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The 21st century witnessed two significant events- India’s rapid expansion in trade and investment; and growth of global production networks, which enabled production, sale, and distribution of products to be undertaken in different countries. Since the different processes could be performed in different parts of the world, this further led to an increase in intra-group transactions, also known as related party transactions, internationally. The most significant rise was observed in the sale of goods and services by holding and subsidiaries companies to each other.

 The Arm’s Length Principle

Countries around the world have huge differences in tax rates. These differences give incentive to the multinational enterprises to shift profits from high tax countries to ones with lower tax rates. This shifting of profits can be easily achieved via internal transactions, a holding company providing financing or consultancy services to its subsidiaries, a manufacturing branch supplying finished product to a distributing branch, one associated enterprise supplying provision of services to another. The MNEs can set the price and control the terms and conditions of these transactions and thereby influence the amount of profit and resultant amount of tax due. To prevent this from happening, tax administrations (organized in the OECD) invented the arm’s length principle (Article 9 of the OECD Model Convention) which requires that controlled transactions are done at market rates.

The arm’s length principle can therefore be defined as: “entities that are related via management, control or capital in their controlled transactions should agree the same terms and conditions which would have been agreed between non-related entities for comparable uncontrolled transactions”. If this principle is met, one can conclude that the terms and conditions of the particular transaction are at arm’s length.

Introduction of Transfer Pricing in India

The Ministry of Finance’s concerns regarding possible tax avoidance practices by manipulations in the prices charged or paid, in intra-group transactions, started increasing gradually with the increase in the economic activity reported by these Multi-National Companies. These concerns prompted the then Indian Government to eventually introduce the Transfer Pricing (TP) Regulations via The Finance Bill (2001). In the Income Tax Act, 1961 (IT Act) sections 92A to 92F (replacing the earlier section 92) relating to Transfer Pricing were inserted along with definitions to some key terms like associated enterprise, international transactions, and Arm’s Length Price (ALP). The process to determine the ALP along with other Compliance Procedures and Documentations required were also laid down in lines with International practices. Just in the span of a decade, from 2005-06 to 2014-15 the number of transfer pricing audits increased more than 4 times, from 1000 to 4290.[1]

Documentation required as per the Act

Section 92D(1) of the act says “Every person who has entered into an international transaction or specified domestic transaction shall keep and maintain such information and document in respect thereof, as may be prescribed in Rule 10D; Provided that the person, being a constituent entity of an international group, shall also keep and maintain such information and document in respect of an international group as may be prescribed.” TP Documentation requirement as per Rule 10D of the Indian Income Tax Rules, 1962 include:

  • Entity related

1. Ownership Structure

2. Profile of multinational group

3. Business description/ Profile of industry

  • Price related

1. Nature and terms (including price) of international transactions.

2. Description of functions performed, risk assumed, and assets employed (functional analysis)

3. Records of economic and market analysis (economic analysis)

4. Record of budgets, forecasts, financial estimates

5. Any other record of analysis (if, any) to evaluate comparability of international transaction with uncontrolled transaction(s)

6. Description of method considered with reasons of rejection of other methods.

  • Transaction related

1. Details of transfer pricing adjustment(s) made (if, any)

2. Any other information e.g., data, documents like invoices, agreements, price related correspondence, etc.

The ideal TP Documentation flow includes.

  • Executive summary
  • Industry analysis
  • Company analysis
  • Intercompany transactions
  • Functional analysis
  • Evaluation of methods
  • Economic analysis
  • Conclusions

The above-mentioned documentation is to be done for what is known as a Local File, which is to be documented with the company itself. Apart from this, two other files are also required subject to certain conditions.

Master File– To be filed with the IT department, if

Consolidated revenue of International Group for the accounting year > INR 500 crore


Aggregate value of International transaction > INR 50 crore


Aggregate value of International transaction pertaining to intangible property > INR 10 crore

Country by Country Report– Needs to be filed with IT Department, if

Consolidated revenue of International Group > INR 6,400 crore

These 3 together comprise the Three tier transfer pricing documentation structure

Companies to whom transfer pricing regulations are applicable must file their returns of tax on or before 30th November following the close of the relevant tax year. The prescribed documents must be maintained for a period of eight years from the end of the relevant tax year and must be updated annually on an ongoing basis. It is also imperative to obtain an Independent Accountant’s Report in Form 3CEB in respect of all international transactions between AEs and the same must be submitted by the due date of the tax return filing, on or before 30th November.

Penalties for Non-compliance as per the Act 

Section Nature of Penalty Quantum of Penalty
270A Penalty for under-reporting of income as a consequence of failure to report international transactions, deemed international transactions 50% of the amount of tax payable in case of underreporting and a penalty of 200% of the amount of tax payable in case of misreporting
271AA Penalty for: failure to maintain documentation prescribed under Section 92D of the Act, failure to report a transaction, or maintaining or furnishing incorrect information/ document 2% of the value of international transaction
271G Penalty for failure to furnish documentation prescribed under Section 92D(3) of the Act 2% of the value of international transaction
271BA Penalty for failure to furnish Accountant’s Report in Form 3CEB as required under Section 92E INR 100,000

Transfer Pricing(‘TP’) Methodology

The Indian Transfer Pricing Regulations have prescribed mainly six TP methods that multinational enterprises (‘MNEs’) and tax administrations can use to determine accurate arm’s length price (‘ALP’) for international transactions/specified domestic transactions between associated enterprises (‘AEs’). We have tried to use very plain language to make it more understandable to the general folks. We hope this article assists in application of TP methods more accurately and efficiently.

Comparable Uncontrolled Price (‘CUP’) method

CUP is a traditional and mostly preferred method for determining ALP where comparable data are available in commercial databases. It is the price of goods or services and conditions of a controlled transaction with those of an uncontrolled transaction.

The Guidance Note on TP recommends the following type of transactions in which CUP can be adopted:

  • Transfer of Goods
  • Provision of Services
  • Intangibles
  • Loans and provision of financial services

This method is the most reliable method for satisfying ALP. However, while determining the comparability of controlled and uncontrolled transactions, each material factor has to be taken into consideration. Hence, this method is not recommended unless the goods or services are highly comparable.

The OECD Guidelines recommend the use of CUP under the following circumstances:

  • Where an AE sells the same product or services as is sold to independent third parties;
  • None of the differences between the International Transaction/Specified Domestic Transaction and the comparable uncontrolled transaction, if any, could materially affect the pricing mechanism; and
  • In case pricing mechanism is affected on account of differences in the nature of transactions as discussed above, reasonably accurate adjustments can be made to eliminate such differences.

2. Resale Price Method or Resale Minus Method (‘RPM’)

This method takes into consideration, the price at which a product or service has been sold to unrelated parties which was initially bought or obtained from AEs. This price can be referred to as ‘resale price’. For application of RPM, the reselling of product or service should happen without adding any significant commercial value to the same. It means it will be more suitable in cases where only basic sales, marketing and distribution activities are undertaken.

For the purpose of applicability of RPM, the resale price of the goods is reduced by the gross profit margin which is determined by comparing the gross profit margins in a comparable uncontrolled transaction. Further, costs which are associated with the purchase of such product such as the customs duty are deducted. The price so arrived is taken to be the ALP for a controlled transaction between the AEs.

3. Cost Plus Method (‘CPM’)

This method emphasizes mostly on on costs of the supplier of goods or services in the controlled transaction. Afterwards, a gross profit mark-up must be added in the cost. This cost includes the direct as well as the indirect costs of production incurred. But operating expenses of an entity (like overhead expenses) are not part of this mark-up. This method is mostly used in respect of transfer of goods, property or service provided between AEs.

The Guidance Note on TP and OECD Guidelines recommend the following type of transactions for which the CPM can be adopted:

  • Provision of services
  • Transfer of semi-finished goods
  • Joint facility arrangements
  • Long-term buying and selling arrangements.

As there is no proper definition given for direct and indirect costs of production in the Indian TP regulations, costs are to be allocated as per normal accounting policies. The functions performed, the assets deployed, and the risk undertaken (‘FAR Analysis’) should be given due consideration for deriving gross profit mark-up of entities in similar comparable uncontrolled transactions.

4. Profit Split Method (‘PSM’)

This method satisfies the arm’s length principle by comparing the profits earned by parties engaged in comparable uncontrolled transactions. In case of transactions involving transfer of unique intangibles or where the activities of the parties to the transaction are so inter related that the contribution of individual parties cannot be valued separately, the application of PSM is considered. This means PSM is best applicable on combined services provided by AEs in a particular transaction.

Firstly, the combined net profit of all AEs engaged in the International Transaction/Specified Domestic Transaction is computed. Then, proportionate contribution by each of the AEs is evaluated by doing FAR Analysis. This combined net profit is then split amongst the AEs on the basis of their contribution.

The Guidance note on Transfer Pricing recommends an alternative approach under which a basic return shall first be allocated to the AEs having regard to the market forces. The residual profits would then be allocated to AEs as explained above. This approach would be useful where an AE has deployed unique intangibles.

5. Transactional Net Margin Method (‘TNMM’)

TNMM is the most preferred method by MNCs, for satisfying arm’s length principle as it takes into consideration, the net profit margin earned in a controlled transaction to the net profit margin earned by a third party with a similar transaction. It can also consider the net margin earned by a third party on a comparable transaction with another third party.

The Guidance note on TP recommends the following type of transactions where TNMM can be adopted:

  • Provision of services
  • Transfer of semi-finished goods
  • Distribution of finished products where any other method cannot be adopted

This method particularly considers the factors such as cost incurred, sales, assets utilized etc. in assessing the net profit margin. The exact definition of net profit margin is not provided under Indian TP regulations. OECD suggests use of operating margins for application of this method. In case there are any functional differences, the same needs to be adjusted for accurate comparison between the International Transaction/Specified Domestic Transaction and the comparable uncontrolled transaction.

6. Other Method

CBDT has now prescribed the ‘other method’ retrospectively with effect from April 1, 2012 vide Rule 10AB. Rule 10AB shall apply to Assessment Year 2012-13 (i.e., FY 2011-12) and subsequent years.

The new rule introduced in this respect deals with comparing actual price of uncontrolled transaction, which appears to be similar to the CUP Method. The rule introduces the concept of hypothetical third party transactions. It recommends use of price which would have been charged or paid in an uncontrolled transaction like quotations, price publications etc.

In line with the OECD Guidelines, the other method provides for a relaxation on selection of five prescribed methods for determination of ALP.

[1] Ministry of Finance, Government of India. Annual Report: 2013-14. 2014. url: sites/default/files/AnnualReport2013-14.pdf.


Ashish Modi and Piyush Prateek


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  1. Nem Singh says:

    Very good compilation to understand the basic fundamentals of working arm’s length price under transfer pricing regulation domestic as well as foreign.

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May 2024