INTM467140 - Establishing the arm's length price: gathering your own evidence - Searching for comparables: making adjustments to potential comparables
The OECD Transfer Pricing Guidelines are detailed and cover a lot of different issues. However the Guidelines are based on a fundamental principle - that transactions between connected parties should be priced in accordance with the arm's length standard and that the key to establishing the arm's length price is a comparison with transactions between independent parties.
As part of the exercise of establishing an arm's length price you will need in the first instance to decide at what level you are comparing transactions.
- Comparing a single transaction, e.g. the sale price, and terms of sale of a particular product.
- Comparing a bundle of transactions, e.g. a licence agreement, a contract for services, a distribution agreement, etc.
- Comparing results of independent companies at the gross margin level.
- Comparing results of independent companies at the net margin level.
- Comparing results of independent companies by reference to some other measure, such as return on capital, ratio of costs to gross margin, etc.
The OECD Guidelines recognise that slight differences between companies can be adjusted for. However, it is unlikely that significant differences can be taken into account in a meaningful manner.
You may need to consider adjustments made in transfer pricing reports; you may need to make adjustments to comparables that you are putting forward as an alternative. Do not use unsuitable comparables in the first place. However many adjustments you make, you will not be able to turn the Channel Tunnel operation into a suitable comparable to a business that brews and bottles premium lager.
- It is difficult to compare cases on the basis of capital employed as this presupposes that the tested party has a capital structure you will find at arm's length. If the tested party is part of a group this is a false premise and making adjustments is difficult. It is easier to make adjustments when comparing return on assets.
- The information needed to make adjustments is going to be limited. Commercial databases provide only the information that is publicly available. You will find little in the way of breakdown of profit and loss entries for example.
- Keep adjustments as simple as possible. If you think that a detailed economic formula is needed, using multiple variables, then you are very likely trying to do too much. Similarly, be sceptical of large numbers of very detailed adjustments; you may well find that the adjusted comparables bear little resemblance to what they started out life as.
- Consider carefully any adjustments that seek to turn independent comparable transactions or company results into some strange hybrid which you would be very unlikely to find in the commercial world.
- Some adjustments will be based on balance sheet figures, for example stock and trade debtors. These figures are snap shots and may not be representative for the whole year, particularly if the trade is subject to seasonal variations.
- Adjustments can only be taken so far before any comparison is rendered meaningless. Consider a set of comparable companies showing a range of net margins between 3% and 5%; after making adjustments, the range is 0% to 3%. Any exercise where the adjustment or series of adjustments significantly alters the range of prices or results is liable to be flawed.
The OECD Transfer Pricing Guidelines do not specify what sort of adjustments should be made, or how they should be calculated. Some of the more common adjustments you might encounter are
- Stock/cost of sales
- Trade debtors/sales
- Costs relating to a particular function that is not carried out by some of the comparables or the tested party
