5 Methods of Transfer Pricing

Transfer pricing is the practice of determining the price of goods, services, and intellectual property exchanged between related entities within a multinational corporation. It plays a crucial role in tax compliance and financial structuring, ensuring transactions reflect market value. The Income Tax Act, 1961, and the Central Board of Direct Taxes (CBDT) govern transfer pricing regulations in India.

Companies use transfer pricing to allocate revenue and expenses among subsidiaries, influencing taxable income across different jurisdictions. This helps in tax optimisation while ensuring compliance with arm’s length pricing standards. Various methods are used to calculate transfer prices, ensuring fair value allocation. Each method follows a structured approach to prevent profit shifting and tax evasion.

Understanding different transfer pricing methods is essential for businesses to comply with regulations and avoid disputes. Below are the five key methods approved under Indian tax laws and OECD (Organisation for Economic Co-operation and Development) guidelines, ensuring accurate and transparent pricing across global transactions.

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List of 5 methods of transfer pricing

Transfer pricing involves setting prices for transactions between related entities within a multinational enterprise. These transactions can include the transfer of goods, services, intellectual property, or financial arrangements. The Indian tax authorities, following OECD guidelines, mandate that such transactions adhere to the arm’s length principle, ensuring that transfer prices reflect market conditions. To achieve compliance, businesses can use different methods to determine appropriate transfer pricing.

The Income Tax Rules, 1962, prescribe five key methods: the Comparable Uncontrolled Price Method, Resale Price Method, Cost Plus Method, Comparable Profits Method, and Profit Split Method. Each method has its own relevance, depending on the nature of the transaction, industry, and availability of comparable market data. Selecting the most suitable method helps businesses comply with Indian tax regulations, avoid disputes, and maintain operational efficiency. Understanding these methods is essential for multinational companies operating in India, ensuring tax compliance while optimising financial performance in cross-border transactions.

Comparable uncontrolled price method

The Comparable Uncontrolled Price (CUP) Method is widely considered the most direct and reliable approach to transfer pricing. It determines the transfer price of a transaction by comparing it with a similar transaction that occurs between independent entities under comparable conditions. This method ensures that intra-group transactions reflect fair market value and comply with arm’s length pricing. The effectiveness of the CUP method depends on the availability of accurate and relevant market data, as prices can be influenced by factors such as volume, contractual terms, and economic conditions.

This method is particularly suitable for transactions involving commodities, financial instruments, and intellectual property, where publicly available pricing data exists. However, its applicability may be limited if identical transactions between independent entities are unavailable or if significant differences exist in terms and conditions. The Indian tax authorities prefer this method when sufficient comparable data is available, as it provides a straightforward and transparent way to determine transfer prices in intra-group transactions.

The resale price method

The Resale Price Method (RPM) is used when a company purchases goods or services from a related entity and then resells them to an independent party. The transfer price is determined by taking the final resale price and deducting an appropriate gross margin, which reflects the functions performed, risks assumed, and market conditions. This method is commonly applied in distribution, retail, and wholesale businesses, where products are acquired from related entities and resold without significant value addition. RPM is particularly effective when reliable industry benchmarks for gross profit margins are available.

However, it is less suitable for unique or highly customised products, where standardised resale margins may not exist. The method ensures that the selling entity earns a reasonable return on its activities while maintaining compliance with Indian tax regulations. By focusing on gross margins rather than direct pricing, RPM provides flexibility but requires careful consideration of market trends and economic conditions to determine an appropriate transfer price.

The cost plus method

The Cost Plus Method (CPM) determines transfer pricing by adding an appropriate markup to the cost incurred by a related entity in producing goods or providing services. This method ensures that intra-group transactions generate a reasonable profit, reflecting the costs and efforts involved. CPM is widely used in manufacturing, contract services, and procurement transactions, where goods or services are provided between related entities. It is particularly beneficial for low-risk manufacturers and service providers, as it ensures a stable return based on cost structures.

However, its effectiveness depends on the accurate determination of direct and indirect costs, along with selecting an appropriate profit markup that aligns with industry standards. One challenge with this method is that it does not account for market demand and competitive pricing, which could result in discrepancies if applied without external benchmarking. Despite this limitation, the Indian tax authorities consider CPM a reliable approach when cost data is well-documented and comparable market information is available.

The comparable profits method

The Comparable Profits Method (CPM) evaluates the net profitability of a controlled transaction by comparing it to the financial performance of independent companies engaged in similar activities. Instead of focusing on direct price comparisons, this method analyses key financial indicators such as Return on Sales (ROS), Return on Assets (ROA), and Operating Margins. It is particularly useful when direct market price comparisons are unavailable, making it a preferred choice for service industries, consulting firms, and technology companies.

CPM ensures that the profitability of a related entity remains consistent with market norms, reducing the risk of profit shifting and tax avoidance allegations. However, the method requires extensive financial data and careful selection of comparable companies to ensure accuracy. In India, tax authorities scrutinise the application of this method to prevent misallocation of profits within multinational enterprises. While CPM provides flexibility in determining fair transfer prices, its reliance on financial ratios makes it complex and data-intensive, requiring detailed financial analysis and benchmarking.

The profit split method

The Profit Split Method (PSM) is applied in cases where multiple related entities contribute significantly to a transaction, making it difficult to allocate profits based on standard pricing methods. Instead of setting a fixed transfer price, this method divides the total profits among the participating entities based on their relative contribution to value creation. PSM is commonly used in joint ventures, research and development collaborations, and transactions involving intangible assets.

It ensures that each entity involved in the transaction receives a fair share of the profits, reducing the risk of tax disputes and profit misallocation. The method requires a detailed analysis of value drivers, risk-sharing, and functional contributions to justify profit allocation. While PSM provides transparency, it is complex and data-intensive, requiring businesses to maintain detailed financial records and justifications for profit distribution. The Indian tax authorities accept this method in cases where related entities jointly create significant value, ensuring that transfer pricing aligns with economic realities and regulatory compliance.

Conclusion

Transfer pricing is a crucial aspect of global business operations, ensuring tax compliance and fair value allocation across multinational enterprises. Indian companies must adopt suitable transfer pricing methods to prevent tax disputes and comply with CBDT and OECD guidelines.

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