When an expenditure is incurred on behalf of a group, we often split the bill equally. However, if certain services are availed only by a category of people, it would be unfair to charge a share of total expenditure on their tab. For example, on a trip, some people may have opted for an optional safari, while others would have refrained from the same. Thus, to be fair and square, the expenditure towards the trip should be split according to the facilities that each person has availed. This is the very premise of the Resale Price Method of computing Arm’s Length Price in Transfer Pricing. The original cost of production or purchasing is not something that the entrepreneur has full control over, as almost the majority of costs are certain to incur, to produce the goods, or in the provision of services. Similarly, the price that the ultimate customers would pay is also decided by the market forces. Thus, the difference between the cost and price of the product or service is the profit of the entire group of enterprises involved, and thus, the profits of such a venture must also be split according to the functions performed and the risks undertaken by each enterprise.
Key Terms Used
Before we explain the method, let’s understand a few important terms used in our discussion ahead:
Resale Price (RSP): The ultimate price at which the product or service is sold to an outside unrelated party is termed as ‘Resale Price’. For e.g. If, Alpha produces goods and transfers it to its associated enterprise Beta, and Beta sells it to an independent customer at INR 500 per piece, the Resale Price in such case would be INR 500 and transfer price will be decided using this price.
Gross Profit Margin (GPM): The ratio of gross profit to the resale price that the enterprise ultimately selling the product should earn or usually earns, to cover its selling and administration expenses, and the risks incurred, is called as the ‘Gross Profit Margin’. For e.g., If resale price is INR 500 per piece, and the selling company buys at INR 400 per piece, INR 100 is the gross profit and 20% would be the Gross Profit Margin.
What is the Resale Price Method?
The Resale Price Method (often referred to as RSP Method) is a traditional method that focusses on the ultimate selling company. According to this method, the starting point should be Resale Price and after reverse calculating from the Resale Price, we obtain the Transfer Price. As every selling enterprise adds value to the product and resales at price higher than the purchase price, the Resale Price method does a reverse calculation to exclude such value addition and the profits to arrive at a price that should have been the buy price. The exclusion from Resale Price is the Gross Profit Margin of the ultimate selling company, which encompasses the profits of the company over and above the selling and distribution expenses and matches the reward for risks incurred.
Thus, if we formulate the transfer price it would be equal to ‘Resale Price–Gross Profit’, where Gross Profit is arrived by ‘Resale Price x Gross Profit Margin’. Thus, TP = RSP x (1 – GPM).
For e.g. Alpha produces an item incurring all necessary costs and transfers it Beta. Beta then sells this product to an independent customer at INR 500 per item. It sells 40,000 such items in one consignment and incurs INR 2 million towards selling and distribution. Now, the gross profit margin must cover at least the selling and distribution costs. Let’s say 20% is an appropriate gross profit margin. Thus, Transfer Price in such case would be = 500 x (1 – 20%) = INR 400. Thus, Alpha would transfer the product at this transfer price which is expected to reasonably cover the expenses incurred by Alpha and still leaving the enterprise with appropriate profits.
From the example, it is clear that the Gross Profit Margin is the key constraint. In fact, it’s the computation of Arm’s Length Gross Profit Margin (Range) which will ultimately decide the Arm’s Length Price. Based on the types of transactions used as comparables, there can be two methods of determining the Gross Profit Margin:
- By Transactional Comparison –Comparable transactions that have taken place with other independent enterprises can be used to determine the gross profit margin.
E.g. If Beta buys from both Alpha (Associated Enterprise) and ABC Ltd (Independent Enterprise), then the Gross Profit Margin earned by Reselling products of ABC Ltd can be used as Gross Profit Margin for the transaction with Alpha.
- By Functional Comparison– Transactional comparison may not be always possible, as the enterprise may be dealing exclusively with the associated enterprise for the procurement of specific items or services. In such cases, a functional comparison with peers in the industry may be used to determine the Gross Profit Margin. Thus, instead of finding comparable transactions, this method focuses on finding comparable enterprises.
E.g. If Beta buys Umbrellas from Alpha (associated), and Omega Ltd is another enterprise in the industry dealing in Umbrellas with Theta Ltd (associated), then the gross profit margin in case of Omega-Theta transaction can be applied to Alpha-Beta transactions.
After computing the gross profit margin, one must take into account the product or services being transacted, the contractual terms, the economic circumstances under which such transaction has occurred and the business strategies surrounding the transaction. After considering results of such comparison, the gross profit of an uncontrolled transaction will be considered comparable if –
- There are no materially profit-altering differences in the transactions being compared, or
- If there are any material differences between the transactions, they can be adjusted with reasonable accuracy.
Computation of Arm’s Length Price under the RSP Method
Step 1 – Determine the Resale Price of the product or service transferred from the associate enterprise.
Step 2 – Determinecomparable transactions with unrelated parties or such other comparable transactions between two independent enterprises. Perform comparability analysis on the transactions being considered, and select the most appropriate transactions as comparables. Comparability analysis must consider the following points:
- Product Comparability – characteristics, quality, end-use, novelties, features, addon products, after-sales services, etc.
- Contractual Terms –the credit period offered, allied transactions, term period of the contract, the quantity contracted, the place of delivery, etc.
- Risk Incurred – In a transaction between Associated Enterprises, the associated enterprise may not be selling directly to end consumers. However, in an open market transaction, an independent entity is exposed to inventory risk and consumer default risk. These risks undertaken by the other associated enterprise must be quantified and adjusted to the price. There may be similar risks that may require adjustments.
- Geographical Factors – the location where the product is sold or produced, the Government regulations, the applicable taxes, the sources of raw materials, etc.
Step 3 – Analyse the differences between the controlled transactions and the uncontrolled transactions considered as comparable. Quantify the functional differences in terms of impact on the Profit Margin and make adjustments to arrive at Gross Profit Margin.
Step 4 – Reduce the Gross Profit from the Resale Price to arrive at the Transfer Price.
Advantages and Disadvantages of the RSP Method
- The method is based on Market Price and thus represents a method based on demand, thus making it more reliable in situations where there is a weak relationship between cost and sale prices.
- The method can be used to ensure that the distributor companies do not make inappropriate profits, as the distributors earn arm’s length gross profit margin, and thus, excess profits are transferred to the manufacturing enterprise.
- If the associate enterprise on the buy-side does significant value addition before selling to customers, it may lead to complex calculations in arriving at the gross profit margin.
- Not all enterprises follow the same accounting principles and therefore, computing comparable gross profit margin may sometimes involve undoing the differences between accounting policies.
- Establishing gross profit margin of an uncontrolled transaction and adjusting the same according to the transaction of the enterprise with reasonable accuracy is difficult and can often be a long process as it requires a detailed analysis of both the transactions, the products and the economic conditions.
When to use the Resale Price Method?
The Resale Price Method works only under specific circumstances and therefore, one must firstly brainstorm on the following points, before proceeding with this method, to ensure the viability of its results:
- Distributor Companies–Resale price is much suitable in a model where one enterprise produces and another enterprise only resells. In such cases, the gross profit can be easily determined and split between the two enterprises or multiple enterprises.
- When the Cost Plus Method is not reliable –A better alternative to the Resale Price method is Cost Plus Method where all costs are billed at a fixed margin and excess profits are retained by the Distributor company. In a way, it is exactly opposite of the Resale Price Method where excessive profits get accumulated with the distributor company.
- Reliable calculation of Cost of Goods Sold–A reliable calculation of Cost of Goods Sold is pre-requisite to arriving at Gross Profit Margin. Thus, if the COGS of the transaction cannot be established without any complications, the resale price method may not produce reliable results.
- No Major Value Addition by Distributing Enterprise – The distributor enterprise dealing with the ultimate customer should not be holding major intangibles or making significant value additions to the product or service. Further, there should not be a long chain of enterprises dealing with the product before ultimate sale to customers as it may involve a complex calculation of resale price at multiple levels.