INTM467080 - Establishing the arm's length price: gathering your own evidence
Searching for comparables: why use comparables?
The OECD Transfer Pricing Guidelines are based around a
fundamental principle of comparing the intra-group transaction in
question against identical or similar transactions carried out
between the tested party and an independent, or between
independents. This theme is followed through all the various OECD
methodologies, as discussed from
INTM463000 onwards.
The ideal aim is to find a comparable uncontrolled price
('CUP'). Here you are comparing the terms of the intra-group
transaction with an identical transaction carried out between (or
with) independent parties. The search is for an identical
transaction, not a company carrying out the same activities. This
is usually very difficult, but not impossible.
Moving through the methods, the cost plus and resale minus
methods look to compare transactions at the gross margin level.
With a transactional net margin method ('TNMM') you will probably
be comparing net margins of comparable companies. It may be easier
to locate comparables at this level.
In all cases the comparison being made, be it transactions,
gross margins, net margins, etc, must be as close to identical as
possible. Adjustments can be made if necessary to transactions that
are similar, to try and remove any minor differences. Every
business transaction has a particular set of economic
characteristics. The differences between two different transactions
may be marginal, they may be significant, or they may be somewhere
in between.
If the differences are marginal, then the two transactions
will be comparable, as a marginal difference is one which would not
affect the price of the transaction. Consider the following set of
examples that try to find a CUP:
1. Company A sells DVD players to unconnected company B in the
UK for £70 per unit. Company B sells the DVDs to the public in
the UK for £100 each. In 2002, company B contracts to buy
10,000 units.
Company A also sells the DVDs to fellow group affiliate
company C in the UK. The price per unit is also £70 and
company C sells them on to the public in the UK at £100 per
unit. The other terms, such as delivery charges, credit period,
etc., are the same as for company B. In 2002, company C contracts
to buy 10,400 units.
The two transactions are almost identical. The only
difference is that company B contracted to buy 10,000 units,
whereas company C contracted to buy 10,400 units. The difference is
marginal and at arm’s length company C would most likely pay
the same price per unit as company B.
If the differences are such that an independent would take them into account when negotiating a price, then so must you in trying to calculate an arm's length price for the similar intra-group transaction. For example:
2. The facts are same as in 1. above, apart from the issue of
warranties. If a DVD bought by company B is found to be faulty when
it is sold, then company B can return the DVD player to company A
and receive a full refund. Company C however has to bear the cost
of any warranties itself. 1 in every 100 units has a fault and has
to be repaired or replaced. On average half the faulty DVDs need to
be replaced completely, the other half cost on average £35
each to repair.
The transactions are similar, company B and company C are
contracting to buy roughly the same amount of DVDs in 2002. The
difference is the question of warranties, and adjustments can be
made to overcome this difference. The adjustments must reflect
those that would be made between third parties.
Company B buys 10,000 DVDs at £70 per unit, a total of
£700,000.
Company C buys 10,400 DVDs at £70 per unit, a total of
£728,000, but has to factor in the cost of warranties. 0.5%,
or 52 of the DVDs will need to be replaced completely, at a cost of
£3,640. 0.5%, or 52 of the DVDs will need repairs costing half
the price of a single unit, at a cost of £1,820. The
additional warranty costs of £5,460 are split between the cost
of each of the 10,400 units, at a cost of £0.52 per DVD. So if
the price charged to C is reduced to £69.48 per unit, the
difference has been more or less eliminated.
(Even something that seems relatively straightforward still
has its problems. By reducing the price to £69.52 per unit,
the warranty cost for replacing the faulty units is slightly lower
than if the price was £70. The price can be fine-tuned if
necessary, by carrying out the same calculations, but you still
have the same problem with the adjusted price. Luckily by this
stage the difference has become marginal and would most likely be
ignored by independent parties.)
However, there comes a stage when either an adjustment can’t be made, or so many adjustments have to be made as to make the comparison meaningless. For example:
3. As in example 1. company A supplies DVDs to company B at
£70 per unit. Company B can sell them in the UK and contracts
to buy 10,000 in 2002. Company C, an affiliate of company A, based
in the UK, is granted a 5-year licence to distribute DVDs
throughout Europe. Company C contracts to buy 2 million units in
2002, with various options to acquire another 500,000.
Company C sells the DVDs at different prices in Europe,
depending on the country. The licence is exclusive to Europe
– company C will sell its DVDs under a different brand name
to company B, although the DVDs are essentially the same. The brand
name used by company C has been used to successfully sell
televisions and videos in the previous ten years. Company C buys
the DVDs in euros and has to account for warranty and shipping
costs.
The difference between the transactions undertaken by
companies B and C in 2002 are significant, and between independent
parties would be very likely to affect the price materially.
When considering whether two transactions are comparable the OECD Transfer Pricing Guidelines recommend you take account of the following economic transactions:
- The characteristics of the property or services.
- For tangible goods this will include physical features, quality, reliability, volume and availability of supply.
- For the provision of services, the nature and extent of those services.
- For intangible property, the type of the property (patent, trademark, etc.), the form of the transaction (licence, sale, etc.), the duration and degree of protection and the anticipated benefits.
- Functional analysis – comparing the functions undertaken by the parties being tested (e.g. does one party sell goods wholesale, and the other sell the same goods retail)?
- Pay particular attention to the structure and organisation of each group.
- Consider in what capacity the taxpayer performs its functions e.g. whether certain activities constitute part of a parent company's responsibilities as shareholder .
- It is not the number and type of function undertaken that is important, it is the economic significance of the functions.
- Take account of physical assets used in the business (e.g. factories, warehouses, plant & machinery, etc.) and also intangible assets such as brand names.
- The risks assumed by each party are important, and these can include price fluctuations, risks associated with buildings and plant, the success or failure of R & D, exchange and credit risk, debtors, stock obsolescence and environmental risks.
- The contractual terms of the transactions – these reflect the functions and risks assumed by each party. Does the contract contain terms that are unlikely to be found in contracts between independent parties, or is the form of the contract not followed in practice?
- Economic circumstances – prices vary across different markets even for the same goods or services. To compare transactions you must consider whether the following (amongst others) are comparable:
- Geographic location.
- Size of the market.
- Competition and size and importance of competitors.
- Availability of substitute goods and services.
- Levels of supply and demand.
- Consumer purchasing power
- Government regulations
- Costs of productions (e.g. costs of local labour and raw materials)
- Business strategies such as innovation and new product development, degree of diversification, risk aversion, likely political changes, labour laws, etc. It will also be important to consider who devises the business strategy, and who carries it out. Market penetration schemes or market expansion schemes can be particularly problematic as pricing structures and levels of marketing expenditure will be different for supporting the sales of a new product, compared with say a mature market for those goods. You must consider carefully who is bearing the costs of a market penetration scheme and for how long and compare this to what would happen between independents.
The aim is to compare like with like.
