less: Subsidy | 20 |
| Arm Length Price for each set | 180 |
| Sale Price for Subsidiary for each set | 180 |
| Number of Sets | 60 |
| Sale Value of Consignment | 10800 |
(Note: Benefit of 10% Discount will not be available to Foreign Subsidy as it is not meeting requirement of Bulk Orders)
Illustration 15:
ABC Ltd. is a foreign subsidiary company of XYZ Ltd. XYZ Ltd. sells refrigerators to ABC Ltd. at a price of $ 10,000 each for sale to its dealers in Singapore. In other States, XYZ Ltd. is directly selling to their dealers at $ 12,000 with a warranty of one year ($ 500 for each fridge). ABC Ltd. does not offer such warranty. Quantity sold to ABC Ltd. is 8000 units and to dealers of XYZ Ltd. is 3000 units. Discuss the method to be applied to arrive at the arm’s length price and compute the ALP. How is the assessment of XYZ Ltd. going to be affected?
Sol ABC Ltd. and XYZ Ltd. are associated enterprise as ABC Ltd is subsidiary of XYZ Ltd. Comparable product (fridge) is sold to dealers (Uncontrolled transactions). Hence in given circumstances Comparable Uncontrolled Price (CUP) Method for determining arm’s length price can be applied
| Particulars | Amount |
| Sale price charged to Dealers of XYZ Ltd. (a) | 12,000 |
| cost of warranty included in price (b) | 500 |
| Arm length price (C = a – b) | 11,500 |
| Actual price paid by ABC Ltd. to XYZ Ltd. (D) | 10,000 |
| Difference per unit (C-D) | 1,500 |
Addition required to be made in the computations of the total Income of XYZ Ltd. (1500 x 8000 units) 12,00,0000
Illustration 16:
Indira Ltd, an Indian Company supplied billets to Charles Ltd. an UK based company which holds 40% of the shares of Indira Ltd., during the previous year 2021-22. Indira Ltd. also supplied the same product to another UK based company, Vales Ltd., an unrelated entity. The transactions with Charles Limited are priced at Euro 400 per MT (FOB), whereas the transactions with Vales Ltd. are priced at Euro 700 per MT (CIF). Insurance and Freight amounts to Euro 200 per MT. Compute the arm’s length price for the transaction with Charles. Limited.
Sol Here, since the foreign company, Charles Ltd., holds more than 26% shares in Indira Ltd., both be deemed to be associated enterprises within the meaning of section 92A. As Indira Ltd. supplies similar product to an unrelated entity, Vales Ltd. UK, the transactions between Indira Ltd. and Vales Ltd. can be considered as comparable uncontrolled transactions for the purpose of determining the arm’s length price of the transactions between Indira Ltd. and Charles Ltd. Thus, Comparable Uncontrolled Price (CUP) method of determination of arm’s length price (ALP) would be applicable in this case. Transactions with Charles Ltd. are on FOB basis, whereas transactions with Vales Ltd. are on CIF basis. This difference has to be adjusted before comparing the prices.
| Particulars | Amount |
| Price per MT of billets to V Ltd. (A) | 700 |
| Cost of insurance and freight per M.T. (B) | 200 |
| Adjusted price per M.T (C – D) | 500 |
Since, the adjusted price for Vales Limited, UK is greater than the price fixed for Charles Ltd., the arm’s length price be Euro 500 per MT
Illustration 17:
Indian company imports raw material from its foreign subsidiary at $ 5 lakhs during the P.Y. 2017-18. Indian company has maintained documents for such international transaction as per Section 92D and included such transactions in income-tax return and Form No.3CEB at $ 5 lakhs. During assessment proceedings, the TPO determined the ALP of such transaction at $ 3 lakhs. Amount of penalty to be levied on Indian Company for underreporting of income u/s 270A would be?
Sol:- Nil
Illustration 18:
A Ltd, an Indian co. purchases the Monitor from the Z Inc, the foreign co. (associate co. of A Ltd) @ 25000. And, if A Ltd, purchased such services from the any web development co. in India, that will cost @ 17000. Compute the amount, If any to be adjusted in the above-mentioned transaction.
Sol:The amount payable in the India, for similar services shall be taken as the amount of $ 17000 as the Arm Length.
Here the difference to be adjusted, which was extra booked by the A Ltd = 25000-17000 = 8000.
Illustration 19:
A Inc, a foreign co. selling led for $ 25,000 (before adjustments) to B ltd its sister concern in India. And the same led sold by A Inc. to C Ltd at the price of $ 15000. Here, A Inc will bear the transportation cost of B Ltd which is 1500 of each unit. And, there is 10% discount to B ltd. Show the computation by the CUP method. There are total 50 unirs sold in above-mentioned transaction.
Sol:- Here, the amount paid by the C Ltd to the A Inc is taken as base price i.e. Arm Length Price = 15000
Computation of comparable price paid by the B Ltd to A Inc. :-
Amount payable by the B Ltd = 25000
(-) Discount on sale @ 10% = (2500)
(-) Transportation cost bear by A Inc. = (1500)
Net Comparable Price = 21000
Hence, amount extra booked by the B Ltd in its books of A/c for the expense :- 21000-15000 = 6000 per Unit
So, total amount to be add back to the B Ltd. = 6000*50 = 3,00,000.
Resale Price Method
Illustration 20:
Assume that there are two distributors selling the same product “Scanners” in the same market under the same brand name. Distributor X offers a warranty while Distributor Y offers none. Distributor X is not including the warranty as part of a pricing strategy and so sells its product at a higher price resulting in a higher gross profit margin (if the cost of servicing the warranty is not taken into account) than that of Distribution Y, which sells at a lower price. The two margins are not comparable until a reasonably accurate adjustment is made to account for that difference.
Illustration 21:
- A Ltd (India) holds 60% equity shares of ABC Inc. (USA). A ltd purchased goods worth INR 20,00,000 from ABC Inc. and sold to unrelated person CC Ltd in India for INR 30,00,000. A ltd paid INR 3,50,000 as customs duty for import of goods from ABC Inc. Normal gross profit margin of A ltd in similar uncontrolled transaction is 25%. Calculate Arm’s length price using resale price method.
Answer:
| Particulars | Price ($) |
| Resale price of goods purchased from ABC Inc. | 30,00,000 |
| Less: Normal gross profit margin @25% | (7,50,000) |
| Less: Expenses (customs duty) | (3,50,000) |
| Arm’s length price | 19,00,000 |
| Purchase price of goods from related party | 20,00,000 |
| Transfer pricing adjustment | 1,00,000 |
Illustration 22:
A ltd. is engaged in trading of Textile. It purchases goods from its related party R Ltd. worth $ 200,000 & sold to Z Ltd., unrelated party for $ 250,000. The GP margin on sale of goods of R Ltd. is 15% while that of unrelated party is 20%. After sales warranty is provided of 1 year by R Ltd. Warranty cost may be taken as 2% of sale price. Calculate Arm Length Price.
Solution:
| Particulars | Amount |
| Resale Price of Goods purchased from R ltd. | 2,50,000 |
| Less: Profit margin w.r.t uncontrolled transaction (20% on Sale) | (50,000) |
| Less: Warranty Cost (2% on Sale) | (5000) |
| Arm Length Price | 1,95,000 |
| Actual Purchase price from R ltd. | 2,00,000 |
| Increase in Income of A ltd. | 5,000 |
Illustration 23:
EFG Enterprises (India) is dealing in electronic goods. It purchased goods from a related party from Russia where Income Tax Rate is 20% worth $ 45,00,000 costing 36,00,000. It resells the goods to an unrelated party for $ 60,00,000 with a GP of 20% on Sales. A Bulk discount on 2% on sales is also provided. Tax Rate in India is 25%. Analyse, whether the transaction carried out by EFG is in Arm’s Length with its related party.
Solution:
| Particulars | Amount |
| Resale Price of Goods purchased from Related party in Russia | 60,00,000 |
| Less: Profit margin w.r.t uncontrolled transaction (20% on Sale) | (12,00,000) |
| Less: Bulk Discount (2% on Sale) | (1,20,000) |
| Arm Length Price | 46,80,000 |
| Actual Purchase price from R ltd. | 45,00,000 |
| Difference | 1,80,000 |
| Yes, International transaction of purchase from related party ismeeting with arm’s length requirements. |
Illustration 24:
AB ltd India holds 60% shares of Biden Inc. of USA. AB ltd purchased goods from Biden Inc for Rs 20,00,000. The same goods were sold to unrelated party Modi ltd in India for Rs 30,00,000. AB ltd paid 350000 as custom duty of import of goods from Biden Inc. GP margin of AB ltd in some uncontrolled transaction is 25%. Calculate arm’s length price using RPM.
Ans:
| Unrelated party sale price | 30,00,000 |
| Less: 25% GP margin | (7,50,000) |
| Less: expenses (Custom duty) | (3,50,000) |
| Arm’s length price | 19,00,000 |
Income of AB ltd to be increased by $ 1,00,000 (20,00,000-19,00,000)
Illustration 25:
Sunil Limited, purchases bicycles from its parent company, Anil UK, at $ 4,50,000 and resold these bicycles to J Limited, an independent third party for $ 5,00,000.
Sunil Limited purchases bicycle from Anant limited, another Non – AE and resold the same to S Limited, a WOS of Anant Limited. Sunil Limited earned gross profit margin of 20% on sales on such transaction.
There are no expenses in connection with purchase of bicycles and no functional or other differences which could affect the gross profit margin earned by Sunil Limited. Compute arm’s length price?
Ans:
| Particulars | Amount |
| Resale price to J ltd | 5,00,000 |
| Less: Normal GP margin | 1,00,000 |
| Less: Expenses | NIL |
| Arm’s length price | 4,00,000 |
Ilustration 26:
Sunil Limited, purchases bicycles from its parent company, Anil UK, an at $ 4,50,000 and resold these bicycles to Jumman Limited, an independent third party for $ 5,00,000. Sunil Limited purchases bicycle from Amaanat Limited, another Non – AE and resold the same to Sammanit Limited, a WOS of Amaanat Limited. Sunil Limited earned gross profit margin of 20% on sales on such transaction. There are no expenses in connection with purchase of bicycles and no functional or other differences which could affect the gross profit margin earned by Sunil Limited? Compute Arms’ length price under Resale Price Method
Ans:
| Particulars | Amount | |
| Resale price of bicycle to Jumman Limited | 5,00,000 | |
| Less | Normal Gross profit margin earned by Internal Comparable | 1,00,000 (5,00,000*20%) |
| Expenses in connection with purchase of bicycle | Nil | |
| ALP of bicycle purchased from Anil UK | 4,00,000 |
Illustration 27:
AE 2 purchases bicycles from AE 1 at $ 4,50,000. AE 2 resold these bicycles to Non – AE1 at $ 5,00,000. AE 2 purchases bicycles from Non – AE 2 and resold the same to Non – AE 3. AE 2 earned gross profit margin of 20% on sales on such transaction. AE 2 offers extended warranty of one-year to Non – AE 1. The estimated cost of extended warranty is $ 2,000.
Compute Arms’ length price under Resale Price Method (RPM) Transfer Pricing?
Ans:
| Particulars | Amount | |
| Resale price of bicycle to NON-AE 1 | 5,00,000 | |
| Less | Normal Gross profit margin earned by Internal Comparable | 1,00,000 (5,00,000*20%) |
| Expenses in connection with purchase of bicycle | Nil | |
| Adjustment of Extended Warranty | Nil | |
| ALP of bicycle purchased from AE 1 | 4,00,000 |
Note : –
Cost of extended warranty would not affect the gross profit margin as warranty costs are only charged to profit and loss account. Thus, no adjustment would be made for extended warranty as it has no effect on gross profit margin earned by AE 2.
Illustration 28:
Sunil Limited, purchases bicycles from its parent company , Anil UK, an at $ 4,50,000 and resold these bicycles to Jumman Limited , an independent third party for $ 5,00,000.
Sunil Limited purchases bicycle from Amaanat Limited, another Non – AE and resold the same to Sammanit Limited , a WOS of Amaanat Limited. Sunil Limited earned gross profit margin of 20% on sales on such transaction.
There are no expenses in connection with purchase of bicycles and no functional or other differences which could affect the gross profit margin earned by Sunil Limited ?
Compute Arms’ length price under Resale Price Method?
Solution: Computation of Arm Length Price:
(Amount in Rs)
| Resale price of bicycle to Jumman Limited | 5,00,000 |
| Less: Normal gross profit margin earned by internal comparable (5,00,000 * 20%) | 1,00,000 |
| Less : Expenses in connection with purchase of bicycle | Nil |
| Arm Length Price | 4,00,000 |
Illustration 29:
AE 2 purchases bicycles from AE 1 at $ 4,50,000. & resold these to Non – AE 1 at $ 5,00,000. AE 2 purchases bicycles from Non – AE 2 and resold the same to Non – AE 3. AE 2 earned gross profit margin of 20% on sales on such transaction before any discount. Differences in comparable transactions :-
- AE 2 incurred freight of $ 20,000 on purchase from AE 1. However, no freight was incurred on purchases made from Non – AE 2.
- Non – AE 1 purchased a larger order due to which it was given quantity discount by AE 2. Such quantity discount reduces the gross profit margin (as above) with Non – AE 1 by 3% on sales.
Compute Arms’ length price under Resale Price Method (RPM)?
Solution: Computation of Arm Length Price:
(Amount in Rs)
| Resale price of bicycle from Non – AE 1 | 5,00,000 |
| Less: Normal gross profit margin earned by internal comparable {5,00,000 * (20%-3%)*} | 85,000 |
| Less : Expenses in connection with purchase of bicycle | 20,000 |
| Arm Length Price | 3,95,000 |
*Note : Comparable gross profit margin is 20%. However, due to quantity discount gross profit margin with Non – AE 1 is reduced by 3%. Thus, comparable gross profit margin should also be reduced by 3% (i.e., from 20% to 17%).
Illustration 30:
A ltd buys from its parent company B in Germany @Rs 18000 per unit and sells it at Rs 20000 per unit. A ltd also buys from C LTD an unrelated party at Rs 12000. A sells them at 15000 per unit. Selling and Distribution and other overhead expenses incurred by him Rs 1500.
Compute Arms’ length price under Resale Price Method (RPM)?
Solution: Computation of Arm Length Price:
(Amount in Rs)
| Resale price Purchased From B Ltd. | 20,000 |
| Less: Normal gross profit margin earned by internal comparable {20,000*10%*} | 2,000 |
| Less : Expenses in connection with purchase of unit | 1,500 |
| Arm Length Price | 16,500 |
* Working Note : Calculation of Gross Margin :
(Amount in Rs)
| Resale price Purchased From C Ltd. | 15,000 |
| Less: Cost of goods Sold | 12,000 |
| Less : Expenses in connection with purchase of unit | 1,500 |
| Gross Margin | 1,500 |
| % of Gross Margin | 10% |
Cost Plus Method
Illustration 31: Delta is a domestic manufacturer of timing mechanisms for mass- market keyboards. A sells this product to its foreign subsidiary Beta. Delta earns a 5% gross profit mark up with respect to its manufacturing operation. X,Y, and Z are independent domestic manufacturers of timing mechanisms for mass- market keyboards. X,Y and Z sell to independent foreign purchase$ X,Y and Z earn gross profit mark ups with respect to their manufacturing operations that range from 3% to 5%. Delta accounts for supervisory, general and administrative costs as operating expenses, and thus these costs are not reflected in cost of goods sold. The gross profit mark ups of X,Y and Z, however, reflect supervisory, general, and administrative costs as part of costs of goods sold. Therefore, the gross profit mark ups of X, Y and Z must be adjusted to provide accounting consistency.
Illustration 32
ABC Ltd., Canada holds 35% shares in LMN Ltd., India. LMN Ltd. develops software and does both onsite and offsite consultancy services for the custome$
LMN Ltd. during the year billed ABC Ltd. Canada for 120 man-hours at the rate of INR 1,800 per man hour. The total cost (direct and indirect) for executing this work amounted to INR 2,25,000.
However, LMN Ltd. billed XYZ Ltd., India at the rate of INR 2,800 per man hour for the similar level of manpower and earned a Gross Profit of 50% on its cost. The transactions of LMN Ltd. with ABC Ltd. and XYZ Ltd. are comparable, subject to the following differences:
As ABC Ltd. gives business in large volumes, LMN Ltd. offered to ABC Ltd., a quantity discount which may be valued at 10% of normal gross profits.
Compute the Arm’s Length Price along with income to be increased under the Cost Plus Method.
| Particulars | Price ($) |
| Gross Profit mark-up on cost in case of XYZ Ltd. [an unrelated party] | 50% |
| Less: AdjustmentsQuantity discount to ABC Ltd. [Quantity discount is allowed to ABC Ltd. as it gives business in large volumes, but the same is not provided to XYZ Ltd. Therefore, it shall be adjusted] [10% of 50%, being gross profit] | (5%) |
| Arm’s length gross profit mark up to cost | 45% |
| Cost incurred by LMN Ltd. for executing ABC Ltd.’s work | 2,25,000 |
| Add: Adjusted gross profit (` 2,25,000 x 45%) | 1,01,250 |
| Less: Actual Billed Income from ABC Ltd. (` 1800 x 120 man hours) | 2,16,000 |
| Total Income of LMN Ltd to be increased by | 1,10,250 |
Illustration 33:
X Limited has transferred goods to its wholly owned subsidiary Y Limited for INR 1,00,000. X Limited has incurred following cost of production for such goods: Cost of Raw Material: INR 60,000 Labour Cost: INR 15,000 Apportioned Indirect Cost: INR 20,000 Total Cost of production: INR 95,000 Profit Mark up: 20%
Solution: In this example, Arm’s Length Price for a transaction entered into with a wholly-owned subsidiary is INR 1,14,000 (INR 95,000 plus Profit Markup of 20%). Therefore, for the purpose of Income Tax, such transaction shall be deemed to be entered at INR 1,14,000.
Illustration 34:
Associated Enterprise-A, a computer manufacturer in Thailand, manufactures under a contract for Associated Enterprise B. Associated Enterprise B would instruct Associated Enterprise-A about the quantity and quality of computers to be manufactured.The Associated Enterprise-A would be guaranteed of its sales to Associated Enterprise B and would have little or no risk.
Solution: Let’s assume that the Cost of goods sold is INR 50,000. Also, assume that the arm’s length markup which Associated Enterprise-A should earn is 40%. The resulting arm’s length price between Associated Enterprise-A and Associated Enterprise B is INR 70,000 (i.e. INR 50,000 x (1 + 0.40)).
Profit Split Method
Illustration 35:
MM Ltd incorporated in UK received order to develop a software for Nano Inc. US and consideration for same is $2,00,000. MM ltd executed such order in joint venture with BB ltd and Odi Ltd India based companies. Odi ltd holds 30% equity shares of BB ltd and 27% equity shares of MM Ltd. Consideraion of $ 2,00,000 is distributed amongst MM ltd, BB ltd and Odi ltd $1,00,000, $50,000 and $50,000 respectively.
Cost incurred to develop the software is $1,60,000. Relative contributions by MM ltd, BB ltd and Odi ltd in FAR is 40:40:20.
Cost incurred by BB ltd is $42,000. Calculate ALP for BB ltd.
| Particulars | Price ($) |
| Total profit from joint venture ($ 2,00,000 – $ 1,60,000) | 40,000 |
| Distribution of profit on relevant contribution ratio: | |
| MM ltd : $40,000 * 40% | 16,000 |
| BB ltd : $40,000*40% | 16,000 |
| Odi ltd : $40,000*20% | 8000 |
| Calculation of ALP for BB Ltd | 1105 |
| Cost incurred : | 42,000 |
| Add: profit | 16,000 |
| Arm’s length price | 58,000 |
| Profit to be increased of BB ltd : $58000- $50,000 | 8000 |
Illustration 36:
The success of an electronics product is linked to the innovative technological design both of its electronic processes and of its major component. That component is designed and manufactured by associated company A; is transferred to associated company B which designs and manufactures the rest of the product; and is distributed by associated company C. Information exists to verify by means of a resale price method that the distribution functions, assets and risks of Company C are being appropriately rewarded by the transfer price of the finished product sold from B to C.
The most appropriate method to price the component transferred from A to B may be a CUP, if a sufficiently similar comparable could be found. However, since the component transferred from A to B reflects the innovative technological advance enjoyed by company A in this market, which is found to be a unique and valuable contribution by company A, in this example it proves impossible (after the appropriate functional and comparability analyses have been carried out) to find a reliable CUP to estimate the correct price that A could command at arm’s length for its product. Calculating a return on A’s manufacturing costs could however provide an estimate of the profit element which would reward A’s manufacturing functions, ignoring the profit element attributable to the unique and valuable intangible used therein. A similar calculation could be performed on company B’s manufacturing costs, to give an estimate of B’s profit derived from its manufacturing functions, ignoring the profit element attributable to its unique and valuable intangible. Since B’s selling price to C is known and is accepted as an arm’s length price, the amount of the residual profit accrued by A and B together from the exploitation of their respective unique and valuable intangibles can be determined. At this stage the proportion of this residual profit properly attributable to each enterprise remains undetermined. The residual profit may be split based on an analysis of the facts and circumstances that might indicate how the additional reward would have been allocated at arm’s length. The R&D activity of each company is directed towards technological design relating to the same class of item, and it is established for the purposes of this example that the relative amounts of R&D expenditure reliably measure the relative value of the companies’ contributions. This means that each company’s unique and valuable contribution may reliably be measured by their relative expenditure on research and development, so that, if A’s R&D expenditure is 15 and B’s 10, giving a combined R&D expenditure of 25, the residual could be split 15/25 for A and 10/25 for B.
Solution:
- Profit & Loss of A and B
- Determine routine profit on manufacturing by A and B, and calculate total residual profit
It is established, for both jurisdictions, that third-party comparable manufacturers without unique and valuable intangibles earn a return on manufacturing costs (excluding purchases) of 10% (ratio of net profit to the direct and indirect costs of manufacturing).2 A’s manufacturing costs are 15, and so the return on costs would attribute to A a manufacturing profit of 1.5. B’s equivalent costs are 20, and so the return on costs would attribute to B a manufacturing profit of 2.0. The residual profit is therefore 6.5, arrived at by deducting from the relevant net profit of 10 the combined manufacturing profit of 3.5.
- Allocate residual profit
The initial allocation of profit (1.5 to A and 2.0 to B) rewards the manufacturing functions of A and B, but does not recognise the value of their respective unique and valuable contributions that have resulted in a technologically advanced product. Since in this case it is determined that the relative share of total R&D costs incurred by A and B in relation to the product is a reliable proxy for the value of their respective unique and valuable contributions, the residual can be split between A and B on that basis. The residual is 6.5 which may be allocated 15/25 to A and 10/25 to B, resulting in a share of 3.9 and 2.6 respectively, as below: A’s share 6.5 x 15/25= 3.9 B’s share 6.5 x 10/25= 2.6.
- Recalculate Profits
A’s net profits would thus become 1.5 + 3.9 = 5.4. B’s net profits would thus become 2.0 + 2.6 = 4.6. The revised P & L for tax purposes would appear as:
Illustration 37:
Company A, resident in Country A, is the parent company of Retail Group, an MNE group engaged in the retail fashion industry. Over the years, Company A has developed know-how and has enhanced the value of the trademark and associated goodwill of its business through intensive marketing activities. In this case, the intangibles developed and owned by Company A do not qualify as hard-to-value intangibles.
To expand the business into the Country B market, Company A enters into an agreement with Company B, a member of Retail Group resident in Country B. Under this agreement, Company A grants to Company B the rights to utilise the know-how and to use the trademarks for the purpose of fashion retailing in Country B. Company B has extensive experience in retail fashion distribution and has a strong track record in building brand recognition and loyalty in Country B through its in-house team which develops and implements innovative marketing strategies and activities.
The accurate delineation of the transaction indicates that the contributions of both companies are unique and valuable to the Retail Group’s business in Country B. In the scenarios presented below, the transactional profit split is found to be the most appropriate method for determining the compensation for the rights granted by Company A to Company B on the basis that both parties to the transaction are making unique and valuable contributions.
Scenario:
The accurately delineated transaction shows that Company A does not share in the assumption of any of the economically significant risks associated with the marketing and exploitation activities of Company B related to the licensed intangibles. Under these circumstances, the application of the transactional profit split should be based on the profits anticipated to be generated by Company B from commercialising the products over an appropriate period. The relative value of the contributions made by Company A and Company B will be used to determine a split of the anticipated profits of Company B resulting from the combined contributions of the enterprises. The payment for the transaction may take a variety of forms, including a lump sum payment to Company A or a sales-based royalty.
Solution:
Assume A and B are two associated enterprises situated in two different tax jurisdictions. Both manufacture the same widgets and incur expenditure that results in the creation of a unique and valuable intangible which they can mutually use. For the purpose of this example, it is assumed that the nature of this particular unique and valuable intangible is such that the value of A and B’s respective unique and valuable contributions in the year in question is proportional to A and B’s relative expenditure on the intangible in that year. (It should be noted that this assumption will not always be true in practice.) Assume A and B exclusively sell products to third parties. Assume that it is determined that the most appropriate method to be used is a residual profit split method; that the manufacturing activities of A and B are less complex, non-unique transactions that should be allocated an initial return of 10% of the Cost of Goods Sold; and that the residual profit should be split in proportion to A’s and B’s expenditure in relation to the unique and valuable intangible. The following figures are for illustration only:
Step one: determining the initial return for the non-unique manufacturing transactions (Cost of Goods Sold + 10% in this example)
Step two: determining the residual profit to be split
- a) In case it is determined as the operating profit
- b) In case it is determined as the operating profit before overhead expenses (assuming it is determined that the overhead expenses of A and B do not relate to the transaction examined and should be excluded from the determination of the relevant profits to be split):
As shown in the above example, excluding some specific items from the determination of the relevant profits to be split implies that each party remains responsible for its own expenses in relation to it. As a consequence, the decision whether or not to exclude some specific items must be consistent with the accurate delineation of the transaction.
Transactional Net Margin Method
Illustration 38:
If A produces clocks and sells it to B who in turn sells it to customers at INR 500 per piece. Now, in this case, B is a less complex entity as it only a sales company and does not manufacture the product. We also have the price of the clocks readily available. Thus, we would take B as the tested party, and Resale price as the base. Thus, if we earn INR 100 per piece overall, the Transactional Net Margin would be 20% of the Sale Price. This margin has to be compared with other transactions and it has to be established if the same is comparable.
Illustration 39:
X Limited has sold 20,000 units of White bags to its wholly owned subsidiary based outside India for INR 2,00,000. Net Profit Margin for such a transaction is 15%.
X Limited sold 50,000 units of black bags to an unrelated enterprise for INR 4,50,000. Net Profit Margin for such a transaction is 25%.
For sale of more than 30,000 units X Limited provides a bulk discount of 1%.
Also, Profit Margin on Black bags is 2% more as compared to White Bag.
Therefore, adjusted Net Profit Margin for comparable uncontrolled transaction will be 24% (25%+1%-2%).
| Particulars | Price (INR) |
| Transaction value | 2,00,000 |
| Net Profit Margin of International Transaction | 15% |
| Cost of Goods sold (2,00,000* 85%) | 1,70,000 |
| Net Profit Margin for computation of Arm’s Length Price | 24% |
| Arm’s Length Price170000*100/76 | 223684 |
| Difference will be added to the income of X ltd. | 23,684 |
Illustration 40:
XYZ India procures computer software (“Z”) from SB Singapore @ $ 1,500 per Software. Subsequently the company incurs an additional advertisement expenditure in India of $ 600 per pack and the product is ultimately sold at $ 3,000 per Software. XYZ India also procures packaged software (“T”) from its subsidiary company in UK @ $ 700 per Software.
The company incurs an additional expenditure of $ 200 per Software and the product is ultimately sold at $ 1,200 per Software. Compute the arm’s length price as per TNMM, assuming the difference in product is not material?
Solution: –
Computation of Net profit margin realized from an unrelated party in a comparable uncontrolled transaction:
Computation of Arm’s length price of international transaction with the AE: –
| Particulars | Amount ($) |
| Sale price of T – (A) | 1,200 |
| Net profit margin ratio | 30% |
| Net profit margin – (B) | 360 |
| Total Cost (A – B) | 840 |
| Less: – | |
| Additional expenditure in India | 200 |
| Arm’s length price per unit | 640 |
| Transfer price per unit | 700 |
| TP adjustment per unit | 60 |
ILLUSTRATION 41:
FP is a publicly traded Country A corporation with a Country B subsidiary named BCO that is under audit for its 2009 taxable year. FP manufactures a consumer product for worldwide distribution. BCO imports the assembled product and distributes it within Country B at the wholesale level under the FP name. FP does not allow uncontrolled taxpayers to distribute the product. Similar products are produced by other companies but none of them is sold to uncontrolled taxpayers or to uncontrolled distributo$ Based on all the facts and circumstances, Country B’s taxing authority determines that the TNMM will provide the most reliable measure of an arm’s length result. BCO is selected as the tested party because it engages in activities that are less complex than those undertaken by FP. There is data from a number of independent operators of wholesale distribution businesses. These potential comparables are further narrowed to select companies in the same industry segment that perform similar functions and bear similar risks to BCO. An analysis of the information available on these taxpayers shows that the ratio of operating profit to sales is the most appropriate profit level indicator, and this ratio is relatively stable where at least three years are included in the average. For the taxable years 2007 to 2009, BCO shows the following results:
Solution:
After adjustments have been made to account for identified material differences between BCO and the uncontrolled distributors, the average ratio of operating profit to sales is calculated for each of the uncontrolled distributo$ Applying each ratio to BCO would lead to the following comparable operating profit (COP) for BCO: The data is not sufficiently complete to conclude that it is likely that all material differences between BCO and the uncontrolled distributors have been identified. The Country B taxing authority measures the arm’s length range by the interquartile range of results, which consists of the results ranging from $19,760 to $34,840. Although BCO’s operating income for 2009 shows a loss of $4,600, the tax authority determines that no allocation should be made, because BCO’s average reported operating profit of $20,000 is within this range.
