Arm’s Length Price can be computed by the following methods;
1. Comparable Uncontrolled Price Method
2. Resale Price Method
3. Cost Plus Method
4. Profit Split Method
5. Transaction Net Margin Method
6. Such other methods as may be prescribed by the board
1. Comparable Uncontrolled Price Method:
Under this method the price charged or paid for any item under any comparable uncontrolled transaction or transactions should be
Example
A U.S. car rental company needs to determine how to price the use of its brand name and logo by its Canadian subsidiary. The company’s transfer pricing team must find an example of a licensing agreement the company has made with an independent third party to use their branding. If that arrangement is sufficiently comparable, the car rental company can apply the same price it charges the independent third party to its Canadian subsidiary for the use of the brand and logo.
2. Say a diamond company is trying to determine an appropriate amount to charge its subsidiary for diamonds. The diamond company has no relationships with third parties and thus has no similar internal transactions to use. Its transfer pricing team can apply the external CUP method by identifying comparable transactions between two unrelated companies. Assuming that identifies sufficiently comparable transactions, to be accepted by tax authorities, the diamond company should charge its subsidiary a price comparable to the market price of diamonds.
3.Another example using CUP method is a company that manufactures industrial equipment and parts and sells them to third parties at set prices. The company also sells parts and equipment to related entities. In this case, it’s fairly straightforward; the company can use the prices it charges to third parties to determine prices for goods sold to related parties—if the sales volume and terms are similar. For example, if the company charges a lower price per unit to third parties who place large orders, and the company sells a similar number of units to a related party, the defensible transfer price is the discounted price for large orders offered to third parties.
2. The Resale Price Method –
Price charged for goods sold to unrelated enterprise
Example
A U.S. company that distributes running shoes buys shoes from a related company in Ireland. It also purchases similar shoes from another, unrelated supplier. Assuming that the terms and conditions of the related and unrelated party transactions are comparable, the RPM can be applied to ensure the Irish company charges its related U.S. distributor a price comparable to the price charged by the unrelated third-party supplier.
The RPM stipulates that the gross margin earned by the U.S. distributor on shoes purchased from the related company must be the same as the margin earned on sales of shoes purchased from the unrelated supplier. If the distributor makes a gross profit of $65 on each pair of shoes from the unrelated supplier sold for $100, the gross profit margin is 65%. This is the gross margin which must be used to determine the price of the shoes the distributor purchases from its related Irish supplier.
3. The Cost Plus Method
The cost plus method (CPLM) works by comparing a company’s gross profits to the overall cost of sales
A French corporation produces products under contract for its German-based parent company and needs to determine the appropriate markup (gross cost plus) for the goods it sells to its German partner. If the French company has made similar comparable transactions with third parties, the markup used for those transactions can be applied to the sales the company makes to the related German company. If the French company has made no comparable third party transactions, then the transfer pricing team can identify several companies similar to the French manufacturer and apply those companies’ average gross cost plus to the transactions with the related German company.
4. The Profit Split Method
Normally PSM is applicable where assessee executes an order in joint venture with its associate enterprise.
Example
A pharmaceutical company affiliate performs research and development (R&D) to bring a new drug to market. The affiliate bears the costs and risks of launching the new drug. The two related parties need to determine the right profit split and decide that they’ll use the contribution PSM to divide profits from sales of the new drug.
The two parties have invested a total of $500 million in bringing the medication to market. The R&D company invested $375 million—or 75% of the total investment. Therefore, 75% of the profits will go to the R&D company, with the remaining 25% going to the pharmaceutical manufacturer.
5. The Comparable Profits Method
The comparable profits method (CPM), also known as the transactional net margin method (TNMM), helps determine transfer prices by looking at the net profit of a controlled transaction between associated enterprises. This net profit is then compared to the net profits in comparable uncontrolled transactions of independent enterprises.
Example
A U.S.-based clothing company with global reach establishes a Canadian distribution affiliate. The U.S. parent company supplies products, sets business strategies, finances the global operations, and owns the intellectual property (trademarks, designs, and operational know-how) for its global affiliates. The parent company needs to determine how much profit the Canadian distributor should earn for its operations.
The transfer pricing team identifies similar distributors in Canada, calculates their pre-tax profit margins, and establishes a typical profit margin range. Prices are set to allow the related Canadian distributor to earn a pre-tax profit that falls within that typical margin range.
