INTM576020 - Thin capitalisation: working a case - knowledge and negotiation: Getting to know similar businesses - comparables

This means trying to find comparable businesses in comparable situations, but which are operating at arm’s length. Looking at their profiles, results, etc, can give some indication as how close the transactions under review are to meeting the arm’s length standard. In most cases it is very difficult to find a single comparable which can do this, but what they can show about the factors which emerge as affecting a particular sector or industry may be more reliable. Themes and patterns which are common across an industry or business sector, may be indicative of how a business within that sector might be likely to behave if it was operating at arm’s length from its sources of funding.

At the individual company level, reliable comparables are difficult to come by. Comparables submitted in support of proposals for a thin cap agreement often include companies working with different business models, for example where data on private equity buy outs is submitted in support of more traditional long-term investment businesses. Comparables are also often offered which are for businesses which, from HM Revenue & Customs’ viewpoint, have the same problem as the company under review, in that they are themselves part of a larger group and involved in funding relationships which are not arm’s length. Given that most transfer pricing work involves multinational groups, this difficulty is natural.

As with most transfer pricing work, useful comparables for thin cap cases are often difficult to find, perhaps more difficult than with goods and services, despite the apparent simplicity of the transactions. This is because, amongst other things:

• the type of information which is available publicly is unlikely to reveal much about the underlying impulses and direction of the business; funding is often inextricable linked to issues that are commercially sensitive, such as acquisition goals.
• HMRC can only make use of publicly available information, and cannot share knowledge gleaned in the course of other enquiries; also, by definition these other companies have often themselves been subject to transfer pricing enquiry or made applications for forward agreements. However, it will be an advantage for an officer of HMRC to be able to discuss business sectors in an informed way from having knowledge of companies in similar fields.
• comparables are usually presented to HMRC in a fairly superficial way, without detailed comparison of factors such as position in the market, risk profile, product range and durability, strength of management team, acquisitiveness, success of current strategies, and depth of innovation.
• a range of values drawn from comparables is often presented as an arm’s length range, but that range is sometimes very wide and it is the facts of the specific case that determine a company’s place in that range.
• finding another UK borrower in a similar situation at the same time is rare.

This is not to decry the search for comparable uncontrolled transactions, but transfer pricing remains an art not a science. Approximations may often be found that will act as a helpful starting point in discussions, but they can often do little more than indicate characteristics of borrowing in certain business sectors at particular times.

If a group or company is serious about its contention that the terms of a connected party loan are at arm’s length, it should be prepared to demonstrate its case. It may do this by presenting comparables, and these need to be carefully analysed, tracing from start to finish the process by which the evidence was produced, examining critically the assumptions which underpin the selection and the reasons for inclusion or exclusion. The process by which comparables are produced is in practice often fairly mechanistic, starting with a wide range of possible arm’s length values, which are then narrowed using statistical methods rather than by distinguishing similarities and differences between the businesses within the set.

Any presentation of comparables to HMRC should be accompanied by details of

• the sources of data - which commercial databases were used, etc
• what search terms were employed in the selection - key words, industry codes (such as the Standard Industrial Classification (SIC) codes which allocate a four digit code to each industry type
• how the search was limited by factors such as turnover parameters e.g. all companies with turnover between £10m - £50m
• how anomalies were weeded out e.g. multinationals - where their own transfer pricing may cloud the issue, and non-comparable business models such as private equity and PFI.

All of these assumptions should be reviewed.

The use of in-house credit ratings for pricing debt is covered at INTM586170.

It is often relatively easy for HMRC to question the validity of a set of comparables by indicating where private equity cases have been used as a comparable for long-term investment in a more traditional business model, or pointing out which of the comparables is itself part of a multinational group and unlikely to have been borrowing on a standalone basis. These criticisms are perfectly valid, and do tend to undermine the whole set. However, it is quite another matter to put something acceptable in the place of these comparables. The best method is often a close examination of the circumstances of the particular case, but informed by broader characteristics of the business sector concerned.

HMRC offices have access to publicly available commercial databases of company information which can be used as the starting point in looking for comparables. However, some degree of expertise is needed to be able to use them effectively.

When a potential set of comparables has been found, HMRC may already have information on the companies concerned which will be helpful in determining how close the comparables really are. However, as indicated above, only publicly available information may be used in discussion or negotiation of cases. An internet search may confirm the availability of at least some of the information from public sources, especially in the case of large multinational groups, significant mergers and takeovers, major contracts, etc, but greatest of care should be taken not to divulge commercially sensitive information.

There are several places in HMRC, such as the Large Business Service sector teams, where specialist information may be obtained about specific business sectors, even about how answers have been found to common problems, and the Transfer Pricing Team at Business International may either have information about particular types of business or know where it may be found.

There is no database at Business International or anywhere else that will provide the ‘correct’ answer for each case.