Use of comparables in determining transfer prices

Comparables are controlled or uncontrolled transactions which are comparable if none of the differences between the transactions could materially affect the factor being examined. These transactions may have taken place between enterprises that belong to a multi-national group or between non-related independent groups and are used for transfer pricing analysis.1 This process is known as comparability analysis.
Use of comparables2 gives rise to issue whether the conditions in the commercial or financial relations of associated enterprises are arm's length or whether instead one or more special conditions exist (ie conditions that are not arm's length). The primary drivers for doing a comparability analysis are for the taxpayer to determine how transfer prices should be established and for the tax administration to determine whether on transfer pricing adjustment may be made. The comparison of conditions should be broader than a mere comparison of prices or margins.3
The most direct way to establish whether the conditions made or imposed between associated enterprises are arm's length is to compare the prices charged in controlled transactions undertaken between those enterprises with prices charged in comparable transactions undertaken between independent enterprises.4 However, there will not always be comparable transactions available to allow reliance on this direct approach alone, and so it may be necessary to compare other less direct indicia, such as gross margins, from controlled and uncontrolled transactions to establish whether the condition between associated enterprises are arm's length.
In practice, many tax administrations and practitioners rely primarily on comparison of prices or margins in order to determine the arm's length nature of a transaction. It may be worth noting that: (a) comparison is needed to justify an adjustment5 (b) proposed comparisons should be supported with documentation (c) where no conditions are made there is no need to proceed with comparisons (d) adjustment is based on determination of the profits.
Then there are timing issues in comparability with respect to the time of origin, collection and production of information on comparability factors and comparable uncontrolled transactions that are used in a comparability analysis. And different practices are prevalent to resolve some of the emerging issues.
1. For example when information on comparable uncontrolled transactions is collected either by the taxpayer or by a tax administration then what will be the point in time.
2. Whether information on uncontrolled transactions that is used in a comparability analysis always needs to pertain to the same year as the taxpayer's controlled transaction under review, or whether - and if so in what circumstances and to what extent - information pertaining to years prior or subsequent to the year of the taxpayer's controlled transaction can be used.
3. Or when information collected is produced by the taxpayer and give to the tax administration, at the appropriate point in time.
While the first and third issues as stated above are to a large extent procedural issues, there is obviously a link between the first two issues and the comparability analysis as the extent of available information pertaining to a given year can depend on the timing of collection.
In order to resolve timing issues,6 it would be appropriate for a taxpayer to:
i. Determine whether comparable data from uncontrolled transactions are available.
ii. Ensure that no contemporaneous obligation exists at the time the pricing is determined or the tax return is filed to produce these types of documents or to prepare them for review by a tax administration.
iii. Where necessary to ensure that documents are submitted in a timely manner when requested by the tax administration during the course of an examination.7
iv. That information is available to him at the time when transfer pricing is being determined.
v. Provide the information even if the information available is incomplete since the tax administration will have to make a determination of arm's length transfer pricing.8
Provided that any documentation requirement (at the tax return filing stage) may be limited to requiring the taxpayer to provide information sufficient to allow the tax administration to determine approximately which taxpayer's case needs further examination.
Timing of collection of information by the taxpayer A taxpayer may try to identify third party comparables to support its future transfer pricing policy, eg as a routine exercise linked with the budgetary process, or as part of an APA negotiation.
Assume, for example, that a taxpayer has computed the prices of its 2005 intra-group transactions on the basis of data collected at the end of 2004. Typically such data would comprise market and product information available at the end of 2004 and internal comparables where they exist. It may be completed by a search for external comparables but in such a case available third party information may only pertain to 2002 and 2003. Assume that in 2006, when preparing its 2005 return, the taxpayer updates its comparability study and obtains third party data pertaining to 2004 and/or 2005 that is significantly different from the data collected on prior years. As a result, the profit or margin which was used as the basis for the calculation of the transfer prices in 2005 - based on the initial search for comparables - becomes (to fall) out of the updated range. Alternatively, or in addition, assume that in 2008, when the taxpayer's 2005 return is being audited, a comparability study reveals third party data pertaining to 2005 which has become available in the interim and which suggests that the transfer prices originally calculated or reported for 2005 fall outside the updated range.
When this approach is followed, it will be valuable to take into account the information9 that was available to the prudent business manager at the time that the manager would have had to make such pricing decisions. As a result, documentation prepared in accordance with the prudent business manager principle at the time the transactions are organised could include market information, internal comparables where they exist and may be completed by external comparables where appropriate.
This approach can be adopted for pragmatic reasons. It is not intended to deny upfront pricing practices and documentation where such upfront pricing practices and documentation can be properly implemented and may also be used to complement this practice. It is not intended to allow injudicious use of subsequent data.10
If compensating adjustments are permitted in the country of one associated enterprise but not permitted in the country of the other associated enterprise, double taxation may result because of corresponding adjustment relief which may not be available if no primary adjustment is made.11 Accordingly tax authorities can use their best efforts to resolve any double taxation which can arise from different country approaches to year-end adjustments and that may be submitted to them under a Mutual Agreement Procedure.
At the time of audit the following kinds of documentation are required:
-- Information used in setting up prices or testing outcomes.
-- Where the documentation provided is not sufficient to provide such information to support the prices used,
-- To develop the transfer pricing analysis on relevant transactions which are identifiable in the context of the audit, say for example production of some external comparables in cases where no internal comparables are identifiable.12
The most reliable source of information is information relating to the terms and conditions of the controlled transaction under review and the arm's length terms and conditions of comparable uncontrolled transactions13 undertaken at the same time as that of the controlled transaction, whether or not collected at the time of the controlled transaction.
External comparables The details and outcomes associated with external comparables may not be reported until after the filing due date. Economic environment of the taxpayer's controlled transaction
The contemporaneous uncontrolled transactions may provide the most reliable comparables because they can be expected to have been carried out in an economic environment that is the same as or similar to the economic environment of the taxpayer's controlled transaction.
Year may not be most relevant factor In some cases the year may not be the most relevant reference. For example a transaction that took place in November 2001 might be more comparable to a transaction in the same industry that took place in January 2002 than to one that took place in January 2001.
Relevancy of Cycles Transactions (being compared) are subject to cycles like product cycles or business cycles; it is desirable to the extent possible to make sure that the transactions being compared are at least broadly at the same point in the cycle.
Use of multiple year data Contemporaneous information may be expected to provide the most reliable information to apply in a comparability analysis because the information relates to conditions under reference.
The use of data relating to years subsequent to the year of the transaction from years following the year of the transaction may also be relevant to the analysis of transfer prices, but care must be taken by tax administrations to avoid the use of hindsight.14
It would not be reasonable for taxpayers to determine their transfer prices once and forever. Transfer prices may be reviewed from time to time as needed by normal business considerations.
Taxpayers are expected to monitor and review the conditions of their international related party transactions where such transactions are significant or complex, in order to account for changes in economic realities.
Internal Comparables Comparable uncontrolled transactions15
It refers to both internal and external comparables, taxpayer and a non-related party or between an independent enterprise and a non-related enterprise. The resale price16 margin of the reseller in the controlled transaction may be determined by reference to the resale price margin that the same reseller earns on items purchased and sold in comparable uncontrolled transactions.
In the resale price method an internal comparable would be a purchase transaction by the same taxpayer from an unrelated party of comparable products in comparable conditions for resale to third parties. The cost plus mark17 up of the supplier in the controlled transaction can ideally be established by reference to the cost plus mark up that the same supplier earns in comparable uncontrolled transactions.
External comparables It is desirable to determine whether internal comparable exist before starting a search for external comparables. It may be added that easy availability of external data sources may undermine a proper and sound transfer pricing determination and the use of internal comparables.
A preference for internal comparables where they exist is preferred as they are reliable enough. Internal comparables are likely to have a more direct and closer relationship to the transactions under review18 due to the following reasons:
(a) Comparing two purchase transactions carried out by the same buyer in the case of a resale price method for instance or to sales transactions carried out by the same supplier in the case of a cost plus method for instance, enhances the quality of the comparability analysis. (b) Comparing the gross or net margins that the same taxpayer earns with a related and an unrelated party makes the financial analysis easy and more reliable since reliance is being placed on identical accounting standards and practices.
External comparables can be used when internal comparables either do not exist or do not provide reliable and sufficient information.19 Presence of internal comparables does not mean that any transaction between a taxpayer and an unrelated party can be regarded as a reliable comparable. These comparables must satisfy the five comparability factors20 in the same way as external comparables. For instance assume the manufacturing and sale by a taxpayer to a foreign related party of one million units of a given product per year representing 90% of the taxpayer's sales. Also assume that during the year concerned, the same taxpayer also makes a marginal sale of 10 units of the same product to an unrelated party. The difference in volumes between both transactions is likely to materially affect comparability. A proper effort may be made to adjust that difference. If, in spite of that effort, such a difference cannot be reliably adjusted, the transaction between the taxpayer and its unrelated customer may not be a valid comparable and a search for external comparables may have to be performed.
Internal comparables and particular transactions Internal comparables, where they exist, may be useful in the determination of the arm's length service charges for transactions involving intangibles. It is in effect in the area of intangibles that reliable external comparables are the most difficult to find.
Determination of available sources of information and their reliability Potential external comparables can currently be classified into:
A - Informal and confidential information on third parties;
B - Databases consisting mainly of profiles filed by companies.
C - Public information such as industry surveys performed by financial analysts and annual reports published by listed companies for regulatory purposes and shareholders' information and information displayed on companies' websites.
Significant amounts of internal information will always be required in order to be able to perform a reasonable comparability analysis. Informal and confidential information
The use of such data in the context of transfer pricing raises procedural issues in terms of documentation and of burden of proof where no evidence can be produced because of confidentiality issues. This type of information is by nature non-exhaustive and may introduce additional subjectivity in the analysis. Use of informal and confidential information by a tax administration
Information from third party tax returns or audits, that is unavailable to the taxpayer, qualifies as "secret comparables" because confidentiality rules would prevent administrations to disclose the identity of these to other taxpayers. There are divergent practices relating to the use of "secret comparables" in transfer pricing adjustments amongst OECD countries. Secret comparables raise procedural issues in terms of documentation and burden of proof. And some countries on the name of fairness strongly oppose the use of secret comparables. Their reliability is also at stake.
Database in commercial use can be divided into two types namely, commercial and proprietary database. A number of limitations to commercial databases are frequently identified,21 OECD Guidelines do not contain any reference to commercial databases.22
Proprietary databases developed by consulting firms Proprietary databases generally raise similar issues as commercial databases that are more broadly commercialised. They also raise a further concern with respect to exhaustively of data. Public information can be usefully used to complement and improve the quality of search in foreign sources or non domestic comparables, the issue of transparency will always arise.
Uncontrolled transactions It is becoming virtually impossible to find truly independent economic actors. Generally, in a particular market all distributors in a given business sector are owned by multinational groups. In any case these comparables have to satisfy the comparability factors.23.
Commentators generally indicate support for comparability factors that are regarded as theoretically sound; while unanimously point out the difficulty in practice in applying the comparability standards where sufficiently detailed information is not available in the public domain. In the opinion of these commentators some flexibility, on a case by case basis, may be considered in judging the need to satisfy all five of the comparability factors. It is rarely if ever possible to identify comparables which meet and can be shown to meet the rightly exacting standards.
Process for identifying comparable transactions using data
Step 1: Broad-based analysis.24
Step 2: Determination of years to be covered.
Step 3: Review of the controlled transaction(s) under examination, in order to identify the relevant factors that will influence both the choice of the appropriate method(s) and the comparability analysis.25
Step 4: Review of existing internal comparables.26
Step 5: Determination of available sources of information on external comparables where such external comparables are needed.
Step 6: Choice of the relevant transfer pricing method(s) and, depending on the method(s), definition of the relevant indicia (eg definition of the relevant net profit indicator in case of a TNMM).
Step 7: Identification of potential comparables: defining the key characteristics to be met by any uncontrolled transaction in order to be regarded as potentially comparable.27
Step 8: Determination of and making comparability adjustments.
Step 9: Interpretation and use of data collected, determination of the arm's length remuneration.
Step10: Ensure adjustment for material changes and to document these processes.
The "additive" and the "deductive" approaches
"Additive" approach, consists in the taxpayer drawing up a list of third parties that he believes carry out potentially comparable transactions. The taxpayer then collects as much information as possible on transactions conducted by these third parties to confirm whether they are in effect acceptable comparables, based on the pre-determined comparability criteria.
The second possibility, the "deductive" approach, starts with a wide set of companies that operate in the same sector of activity, perform similar broad functions and do not present economic characteristics that are obviously different. "Deductive" approach typically starts with a search on a database. "Deductive" approach is not appropriate to all cases and all methods.28
It is very important that the taxpayer justify and document the criteria used to include or exclude particular third party data in order to ensure a reasonable degree of objectivity and transparency, ie in particular the process should be reproducible by a tax administration that wishes to assess it. It is also very important that third party data be refined using qualitative criteria. It would be improper to use financial information relating to the transactions of a large sample of companies that have been selected solely because they are classified.
Where deductive approach is followed in a proper way, the acceptability of the outcome might be easier to ascertain than with the additive approach because the review of the comparability study would concentrate on the relevance of the selection criteria retained, ie the "deductive" approach is generally capable of providing better transparency, objectivity and reproducibility than the "additive" approach.
The "additive" approach may be used as the sole approach where a taxpayer has knowledge of a few third parties that are engaged in very similar transactions. The "additive" approach presents similarities with the approach followed by a taxpayer when identifying internal comparables. It may encompass both internal and external comparables.
The "additive" and "deductive" approaches are often not used exclusively. In a typical "deductive" approach, in addition to searching public databases, it is common to add lists of third parties if a database is being searched for automotive engines then a list of companies building marine engines may be added to allow those companies to be considered for reliability as comparables.
1. According to Para 1.33 of the OECD Transfer Pricing (TP) Guidelines 2005, for such a comparison to be useful, the economically relevant characteristics of the situation being compared must be sufficiently comparable.
2. To be comparable means that none of the differences (if any) between the situations being compared could materially affect the condition being examined in the methodology (eg price or margin) or that reasonably accurate adjustments can be made to eliminate the effect of any such difference.
3. Paragraph 1 of Article 9 of OECD Model Tax Convention.
4. Para 2.5 of the OECD Transfer Pricing Guidelines ibid.
5. Article 9 ibid, n.3 supra
6. Paragraph 5.3, 5.4, 5.5, 5.9 and 5.14 of the OECD Transfer Pricing Guidelines ibid.
7. Tax administration's ultimate interest would be satisfied.
8. Adequate record keeping practices and the voluntary production of documents can improve the persuasiveness of its approach to transfer pricing.
9. Which would usually extend beyond external or third party data.
10. A comparable uncontrolled transaction is a transaction between two independent parties that is comparable to the controlled transaction under examination. It can be either a comparable transaction between one party to the controlled transaction and an independent party ("internal comparable") or between two independent parties, neither of which is a party to the controlled transaction ("external comparable").
11. Article 25 of OECD Model Tax Convention.
12. Para 5.15 of the OECD Transfer Pricing Guidelines ibid.
13. Contemporaneous uncontrolled transactions are comparable uncontrolled transactions undertaken or carried out during the same period of time as the taxpayer's controlled transaction under review, whether or not information on said transactions is collected at that time.
14. Paragraph 1.51 of OECD TP Guidelines ibid.
15. In this regard transfer pricing guidelines implicitly refers to both internal and external comparables.
16. Resale price method, paragraph 2.15 of OECD TP guidelines ibid.
17. For the cost plus method, see paragraph 2.33 of OECD TP guidelines ibid.
18. See paragraph 1.70 of the OECD TP Guidelines ibid.
19. 2.15, 2.33 and 3.26 of the OECD TP Guidelines ibid.
20. These include: a) Characteristics of property or services; b) Functional analysis; c) Contractual terms; d) Economic circumstance; e) Business strategies.
21. Cost of information is a significant issue, especially for small and medium sized taxpayers, but also for relatively small or less risky transactions. In this respect the usefulness of having recourse to commercial databases - as it is the case for all sources of information - should be tested in accordance with a reasonable evaluation of the facts and circumstances of the case. As indicated in paragraph 5.6 of the 1995 TP Guidelines: "... the taxpayer should not be expected to incur disproportionately high costs ... to engage in an exhaustive search for comparable data from uncontrolled transactions if the taxpayer reasonably believes, having regard to the principles of this Report, either that no comparable data exists or that the cost of locating the comparable data would be disproportionately high relative to the amounts at issue".
22. Commercial databases are one possible source of information among others. Their importance should not be overstated. It is not compulsory for a taxpayer to use a commercial database if reliable information is available from other sources - eg internal comparables or market intelligence developed and maintained for non tax reasons, as well as alternative sources of information. On the other hand, there is no reason to systematically rule out the use of all commercial databases as in some cases they provide the best available information.
23. n 20 supra
24. (eg industry analysis, analysis of value-drivers, nature of the competition experienced and economic and regulatory factors).
25. In particular the scope, type, value and timing of the controlled transaction(s), as well as information on the five comparability factors (characteristics of property or services, functional analysis, contractual terms, economic circumstances and business strategies).
26. Where necessary (ie where satisfactory internal comparables are not available), decision to look for external comparables.
27. Based on the relevant factors identified in Step 3 and in accordance with the comparability standards set forth in paragraphs 1.19 to 1.35 of the OECD TP Guidelines ibid (ie functional analysis, economic circumstances, etc).
28. eg it is not appropriate for the CUP method.
(The writer is an advocate and is currently working as an associate with Azim ud Din Law Associates)