Some considerations on the Transfer pricing comparability analysis process

The comparability analysis is defined in the glossary of the OECD Guidelines as:

“A comparison of a controlled transaction with an uncontrolled transaction or transactions. Controlled and uncontrolled transactions are comparable if none of the differences between the transactions could materially affects the factor being examined in the methodology (e.g. price or margin) or if reasonably accurate adjustments can be made to eliminate the material effects of any such differences.”

As with many transfer pricing concepts, making the aforementioned comparison may seem like a simple task, but in practice, it requires a deep understanding of the transaction to be analyzed and the identification of potential comparable transactions, which will determine the most appropriate method for conducting the analysis. Although there is no single way to carry out this process, it would be expected that there are quite a few similarities between the processes carried out by different professionals dedicated to transfer pricing analysis. The differentiation of the results could be the product of the professional’s expertise, effort/dedication to analysis and/or documentation, and availability of information, which in the case of using external advisers, the cooperation of the taxpayer with his adviser would be a key element.

Beginning with the 2010 update of the OECD Guidelines in Chapter III regarding comparability, a typical or exemplary process for Transfer Pricing Comparability Analysis was incorporated. Although the steps of this process seem to be more oriented to the most commonly applied methods (e.g.: methods based on profitability) or their sequence could vary a bit in practice (the guidelines mention that the process is not linear) and on the other hand, the update of the OECD Guidelines in 2017 incorporated the results of the BEPS action plan, this typical process represents a good reference of what a comparability analysis should be.

Suggested steps in this typical process are as follows:

  • Step 1 – Determination of the years to be covered (in the analysis): It refers to the fiscal years covered by the analysis. Documentation obligations usually require that the documentation be contemporaneous, so frequently the analysis corresponds to a fiscal year and thus is consistent with the annual filing of income tax.

  • Step 2 – Broad-based analysis of the taxpayer’s circumstances: Represents what the industrial analysis in practice is, including the external aspects of the environment in which the taxpayer operates (locally and globally). It is important that this analysis keeps the focus on those elements of greater relevance in the later steps of the process.

  • Step 3 – Understanding the controlled transaction(s) under examination, based in particular on a functional analysis (where necessary), the most appropriate transfer pricing method to the circumstances of the case, the financial indicator that will be tested (in the case of any of the methods based on the result or profitability of operations), and to identify the significant comparability factors that should be taken into account: The comparability factors (Contractual Terms, Functional Analysis, Characteristics of the Good or Service, Economic Circumstances and  Business Strategies) present in the transaction should be identified in order to subsequently select potential comparables.

  • Step 4 – Review of existing internal comparables (if any): Given that internal comparables, when they exist, can generally be more directly and closely related to the related transaction and their accounting treatment is very similar, if not the same. This is why using external comparables without taking the time to identify and analyze potential internal comparables can place the taxpayer at unnecessary risk. There is an expression that the transactional Net Margin Method (TNMM) is the method of last resort used in 90% of the cases. However, there are many cases in which Tax Administrations have made significant adjustments because when carrying out their audits they have identified internal comparables not considered by the taxpayer. It is vital to do the proper review and if there are similar transactions with third parties that are not internal comparables, document the reasons why those transactions do not meet the comparability criteria and it is more appropriate to use external comparables.

  • Step 5 – Determination of available sources of information on external comparable (taking into account their relative reliability): For certain transactions such as financial transactions or commodity trading, there is usually public information from the different markets that could allow the application of the Comparable Uncontrolled Price (CUP) method. When for the transaction under analysis there is no such public information (on prices) and there are no external comparable prices, usually a method based on profitability is applied, such as the TNMM, based on the financial information of public companies listed in the capital markets, which for regulatory and shareholder reporting purposes must make available to the public relevant information on their management, performance and results, including their financial statements. This information is classified, tabulated and standardized by database providers. Some jurisdictions, mainly developing countries, have explicitly included in their regulations that preference should be given to the use of national comparables over foreign ones.

  • Step 6 – 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 the transactional net margin method): The fundamental element for the selection and application of the best method depends on the availability of information from comparables, so the correct application of steps 4 and 5 is essential in this step. With the exception of the application of the CUP, in this step the analyzed part must be selected, that is, based on the information of which of the two parties involved in the transaction the method will be applied. The tested party is usually the simplest entity with routine functions, assets, and risks, with reliable and available information. It is also necessary to select the profit level indicator (PLI) to use.

  • Step 7 – Identification of potential comparable  – 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: This step constitutes the application of steps 4, 5, and 6 in greater depth, while still considering the accurate delineation of the transaction and the risk analysis together with the comparability factors (mentioned above).

  • Step 8 – Determination and application of the comparability adjustments where appropriate: It consists of the application of adjustments to the information that allows increasing its comparability with the transaction or the tested party.

  • Step 9 – Interpretation and use of the data collected and determination of the Arm’s Length remuneration. The price agreed in the transaction, or the profitability of the tested party is contrasted with the range of results resulting from the selection of comparables.

Both the business models of taxpayers and the international tax environment continue to evolve, which demands that the transfer pricing analysis process also continues to do so, and specialists will continue to enrich their work and analysis methodologies without necessarily ceasing to use as a reference this typical process illustrated in the OECD Guidelines.

 

Disclaimer. Readers are informed that the views, thoughts, and opinions expressed in the text belong solely to the author, and not necessarily to the author's employer, organization, committee or other group the author might be associated with, nor to the Executive Secretariat of CIAT. The author is also responsible for the precision and accuracy of data and sources.

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