Comparability in Transfer Pricing
Comparability is an important part of transfer pricing analysis. Transfer pricing rules generally prescribe standards for determining whether the prices, transactions, profitability, or other financial information of unrelated parties are sufficiently comparable with related-party transactions.
The data used for comparison must be reliable, and the method of comparison should produce a reliable result. Under the U.S. and OECD transfer pricing rules, reliable adjustments should be made for differences between the related-party transaction and the comparable uncontrolled transaction if such differences can materially affect the matter being examined.
If reliable adjustments cannot be made for material differences, the reliability of the comparison becomes doubtful. Comparability may generally be improved by using multiple data points. Transactions carried out outside the ordinary course of business are normally not considered comparable with transactions conducted in the ordinary course of business.
Factors Affecting Comparability
While determining comparability, the contractual terms of the transaction must be examined. These terms may be contained in a formal written agreement or may exist without a written contract.
The functions performed, assets used, and risks assumed by each party must also be considered. This examination is commonly known as Functions, Assets, and Risks Analysis or FAR Analysis.
The characteristics of the property transferred or services provided are also important because differences in quality, features, or the extent of services may affect the transaction price.
The economic circumstances of the parties and the market in which they operate must also be considered. Geographic location, competition, and consumer purchasing power may result in different prices for similar goods or services.
Another important factor is the business strategy followed by the parties. For example, a start-up may focus on customer acquisition, while a mature business may focus more on profitability. Therefore, their pricing strategies may be different.
Nature of Property or Services
The highest degree of comparability is generally achieved when identical goods, property, or services are compared. However, exact similarity may not always be possible.
In some cases, reliable adjustments can be made for differences in features, quantity, or quality. For example, the price of gold may be adjusted according to the actual weight and purity of the gold being compared.
Thus, differences in the characteristics of property or services do not automatically prevent comparison if their effect on price can be reliably adjusted.
Functions, Assets, and Risks Analysis
The parties to a transaction may perform different functions and assume different risks. These differences can directly affect the price of a transaction.
For example, a seller of machinery may provide a warranty, while another seller may sell similar machinery without a warranty. A buyer may be willing to pay a higher price where a warranty is provided.
Important functions and risks that may affect transfer prices include product development, manufacturing and assembly, marketing and advertising, transportation and warehousing, credit risk, product obsolescence risk, market and entrepreneurial risks, collection risk, financial and currency risks, and company or industry-specific factors.
The analysis of these factors is an important part of FAR Analysis.
Terms of Sale
The manner and terms of a sale may have a material impact on the transaction price. Buyers may be willing to pay a higher price if they are allowed to defer payment or purchase goods in smaller quantities.
Important terms that may affect price include payment timing, warranty conditions, volume discounts, duration of rights to use a product, and the form of consideration.
Therefore, transactions with materially different terms of sale may not be directly comparable unless reliable adjustments can be made.
Market Level, Economic Conditions, and Geography
Prices may differ according to the market level at which goods, services, or property are supplied. Transactions may take place from producer to wholesaler, wholesaler to wholesaler, wholesaler to retailer, or directly for final consumption.
Market conditions and prices may differ significantly at each level. Prices may also vary between different geographic locations and economic environments.
The market share of buyers or sellers may also affect pricing. A party with a large market share may obtain volume discounts or may have sufficient bargaining power to negotiate lower prices.
Therefore, comparable transactions should generally operate at the same or similar market level, economic environment, geographic location, and market conditions.
Testing of Transfer Prices
Tax authorities generally examine the prices actually charged between related parties to determine whether a transfer pricing adjustment is necessary.
The prices charged in related-party transactions are compared with prices charged in comparable transactions between unrelated parties. This process is known as testing of transfer prices.
Testing may be conducted by tax authorities during the examination of tax returns. In some systems, taxpayers are required to perform transfer pricing testing before filing their tax returns.
The method used for testing transfer prices is known as a transfer pricing method.
Best Method Rule
Some tax systems give preference to a particular transfer pricing method. However, the OECD and U.S. transfer pricing systems generally follow the Best Method Rule.
Under this rule, the method selected should be the method that produces the most reliable measure of an arm’s-length result.
The selection of the best method depends on the comparability of the tested and independent transactions, the reliability of available data and assumptions, and whether the results obtained under the method can be supported by other methods.
Comparable Uncontrolled Price Method
The Comparable Uncontrolled Price (CUP) Method is a traditional transfer pricing method. It determines the arm’s-length price by comparing the price charged in a controlled transaction with the price charged in a comparable transaction between unrelated parties.
The OECD and countries following the OECD Guidelines generally consider the CUP Method to be the most direct transfer pricing method, provided that differences between controlled and uncontrolled transactions do not materially affect the price.
If differences affect the price, the CUP Method may still be applied when the effect of those differences can be reliably estimated and appropriate adjustments can be made.
For example, if the only difference between two transactions is the payment period, such as 30 days instead of 60 days, an interest adjustment may be made.
For standardized products such as commodities, prices from transactions between unrelated parties may be available. These are known as external comparables.
A transaction between the tested party and an unrelated party may also be used for comparison. Such transactions are known as internal comparables.
The CUP Method may be difficult to apply to licenses and transactions involving unique intangible property because reliable comparable transactions may not exist. In such cases, valuation methods based on profit projections may be required.
Other Transactional Transfer Pricing Methods
Cost-Plus Method
Under the Cost-Plus Method, goods or services are priced on the basis of the actual cost incurred plus a fixed mark-up.
Transfer pricing testing is performed by comparing the mark-up percentage charged in the related-party transaction with the mark-up applied in comparable transactions involving unrelated parties.
Resale Price Method
Under the Resale Price Method (RPM), goods are sold or purchased at a standard resale or list price after deducting an appropriate discount.
The arm’s-length nature of the transaction is tested by comparing the discount percentages applied in related-party and comparable unrelated-party transactions.
Gross Margin Method
The Gross Margin Method is similar to the Resale Price Method. It is recognized as a transfer pricing method in certain tax systems.
Profit-Based Transfer Pricing Methods
Profit-based methods may be used when reliable transactional data is not available. In some cases, adjustments required for differences in market or economic conditions may not be sufficiently reliable. Therefore, a profit-based method may provide a more reliable result.
Comparable Profits Method
Under the Comparable Profits Method (CPM), the profit levels of companies operating in similar industries and under similar conditions are compared with the profit level of the tested party.
Transactional Net Margin Method
The Transactional Net Margin Method (TNMM) examines the profitability of similar businesses. Although it is called a transactional method, the analysis is mainly based on the profitability of comparable businesses.
CPM and TNMM have the practical advantage of being relatively easier to implement because they rely on microeconomic analysis of financial data rather than comparison of specific transactions.
Profit Split Method
Under the Profit Split Method, the total combined profits of related enterprises are divided between the parties according to an appropriate allocation method.
Two commonly recognized forms are the Comparable Profit Split Method and Residual Profit Split Method.
Under the Comparable Profit Split Method, the profit split is based on the combined operating profits of comparable uncontrolled taxpayers carrying out similar transactions and activities.
The Residual Profit Split Method follows a two-step process. First, profits are allocated to routine business operations. The remaining or residual profit is then allocated according to the non-routine contributions made by the parties.
The residual profit may be allocated using external market benchmarks or estimates based on capitalized costs.
Tested Party and Profit Level Indicator
When transfer pricing analysis is conducted using CPM or TNMM, it may be necessary to select one of the related parties as the tested party.
The tested party should generally be the party whose functions and risks can be most reliably compared with those of independent enterprises. In most cases, the party with the simpler and more easily comparable functions and risks is selected as the tested party.
Adjustments may be required for differences in inventory levels, receivables, or other financial factors between the tested party and comparable enterprises.
Transfer pricing analysis also requires the selection of an appropriate Profit Level Indicator (PLI). The indicator may include net profit from the transaction, return on assets employed, or another appropriate measure of profitability.
The reliability of CPM and TNMM is generally improved by using a range of results and multiple-year data.
Intangible Property and Transfer Pricing
Valuable intangible property is often unique, and comparable intangible assets may not be available. Therefore, determining an arm’s-length price for intangible property can be difficult.
The economic value created by an intangible may be reflected in the price of goods or services or through the payment of royalties for the use of intangible property.
Where the same intangible property is licensed to an independent party, the licensing transaction may provide a comparable price.
The Profit Split Method is particularly designed to consider the value created by intangible assets when allocating profits between related enterprises.
Services Between Related Enterprises
Enterprises may obtain services from related or unrelated parties. Within a multinational group, one group company may provide services to another group company.
Two major transfer pricing issues arise in relation to related-party services. The first is whether the services were actually performed and justify payment. The second is whether the price charged for the services is at arm’s length.
Tax authorities may examine whether the services actually benefited the related enterprise that was charged for them. If the services were not performed or the enterprise receiving the charge did not obtain a direct benefit, the tax authority may disallow the charge.
Stewardship Services
Some transfer pricing rules distinguish stewardship services from other services. Stewardship services are generally activities performed by an investor for its own benefit in managing its investments.
Charges to the investee company for such services are generally considered inappropriate.
Pricing of Related-Party Services
Where services are actually performed and provide a benefit to the related party, tax authorities may examine and adjust the price charged.
The pricing of services may differ from the pricing of goods because of the different nature of these transactions. However, the basic standards of comparability continue to apply.
Companies commonly provide internal support services such as accounting, legal, and computer services. In certain cases, it may be inappropriate for the group company providing such support services to earn a profit.
The pricing of such services may be tested under the Cost of Services or Services Cost Method.
Where the service forms a key part of the business activities of the enterprise, OECD and U.S. rules generally provide that the service provider should earn an appropriate level of profit. The Cost-Plus Method may be preferred because of its ease of administration.
Cost Sharing and Cost Contribution Arrangements
Multinational enterprises may share the costs of developing or acquiring assets, particularly intangible assets.
Under U.S. rules, group members may enter into a Cost Sharing Agreement (CSA) for sharing the costs and benefits of developing intangible assets.
The OECD Guidelines recognize Cost Contribution Arrangements (CCAs) for sharing the costs of acquiring or developing different types of assets.
Under both systems, costs should generally be allocated among participating members according to their reasonably anticipated benefits. Each participant should bear only its appropriate share of the allocated costs.
Since cost allocations are based on expectations about future events, adjustments may be required when earlier projections prove incorrect. However, the use of hindsight in making cost allocations is generally prohibited.
Written Agreement and Rights of Participants
A key requirement for limiting transfer pricing adjustments relating to the development of intangible assets is the existence of a written agreement between the participating members.
Tax laws may also impose documentation, contractual, accounting, and reporting requirements on participants in a CSA or CCA.
Each participant should generally be entitled to use a portion of the rights developed under the arrangement without making additional payments. For example, a participant may use a process developed under a CCA without paying royalties.
The ownership of rights does not necessarily need to be transferred to each participant. Rights may be divided according to an observable factor such as geographic location.
Platform Contributions
Participants in a CSA or CCA may contribute existing assets or rights for use in developing new assets. Such a contribution is known as a platform contribution.
A platform contribution is generally treated as a deemed payment by the contributing member and may itself be subject to transfer pricing rules or specific cost-sharing rules.
Reasonably Anticipated Benefits
Participants in cost-sharing arrangements must estimate the future benefits expected from the arrangement. These estimates are inherently uncertain because they are based on future events.
Anticipated benefits may be determined by projecting the sales or gross margins of participants in a common currency or by measuring sales in units.
Entry and Exit of Participants
Participants may enter or leave a CSA or CCA. In such cases, the transfer pricing rules may require buy-in or buy-out payments.
Such payments may reflect the market value of the existing stage of development or may be calculated using cost recovery or market capitalization models.
Transfer Pricing Penalties and Documentation
Many jurisdictions impose significant penalties when tax authorities make transfer pricing adjustments.
For example, under U.S. rules, a 20% penalty may apply where the adjustment exceeds US$5 million. The penalty may increase to 40% of the additional tax where the adjustment exceeds US$20 million.
Many countries require taxpayers to maintain documentation showing that related-party prices comply with transfer pricing rules. If documentation is not prepared on time, penalties may be imposed.
In some systems, transfer pricing documentation must be prepared before filing the tax return. Tax authorities are not necessarily required to accept the taxpayer’s documentation and may independently adjust transfer prices.
Some tax systems also allow tax authorities to disregard information that was not provided by the taxpayer within the required time.
In India, transfer pricing documentation must be maintained before filing the return. The documentation is also required to be certified by the Chartered Accountant preparing the company’s return.
Key Exam Points
Comparability analysis examines contractual terms, functions, assets, risks, characteristics of goods or services, economic circumstances, market conditions, and business strategies. The analysis of Functions, Assets, and Risks is known as FAR Analysis.
The Best Method Rule requires the use of the transfer pricing method that provides the most reliable measure of an arm’s-length result.
The major transfer pricing methods are the Comparable Uncontrolled Price (CUP) Method, Cost-Plus Method, Resale Price Method, Comparable Profits Method (CPM), Transactional Net Margin Method (TNMM), and Profit Split Method.
The CUP Method is generally considered the most direct method when reliable comparable transactions are available.
Under the Residual Profit Split Method, profits are first allocated to routine activities and the remaining profit is allocated according to non-routine contributions.
In CPM and TNMM, the tested party is generally the party with the most easily comparable functions and risks.
For related-party services, tax authorities examine whether the service was actually performed, whether the recipient received a benefit, and whether the price charged was at arm’s length.
CSA and CCA arrangements allocate costs according to reasonably anticipated benefits. A written agreement is an important requirement, particularly for intangible asset development.
Transfer pricing rules may impose significant penalties and documentation requirements. In India, transfer pricing documentation must be maintained and certified by a Chartered Accountant.