For the application of transfer pricing methods, it is necessary to make a comparison between the results (prices or margins) of the controlled transaction and the results of comparable transactions (or companies). Thus, when more than one comparable transaction is available, a range is constructed with the comparable results commonly referred to as the arm’s length range. In this regard, the 1995 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Transfer Pricing Guidelines) of the Organization for Economic Co-operation and Development (OECD) stated in paragraph 1.45 that:

“In some cases, it will be possible to apply the arm’s length principle to arrive at a single figure (e.g., price or margin) that is the most reliable to establish whether the conditions of a transaction are arm’s length. However, because transfer pricing is not an exact science, there will be also occasions when the application of the most appropriate method or methods produces a range of figures which are relatively equally reliable. In these cases, differences in the figures that comprise the range may be caused by the fact that in general the application of the arm’s length principle only produces an approximation of the conditions that would have been established between independent enterprises.”

The foregoing then suggested the construction of a range starting with the minimum value of the observations and ending with the maximum value, from which, in principle, it could be inferred that any price or margin agreed between related parties within the minimum and maximum values, would comply with the arm’s length principle. However, paragraph 1.45 continues:

“It is also possible that the different points in the range represent the fact that independent enterprises actually engage in comparable transactions under comparable circumstances that may not establish exactly the same price for the transaction. However, in some cases, not all comparable transactions examined will have a relatively equal degree of comparability. Therefore, the actual determination of the arm’s length price requires exercising good judgment.”

This approach led to the consideration of different ways of calculating the arm’s length range, the most commonly used by practitioners and tax administrations being the interquartile range, which in simple terms consists of limiting the arm’s length range to only half of the values (50%) around the (central value of the observations), so as to exclude extreme values that could be distorted by unidentified elements at the time of analysis. However, we must be cautious because in a similar way, as in statistics, “correlation is not causation,” the mere fact that a group of results has a similar behaviour or magnitude does not necessarily mean that there is homogeneity in terms of comparability factors (terms and conditions, functions, assets, risks, characteristics, economic circumstances, business strategies, etc.). However, the use of the interquartile range has proliferated to the extent that it has been explicitly included in the legislations of many jurisdictions. This was also considered in the 2010 update of the guidelines, in further developing the issue of differences in the comparability of comparable transactions by including in paragraph 3.57 that:

“…while every effort has been made to exclude points that have a lesser degree of comparability, what is arrived at is a range of figures for which it is considered, given process used for selecting comparables and limitations in information available on comparable, that some comparability defects remain that cannot be identified and/or quantified, and are therefore not adjusted. In such cases, if the range includes a sizeable number of observations, statistical tools that take account of central tendency (e.g. the interquartile range or other percentiles) might help to enhance the reliability of the analysis.”

When the arm’s length range is defined and contrasted with the taxpayer’s results, the situation arises in which, being outside the range, it is concluded that the agreed prices or margins generated a lower taxable income than if the prices had been agreed in compliance with the arm’s length principle, giving rise to a transfer pricing adjustment.

These adjustments can be made by the taxpayer proactively when carrying out its transfer pricing analysis and if it is made before the fiscal year is closed, it has the possibility of recognizing this effect in its accounting records by modifying or correcting with its counterpart the agreed terms so as to be able to correctly set the prices, both from the commercial and accounting point of view. If, on the other hand, this situation is identified after the fiscal year is closed or the counterparty is simply not willing to change the terms, it must recognize the effect of the transfer pricing adjustment at the tax level by including this effect as an increase in the tax base in its income tax return.

Although, as mentioned above, the observations of the arm’s length range represent conditions agreed between independent parties, the practice has proliferated that the transfer pricing adjustment is made to the median of the range (central value), to the point that, like the interquartile range, this criterion has been included in several legislations.

The type of adjustments mentioned above is known as the primary adjustment because it is applied to the taxpayer’s taxable income, while the adjustment that could be applied to the taxable income of the counterparty of the transaction in its jurisdiction of residence is called a corresponding adjustment. There are also secondary adjustments, although they are rarely used, which consist of a second adjustment that seeks to capture the financial impact of the transaction, by considering it as a payment of dividend or interest for the funds transferred to or by the taxpayer, as a result of an erroneous determination of transfer prices.

Mexico is the Latin American country that has developed in more detail the regulations on transfer pricing adjustments through miscellaneous resolutions, making the caveat that those that have effect in the accounting and tax spheres are considered real adjustments, while when they have effect only in the taxation sphere they will be considered virtual adjustments. The resolutions also make the distinction of voluntary or compensatory adjustments, which they define as those made by a taxpayer resident in Mexico or resident abroad with permanent establishment in the country, so that a transaction (or transaction) with a related party is considered determined as it would with or between independent parties in comparable transactions and that is carried out before the presentation of the annual tax return, either normal or complementary.

It also distinguishes between domestic corresponding adjustments (recalling that domestic transfer pricing obligations exist in Mexico) and foreign corresponding adjustments (those involving a taxpayer resident in Mexico or a permanent establishment of a non-resident and a resident abroad).

Finally, to avoid transfer pricing adjustments that could cause the company to incur unnecessary risks, the ideal situation is the definition and implementation of clear transfer pricing policies by the taxpayer, which are permanently monitored and periodically updated. Likewise, consider cooperative compliance measures available in the jurisdiction, which reduce uncertainty and help improve the relationship with the Tax Administration.

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