Arm's Length Price — The Five Prescribed Methods Explained (CUP, RPM, CPM, PSM, TNMM)

Transfer pricing is one of the most critical and complex areas of international taxation. Section 165 of the Income Tax Act, 2025 prescribes five methods for determining the arm's length price in relation to international transactions and specified domestic transactions. Rule 79 of the Income Tax Rules, 2026 provides detailed guidance on each method. Understanding these methods is essential for taxpayers and practitioners.

The Statutory Framework

Section 165: Determination of Arm's Length Price

Section 165 provides that the arm's length price in relation to an international transaction or specified domestic transaction shall be determined by any of the following methods, being the most appropriate method:

• Comparable Uncontrolled Price Method (CUP)
• Resale Price Method (RPM)
• Cost Plus Method (CPM)
• Profit Split Method (PSM)
• Transactional Net Margin Method (TNMM)
• Such other method as may be prescribed

Rule 79: Detailed Guidance

Rule 79 provides detailed guidance on the application of each method.

The Five Methods Explained

1. Comparable Uncontrolled Price Method (CUP)

Best For: Transactions involving tangible goods, commodities, or services where comparable uncontrolled transactions exist.

Methodology:

1. Identify the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction
2. Adjust such price to account for differences that could materially affect the price in the open market
3. The adjusted price is taken to be the arm's length price

Key Considerations:

• Requires comparable uncontrolled transactions
• Adjustments for differences in product characteristics, functions, contractual terms, and market conditions
• Most reliable method when comparable transactions exist

Practical Example: A subsidiary purchases raw materials from its parent company. The price charged by the parent is compared to the price charged by an unrelated supplier for similar goods.

2. Resale Price Method (RPM)

Best For: Distribution activities where the distributor adds relatively little value to the product.

Methodology:

1. Identify the price at which property purchased or services obtained from an associated enterprise is resold to an unrelated enterprise
2. Reduce such resale price by the amount of a normal gross profit margin from a comparable uncontrolled transaction
3. Reduce further by expenses incurred directly in connection with the purchase
4. Adjust for functional and other differences
5. The adjusted price is the arm's length price

Key Considerations:

• Requires comparable gross profit margins
• Adjustments for differences in functions, risks, and assets
• Suitable for distribution and trading activities

Practical Example: A subsidiary purchases finished goods from its parent and resells them to unrelated customers. The arm's length price is determined by subtracting the normal profit margin from the resale price.

3. Cost Plus Method (CPM)

Best For: Manufacturing activities, contract manufacturing, and service provision where costs are well-defined.

Methodology:

1. Determine direct and indirect costs of production incurred by the enterprise
2. Determine the amount of a normal gross profit mark-up from a comparable uncontrolled transaction
3. Adjust the mark-up to account for functional and other differences
4. Increase the costs by the adjusted profit mark-up
5. The sum is the arm's length price

Key Considerations:

• Requires comparable gross profit mark-ups
• Adjustments for differences in functions, risks, and assets
• Suitable for manufacturing and service activities

Practical Example: A subsidiary manufactures goods for its parent. The arm's length price is determined by adding a normal profit mark-up to the manufacturing costs.

4. Profit Split Method (PSM)

Best For: Transactions involving unique intangibles or highly integrated operations that cannot be evaluated separately.

Two Approaches:

Contribution Profit Split Method:

1. Determine the combined net profit of the associated enterprises
2. Evaluate the relative contribution of each enterprise based on functions, assets, and risks
3. Split the combined net profit in proportion to their relative contributions
4. The profit apportioned to the assessee is used to determine the arm's length price

Residual Profit Split Method:

1. Determine the combined net profit
2. Allocate a portion to provide each enterprise with an arm's length return for routine contributions
3. Split the residual net profit based on relative contributions
4. The aggregate is used to determine the arm's length price

Key Considerations:

• Requires reliable external market data
• Suitable for transactions with unique intangibles
• Complex and data-intensive

Practical Example: A parent and subsidiary jointly develop a new product. The profits from the product are split based on their relative contributions.

5. Transactional Net Margin Method (TNMM)

Best For: A wide range of transactions, particularly when comparable transactions are difficult to identify.

Methodology:

1. Compute the net profit margin realised by the enterprise from the international transaction in relation to costs, sales, or assets
2. Compute the net profit margin realised from a comparable uncontrolled transaction
3. Adjust for differences
4. Establish that the net profit margin realised by the enterprise is the same as the net profit margin in the uncontrolled transaction
5. Use this to determine the arm's length price

Key Considerations:

• Most commonly used method in India
• Requires comparable net profit margins
• Suitable for a wide range of transactions

Practical Example: A subsidiary provides software development services to its parent. The arm's length price is determined by ensuring the subsidiary earns a net profit margin comparable to similar companies performing similar functions.

Selecting the Most Appropriate Method

The most appropriate method is selected based on:

1. The nature and class of the transaction
2. The class or classes of associated enterprises and their functions
3. The availability, coverage, and reliability of data
4. The degree of comparability existing between the transactions
5. The extent to which reliable and accurate adjustments can be made
6. The nature, extent, and reliability of assumptions required

Expert Legal Guidance

Understanding the five transfer pricing methods is essential for taxpayers with international transactions. Anuj Desai & Associates provides expert advisory services on Direct Tax Code compliance, helping taxpayers select the most appropriate method and ensure compliance with transfer pricing requirements.

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