6.24 In this approach, firstly, a basic return is determined for each of the enterprises and profits of each such enterprise is ascertained. This amount is reduced from the combined net profits. Residual profits are allocated on the basis of relative contribution.
6.24.1 Steps involved in this approach are as follows:
(i) As detailed in paragraph 21.5(i), determine the combined net profit of the associated enterprises arising from the international transactions in which they are engaged.
(ii) At the first stage, depending on functions performed, assets employed and risks assumed, determine the basic return appropriate to the respective activities. Allocate the combined net profit on the basis of above. This step results in a partial allocation of the combined net profit to each enterprise. For this purpose, the allocation is undertaken with reference to margins of comparable uncontrolled entities.
(iii) the balance of the combined net profit is allocated on the basis of the evaluation of the relative contribution as discussed in paragraph 21.5(ii).
(iv) the total net profit from such two-tier allocation is taken to arrive at the arm’s length price. The profits so apportioned to the AE when added to the costs incurred by it in relation to international transaction would result in arm’s length price.
6.25 The application of the profit split-method can be understood with the following example:
AE1 Ltd., is an Indian company. The shareholding pattern of AE1 Ltd., is as follows;
Shareholder’s name Status % holding
AE2 Ltd. Foreign Company 30
AE3 Ltd. Foreign Company 30
Financial Institutions Indian Company 10
Public 30
AE1 Ltd., is an investment advisory company, which in association with AE2 Ltd. assists its clients with foreign acquisitions.
AE3 Ltd., which is based in U.S.A., has worldwide presence. AE1 Ltd. is approached by M for identifying potential target companies for acquisitions in the USA. In order to serve M, AE1 Ltd. and AE3 Ltd., have each contributed integrally to identification of potential target and assisting M with the acquisition process. For the above, AE1 Ltd., received consideration of US$
50,000. The financials are as follows;
AE1 Ltd. AE3 Ltd.
Revenue 30000 20000
Cost 20000 8000
Profit 10000 12000
Factors to be considered:
(a) The normal basic return is ordinarily calculated as a percentage of the costs incurred or gross revenues or capital employed. In this example, it is assumed as a percentage of the cost.
(b) Based on the FAR analysis, the basic return for AE1 Ltd., and AE3 Ltd., are determined to be 15% and 10% respectively. Accordingly, the normal basic return for AE1 Ltd. in India for the aforesaid
Methods of Computation of Arm’s Length Price (c) On the basis of functions performed, risks assumed and assets
employed, the relative contribution may be taken at 70%, 30% for AE1 Ltd. and AE3 Ltd., respectively.
Determination of arm’s length price under profit split method:
First Approach: Total Profit Split Method
1. Associated enterprises : AE1 Ltd. and AE3 Ltd.
2. Ultimate delivery of product is : By AE3 Ltd. to M Ltd.
3. International transaction : AE1 Ltd. and AE3 Ltd.
Details US$
Price charged by AE3 Ltd from M Ltd 50,000
AE3 Ltd share of revenue 20,000
AE1 Ltd share of revenue 30,000
Combined total profits 22,000
Evaluation of relative contribution
AE1 Ltd : India return – 70% 15,400
AE3 Ltd : US return – 30% 6,600
Total 22,000
Total return for AE1 Ltd 15,400
Total cost of AE1 Ltd 20,000
Income of AE1 Ltd on arm’s length price (A) 35,400
Actual revenue (B) 30,000
Increased income (A-B) 5,400
Note: In this example, the basic return is not required to be taken into account.
Second Approach: Residual profit split method
Details US$
Price charged by AE3 Ltd from M Ltd 50,000
AE3 Ltd share of revenue 20,000
AE1 Ltd share of revenue 30,000
Combined total profits 22,000
1. Basic return
AE1 Ltd : India return 3,000
AE3 Ltd : US return 800
Total 3,800
2. Residual net profit 18,200
AE1 Ltd: India return – 70% 12,740
AE3 Ltd: US return – 30% 5,460
Total 18,200 Total return for AE1 Ltd (12740 + 3000) 15,740
Total cost of AE1 Ltd. 20,000
Income of AE1 Ltd. on arm’s length price (A) 35,740
Actual revenue (B) 30,000
Increased income (A-B) 5,740
The following points are to be noticed:
(a) It is the profit from a transaction with the associated enterprise that needs to be ascertained. If there are other transactions, which contribute to the profits, then the profits from transactions with associated enterprise may have to be arrived at on some approximation.
(b) The rule itself provides an alternative method to arrive at the arm’s length price being the two-tier profit split-method;
(c) If in either of the alternatives, a range of figures is available, the arithmetical mean of such figures may be adopted as the arm’s length price. It may however not be possible to adopt the arithmetical mean of the two alternatives.
(d) Under the two-tier split-method, the basic rate of return may have to be adopted having regard to the profits compared to the net worth of the enterprise. Such rate of return may not be uniform for all the associated enterprises involved in the transaction.
(e) This is the only method for which the Rule itself has prescribed the types of transaction to which it may be applicable.
(f) Even though the computation proceeds with the profits from a transaction, the purpose is only to arrive at the arm’s length price of a
Methods of Computation of Arm’s Length Price price in the international transaction that an adjustment may be made to the income returned.