Determination of Transfer Price in practice is totally different from that of the theory described in section 14.6. It is not only complicated but also very specialized job and firms requiring formulation of their Transfer Pricing policies rely on big consulting firms.
Determination of Optimal Transfer Price consists of the following steps:
Step 1:
At the very outset an international transaction is identified which takes place between two Associated Enterprises (AEs). By AEs we mean (i) two enterprises, of which one enterprise directly or indirectly participates in Management or contributes Capital in or Controls the other enterprise or (ii) two enterprises which have a common senior enterprise, which directly or indirectly participates in the management, or contributes capital or controls both these enterprises.
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While this is the generic definition of AE, the definition of AE in TP law of a country may be more specific (i.e. laying down the tests of capital, management or control).
Further, if a particular enterprise carries our transactions with a number of group companies, then Step 1 will also involve identification of the AEs along with the transactions. It may be so that all group companies are not AEs as per definition of the local TP law.
Step 2:
Functions performed by, Assets employed in and the Risks involved (FAR) with both the enterprises with respect to the transaction under review are analyzed.
Step 3:
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On the basis of FAR analysis, the AE which is less complicated between the two is identified as the Tested Party.
Step 4:
Depending on the FAR analysis of the AEs, the characterization of the AEs with respect to the transaction under review is determined. The entity may be characterized as Service Provider, Limited Risk Distributor, Toll Manufacturer, and Contract Manufacturer etc.
Step 5:
This step involves determination of the method to be used to arrive at the arm’s length price of the transactions between the AEs. The Methods are classified into two categories: Traditional Methods and Transactional Methods. The former includes
Comparable Uncontrolled Price Method (CUP), Resale Price Method (RPM) and Cost plus Method (CPM). The latter encompasses Transactional Net Margin Method (TNMM) and Profit Split Method (PSM).
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Selection of the most appropriate method depends on various factors, such as (i) nature of the transaction, (ii) characterization of the AEs, (iii) availability of appropriate comparable internal or external data, (iv) possibility of making adjustments to comparable data.
Step 6:
For application of the most appropriate method, reliable internal or external comparable data are required.
Internal comparable data are related to transactions of the AEs with third parties, which are same or similar to the transactions between the AEs.
External comparables are normally obtained with the help of Commercial dataset and information, whereby the comparable companies engaged in the same or similar business/transactions are selected and their performances in terms of quantitative attributes (known as Profit Level Indicators or PLIs) are ascertained. This step is called Benchmarking.
Step 7:
Arm’s Length Price and Arm’s Length Range are determined from step 6. Arm’s length price or profit rate (depending on the method applied) is determined based on common statistical measures such as median, mean or inter-quartile range. In case the price is not determined directly, the arm’s length profit rate is applied to arrive at the Arm’s Length Price. The selection of the statistical measure often depends upon the specific requirements of the Tax authorities of the countries where the AEs operate.
A range of +/- 5% on the ALP is accepted in the Indian law. This range is called Arm’s Length Range. In contrast, many European countries use the median and inter quartile range or even the full range (i.e., minimum and maximum).