How to select TP Valuation Methods.

Factors determine the Most Appropriate method (MAM) rule 10C(2).

·         

       Nature and class of international transactions.

·         Class of associated enterprises and functions performed.

·         Availability and reliability of data

·        

Degree of comparability

·         Extent and reliability of adjustments.

·         Nature extent and reliability of assumptions.

Transfer Pricing Method

Ø  Traditional transactional method

·         CPM –

·         RPM-

·         CPM

Ø   Transaction profit method

·         PSM

·         TNMM

Comparable Uncontrolled Prices method (CUP):

In this method, price charged in an uncontrolled deal between comparable entities is recognized and evaluate with the verified entity price to determine the Arm’s Length Principle.

The CUP method offer the finest evidence of ALP. A arm’s length price may arise where:

• Tax payer or another member of the associate group sells the product, in comparable sizes and in the comparable terms to ALP in similar promote markets (internal comparable).
• An ALP party sells the similar product, in similar size of quantity and in the comparable conditions to other arm’s length party in similar markets (an external comparable).
• The taxpayer of the entities buys the similar quantities, in comparable quantities and in the similar terms from the associate parties in the comparable markets (internal comparable).
• An ALP party buys the particular goods, in comparable quantities and in the similar terms from the other arm’s length associate party in similar markets (external comparable).

Cost Plus Method (CPM):

In this method, the total price of intangible incurred by the tested parties in transferring products and services to Associated Enterprises is measured and the sum of gross profit spot used by similar enterprises in comparable transactions with self-determining associated enterprises is determined. The sum of gross spot arrived at is used to take into account functional and other variation to determine ALP. The extra similarities in the functions, risks and property, the extra likely it is that the cost plus method will create an suitable estimation of an arm's length result.

In common, for reason of apply a cost-based method, costs are divided into three categories:

1. Direct costs:- raw materials;
2. Indirect costs:- repair and maintenance which may be allot among several goods.
3. Operating expenses:- selling, general, and organizational expenses.

The cost plus method uses limits calculated after direct and indirect costs of goods. Correctly shaping cost under the cost plus method is important. Cost is typically calculated in agreement with accounting values that are usually accepted for that exacting industry in the region where the products are produced.

The cost base of the deal of the associated parties to which a mark-up is to be applied be calculated in the same way and returns comparable functions, risks, and properties as the cost base of the similar transactions. Where cost is not exactly resolute in the same way, both the mark-up and the transfer will be used.

Resale Price Method (RPM):

RPM method is related to CPM. This method is used where the vendor adds similarly little value to goods owned from associate enterprises. Here, Arm’s Length Price is determined by reducing the relevant gross profit mark-up from the sale price charged to free entity.

The resale price method starts with the resale price to arm's length entities (of a goods buy from an non-arm's length entities ), minimized by a similar gross margin. This similar gross margin is resolute by reference to either:

1. The resale price margin earned by a associate of the group in similar uncontrolled transactions (internal comparable); or
2. The resale price margin earned by an arm's length enterprise in similar uncontrolled transactions (external comparable).

Beneath this method, the arm's length price of products obtain by a taxpayer in a non-arm's length deal is resolute by reducing the price understand on the resale of the products by the taxpayer to an arm's length entities, by an suitable gross margin. This gross margin, the resale margin, should allow the vendor to:

1. Recover its operating costs; and
2. Earn an arm's length profit support on the factors achieve, properties used, and the risks understood.

Profit Split Method (PSM):

This method is used when associate enterprise transactions are included that it becomes very hard to conduct a transfer pricing analysis on a transactional base. The priority function to do is combined net profit acquiring to connected entities from a transaction is decide. After that combined net profit is allotted in between connected entities with mention to market income gained by free enterprises in comparable transactions.

In this Profit Split Method (PSM):

1. First move is to decide the sum of profit gained by the associate parties from a controlled transaction. The Profit Split Method (PSM) allots the total incorporated profits connected to a controlled transaction, not the total profits of the associate group as a complete. The profit to be split is usually the operating profit, before the reduce of interest and taxes. In some satiations, it may be suitable to split the gross profit.
2. Second move is to split the profit among the associate parties base on the comparative price of their assistance to the non-arm's length dealings, allowing for the functions assumed, the properties used, and the risks understood by each non-arm's length associate parties, in connection to what arm's length parties would have taken.

Profit Split Method (PSM) applied where:

1. The functioning of two or more non-arm's length associate parties are extremely included, making it hard to assess their dealings on an entity basis; and
2. 4. The continuation of valuable and sole intangibles makes it hard to set up the proper stage of comparability with uncontrolled dealings to relate a one-sided method.

Due to the difficulty of international operations, one group of the global group is rarely allowed to the total return attributable to the important properties, such as intangibles.

What is TNMM

·         Identify net profit margin realized by the enterprise from an international transaction with regard to an appropriate base

·         Identify net profit margin from a comparable uncontrolled transaction or a number of such transactions having regard to the same base

·         Adjust for differences that could affect net profit in the open market

·         Adjusted net profit used for establishing Arm’s Length Price

Where to use TNMM

·         Provision of services.

·         Distribution of finished products where RPM cannot be adequately applied or in case of a full-fledged distributor

·         Transfer of semi finished goods

Strengths and Weakness of TNMM

Strengths:

·         less affected by transactional differences

·         more tolerant to some functional differences

·         classification of expenses in the gross margin frequently makes it difficult to evaluate the comparability of gross margins; the use of net margins may avoid the problem

·         Being a one-sided method, it is required to examine the financial indicator of the tested party alone

Weaknesses:

·         net margin can be influenced by some factors that either do not have an effect, or have a less substantial or direct effect

·         these aspects may make accurate and reliable determinations of arm's length net margins difficult

Summary of Methods

Method	Comparability Requirements	Approach	Remarks
CUP	Very High	Prices are benchmarked	Very difficult to apply as very high degree of comparability required
RPM	High	Gross Profit margins are benchmarked	Difficult to apply as high degree of comparability required
CPM	High	Gross Profit margins are benchmarked	Difficult to apply as high degree of comparability required
PSM	Medium	Operating Profit margins are benchmarked	Complex Method, sparingly used
TNMM	Medium	Operating Profit margins are benchmarked	Most commonly used method

Most Appropriate Methods:

Cost plus method (CPM): this method is generally used where semi finished products are transferred.
Comparable Uncontrolled Prices Method (CUP): ): this not favorable as no public database is accessible concerning prices apply by autonomous enterprises in import of comparable products.
Resale Price Method (RPM):): In this method the vendor adds comparatively small or no value to goods taken from associate enterprises. In the current case in this method may be taken as the very important method as similar data of comparable deals by independent entities is available.
Profit Split Method (PSM): PSM method is used when associate enterprises are so combined that it turns into difficult to make transfer pricing analysis on transactional methods basis.
Transactional Net Margin Method (TNMM): In this method generally apply in the case of transfer of partially completed products, distribution of completed goods and where RPM cannot be sufficiently applied. In general RPM more suitably applied in this case, TNMM is also not right.

Methods of Profit level indicator  (PLI)

RPM	CPM	TNMM
GP/Sales	GP/COP	OP/Sales or OP/TC

Choice of PLI

Method	PLI	Formula	Typically used for
RPM	Gross margin	Gross Profit/ Sale	Distributor
Cost Plus	Gross cost plus	Gross Profit/ COGS	Manufacturer/ Service provider
TNMM	Net/Full cost plus (Return on total costs)	Operating profit/Total costs (Total costs = COGS + OPEX)	Manufacturer/ Service provider
TNMM/ PSM	Operating margin	Operating Profit/Net sales or net turnover	Manufacturer/ Distributor/Service provider
TNMM/ PSM	ROA	Operating Profit/Operating assets	Manufacturer/ Distributor/Service provider
TNMM/ PSM	ROCE	Operating Profit/Total assets – Current Liabilities	Manufacturer/ Distributor/Service Provider