TAX MATTERS: Transfer pricing comparability analysis

TRANSFER pricing is based on comparable analysis of profits of an associated party in a controlled relationship with those of uncontrolled taxpayers to determine whether they have been made at arm’s length dealings.

A controlled transaction meets the arm’s length standard if the results or conditions of the transaction are consistent with those found, made or imposed on uncontrolled taxpayers, had they engaged in a similar transaction under similar conditions.

The two major factors to consider in establishing whether the results are consistent are the degree of comparability between the controlled transactions and uncontrolled transactions, and the quality of the data assumptions used in the analysis. Comparability analysis is only meaningful when the economically relevant characteristics of the situations being compared are sufficiently comparable.

The differences if any, should not materially affect the conditions being examined, or that reasonably accurate adjustments can be made to eliminate the effect of any such differences. Also important in determining the degree of comparability is the background of how unrelated companies evaluate potential transactions. To establish the degree of actual comparability and then to make appropriate adjustments to establish arm’s length conditions, it is necessary to compare attributes of the transactions of enterprises that would affect conditions in arm’s length dealings, as discussed in this article.

The difference that may exist in the specific characteristics of products or services may largely explain the differences in the open market prices of those products or services. The comparability analysis of product or service characteristics is of essence when comparing the prices of controlled and uncontrolled transactions as opposed to profit margins comparison.

In practice, product or service characteristics analysis is appropriate when using the comparable uncontrolled price transfer pricing method (CUP). The characteristics that may be analysed for tangible products are the physical features of the property, its quality, reliability and the volume of supply. In the case of services, consideration should be given to the nature and extent of the services, and for intangible property the form of transaction matters in comparability analysis.

A functional analysis aims to identify and compare the economically significant activities and responsibilities undertaken or to be undertaken by each party to a transaction in question. The importance of functional analysis stems from the argument that economic rent is largely explained by the functions performed by the independent enterprise in a perfect market. It focuses on comparison of functions undertaken or to be undertaken by independent enterprises and related enterprises in an examined transaction.

In this regard, the structure and organisation of the group and in the juridical capacity in which the taxpayer performs its functions is very important. The functions that need to be identified for purposes of comparability analysis are design, manufacturing, assembling, purchasing, research and development, marketing etc.

The principal functions performed by the party under examination should be identified and adjusted where differences exist to eliminate the material effects of such differences. The functional analysis should take into account the assets employed, the type of assets used, the use of valuable intangible and the nature of assets used i.e. their age, market value, location, property rights protection etc.

The contract terms of transactions generally define explicitly or implicitly how the responsibilities, risks and benefits are to be shared between the parties. The contractual terms can be found in correspondences between the parties other than in a written contract or may also be implied from the conduct of the parties and the economic principles governing relationships between independent enterprises. A contractual analysis may be carried out as part of functional analysis.

The prices of goods and services may differ due to different economic environments or markets in which enterprises operate. A comparison controlled transaction must be made against uncontrolled transaction operated or traded within the same market or economy.
The economic circumstances that may be relevant in the determination of market comparability include geographic location, the size of the markets, the competition within the market, the relative bargaining power of buyers and sellers, availability of substitute goods and services, level of supply and demand in the market as a whole and in particular regions, consumer purchasing power, nature and extent of government regulations, cost of factors of production etc.

The comparability aspects of business strategies may include market penetration, innovation and new product development, degree of diversification, risk aversion, assessment of political changes, and impact of existing and planned labour laws, duration of arrangements and other factors bearing upon the daily conduct of business.

The guidelines on transfer pricing set out a 10 step (non-sequential) process for performing a comparability analysis. The application of the steps is not compulsory but is regarded as being “good practice”.

These steps are broad-based analysis of the taxpayer’s circumstances, determination of years to be covered, functional analysis, reviewing of internal comparables, determination of available sources of information on external comparables, selection of the most appropriate transfer pricing method, identification of potential comparables, determination of and making comparability adjustments where appropriate, interpretation and use of data collected, and implementation of support process

In conclusion, transfer pricing guidelines, analyses the basis for undertaking or not undertaking adjustments to the comparables and tested party, concluding that, if possible, adjustments must be made where differences exist, which could materially affect the comparison.
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Tapera is the founder of Tax Matrix (Pvt) Ltd and chief executive of Matrix Tax School. He writes in his personal capacity.