Advanced Direct Tax Laws and Practice · Transfer Pricing and General Anti Avoidance Rules (GAAR)

Methods of Determining Arm's Length Price in Transfer Pricing

Updated 11 October 2026 · Fact-checked

The arm's length price (ALP) of an international or specified domestic transaction is found by the most appropriate method out of five named methods: CUP, resale price, cost plus, profit split and TNMM, or any other method the Board prescribes. You pick the method by looking at the nature of the transaction, the functions performed and other relevant factors, then apply it.

Understand Methods of Determining Arm's Length Price

Two related companies can fix prices between themselves to shift profit to a low-tax country. Transfer pricing law stops this by asking one question: what price would two unrelated parties have agreed on? That price is the arm's length price (ALP).

Section 165(1) of the Income-tax Act, 2025 lists the ways to find it. The ALP is determined by the most appropriate method out of: comparable uncontrolled price (CUP) method, resale price method (RPM), cost plus method (CPM), profit split method (PSM), transactional net margin method (TNMM), and such other method as the Board may prescribe.

The methods fall into two groups. CUP compares a price directly with the price in a similar uncontrolled deal. RPM and CPM start from a gross margin: RPM works back from the resale price of a distributor, CPM builds up from the cost of a supplier. TNMM compares a net profit margin. PSM splits the combined profit of the related parties in proportion to what each contributes. The first three are traditional transaction methods; PSM and TNMM are profit-based methods.

There is no fixed ranking in the section text. Under section 165(2), the most appropriate method is selected having regard to the nature of the transaction or class of transaction, the class of associated enterprise, the functions performed by them, and other relevant factors the Board may prescribe. It is then applied in the manner prescribed. Your job in an answer is to justify the choice from the facts.

The method can yield one price or several. If only one price results, that price is the ALP. However, if the actual price differs from it by no more than the notified percentage (capped at 3% of the actual price), the actual price can be taken as the ALP. If more than one price results, the ALP is determined in the prescribed manner.

Key rules to remember

Methods under section 165(1): CUP | RPM | CPM | PSM | TNMM | other method prescribed by the Board; The ALP is found by the most appropriate method among these.
Comparable uncontrolled price (CUP): ALP = price in comparable uncontrolled transaction (after adjusting for differences); Most direct method. Needs close comparability of product and terms.
Resale price method (RPM): ALP = Resale price to unrelated party − (Resale price × Gross margin %) − other adjustments; Used for a reseller or distributor who adds little value. Gross margin % is taken from comparable uncontrolled deals.
Cost plus method (CPM): ALP = Direct and indirect cost of production + (Cost × Gross profit mark-up %); Used for manufacturers, assemblers or service providers selling to associated enterprises. Mark-up comes from comparable uncontrolled deals.
Transactional net margin method (TNMM): Net profit margin = Net profit ÷ Base (cost, sales or assets); Compare the tested party's margin with margins of comparable uncontrolled parties, after adjusting for differences.
Profit split method (PSM): Combined profit split among associated enterprises in proportion to relative contribution; Used for highly integrated transactions or those involving unique intangibles, where one-sided testing is not reliable.
Choice among results (section 165(3)): One price: that price, or actual price if variation ≤ notified % (not above 3% of actual price). More than one price: as prescribed.; The tolerance range is notified by the Central Government.

How to solve Methods of Determining Arm's Length Price questions

Use the same sequence for any question on methods of arm's length price, whether it is theory or numerical.

1Identify the transaction and the parties: confirm it is an international transaction or specified domestic transaction between associated enterprises.
2List the facts that matter: product or service, functions performed, assets used, risks, intangibles, and whether comparable uncontrolled deals exist.
3Choose the most appropriate method under section 165(2) and give reasons from those facts. Say why the other methods fit less well.
4Apply the method in steps: write the formula, insert the figures, and make comparability adjustments if the data gives them.
5Compute the ALP. If one price results, compare it with the actual price and check the tolerance under section 165(3)(a)(ii).
6State the consequence: if the ALP is higher than the actual price for income-raising adjustment, the Assessing Officer can compute income on the ALP under section 165(6), with the primary adjustment figure stated.
7Close with a one-line conclusion giving the ALP and the method used.

Quickest way: Fact-to-method matching

When to use it: Use this when time is short and the question asks you to choose or justify a method.

Identical product sold to related and unrelated parties: CUP.
Related party buys and resells without much change: RPM (work back from the resale price).
Related party manufactures or provides service and sells to an associated enterprise: CPM (add mark-up to cost).
Both parties contribute unique intangibles or the business is highly integrated: PSM.
Data is available only at net margin level or no reliable gross data: TNMM.
Write the formula in one line, substitute numbers, and state the ALP.

Common mistakes in Methods of Determining Arm's Length Price

Treating the methods as a strict order where CUP must always be used first.
Students carry over a ranking from other sources.
Fix: Quote section 165(2): the most appropriate method is selected on the nature of the transaction, functions performed and other relevant factors. Justify the choice from the facts.
Confusing RPM and CPM.
Both use a gross margin, so they look alike.
Fix: RPM deducts a margin from the resale price (reseller). CPM adds a mark-up to cost (producer or service provider).
Applying the gross margin to the wrong base in RPM.
Students apply the percentage to cost instead of resale price.
Fix: In RPM the margin is a percentage of the resale price. In CPM the mark-up is a percentage of cost.
Ignoring the tolerance range in section 165(3).
Students stop once the ALP is computed.
Fix: When one price is found, compare it with the actual price. If the variation is within the notified percentage (not more than 3% of the actual price), the actual price is taken as the ALP.
Saying the Assessing Officer can determine ALP at will.
Students skip the conditions in section 165(4) and the show-cause notice in 165(5).
Fix: State the triggers (price not per method, documents not maintained, unreliable data, failure to furnish information) and that a show-cause notice must precede the determination.
Stating a 3% tolerance as fixed in the Act.
The figure is remembered without the wording.
Fix: Write that the percentage is notified by the Central Government and cannot exceed 3% of the actual price.

Worked examples

Example 1

Indian company Aarav Traders Ltd buys a machine part from its foreign associated enterprise for ₹9,50,000 per unit. It resells to unrelated Indian customers at ₹12,00,000 per unit. Comparable independent distributors earn a gross margin of 20% on resale price. Using the resale price method, find the ALP of the purchase and say whether an adjustment arises (ignore other adjustments and tolerance).

Show the solution

Resale price to unrelated party = ₹12,00,000.
Gross margin at 20% of resale price = 12,00,000 × 20% = ₹2,40,000.
ALP of purchase = 12,00,000 − 2,40,000 = ₹9,60,000.
Actual price paid = ₹9,50,000, which is lower than the ALP of ₹9,60,000.
For the Indian buyer, a lower purchase price means higher profit, so no downward adjustment to the Indian taxpayer's income arises on this transaction.

Answer: ALP = ₹9,60,000 per unit. The actual price of ₹9,50,000 is lower, so the price paid is not inflated and no increase in Aarav's income arises on this purchase.

Example 2

Ishaan Components Pvt Ltd, an Indian manufacturer, sells goods to its foreign associated enterprise at ₹14,00,000 per consignment. Its direct and indirect cost per consignment is ₹11,00,000. Comparable independent manufacturers earn a gross mark-up of 30% on cost. Using the cost plus method, find the ALP and the primary adjustment (ignore tolerance). Also state why CPM suits this case.

Show the solution

Cost of production = ₹11,00,000.
Mark-up at 30% of cost = 11,00,000 × 30% = ₹3,30,000.
ALP = 11,00,000 + 3,30,000 = ₹14,30,000.
Actual price = ₹14,00,000. Difference = 14,30,000 − 14,00,000 = ₹30,000 per consignment.
The ALP is higher than the price charged, so income of the Indian seller increases by ₹30,000 per consignment.
CPM suits because the Indian company is a manufacturer selling to an associated enterprise and reliable gross mark-up data of comparable manufacturers exists.

Answer: ALP = ₹14,30,000 per consignment. The primary adjustment is an increase of ₹30,000 per consignment in the Indian company's income.

Exam tips

Always cite section 165(1) for the list of methods and 165(2) for how the most appropriate method is chosen.
Justify the method from the given facts in one or two lines. Marks go to reasoning, not to the name alone.
In numericals, show the formula, the substitution and the final ALP on separate lines. Then state the adjustment.
Remember the direction: a seller's income rises if ALP is above the price charged; a buyer's income rises if ALP is below the price paid.
For theory questions on powers, mention the section 165(4) conditions and the show-cause notice under 165(5).

Practice questions from Transfer Pricing and General Anti Avoidance Rules (GAAR)

Methods of Determining Arm's Length Price in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Methods of Determining Arm's Length Price: frequently asked questions

How many methods of determining ALP are there?

Section 165(1) names five methods: CUP, resale price, cost plus, profit split and TNMM. It also allows such other method as the Board may prescribe.

How do I select the most appropriate method?

Section 165(2) says to have regard to the nature of the transaction or class of transaction, the class of associated enterprise, the functions performed, and other relevant factors the Board may prescribe. Link each fact in the question to the method you choose.

What is the difference between the resale price method and the cost plus method?

RPM starts with the price at which a buyer resells to an unrelated party and subtracts a gross margin to reach the ALP. CPM starts with the supplier's cost and adds a gross mark-up. RPM suits distributors; CPM suits manufacturers and service providers.

When can the actual price be accepted even if it differs from the computed ALP?

When only one price is determined and the variation from the actual price does not exceed the percentage notified by the Central Government, which cannot be more than 3% of the actual price, the actual price is taken as the ALP.