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).
This Note looks at the practical steps involved in actually carrying out a Comparability Analysis, which is a fundamental component part of the arm’s length principle, and builds on the concepts introduced in my two previous Notes.
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. The OECD-approved Transfer Pricing methods will be the subject of my next Note in this category.
Let’s start with a recap……
In today’s globalised economy, a multinational enterprise’s manufacturing may occur in one country and assembly in another, whilst sales and marketing are likely to be based in local markets or on the internet. The management, R&D and finance functions are likely to be similarly dispersed across the globe.
Where such transactions in goods and services take place between associated enterprises and across international borders it is necessary to establish Transfer Prices for those transactions.
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 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.
In order to ensure a sufficient degree of objectivity, 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 data excluded in screening process.
The objective of the comparability analysis is to identify one or a range of independent enterprises that engage in similar transactions in similar circumstances. These can then be used to benchmark the arm’s length price (or alternative indicator) for the least complex party involved in the controlled transaction under review (i.e. the “tested party”).
So, how do you actually carry out a comparability analysis?
It would normally involve a broad database search for potential comparables followed by both quantitative and qualitative screening and finally adjustments to compensate for any remaining differences between the final set of comparables and the tested party.
Quantitative factors might include turnover and profit data, or various financial ratios, on the basis that such data reflects the tested party’s functional and risk profile.
Qualitative factors could include a review of business descriptions, information from other databases, internet search, website review etc.
The following is a typical approach:
- Determine the years to be covered.
- Analyse and understand the controlled transaction(s) under examination, based on a functional analysis. Choose the tested party and identify the significant comparability factors to take into account (see my previous notes). The “tested party” 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.
- Review existing internal comparables, if any, i.e. where the tested party undertakes the same or similar transactions with connected parties and also with unconnected third parties.
- If no internal comparables, determine which of the available database sources of potential external comparables is the most appropriate for the case under review, e.g. covers the appropriate geographic area.
- Select the most appropriate Transfer Pricing method for the circumstances of the case. (This will be the subject of my next Note in this category.)
- Run your search for potential comparables from the chosen database. (The actual search process is outlined below.) Focus on the key characteristics to be met by any uncontrolled transaction to be regarded as potentially comparable. Base this on the factors identified in Step 2 above.
- Determine and make comparability adjustments where appropriate, to compensate for any remaining differences between the potential comparables and the tested party. This might be necessary, for example, where there are no suitable local comparables and the search must be widened to include other countries where market conditions may be different. Please note however that a comparability adjustment should only refine the results and should not be used to make a non-comparable, comparable. If you need to make an adjustment to a company so that it can be considered a comparable, you should probably reject that company altogether.
- Sometimes it’s possible to arrive at a single figure (e.g. price or margin) that establishes whether the conditions of a controlled transaction are arm’s length. However, it’s more likely that our analysis produces a range of figures. A wide deviation among the points in that range indicates that some may be less reliable than others. If this is the case, further analysis of the extremes may be necessary to determine whether they should be included. When the dataset eventually comprises results of relatively equal and high reliability, any point in the range satisfies the arm’s length principle. Therefore, provided the controlled transaction’s result falls within that range it can be treated as an arm’s length transaction.
Point 6 above refers to running the search for potential comparables from the chosen database. Here’s an outline of that search process. Some steps may be obvious but are included for completeness.
- Selection of Industry (e.g. SIC codes or similar)
- Selection of Geographic Region
- Exclude controlled companies, i.e., 50% or above owned by another company
- Exclude companies for insufficient data. For example, if you’re looking for three years of data for each potential comparable to adjust for different points in a business cycle, then you may want to deselect those with less than three years of data.
- Exclude companies with sustained operating losses. For example, “start‐up” companies may have to adopt the strategy of selling their products at a lower margin or to bear losses for a time to get established. Therefore they may not be suitable comparables to a company with a stable track record over many years.
- Exclude companies for incomparable functions, e.g., significant R&D, intangibles, marketing, distribution, services, or different scale of business based on sales, expenses, assets, etc.
- This leaves you with your refined but unadjusted comparable set. You would now need to go through them manually to adjust for material differences with the tested party.
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 various Transfer Pricing methods used to set the arm’s length price for a controlled transaction.
Bye for now.
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