International Taxation – Computation of ALP

International Taxation – Computation of ALP

Hello Readers, Hope you have read the previous parts.

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Let’s proceed further….

Computation of ALP:

I had already discussed CUP method of computation of ALP, so now let us discuss other parts:

Method 2: Resale Price Method

The resale price method (RPM) is a method which compares the gross margins (i.e. gross profit over sales) earned in transactions between related and unrelated parties for the determination of the ALP. The RPM requires high level of functional comparability and is mainly applicable where the controlled party is a distributor.

Assessee is recognized as a part of distribution system:

  • When the tested party (the party which has been selected for computation of ALP) purchases products/acquires services from related party and resells the same to independent parties.
  • Where the reseller does not add substantially to the value of the product/services.


Father Ltd. & Son Ltd. are Associated/Related parties. Son Ltd. & Stranger Ltd. are unassociated/unrelated parties.

The following transactions took place between them:

Father Ltd. >>>> Rs. 100 >>>> Son Ltd.

Son Ltd. >>>>>> Rs. 100 (25% resale margin included) >>>> Stranger Ltd.

Father Ltd has sold mobile phone to Son Ltd at Rs.100.

Son Ltd sold the same mobile to Stranger Ltd at Rs.100 but with resale margin of 25%. Now that means Stranger Ltd has earned Rs.25 on the sale of mobile (100*25%) and therefore it is assumed that Son Ltd. has purchased the mobile from Father Ltd. at Rs.75 (100-25).

Therefore, the ALP between the Father Ltd. & Son Ltd. is Rs.75.

Assumption: No other costs have been incurred by Son Ltd. for simplicity purposes).

Method 3: Cost Plus Method

The Cost plus method (‘CPM’) determines an arm’s-length price by adding an appropriate gross profit margin to an associated entity’s costs of producing goods or services.

This method probably is most useful where semi-finished goods are sold between related parties, where related parties have concluded joint facility agreements or long-term buy-and-supply arrangements, or where the controlled transaction (transaction between related parties) is the provision of services.


The Son Ltd. has purchased manufactured goods from Father Ltd.

The cost of goods manufactured by Father Ltd. is Rs. 500

The similar transaction is entered into between Father Ltd. & Stranger Ltd. with gross profit margin of Rs. 250 i.e. total of 750 (500+250). Thus, the arm’s length price between Son Ltd. & Father Ltd. is also arrived at is Rs.750.

Method 4: Profit Split Method:

The Profit Split Method (PSM) evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is at arm’s length with reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss.

The combined operating profit or loss must be derived from the most prominently identifiable business activity of the controlled taxpayers for which data is available that includes the controlled transactions (relevant business activity).

Allocation of profits must be made in accordance with one of the following allocation methods:

  1. Comparable profit split – Under this method, uncontrolled taxpayer’s percentage of the combined operating profit or loss is used to allocate the combined operating profit or loss of the relevant business activity.
  2. Residual profit split – Following the two-step process:     
  •  Allocate income to routine contributions       
  • Allocate residual profit.

Suppose in the above example, Net profit margins from all transactions were USD 100M.

Depending on the contribution of each AE, the net profit of USD 70M will be distributed to all AEs (i.e. Allocate income to routine contributions).

Further, after the respective contribution is allocated specifically, the residual profit of USD 30M will be distributed among AEs based on various factors.

Total profit for Related Party X:

  1. Income for specific contribution (suppose 40% by X and 60% by Y) made by X: USD 28M (i.e. USD 70M x 40%)
  2. Income as residual profit (i.e. 50:50) (allocated considering various factors): USD 15M (i.e. 30M x 50%)

Total Arm’s length profit of related party X: USD 43M (USD 28M + USD 15M)

Method 5: Transactional Net Margin Method (TNMM):

Under the Transactional net margin method (TNMM), an arm’s-length price is determined by comparing the operating profit relative to an appropriate base (example costs, sales, assets) of the tested party with the operating profit of an uncontrolled party engaged in comparable transactions.

Example: The following pic shows the similar transaction between unrelated parties.

The AE1 has purchased raw materials from its AE2 and manufactures goods for sale to third parties.

The similar transaction is entered into by unrelated parties with net margin of 5% of sale price i.e. Rs.500 (10,000*5%) as shown in the example.

Therefore, transaction between AE1 & AE2 is also taken at net margin of 5%. Now suppose if AE1 has transferred the goods at Rs. 12,000, then the net profit will be taken at 5% i.e. Rs.600 (12,000*6%).

Method 6: Other Method as may be prescribed by the CBDT:

The Other method allows the use of ‘any method’ which takes into account

  • the price which has been charged or paid or
  • would have been charged or paid for the same or similar uncontrolled transactions with or between non-associated enterprises, under similar circumstances.

The various data which may possibly be used for comparability purposes under this method could be third party quotations, valuation reports, tender/Bid documents, documents relating to the negotiations, standard rate cards, commercial & economic business models; etc.

Note: For applying the above methods, the comparability of the international transaction with an uncontrolled transaction is to be judged with reference to the following factors:

  • The specific characteristics of the property transferred or services provided in either transaction;
  • FAR Analysis (will discuss in later parts of the series).
  • The contractual terms (whether or not such terms are formal or in writing) of the transactions.
  • Conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail.

So, here I am ending this part.

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