Most countries’ Transfer Pricing rules are based on the “arm’s length principle”, as defined by the Organisation for Economic Co-operation and Development (OECD).
The concept of “comparables” and their importance to the arm’s length principle was introduced in my previous Note in this category.
This Note looks at the five factors which the OECD Guidelines suggest be considered in a comparability analysis.
A comparability analysis basically means identifying comparable transactions to the connected-party transaction being reviewed, but between independent unconnected businesses.
Such comparables are then used to fix the arm’s length indicator, e.g. price or margin etc. (or the arm’s length range for a particular indicator) for such transactions. As a result, the arm’s length nature of the transaction under review can be confirmed (or otherwise).
The choice of comparables must also be considered alongside the choice of the most appropriate Transfer Pricing method for the case under review. By this I mean the most appropriate benchmark for the facts and circumstances of the case, e.g. gross margin or net margin etc. This will be the subject of a future Note.
Perhaps I should have mentioned this earlier, but there are clearly two parties to “the transaction under review”. These are likely to be members of the same corporate group. So what side of the transaction is tested for consistency with the arm’s length principle? The seller or the buyer?
It’s obviously unnecessary to test both sides, so we choose one to be the “tested party”.
This is normally the party to the controlled transaction to which a Transfer Pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found. It will most often be the one that has the less complex functional analysis. (See comparability factor number 2 below.)
Let’s start with a recap……
The transfer price is the price charged in a transaction between two connected parties. These are usually members of the same corporate group.
The focus is on connected parties because their transfer price may not be the same as the price charged for the same transaction between businesses dealing at arm’s length. As a result one or both of the connected parties may gain a UK tax advantage.
Multinational enterprises operating in the UK can use Transfer Pricing to shift their profits abroad. As a result they may pay little or no UK Corporation Tax, even if they comply with the law.
However, the UK’s Transfer Pricing legislation aims to prevent multi-nationals from manipulating their transfer prices to gain a UK tax advantage and the arm’s length principle is its cornerstone.
An analysis of controlled (i.e. connected party) transactions and their equivalent uncontrolled (i.e. arm’s length) transactions is referred to as a “comparability analysis”. This is at the heart of the application of the arm’s length principle.
It is important that the process followed in the comparability analysis be transparent, systematic and repeatable. You must keep records of your screening criteria, reasons for adopting those criteria, and for the data excluded in screening process. (My next Note in this category outlines the practical steps taken in a comparability analysis.)
Remember that “Comparable” does not mean “identical”.
It means that none of the differences (if any) between the situations being compared could materially affect the price or financial indicator being examined, or that reasonably accurate adjustments can be made to eliminate the effect of any such differences.
The OECD Guidelines set out the following five comparability factors to consider in your analysis. The relative importance of these may vary from case to case, depending on the specific facts and circumstances of the case under review.
1. The characteristics of the property or services
Differences in, for example, quality, reliability, availability etc., often account for differences in the open-market price of a transaction.
This can be more or less important depending on the Transfer Pricing method being used.
For example, comparability analyses for Transfer Pricing methods based on gross or net profit indicators often put more emphasis on functional than on product similarities.
So an uncontrolled business that manufactures and sells kettles may be an acceptable comparable for a controlled business that manufactures and sells toasters.
2. Functional analysis
In transactions between two independent enterprises, pricing usually will reflect the functions that each enterprise performs (taking into account assets used and risks assumed).
Therefore, in determining whether controlled and uncontrolled transactions or entities are comparable, a functional analysis is necessary. This seeks to identify and compare the economically significant activities and responsibilities undertaken, assets used and risks assumed by the parties.
One party may perform a large number of functions relative to the other party. However, it is the economic significance of those functions in terms of their frequency, nature, and value to the respective parties that is important.
The functional analysis should also consider the type of assets used, such as plant and equipment, the use of valuable intangibles, financial assets, etc. The nature of the assets used must also be considered, such as the age, market value, location, property right protections available, etc.
3. Contractual terms
In arm’s length transactions, the contractual terms generally define explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the parties. As such, an analysis of contractual terms should be a part of the functional analysis.
However, where no written terms exist, the contractual relationships of the parties must be deduced from their conduct.
4. Economic circumstances
Arm’s length prices may vary across different markets, even for transactions involving the same property or services.
Therefore, to achieve comparability requires that the markets in which the independent and associated enterprises operate do not have differences that can have a material effect on price or that adjustments can be made to compensate for any differences.
The existence of an economic, business, or product cycle is an example of economic circumstances that may affect comparability. However, this may be mitigated by the use of multiple year data.
5. Business strategies
Finally, business strategies, such as risk aversion, market penetration, etc. must also be examined when determining comparability.
It’s also necessary to consider whether there is a plausible expectation that a particular business strategy being followed by connected parties will produce a return sufficient to justify its costs. The strategy should also be expected to bear fruit within a period of time that would be acceptable in an arm’s length arrangement.
If such an expected outcome was implausible at the time of the transaction, or if the business strategy is unsuccessful but is still continued beyond what an independent enterprise would accept, the arm’s length nature of the connected party business strategy may be doubtful.
Detailed guidance on the application of the arm’s length principle can be found in the OECD Guidelines, Chapter 1. These guidelines are periodically updated by the OECD. The last update was approved by the Council of the OECD on 22 July 2010.
I think that’ll do for today.
My next Note in this category will look at the practical steps involved in actually carrying out a Comparability Analysis.
Bye for now.
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