The Inland Revenue Department, Hong Kong, has released a comprehensive “Departmental Interpretation and Practice Note No. 48 on the Advance Pricing Arrangement“. The salient features of this Note are as follows:

Transfer pricing and APAs

This Departmental Interpretation and Practice Note (DIPN) is intended to provide guidance for enterprises seeking an Advance Pricing Arrangement (APA). It explains the APA process and the terms and conditions of the APA process prescribed by the Commissioner.

2. The Commissioner agrees that the arm’s length principle is the international transfer pricing standard that should be used for tax purposes and the behaviour of independent enterprises should be used as a benchmark to determine the arm’s length consideration or profits in relation to controlled transactions.

3. In the comprehensive double taxation agreements (DTAs) concluded by Hong Kong, the Associated Enterprises Article has incorporated provisions which mandate the adoption of the arm’s length principle for pricing controlled transactions. When administering the provisions of the Inland Revenue Ordinance (IRO), the Commissioner will ensure that enterprises operating in Hong Kong declare a level of profit from controlled transactions that is commensurate with the functions carried out, the assets used, and the risks assumed in Hong Kong.

4. The APA process, which is voluntary, will supplement the objection, appeal and other DTA mechanisms for resolving transfer pricing issues. Its scope is flexible and it may cover all or part of the transfer pricing issues of an enterprise. The discussion of complex transfer pricing issues in a non-adversarial environment can stimulate the free flow of information and promote mutual understanding among all parties concerned. The Commissioner does not charge any fee on enterprises during the APA process but enterprises need to be aware that some overseas tax administrations may do so.

The report said that most of the notices had been sent to companies who route their exports through tax havens which the department suspected has been done to evade tax. The orders were issued last month for the assessment year 2008-09. Transfer pricing is about the price at which goods or services are transferred between one country and another within the same organization. Transfer pricing regulations were introduced in 2001-02 to ensure that the country doesn’t lose revenue from companies that undertake cross-border transactions between related parties. Sources said that these adjustments will translate into a tax collection of Rs 400 to Rs 450 crore.



The report quoted a senior income-tax official as saying “Notices have been sent to around 56 companies, most of which are based in Ahmedabad and the industrial belt between Vadodara and Vapi. Pharma firms in the state have received most orders as there the department has found several companies exploiting the tax soaps given in Himachal Pradesh and also use of tax havens like Dubai, British Virgin Islands and Channel Islands to evade tax.”

He was also quoted as saying “Around 650 crore of these adjustments have been done in transactions of five companies, three of which are Ahmedabad and Vadodara-based pharmaceutical companies. In one of the cases we found that the company took tax benefits in Himachal Pradesh and then exported manufactured goods to Dubai and from there to across the world. However, price at which the drug was sent to Dubai was less than half at which it was re-exported from there.”

The report added that the international taxation wing has been given a target of Rs 550 crore for 2011-12. Out of which Rs 300 crore has been collected by December 31. It was pointed out that the wing had in the last fiscal collected Rs 480 crore as taxes against the target of Rs 460 crore.

(Read more here)

Section 92C of the Act provides for computation of ALP, which has to be done by adopting either of the following methods: –

a) Comparable uncontrolled price method; or

b) Resale Price method; or

c) Cost plus method; or

d) Profit split method; or

e) Transactional net margin method; or

f) Such other method as may be prescribed by the Board

9. Where more than one price is determined by the most appropriate method, the ALP shall be taken to be the arithmetical mean of such prices. The Assessing Officer may form his opinion on the basis of material or information or documents in his possession that the price charged or paid in an international transaction has not been determined in the aforesaid manner; or the information and document relating to international transaction have not been kept and maintained by the assessee as required under section 92D(1) and (2) of the Act or furnish any information or document within the specified time as required u/s 92E(3); or computation of ALP is unreliable or incorrect, in that case, he may proceed to determine the ALP in relation to that transaction on the basis of material or information or documents available with him and compute the income accordingly after giving opportunity to the assessee of being heard. Here, the legislation shifts the burden of proof from Tax Authorities to the assessees in showing that the transaction with Associated Enterprises (AEs) was at ALP on the basis of documents maintained and filed by it (assessee). The requirement of maintenance of various documents is to enable the assessee to justify and document Transfer Pricing arrangement.

10. The principle of Transfer Pricing is stated in Article 9 of the OECD or the UN Model Double Taxation Convention. It, however, does not specify the methodology, which is done under the domestic laws. The Indian law on the subject is contained in sections 92 to 92F. The concept of Transfer Pricing is applied in the computation of income from international transaction between the AEs having regard to ALP. Thus, the important aspects of the subject are –

i) Arm’s Length Price (ALP)

ii) International transactions (I.Ts)

iii) Associated Enterprises (AEs)

11. An ‘international transaction’ is a transaction between two or more AEs, either or both of whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property; or provision of services; or lending or borrowing money; and any other transaction having a bearing on the profits, income, losses or assets of such enterprises. A transaction is the transfer of goods or services, involving a physical product or knowledge or a right to use or exploit an intangible asset. The definition of the word ‘transaction’ is an inclusive one. It includes an arrangement, understanding or action in concert, irrespective whether it is formal or in writing; or whether or not it is intended to be enforceable by legal proceedings.

12. ‘Transfer Price’ may mean manipulation of prices in relation to international transactions between the parties which are controlled by the same interest, involving two or more countries with differing tax rates and legislation a realizing profits in the country with the most favourable tax regime so that total tax liability is reduced.

13. Such manipulations are difficult to be established because of the problems of off-shore investigations. For that matter, States have, through Legislation, resorted to a hypothesis of ALP i.e what would have been the price if the transactions were between two unrelated parties similarly placed as the related parties. As regards nature of product and conditions and terms of the transactions. Methodology for the purpose of comparability has been formulated, under the respective domestic laws of the countries. The hypothesis presumes that the tax payer’s income is incorrectly reported on the ALP standard and permits the Revenue authorities to make a determination of true taxable income. This is apart from incorrect reporting because of fraudulent, colourable or sham transactions. The general theory of transfer pricing is that the Legislation is to treat each of the individual price of commonly controlled group as a separate entity, transactions between which are taxable events to be formed to the economic realities that would obtain between independent entities conducting identical transactions at Arm’s Length. To transfer a tangible property, CUP method, or resale price method or cost plus method are applied. If none of them is applicable, the fourth method known as ‘appropriate method’ i.e., comparable profit method or profit split method or unspecified method is applied. It is to be seen if the amount charged is arm’s length by reference to gross profit margin in comparable transaction. The comparability depends on similarity of the product under CUP method.

14. Before deciding the impugned issue let us try to understand the need, the necessity and methodology utilized in international taxation. In the year 1991, the Indian economy started opening up. Foreign investment pouring in as a result of economic reform measures was taken by the Government. Industrial licensing policy was considerably liberalized; tax structure simplified and made internationally compatible. In order to have smooth flow of investment and trade, India has made its economic climate conducive to investment and for that purpose, it has entered into agreements with almost all the capital and technology exporting countries with a view to avoid double taxation of income arising in India by virtue of the business connection. Double taxation agreements are established the way for the States to agree at International Level for resolution of the problems arising from the cross-border trading and investments. The Tax Treaty facilitates investments and trade flow by preventing discrimination between taxpayers, adds fiscal certainty to cross-border operation, prevents evasion and avoidance of tax at international level. Apart from facilitating collection of taxes and attainment of national development goal, the treaty warrants the stability of tax burden, so that its provisions may not be abused by Multi-national Enterprises (MNEs) by fixing prices, terms and conditions of transactions between their controlled enterprises located in different jurisdictions. The treaty requires that such transactions be dealt with as if they are between unrelated parties and even account be rewritten if required, so that real profit would be taxed, which is sought to be manipulated. The relevant provisions of the Act are patterned on the OECD Guidelines1995. These provisions are erosion of Indian tax base by multi-nationals through a mechanism of what is known as “transfer pricing” . In a modern democratic set up, the Governments – Local, State or Central – are modified version of ‘service corporations’ of which all the people in the community are the members and the principle object of the Government is to serve the people, so that we can achieve the goal of establishing egalitarian society as envisaged in the Constitution of India. In India, there is no crown and there is no subject. ‘We, the people of India’, are the real sovereign and it is the people, who decide to tax the community for the benefit and welfare of the society. The Government collects most of the money it needs from its citizens and the companies by taxing their income according to their capacity to pay, to spend on behalf of the citizen in maintaining law and order, defending from outside attack and providing education, health care, social security etc. So taxation is a means of apportioning the cost of Government amongst those, who benefits from it. Non payment of tax by any person when it is due increases the burden of those who pay. That is why Government takes measures to curb evasion of tax resorting to penalty and prosecution. No Government can afford multinational companies to dictate transactions amongst their affiliates and avoid payments of tax in the ‘State’ where it is due, causing substantial loss of much needed public revenue in a welfare state. There are two ways of preventing this: (1) -Global Formulary Apportionment and (2) -Arm’s Length Principle for transfer pricing adjustment. Where tax rates are different between countries, there is a strong incentive to shift income to a lower tax and deductions to a higher tax country, so that the overall tax effect is minimized. There are two different approaches to deal with shifting of the profits from one jurisdiction to another; either to ignore the independent status of the corporations within the group and consequently also the transactions between them or to treat them independent and make adjustments to their income. The former is know as the Global Formulary Apportionment method and the latter is know as transfer pricing adjustment approach. In first, corporate group is taxed as a whole and the global profits allocated amongst the associated enterprises in different countries on the basis of pre-determined formula. In the other, associated enterprises are taxed as separate entities. The latter is mostly adopted, because corporate laws recognize independent status. To illustrate this, suppose an American manufacturing company ‘A’ sells goods to its associated enterprises in a low tax rate country ‘B’ for say $ 100 that enterprise sells it to an unrelated entity in India for $400. Global Formulary Method approach is the transaction between A & B is ignored and the sale between B and the Indian company is treated as if A made it direct and the entire sale proceeds of $400 belongs to A and not just $100. In other words, the income of associated enterprise B ( $ 300) is attributed to the American company. The Arm’s Length transaction adjustment requires that sales price up and consequently, the profit of B increased by $300. In both the case, the conclusion is the same, however, the route is different. Under the transfer pricing approach relationship between the corporations and transactions between them are recognized while under consolidation approach they are ignored. The consolidation approach has many advantages. It prevents transfer pricing by the residents; does away with treaty shopping, which involves re-characterization as well as diversion of income; eliminates the vice of thin capitalization. 15. The League of Nations to international associations of countries created to maintain peace among the nations of the world in the year 1920 and had its headquarters in Geneva, Switzerland. But this association ceased to function after the Second World war and was finally dissolved in April, 1946, and its place was taken by the United Nations. The League played a pioneering role in developing Model Tax Treaties during the period between 1930s and 1940s, its work being taken over in 1960s by the Organization for European Economic Cooperation (in short OEEC). This OEEC subsequently was substituted by the Organizations for Economic Co-operation and Development (OECD). The OECD is a multilateral organization comprised of mostly Western European countries, the United States, Canada, Japan, Australia and New Zealand. Its headquarters are in Paris (France) and it was founded in the year 1961 by replacing OEEC. It was established in the year 1948 in connection with the Marshall Plan, and it provides a forum for representatives of industrialized countries to discuss and attempt to co-ordinate economic and social policies. Its primary objectives are: (i) to maintain and stimulate economic growth and (ii) to increase co-operation and promote economic development within and outside of the territories of the Member countries and assist development and growth of world trade. The OECC and OECD played an important and pioneering role in the development of model tax treaties during 1960s to the present day. The OECD’s work on taxation is managed by Tax Center for Tax Policy and Administration. 16. Seperate taxation and not the consolidation approach is generally favoured because under the Arm’s Length standard, each nation’s tax system operates under its own domestic tax rules subject to relatively minor qualifications of arm’s length prices in certain international transactions. It facilitates sharing of revenue between two States, unlike under the Consolidation Approach. The Consolidation Approach is based on a ‘formulatory apportionment system’, which has its own difficulty of operations. The reasons for the above are that one – it relates to defining ‘relationship’ among corporations as to bring their profits within the formulae, two – to the formulae to be used in the allocation of profits among the jurisdictions and three – to defining world wide tax base used in identifying group of profits. These difficulties are not addressed to in tax treaties. Most of them favoured separate taxation of associated enterprises and the transfer pricing approach. The OECD Transfer Pricing Guidelines are as follows:

1) There are several reasons OECD Member countries and other countries have opted Arm’s Length Principle. The major reason for the same is that the Arm’s Length principle provides broad parity of tax treatment for MNEs and independent enterprises. Because the Arm’s Length Principle puts associated and independent enterprises on a very equal footing for tax purposes and avoids the creation of tax advantageous or disadvantageous that would otherwise distort the relative competition purposes.

2) The Arm’s Length Principle has also been found to work effectively in the vast majority of the cases like there are many cases which involve the purchase and sale of commodities and the lending of money, where Arm’s Length price may readily be found in the comparable transaction undertaken by the comparable enterprises under comparable circumstances. One of the major flaws in the system is that the Arm’s Length Principle dis-regard integral and functional unity of a MNE, which is responsible for greater efficiencies and advantageous competition edge. The function of all its subsidiaries located in various tax jurisdictions cannot be analyzed in isolation of each other; and dealings and transactions within MNEs are treated at par with the dealings and transactions between unrelated parties at Arm’s Length Principle. Transfer Pricing Guidelines as contained in the OECD guidelines are largely followed by various countries, but their implementation by the tax authorities differ. The focus of tax authorities is on increasing national tax base. In an attempt to achieve that objective they lose the international perspective. The same issues are treated in different ways in different jurisdictions, for example, such as allocation of capital risk, entrepreneur function, local market penetration risks and rewards. There are practical difficulties in applying Arm’s Length Principle. The concept of separate taxation is not only confined to the recognition of a corporation as an entity independent of the parent, but also extended to treating a branch of the parent as separate and independent. The Arm’s Length Principle is applied both in the context of transfer pricing and attribution of profits to the Permanent Establishment (PE). Commercial transactions between different parts of the multinational groups may not be subject to the same market forces shaping relations between two independent firms. Open market considerations need not necessarily govern transactions between two enterprises under the same or common control. The prices paid for transaction between members of a multinational enterprise may be fixed in order to meet the convenience of the multinational enterprise or a group as a whole and done in a variety of ways. Such fixing would not have been possible. if the parties to the transaction were independent acting at arm’s length. A transfer price is defined as a price paid for goods transferred from one economic unit to another, assuming that two units involved are situated in different countries, but belong to the same multinational firm. Transfer price is the price charged in a transaction, which means an actual price charged between the associated enterprises in an international transaction. Transfer pricing is widely used in multinational organization, which typically involve a parent company domiciled in one country and a number of subsidiary companies operating in other countries. When multinational firms conduct business within their group, the concept of market pricing or arm’s length pricing has no relevance. Income or deduction is arbitrarily shifted. Supposing A purchases goods worth Rs.100 and sells them to its associated Company B in another country for Rs.200/-, who in turn sells in the open market for Rs.400/-. If A would have sold it directly, itwould have made a profit of Rs.300/- which has been restricted to Rs.100/- by something it through B. The transaction between A & B is arranged and is not subject to market forces. The profit of Rs.200/- has been, thus, shifted to Country of B. The goods have been transferred on a price (transfer-price) which is arbitrary or dictated being Rs.200/- and not being Rs.400/- which is its market price. Transfer between enterprises under the same control and management, of goods, commodities, merchandise, raw-material, stock or services is made on a price, which is not dictated by the market but controlled by such considerations. Transfer of goods or services as aforesaid is as dictated by the market but it is controlled by the consideration of shifting taxable profits or duties or of arranging the direction of cash flow. The developing countries lay heavy restrictions in regard to remittance of profits, but in their engineers to secure access to foreign technology, expertise technical know-how, capital goods and components for their industrial development. The MNCs have changed their investment and technical collaborations, policies and the developing countries unpredictability about political and economic stability of a country may necessitate flight of capital and profit there from. This flight is achieved through the device of transfer pricing.

17. The reason for fixing a price, which is not an Arm’s Length price, whatever be the motive, is the avoidance of the profit from a country where it would have accrued, had the transactions been at Arm’s Length. The avoidance or evasion of tax cannot be the purpose or there could be honest difference of opinion about what should be the Arm’s Length price, the tax authorities are aware that tax is avoided. Therefore, the question of the tax treatment of the transfer pricing is always considered in association with avoidance or evasion of tax. The net effect of transfer pricing abused is that profits properly attributable to one jurisdiction are shifted to another jurisdiction. In controlled transaction if it is not found at arms length shifting of profit and consequently avoidance of tax is heavily presumed even if it is done inadvertently or with purpose. The arms length principle cannot be applied, if income could not be legally received. MNE group to companies seek to achieve the best tax results not only by manipulating export and import prices, but also by manipulating category of income. World over, different categories of income are dealt with differently and so also the treaties on tax are structured. Income is separate into separate categories and each category has its own role for computation as well as tax rate. Business income is taxed at the normal rates in a given country on a net basis whereas royalty, interest and dividend are taxed at reduced rates on gross basis. Therefore, a non-resident tax payer being permanent organization of the subsidiary company incorporated in the source country would be encouraged to categorize business income as royalty or technical fee. Because the parent organization and its subsidiary company are treated as independent entities for tax purposes and treaty purposes, the characterisation of income changes the same result as for unrelated tax payers, for example, the non-resident conferring patent right on a resident may transfer a patent in exchange of shares (producing dividend income) or can leave purchase particulars outstanding as a loan ( producing interest income) or may license patent in exchange for royalties. Thus, the tax manipulation among the related corporations not only involves the use of arbitrary prices, but also conversion of returns on equity, investment to royalty and interest. Transfer pricing may mean manipulation of prices in relation to international transaction between the parties, which are controlled by the same interest, involving two or more countries with different countries having different tax rates and realising profits in the country, which has the payable tax regime resulting into reduction of payable tax liability. Such manipulations are difficult to be caught and established because the taxman is handicapped to make off-shore investigations. With a view to deal such a situation, so that a legitimate tax to which a State is entitled to, a combined effort has been made through legislation. According to which on hypothetical manner such evasion of tax can be controlled, a term known as an ‘arm’s length’ has been coined. What would have been the price if the transactions were between two unrelated parties, similarly placed as the related parties in so far as nature of product, conditions and terms and conditions of the transactions are concerned? For that purpose methodology and modalities to compare the results under perspective domestic laws of a given country have been formulated. According to this hypothesis, it is presumed that tax payer’s income has been incorrectly reported on the arms length standard which permits the revenue authorities to determine a correct taxable income. This methodology is different from incorrect reporting by way of fraudulent, colorful or sham transactions. The basic thesis is that transfer pricing legislation is to treat each of the individual members of a commonly controlled group as a separate entity, the transactions between whom are taxable events to be conformed to the economic realities obtaining between independent entities entering into similar and identical transactions, at arm’s length. Thus, a transfer pricing is a device to control avoidance of tax in a jurisdiction where it is otherwise due. The right to do business in a most beneficial manner given to a businessman is thus abused causing loss to ex-chequer of a country where the profit is drawn and it is shifted to another country. The law does not permit or sanction abuse of such a right. This abuse can be curbed in the following ways:

(1) By establishing an arms length transfer price which requires enquiry/investigation as to what unrelated parties, which are not under common control, would do in similar circumstances. So it is an attempt to establish the prices that would prevail in the market place; or apportioning of over all profit of the enterprises those establishing a fair or proper division of global profits.

(2) By non-deducting of intra firm payment, unless such payments are consistent with normal commercial practices. Therefore, with a view to provide a statutory framework which can lead to computation reasonable, fair and equitable profits and taxing the same in India, in relation to international transactions between two or more associated enterprises, new provisions have been introduced in the Income Tax Act effective from 01.04.2002. These provisions are more or less based on traditional rules outlined in the work of the OECD. For that matter strict conditions have been imposed on the tax payer to maintain and provide documentation of transfer pricing, methodology, non-compliance thereof attracts heavy penalties.

Controlled tax payer means one of the two or more tax payers owned or controlled directly or indirectly by the same interests, and includes the tax payer who owns or controls the other tax payers. Uncontrolled tax payers mean any one of the two or more tax payers not owned or controlled directly or indirectly by the same interest. Likewise control means any kind of control directly or indirectly whether legally or not and however, exerciseable or exercised, including control resulting from the actions of two or more tax payers acting in concert or with a common goal or purpose. Thus, it is the exercise of real control, which is decisive but in its forum or more of its exercise. A presumption of control arises if income or deductions have been arbitrarily shifted. A ‘transaction’ means same assignment, lease, loan, advance, contribution or any other transfer of interest in or right to use any property whether tangible or intangible or money. However, such transaction is effected and whether or not the terms of such transaction are formally documented. Such a transaction also includes performance of any services for the benefit of or taxes, other tax payers. In determining the true taxable income of a controlled taxpayer, the standard to be applied in several case is that of a taxpayer dealing at arm’s length with an uncontrolled tax payer. Whether a transaction results an arm’s length result will to be determined with reference to the results of a comparable under comparable circumstances. Transactions are not ordinarily considered comparable if they are not made in the ordinary course of business or one of the principal purposes of the uncontrolled transaction was to establish an arm’s length result with respect to the controlled transaction. Specific methods for that purpose have been provided for determining arm’s length results, if the transaction’s do not satisfy that standard. Transactions may involve different kinds of transfer such as transfer of property, services, loan or advances and therefore, may require selection of appropriate method for the calculation of arm’s length results. No shift method of priority is recommended The best suitable method for determining a most reliable measure of arm’s length result has to be given priority. In selecting the best method, two factors to be taken into account are:- (i) the degree of comparability and (ii) Completeness and accuracy of the data. Degree of comparability depends on the following factors: (i) Functions identifying and comparing the economical significant activities; (ii) comparing significant contractual terms, (iii) comparing significant reasons (iv) comparing significant economic conditions (v) comparing of property or services and (vi) market strategies, location, savings, etc.

18. The methods to determine arms length price of tangible property are (i) comparable controlled price (CUP) method (ii) Result Price Method (3) CUP plus method (4) ( if none of the above applied) appropriate method is comparable profits method; profits supplied method; unspecified method. The CUP method is one comparable uncontrolled price method, which is defined as transfer price method that compares the price for property or services transferred in a controlled transaction to the prices charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. Thus, CUP method is the most direct and reliable method. The resale price method measures the value of functions performed and is ordinarily used in cases of purchase and resale of tangible property in which the reseller has not added substantial value to the tangible goods by physically altering the goods before resale (packaging, re-packaging, labeling or minor assemble do not constitute physical alteration). This method is not an ordinarily used where the controlled taxpayer uses in its tangible property to add substantial value to the tangible goods. Cost Plus Method is ordinarily used in cases involving the manufacture, assembly, or other production of goods, that are sold to related parties. Comparability under this method is dependent on similarity of functions performed, risks borne and contractual terms, and adjustments to account for the effects of any such differences. With respect to intangible property, the methods which apply are (i) Comparable uncontrolled transaction method which evaluates whether amount charged for controlled transfer of an intangible property was at arm’s length by reference to the amount charged in comparable uncontrolled transactions. This method requires that controlled or the uncontrolled transactions involve either the same intangible property or comparable intangible property. The burden of proof is always on the taxpayer .

Transactional Net Margin Method (TNMM) is applied in a case where the sale its products to its subsidiary and makes no uncontrolled sales in geographic market, but there are other players, who sell similar product to other distributors in that market. The uncontrolled distributors purchase the product from unrelated parties, but there is a difference in that they do not have the brand names. Because reliable assessments can not be made for the brand name, the CUP method can not be used. But when there is a close functional similarity between controlled and uncontrolled function in terms of market in which they occur the volume of the transactions, the marketing activities undertaken by the distributor, inventory levels, fluctuation of currency risks and other relevant functions and risks and reliable adjustments can be made for similar difference in payment terms and inventory levels for same differences in payment term and inventory level, re-sale particulars method just a higher degree of comparability and thus provides a reliable measures on arms length result. It is preferred over TNMM. TNMM is preferred to costly price method but costless method is preferred to TNMM.

TNMM is another method which provides a practical solution to otherwise insolvable transfer pricing problem. This method is used where net margins are determined from the uncontrolled transaction of the same taxpayer in comparable circumstances, or comparable transactions of two independent enterprises with the material differences affecting price between the associated and independent enterprises having been adjusted. If not adjusted, the method is not to be used. This method requires comparison between income derived from the operations of the uncontrolled parties and income derived by an associated enterprise from similar operations. The TNMM is a modified, cost +/- resale price method. Price guidelines defined it as the method, which examined the net profit margin relating to an appropriate base ( for e.g. costs, sales, assets ) that taxpayer realizes from a controlled transaction. This method is used where CUP or resale or cost plus method cannot be applied. In this method focus is on transactions rather than business line or the operating income of the company. As regards comparability, the focus is on comparability in the transaction and enterprises rather than on the same level of comparability in product and function has required in traditional method. This is based on net profit margin relative to anappropriate base – costs, sales, assets- which the taxpayer makes from a controlled transaction. This method has been aptly described in Rule- 10(B)(1)(e) of the Income Tax Rule as under:-

(e)transactional net margin method, by which,—

(i) the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;

(ii)the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;

(iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;

(iv) the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii);

(v) the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction.

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