TRANSFER PRICING CASE STUDIES
WORKSHOP
SAN JOSE
31 MARCH - 4 APRIL 2014
3-c. Comparability
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official views of the OECD or of the governments of its member countries.
1
Reorganization of Chapters I-III:
1995 TP Guidelines
2010 Version
Chapter I: The arm’s length
principle and comparability
Chapter I: The arm’s length principle and
the fundamentals of comparability
Chapter II: Traditional transaction
methods
Chapter II: Transfer pricing methods:
-Part I: Selection of the method
- Part II: Traditional transaction methods
Chapter III: Other methods:
transactional profit methods
- Part III: Transactional profit methods
Chapter III: Comparability analysis
2
The notion of “reliable comparables”
¶¶ 3.2-3.3
• Most reliable comparables in the
circumstances of the case, keeping in mind
the
limitations
in
availability
of
information and that searches for
comparables data can be burdensome
• No requirement for an exhaustive search
of all possible sources of comparables/ all
methods
3
Comparability Analysis
• The 5 Comparability Factors
(para. 1.38 – 1.63 OECD Guidelines)
1.
Characteristics of property or service
2. Functional analysis
3. Contractual terms
4. Economic circumstances
5. Business strategies
Note: For any substantial differences between the compared transactions
or enterprises appropriate comparability adjustments need to be made!
4
Internal and external comparables
¶¶1.33; 3.27-3.38
• Comparable:
– Between one party to the controlled
transaction and a non-associated party
(“internal comparable”)
– Between two independent enterprises, neither
of which is a party to the controlled
transaction (“external comparable”).
5
Internal and external comparables
¶¶1.33; 3.24-3.54
• A « comparable » is:
– An uncontrolled transaction (not between
associated enterprises);
– None of the differences could materially affect
the conditions (price or margin), or
– Reasonably
accurate
adjustments
(“comparability adjustments”) can be made to
eliminate the effects of such differences
6
Internal and external comparables
¶¶1.33; 3.27-3.28
• Internal comparables can:
– Be easier to find and more reliable;
– Be more complete and less costly to document
• This is not always the case  there is no
hierarchy between internal and external
comparables
• But where internal comparables are
reasonably reliable  no need to make a
database search
7
Internal Comparables
Example 1: Contract manufacturing case study
•
For the purposes of evaluating transactions (sales or services) with
related parties, a potential internal comparable would exist if the
taxpayer (tested party) sells the same of similar products or provides
the same or similar
services under comparable conditions to
unrelated (independent) parties.
Controlled
A. Japan
Transaction (Manufacturer)
Potential
A. Japan
Internal
(Manufacturer)
Comparable
Controlled
Transaction
Uncontrolled
Transaction
(arm’s length price)
A. China
(related distributor)
XYZ India
(Independent
Distributor)
8
Internal Comparables
Evaluation of potential
internal comparables
1 Revenue ($)
Sales Volume (#
2
units)
Product Quality /
3
Specification
4 Terms of Sale
5 Terms of Payment
6 Sales Costs
7 Brands
8 Market
Controlled
transaction
(A. Japan to A.
China)
70 million
Uncontrolled
transaction
(A. Japan to
XYZ India)
30 million
100 million
36 million
A. standard
Customized for XYZ
Ex-Factory
Net 30 days
Significant
marketing
expenditure by A.
China
Own brand
Asia
CIF
Net 120 days
Adjust ?
+ or -
Limited expenditure
by XYZ India
Private Label
EMEA
9
Internal Comparables
Example 2: Distribution Company A.
US$ ’000
Overall Financials
Items
Overall
Business
Segmented Financials
Related Party
Third Party
Business/Sales Business/Sales
Net Sales
Cost of Goods Sold
Gross Profit
Sales, General &
Administrative Expenses
Operating Income
Total Cost
144,044
(128,368)
15,676
100,000
(92,000)
8,000
44,044
(36,368)
7,676
(7,273)
(3,000)
(4,273)
8,403
(135,641)
5,000
(95,000)
3,403
(40,641)
Gross Profit Margin
Return on Sales
Operating Income/Total
Cost
10.88%
5.83%
8.00%
5.00%
17.43%
7.73%
6.20%
5.26%
8.37%
10
Internal Comparables
Evaluation of potential
internal comparables
Conclusion?
Related Party Business
- Export -
3rd Party Business
- Domestic Sales -
1
2
3
Product
Markets
Sales Revenue
LCD
Asia
100 million
LCD
India
44 million
4
Sales Volume (# units)
80 million
25 million
5
R&D
Conducted by parent
Local customization
6
Technology/Intangibles
All provided by parent
Limited local intangibles
7
Packaging/Labelling
Provided by parent
Local
8
Price Negotiation
No
Yes
9
Marketing
No
Yes
No
Yes
Raw materials
No
No
Minor
Raw materials
Minor
Raw materials/finished goods
10 Sales & Distribution
11 Warehousing/Logistics
12
13
14
15
16
After Sales Services
Royalties
Market Risk
Inventory Risk
Credit Risk
Yes
Yes, 5% on 3rd party sales
Full
Raw materials/finished goods
Full
11
External Comparables
• For the purposes of evaluating transactions (sales
or services) with related parties, a potential
external comparable would exist if (unrelated) third
parties perform similar functions and sell the same
or similar products or provide the same or similar
services to unrelated parties under similar
conditions.
• Problem: rarely do we find external “comparables”
(except commodities, financial products)
12
External Comparables
• Search process for external comparables
― Selection of Industry – Electronics Manufacturing
― Selection of Region
― Number of companies under the selected industry/region
― Number of controlled companies excluded, i.e., 50% or above owned
by another company
― Number of companies excluded for insufficient data
― Number of companies excluded for sustained operating losses
― Number of companies excluded for incomparable functions, e.g.,
significant R&D, marketing, distribution, services, etc.
― Refined comparable set
― Should loss companies be removed?
13
Typical 9- step process
¶ 3.4
1. Determination of years to be covered
2. Broad-based analysis of the taxpayer’s circumstances
3. Understanding the controlled transaction(s) under
examination, based in particular on a functional analysis, in
order to choose the tested party (where needed), the most
appropriate transfer pricing method to the circumstances of
the case, the financial indicator that will be tested (in the
case of a transactional profit method), and to identify the
significant comparability factors that should be taken into
account
4. Review of existing internal comparables, if any
5. Determination of available sources of information on
external comparables where such external comparables are
needed and the sources’ reliability
14
Typical 9- step process
6.
7.
8.
9.
¶ 3.4
Selection of the most appropriate transfer pricing method and,
depending on the method, determination of the relevant
financial indicator (e.g. determination of the relevant net profit
indicator in case of a transactional net margin method)
Identification of potential comparables: determining the key
characteristics to be met by any uncontrolled transaction in
order to be regarded as potentially comparable, based on the
relevant factors identified in Step 3 and in accordance with the
comparability factors
Determination of and making comparability adjustments where
appropriate
Interpretation and use of data collected, determination of the
arm’s length remuneration
15
Evaluation of a taxpayer’s separate and
combined transactions
•
•
•
•
•
¶¶ 3.9-3.12
Ideally, to arrive at the most precise approximation of fair
market value, the arm’s length principle should be applied on a
transaction-by-transaction basis
However, there are often situations where separate
transactions are so closely linked or continuous that they
cannot be evaluated adequately on a separate basis
For instance, pricing a range of closely-linked products (e.g. in
a product line)
Portfolio approach  business strategy consisting in bundling
certain transactions for the purpose of determining or testing
transfer price
For instance: printers and cartridges, vending coffee machines
and coffee capsules
16
Choice of the tested party
¶¶ 3.18-3.19
• The choice of the tested party should be
consistent with the functional analysis of the
transaction;
• The party 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
17
Information on the foreign
associated enterprise
¶¶ 3.21-3.23
• One-sided methods (cost plus, resale price or
TNMM) require:
– Qualitative information on the comparability
factors of both parties to the controlled
transaction
– Financial information on the tested party
(whether domestic or foreign)
• Two-sided methods (profit split method):
– Financial information on all the parties to the
transactions
18
Foreign comparables
¶ 3.35
• Non-domestic comparables should not be
automatically rejected ;
• Examine whether non-domestic comparables
are reasonably reliable on a case-by-case
basis:
– Five comparability factors
– Careful consideration of market differences and
accounting standards, and of whether reasonably
reliable comparability adjustments can be made
where needed
19
Secret comparables
¶ 3.36
• It would be unfair to apply a transfer pricing
method on the basis of such data unless the tax
administration was able, within the limits of its
domestic confidentiality requirements, to
disclose such data to the taxpayer so that there
would be an adequate opportunity for the
taxpayer to defend its own position and to
safeguard effective judicial control by the courts.
20
Limitations in available comparables
¶¶ 1.37; 3.38-3.39
• Assess the relative importance of missing
information before rejecting a potential
“comparable”
• A pragmatic solution may need to be found on a
case-by-case basis
21
Comparability adjustments
¶¶ 3.47-3.54 + Annex
• Not automatic: whether comparability adjustments
should be performed in a particular case is a matter of
judgement that should be evaluated in light of the
discussion of costs and compliance burden
• Comparability adjustments should be envisaged where
(and only where) they can be expected to increase the
reliability of the results
• Are the comparables data of sufficient quality to warrant
comparability adjustments? Adjustments should not be
made to create the wrong impression that the outcome is
“scientific”
22
Comparability adjustments
¶¶ 3.47-3.54 + Annex
• Too many adjustments or adjustments that greatly affect
the outcome may indicate that the third party transactions
being adjusted is in fact not sufficiently comparable
• On the other hand, comparability adjustments do not need
to be, and in fact should not be, performed to correct
differences that have no material effect on the comparison
• Avoid automatic or « routine » adjustments
• Comparability adjustments need to be documented
(reasons for adjustment/how?)
• Example of a working capital adjustment provided in
Annex
23
24
Arm’s length range and statistical tools
•
•
•
•
¶¶ 3.55-3.62
In some cases it will be possible to arrive at a single
figure (e.g. price or margin)
In most cases: arm’s length range where all figures are
relatively equally reliable
Where it is possible to determine that some uncontrolled
transactions have a lesser degree of comparability than
others they should be eliminated.
If comparability defects remain that cannot be identified
and/or quantified, and are therefore not adjusted  use
of statistical tools that take account of central tendency
might help to enhance the reliability of the analysis
25
Arm’s length range and statistical tools
¶¶ 3.55-3.62
• If the relevant conditions of the controlled transaction
(e.g. price or margin) are within the arm’s length range
 no adjustment should be made
• If the relevant conditions of the controlled transaction
(e.g. price or margin) fall outside the arm’s length range
asserted by the tax administration  the taxpayer should
have the opportunity to present arguments that the
conditions of the transaction satisfy the arm’s length
principle, and that the arm’s length range includes their
results.
26
Arm’s length range and statistical tools
Adjustment to a point in the range:
¶¶ 3.55-3.62
• Point within the range that best reflects the facts and
circumstances of the particular controlled transaction
• Where the range comprises results of relatively equal
and high reliability any point in the range satisfies the
arm’s length principle.
• Where comparability defects remain use measures of
central tendency (for instance the median, the mean or
weighted averages, etc.) to minimise the risk of error due
to unknown or unquantifiable remaining comparability
defects.
27
Loss-making comparables
¶¶ 3.63-3.66
• Not systematically rejected; no systematic
interquartile range in the OECD TP
Guidelines
• But are they truly comparable to the tested
party? (risk profile in particular)
28
Loss-making comparables
¶¶ 1.70-1.72 and ¶ 3.64
• Associated enterprises, as independent
ones, may be loss-making due for instance
to start-up costs, unfavourable economic
circumstances, commercial or industrial
inefficiencies, etc.
29
Loss-making enterprises
¶¶ 1.70-1.72 and ¶ 3.64
• However, an independent enterprise would
not continue loss-making activities unless it
has reasonable expectation of future profits.
 Consistency with the functional and risk profile of
the enterprise
30
Loss-Making Distributors
¶¶ 1.70-1.72 and ¶ 3.64
• Furthermore, an independent enterprise
would not remain loss-making indefinitely.
 Where an associated enterprise remains lossmaking over several years: is it providing a service
to the group by maintaining a commercial
presence?
31
Timing issues
¶¶ 3.67-3.79
• Contemporaneous uncontrolled transactions are
preferred (although availability of information
may be limited in practice); otherwise, past
information can be used as long as it is adjusted
to account in case economic circumstances are
significantly different
32
Questions and/or
comments?