Arm's Length Principle with Tolerance Range (Chapter X of the Income Tax Act 1961)

Arm's Length Principle with reference to the Section 92F of the Income-tax Act 1961 (Chapter X of the Income Tax Act 1961)

Section 92F of the Income-tax Act 1961, defines the arm’s length price as “a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions”.

The arm’s length principle is based on the concept that market forces are the best way to allocate resources and profits of the enterprise and therefore all transactions between associated enterprises should be compared and benchmarked with transactions between independent third parties.

Section 92C of the Income-tax Act 1961, provides several methods for determining the arm’s length price and requires application of the most appropriate method (MAM) it also provides for the power of the authorities to prescribe the appropriate method, having regard to the nature of the transaction or of the type of associated persons/enterprise or the functions performed by such persons/enterprise.

In cases where more than one result is determined by one of the prescribed methods under section 92C of the ITA, the arm’s length price shall be the arithmetic mean, with a tolerance range not exceeding 3% above or below the price of the controlled transaction.

The application of the arm’s length standard is set aside in cases where such application would result in the reduction of income subject to tax, in other words, the arm’s length standard can only apply where an increase in the amount of taxable income and tax collection.

Recently CBDT notifies tolerance range for AY 2020-21 - Government leaves tolerance range unchanged in pandemic times to Streamline the Economic -

It has re-notified the prevailing 1 per cent tolerance range for wholesale trading and the 3 per cent range for all other transactions are undertaken during the financial year ending March 31st, 2020.  

Words of Section 92C of the ITA in respect to tolerance Tag

[Provided that where more than one price is determined by the most appropriate method, the arm's length price shall be taken to be the arithmetical mean of such prices:

Provided further that if the variation between the arm's length price so determined and price at which the international transaction or specified domestic transaction has actually been undertaken does not exceed such percentage not exceeding three per cent of the latter, as may be notified by the Central Government in the Official Gazette in this behalf, the price at which the international transaction or specified domestic transaction has actually been undertaken shall be deemed to be the arm's length price:]